The Evolution of the Private Equity Market and the Decline in IPOs

Michael Ewens is Associate Professor of Finance and Entrepreneurship at the California Institute of Technology; Joan Farre-Mensa is Senior Economist with Cornerstone Research. This post is based on their recent paper.

Recent years have seen a sharp decline in the number of initial public offerings (IPOs) in the U.S. While this decline has garnered considerable attention both in academic and policy circles and in the press, its causes remain unclear (Gao, Ritter, and Zhu (2013); Doidge, Karolyi, and Stulz (2013, 2017)). The debate on the causes behind the IPO decline has been accompanied by a no less intense debate on the consequences of this decline for the U.S. entrepreneurial finance market. Doidge, Karolyi, and Stulz (2013) conclude that while the low IPO rate is “consistent with the view that U.S. financial markets became less hospitable for young, small firms, direct tests of this view, while needed, are beyond the scope” of their study. Our paper, The Evolution of the Private Equity Market and the Decline in IPOs, helps fill this gap by analyzing how the dearth of IPOs has impacted VC-backed startups’ ability to finance their growth.

We begin by examining whether the decline in IPOs has been made up for by an increase in acquisitions. This does not appear to be the case: The fraction of VC-backed startups that are acquired 7 or 10 years after their initial funding round has remained roughly constant since the early 1990s. Instead, the decline in IPOs has been accompanied by an increase in the fraction of late-stage startups that stay independent and privately-held long after they first raise capital. Importantly, these late-stage startups are able to continue financing their growth while remaining privately-held, as indicated by the fact that the age of the average startup raising private capital has doubled since 2000.

Yet IPOs have never been about funding the average startup. Thus, determining the extent to which private investors have filled the gap left by the decline of IPOs requires an investigation of whether private markets are able to finance the growth of the largest startups. Our evidence suggests they are. Of those startups first funded prior to 1997 that were able to go on to raise at least $150 million, 83% did so by going public. By contrast, 64% of those startups that have reached this milestone since 2000 have been able to do so while remaining private.

All told, the private capital going to startups four or more years past their first financing round has grown by a factor of 20 since 1992. Who is providing this capital? Approximately 40% of this growth has been driven by traditional venture capital funds, which increasingly invest in mature startups during the second half of their funds’ life. The rest has been fueled by less traditional startup investors such as private equity (PE) funds, family offices, hedge funds, and, particularly since 2010, mutual funds.

A variety of factors appear to have contributed to the growth in the supply of private capital going to late-stage startups. Kahle and Stulz (2016) note that the Internet has reduced search costs for firms searching for investors (and vice versa), reducing one of the fundamental advantages of centralized stock exchanges. Consistent with this hypothesis, we show that private investors appear to be increasingly willing to invest in late-stage startups with whom they do not have a close geographical connection.

A number of regulatory changes affecting private firms and their investors have also facilitated the process of raising private capital (e.g., de Fontenay (2017)). One notable change was the National Securities Markets Improvement Act (NSMIA) of 1996. NSMIA made it easier for private firms to sell securities by exempting the sales from state-level regulations known as blue-sky laws (public firms have long been exempt from these state laws). Importantly, NSMIA also made it easier for unregistered funds such as VC and PE funds to raise capital: In addition to exempting them from blue-sky laws, it increased the maximum number of investors a fund could have without being subject to the disclosure requirements that apply to investment companies. This increase was particularly important for funds investing in late-stage startups, which tend to be larger and have more investors to meet these startups’ higher capital needs. Consistent with NSMIA being a positive shock to the supply of late-stage private capital, our difference-in-difference analysis reveals that the size of U.S.-based funds increased relatively more after the law’s passage than that of their foreign counterparts—an increase driven by late-stage funds.

Taken together, our results suggest that the growth in the supply of private capital has allowed late-stage startups to continue financing their growth while remaining privately held. A natural question then follows: Are these startups increasingly staying private as a second-best response to their inability to go public—or are they choosing to stay private even though the option to go public remains open to them?

Startup founders have long seen the retention of decision-making control as a key advantage of remaining private (Brau and Fawcett (2006)). Historically, though, founders have had to weigh their desire to stay private and retain control against the limited supply of private capital. No less importantly, successful founders often face pressure to go public from VCs and other startup investors, who favor an IPO to ensure a timely liquidation of their investment and enhance their reputation. We find that the increase in the supply of private capital over the last two decades has been accompanied by an increase in founders’ level of ownership vis-à-vis investors in their startups—and thus in founders’ ability to dictate exit decisions. Consistent with this growing influence of founders over exit decisions being a key driver of the decline in IPOs, we show that exogenous increases in a founder’s equity stake have a negative effect on the likelihood that her startup eventually goes public.

The reasons driving the documented increase in founders’ bargaining power are likely multi-faceted. In addition to the increased supply of private capital coming from old and new investors, technological changes that have decreased startups’ capital requirements early in their lifecycle—when uncertainty is highest and thus capital is most expensive—have likely played a role. Whatever these reasons, our finding that founders with the most control are in fact the most likely to stay private suggests they do so by choice and not as a second-best response to being unable to go public. This conclusion is reinforced by the growing role of mutual funds and other traditional IPO investors in funding late-stage private startups: These investors’ willingness to hold private, illiquid securities suggests they would also be willing to invest in these same startups if they went public.

Taken together, our findings suggest that the scarcity of IPOs need not be seen as a sign that the entrepreneurial finance market is broken and unable to finance the growth of high-potential startups. At the same time, it is important to recognize that the lack of IPOs has greatly changed the degree of oversight and transparency under which some of the most successful firms in our economy now operate.

The complete paper is available for download here.

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