Private for longer: retail (and hedgies) not welcome

Retail is becoming its own worst enemy in forcing a big change in the capital markets

• smallcap indexes and the land of shitcos (and it’s a struggle out there for smidcap investors)

• skipping the minors, and going straight to megacap, but who are these ‘leapfroggers’?

• the best companies are ‘private for longer’ because they want to, not because they need to

• illiquidity premium, but for real, this time—retail is becoming its own worst enemy

• what happens next? dislocation provides opportunity for a different kind of match-making

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Private for longer: retail not welcome

Just to revisit something raised in passing vis a vis retail’s rising prominence in the market.

There’s actually an interesting structural change afoot. It’s not new, per se, but there are implications that I’ve never fully grokked before.

The land of shitcos

Public markets had a certain lifecycle to them.

Big publicly-traded companies used to start out as smaller publicly-traded companies. It makes sense. You go public with an enterprise value of a few hundred million, maybe a billion in today’s dollars, and then you grow into a midcap, and then a large cap, if all goes according to plan.

But that progression of small-to-big is increasingly not the case:

Morningstar

The number of companies that have “descended” to small-cap status, has outweighed the number of small companies that have “ascended” to large-cap status, for the better part of a decade.

Put another way, the small-cap indexes are increasingly populated by companies on their decline, rather than companies on their way up. Big-to-small is happening more than small-to-big.

It’s worth noting because not only does that reflect something of a change from the ~15 years preceding 2018 (when graduates generally outnumbered demotions), it matters for a different reason.

That the small-cap indexes are “net-new shitco” runs counter-narrative to (some) of the appeal of small-cap investing, i.e. to discover the up-and-comers before they graduate to the big leagues.¹ If there are relatively fewer up-and-comers, then stock-picking amongst the small-caps is less like scouting the Cape Cod League, and more like scouting Old Timer’s Day.

It’s not the most compelling story, if you’re a smidcap investor.

And it’s not like up-and-comers have just disappeared. It’s that public market investors don’t even get a look.

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ICYMI

Is retail the smart money, now?

A brief note on housing

Almighty consumer, bnpl edition

Riffing on themes: CRE dispersed, China swallows biotech, and the wealth effect is fake

The month the labor market broke?

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Straight to megacap

Part of what’s happened is that up-and-comers increasingly aren’t starting out in the small caps.

Up-and-comers are skipping the minors and going straight to the big leagues, and boy do they trade differently:

Bloomberg

“Graduates” get a moderate lift when they get added to the S&P500, but “leapfroggers” absolutely rip.

And who are these leapfroggers?

Well, they’re typically high-growth TechCos:

“Retail” favorites, which also all happen to be venture-backed technology companies, get outsized returns upon their inclusion to the index.

Techcos, which are kinda the archetype of up-and-coming-next-gen-start-small-then-get-big companies, aren’t touching the public markets until they’re already pretty huge.

Now, to be clear, the point that the author of these charts is making is different than the one Random Walk is making. The author’s point is that the “index-inclusion pop” isn’t “back” so much as it’s different now. Before, the benefit of getting bought by largecap ETFs was largely washed by loss of being sold by the smidcap ETFs, so the overall lift of joining the index was fairly small. But now, since fewer companies are “graduating,” there is often no offsetting “sell,” there is only “buy”—that’s why the index-inclusion pop is suddenly quite large again.

That’s a good point. Random Walk’s point is somewhat different.

The observation is that smidcap-ville is increasingly not the home of up-and-comers. And it’s not because there are no up-and-comers. It’s because up-and-comers aren’t going public, at all.

Private for longer (because they can)

The very best of the rising stars are simply staying private for longer.

The most exciting privatecos either wait until they’re massive to go public—the leapfroggers—or they just stay private, like Stripe, Databricks, Anduril, and the like.²

Take this index with a grain of salt, but it’s a pretty rough proxy for all the value-creation (on paper at least, but also in large part in reality) that’s happening in the private markets:

Notice.co 50 Index

The Notice 50 Index, which (very roughly) tracks share prices for the top 50 private cos, has wildly “outperformed” the Nasdaq.³

Again, Random Walk has pulled few punches when it comes to private-co valuations, in the main. But, at the very tippity-top of the market, there are some generational companies that (literally) cannot be bought at any price (because they’re (a) awesome, but (b) private, and you don’t get to buy their equity, unless they say so).

That’s kind of a big deal, and not just in the sense of PE/VC guys talking their book.

Stripe isn’t staying private because it thinks the “IPO markets are closed” (because they’re obviously not). It’s staying private because it doesn’t need the public markets. It gets all the money it needs from private market investors, who have raised enough money to make sure that Stripe et al never need the public markets.

