The Private OpportunityRobert Natzler, Investment Manager
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We may be on the cusp of a once-in-a-century change in how rapidly growing companies access capital. Many are staying private for longer, approaching late-stage venture capital rounds with altogether different intentions than they had even two decades ago.
This is not the first time the classic finance textbook story of how companies grow has been challenged. We believe that it is by understanding how we ended up with the current system of company financing, that we can best understand the new, evolved system emerging in front of us today.
How we got here
The classic textbook story about a company’s lifecycle tends to start with an entrepreneur raising capital from friends and relatives then possibly giving some equity to a knowledgeable angel investor or taking out a bank loan. As the business grows, the company may turn to venture capitalists (VCs), who will provide larger amounts of funds as well as useful expertise around recruiting, marketing and legal support.
If everything goes well, the company then ‘graduates’ into public markets via an initial public offering (IPO). The shares will pass into the hands of public market investors, who will be looking for different specific characteristics – perhaps the ability to reinvest and grow even larger, or perhaps a clear framework for paying profits back out in the form of dividends. After a period of time, as the business ages, it may pass into the hands of private equity (PE) buyout funds, which would look to start the process of either rejuvenating the business under new management, or else beginning to close the business down and release its resources for deployment in other businesses elsewhere.
Such is the classic model, drawn from the experience of the second half of the 20th century. As well as describing how companies access capital, it shapes how pension funds and other investors think about allocating it.
What’s important to realise is that this model didn’t apply for much of the 19th century. Until the railways appeared, Wall Street’s purpose was to help governments raise debt. In London, a few hundred companies were traded on exchanges by public shareholders, but these were the exception, not the rule. Most companies around the world achieved scale entirely off the back of private capital, gathered from retained earnings, local banking networks or inter-family alliances.
The railways challenged this model because of the enormous amounts of money they needed to spend up-front in order to buy land and lay track. No family network alone could support such an effort, and so companies were forced to go to Wall Street. Once these railways were built, companies were able to sell their products to a much wider market, forcing their rivals to gain scale or be put out of business. The public markets were born as these local manufacturers raised capital on Wall Street to fund mergers in pursuit of national dominance.
Ron Chernow’s 1990 history, House of Morgan, describes in detail how the classic Wall Street banks were slow to recognise these changes. They left space for new challengers, banks such as Goldman Sachs and Lehman Brothers, which rose to prominence by specialising in financing businesses and factories. The incumbents were left behind because they failed to learn the different financial analysis skills needed for anything that wasn’t a railroad or government.
And the public markets didn’t stop there. The new industries of the 20th century – in autos, petrochemicals and mass manufacturing – proved incredibly capital hungry at early stages. Before products could reach customers, entrepreneurs needed to raise huge amounts of money to build factories and distribution systems. With founders ever more dependent on venture capital support to get their ideas off the ground, companies were increasingly likely to IPO into public markets when the venture capitalists wanted to get their money back. And so it was that the 20th century textbook model, described above, took shape.
© Imaginechina Limited/Alamy Stock Photo.
What we see today
At Baillie Gifford, we see signs that this system is evolving once again. Fewer companies are listing at IPO, and the ones that do are doing so significantly later in their lives than they were previously. The average age of a US company at listing now stands at 12 years, up 50 per cent since the start of the millennium. The aggregate valuation of late-stage private companies has also exploded. In 2006, there was a little under $10bn of value in ‘unicorn’ companies – private businesses with a value of over $1bn. As of 2019, there was more than $1.8tn of value in these businesses. Something is clearly going on!
Source: Baillie Gifford. SpaceX valuation as of August 2020.
I think there are three big factors at work. The fundamental economics of starting a business are changing. Government rules have changed. And, never to be discounted, cultural norms among founders are changing. Let me touch on each in turn.
Economics first. There has been a sharp change in the levels of capital investment most companies need before they’re ready to enter their chosen markets. Historically, an entrepreneur might have to build a factory, set up bricks-and-mortar outlets to achieve national coverage and invest heavily in servers to run IT. Today, it’s possible to rent Chinese manufacturing capacity through Alibaba, hire digital targeted advertising from Facebook and Alphabet, and access the exact amount of required computing capacity through the cloud services of giants such as Amazon Web Services (AWS). The result is that many companies can scale for a much longer time before the founders have their ownership stakes diluted by outside capital providers, whose limited-life vehicles made them historically impatient for an IPO ‘exit’ event.
On top of this, there’s been a revolution in staff count. The biggest employers today have far fewer employees than juggernauts of yesteryear such as GE or Ford. In the 1930s, Ford’s River Rouge Complex in Michigan employed more than 100,000 workers on just a single site. Today, tech companies such as TransferWise are generating hundreds of millions in revenue with barely 2,000 staff members.
Facebook CEO Mark Zuckerberg Rings Nasdaq Opening Be,
Source: ©Bloomberg/Getty Images.
Where hierarchies are needed, modern management software lets them be more flexible than ever before. Effective business systems are easier, cheaper and less reliant on the expertise of senior chiefs from large organisations. The result is that founding teams of talented engineers can run their organisations for much longer before they need to lure in bosses from large corporations with promises of big pay-outs and a company listing.
