Have losses become key to private-market success?

Declining public listings, focus on cash flows, and aggressive pursuit of expansion signal new definition of capitalism

Have losses become key to private-market success?

2019 proved to be a banner year for the U.S. equities market, which achieved an annual return exceeding 30% based on the S&P 500 and the NASDAQ. But taking a step back to see the larger view shows a greater role of private markets, as the number of companies listed on U.S. stock exchanges has declined over the past two decades.

Different reasons have been offered to explain this, including reportedly excessive burdens of regulation on public companies and the massive culling of dot-com companies in the early 2000s. But the most powerful may have to do with profitability — or, more specifically, the increasing irrelevance of profits.

“Listed firms are under constant pressure to deliver profits [as measured by] earnings per share (EPS),” said private equity and venture capital advisor Sebastien Canderle in a blog post published by the CFA Institute. “Private capital investors have demonstrated, however, that a positive EPS serves no purpose.”

In the private-equity space, Canderle noted that capital gains for shareholders are maximized through leveraged buyouts (LBOs) that involve issuing debt to the greatest structurally acceptable degree. Covenant-lite packages and flexible loan structures extended by lenders to regular and preferred clients allow debt commitments to be maxed out and netted off operating profits.

Companies under LBO, he said, often take on aggressive cost-cutting measures such as squeezing suppliers, trimming excess fat from the payroll, and skimping on customer service to the extent that the company’s valuation isn’t hurt by the short-term repercussions while under private-equity ownership.

“Any extra cash generated from these aggressive reorganizations must then be used exclusively to redeem loans or distribute dividends,” Canderle said. “Cash leakage to third parties is inexcusable, pre-tax losses the sign of a job well done.”

In the venture-capital (VC) space, meanwhile, he explained that investors are more fixated on exponential growth that net earnings. With the aim of dominating or controlling a market, VC investors backing start-ups don’t bat an eyelash as they expand at all costs and burn cash quickly.

“Achieving critical mass costs money, and as the recent unicorn stampede demonstrates, start-ups with international ambitions are expected to raise multi-billion-dollar rounds to fuel their expansion,” Canderle said, arguing that the expectation for new businesses to demonstrate sustainability and chart clear paths to profitability is a practice that ended with the dot-com era.

With the rise of global online platforms like Amazon, Google, and Facebook, he said, the classical economic model of monopolies delivering supernormal profit has been upended. Today’s start-ups, he said, aim to quickly cement a monopolistic or impregnable market position, which is the first step on a path to profitability that often extends years past the point when their VC backers have exited.

“The methods adopted by private capital fund managers have changed the definition of capitalism,” he said. “In today’s system, private investors pocket capital gains regardless of the long-term viability of their portfolio companies.”


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