That reflects a really profound change, many years in the making.

It used to be that companies outgrew the private side. The benefit of being public was a massive pool of very liquid capital, which was both larger and cheaper than any private investor could ever offer. The burden was all the reporting, and regulatory stuff, but if you wanted to raise hundreds of millions in fresh, liquid equity, then public was the only way to go.

From the “public’s” perspective, they offered up all that cheap capital, and in return, they got the opportunity to participate in the upside of the brightest and best companies. It was generally considered a fair trade, or at least, a trade that companies basically had to make, at a certain scale.

Now, however, things have changed. Private capital has gotten so large that it can say “Hey Stripe. Don’t even bother with the public markets. Just come to us. We’ll fund you, easy-peasy.”

And Stripe et al are saying “sure. sounds good to us.”

Illiquidity premium, but for real

But why would Stripe let a small group of investors price its equity, rather than let the massive, deep, and liquid markets bid for the best price?

Because private investors (with enough money) can offer something the public markets cannot: predictability (and alignment).

Look, it’s definitely true that regulatory burdens make “going public” more costly than it ought to be, but that’s less of an issue for a company as large as Stripe (although, it’s still an issue).

SVB

The fees and costs of going public are regressive, in that they don’t scale with the size of the raise, so smaller offerings pay a higher share of costs.

Going public is a hassle, and it constrains you in all kinds of annoying and unnecessary ways, but companies learn to live with it (and if they’re large enough, they can afford it).

The real issue for a company like Stripe is that public markets can be bat-shit crazy. We’ve got record levels of volatility, often for the strangest reasons. Meme-stonks. Options galore. I’m not gonna say market volatility makes “no sense,” but it makes a lot less sense than it should.

And wildly fluctuating equity prices is no way to run a business. From Stripe’s perspective, a slightly higher cost of capital is worth the price of stability, that only the private side can offer. The public offers cheaper float, but the catch is that every now and again, the price will fluctuate wildly and unpredictably, sometimes by 5-10%. You can see why it’s a less compelling value proposition than it once was.

Indeed, Dan Sundheim, CIO of D1 Capital, made the point succinctly in his (otherwise fun) conversation with none other than John Collison (of Stripe):

Transcript via Twitter

The public markets can “whip” your stock price up and down on a whim, and that just screws everything up.

For that reason, he doesn’t think he’d take Stripe public, if it were up to him. And the Collison brothers appear to agree.

The point here is that the public (and smidcap investors, specifically) are missing out on generational companies, and while the public can place some of the blame on regulators for denying them that upside, it’s the public itself (and its day-trading habit) that is increasingly to blame.

What happens next? Some changes, some opportunity

So companies, even the best companies (or perhaps especially the best companies), are staying private for longer.

Is that bad?

Well, probably in part. There are always tradeoffs.

• It’s probably good that the public gets to participate in some massive upside (which they kinda do anyway, indirectly through pension, etc. investments in private market funds), so the fact that they can’t, is probably bad.

• It’s also good when companies share their performance with the world because we learn lots of important things that way. Private cos keep that information more siloed. Good for them, perhaps, and their investors, but perhaps less good for the rest of us.

• Plus, we know that private marks are sometimes less volatile for less virtuous reasons, than patience and alignment. Public market price discovery has its virtues, as well—the smidcap hedgies aren’t retail, and they can be awfully smart and incisive.

But, private for longer just is.

Capital flows to opportunity, and independent managers can now raise large enough piles of money to make offers private cos can’t refuse.

The private markets are just going to get deeper and more liquid, and I suspect they will begin to adopt some of the better features of public markets.⁴ That’s a good thing, but it will also further erode the competitive advantages that public markets used to offer (making “private for longer” even more compelling, at the margins).

All is not lost, though, for public markets, I don’t think. There do need to be some subtle and not-so-subtle changes to adapt to the new normal, but that’s healthy and good.

The fact remains that not every up-and-coming private company makes the Notice Top 50. And the ones that don’t aren’t all zeroes, either (although some surly are). These companies (and their investors, especially), do need “exit liquidity,” and liquidity (especially smidcap investors) needs them.

With every dislocation comes opportunity, and in this case, fortunately, there’s a match to be made. It will require some new infrastructure, and some new habits for venture-backed companies, especially, but I’ll dig into those another time.

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Previously, on Random Walk

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1. ShitCo is a technical term for, well, you know what it means. I didn’t make it up though.

2. For reasons I will later explain, this makes sense in most cases, but it really does not, in others.

3. The top 10, to give you a sense:

These are all the rockstar private names, that investors cannot buy enough of, if they’re lucky enough to get the chance.

4. In fact, Random Walk has been working busily behind the scenes on something big and ambitious along these lines.