These fundamental changes in the economics of building and running firms means that founders have more control of their organisations and have it for longer. With these outside pressures to list removed, many are taking the option to stay private for longer, selling down a bit more of their ownership stake rather than rushing into IPO.
Along the way, there have also been helpful changes in government rules. The 2002 Sarbanes-Oxley Act made IPO conditions significantly more stringent, while subsequent regulatory actions have substantially increased the reporting burden on public companies. Some chief financial officers have gone as far as claiming that the cost of being public has risen more than five-fold since 2010 alone! On the other side, the tax changes enshrined in the US JOBS Act of 2017 have made it easier for emerging growth companies to share rewards with employees while remaining private, removing one more historic source of pressure to IPO.
Take that combination of regulatory change and increased founder power, and it’s not surprising that we see another great driver of this trend. Norms are shifting within the founder community. For companies such as Facebook, ringing the stock exchange bell at IPO was a prestigious coming-of-age moment. But as more and more large and famous companies – Airbnb, SpaceX, Stripe, ByteDance (owners of TikTok) – have stayed private, the association between being listed and being successful has weakened. Talking to founders today, we are struck by how many view public markets with distaste, noting the arms-length mistrustful relationships that develop between managers and often all too short-term shareholders.
The World Ahead
These changing trends of business economics, government rules and corporate norms have resulted in a late-stage private market containing increasingly valuable and large companies. That combination points to a 21st century where the classic finance textbook’s neat account seems ever more out of date.
The simple truth is that the kind of companies that are staying private for longer are very different from the young and immature operations that talented early stage VCs specialise in finding and helping. These are not companies that require investor help in making key hires, writing HR policies or designing marketing plans. Far from desiring it, the last thing many of these founders want is one more investor telling them how to run their already highly successful and expanding business.
This matters, as private markets have never just been about access to capital. Management teams get to choose their investors, determining the terms and prices at which they offer stakes in their company. Any investor can write a cheque; but it’s the investor the company wants that gets the chance to write that cheque at an attractive valuation. This is why the best early-stage venture capitalists have specialised for so long on the support areas outlined above; and why it’s so important for us to understand what it takes to be a natural buyer in the rapidly growing late-stage private market.
At Baillie Gifford, we believe that we are natural buyers for these businesses. This began as a tentative hypothesis but has strengthened over the last decade into a core belief. We review it with the help of two key reference points.
Any investor can write a cheque; but it’s the investor the company wants that gets the chance to write that cheque at an attractive valuation.
First, we look at our ability to source proprietary deals. We can access investment opportunities through our own relationships and reputation, rather than through just joining in on bank-promoted rounds. Over the last two years, over 75 per cent of the deals we’ve made have come through these proprietary channels. Second, we look to the frequency with which we receive our full allocations in private funding rounds. In 2019, we received our full allocations more than 95 per cent of the time. For 2020, the figure is standing at a little over 97 per cent. We know this is an exceptionally high level relative to many other participants.
So why do founders choose to partner with Baillie Gifford? For us, this comes down to three points. We are long-term in our approach and understanding, with a proven record of supporting growth businesses both at scale and globally. We use vehicles and structures that let us offer continuous support, walking with the founders through multiple private funding rounds and then staying with them long into the public markets. Using the insight this gives us means we can be aligned with the management as the company grows. Let me take each point in turn.
© Airbnb, Inc.
At Baillie Gifford, long-termism has never just been a punchline. In public markets globally, the average investor has a holding period measured in months. At Baillie Gifford, our average holding period is above seven years. For the flagship strategy that began our private market practice in 2012, that period is nearer 12 years. We’ve always focused much more on the long-term strategic opportunities in front of businesses than on worrying about every potential short-term tactical misstep; and we’ve always been very upfront in sharing our perspectives with boards and fellow investors whenever management have needed our support.
We’ve brought this perspective with us to private markets. The companies we invest in know that we’re in no rush to push them into an IPO. We support them in many cases through multiple private rounds before they seek a listing. And when they do seek that listing, we have the firepower to support them, and then continue to stand by them. At the time of writing, Baillie Gifford clients have almost $5bn deployed into private companies around the world – and around another $40bn deployed into public companies that we first invested in when they were private. This behaviour, in both public and private markets, in turn goes to build our reputation among board members and management teams, helping us secure further introductions to other private opportunities.
Second, the way in which we approach this means that we can offer continuous support. Not for us the seven- or 10-year limited life fund timelines that have been typical of VCs. The vast majority of our private investments have been made from permanent capital vehicles – closed-ended investment companies whose shares are available for trading on stock exchanges. Our clients can buy and sell shares in these vehicles, allowing us to promise companies that we will never pressure them into timing a financing event simply to provide us with liquidity. These vehicles also have the ability to hold companies into public markets. Rather than just passing holdings as an introduction to a separate team, we can then continue to support them as they progress to public markets over many years from within the same team and vehicle that first invested.
This continuity point applies at a broader level too. There is no firewall at Baillie Gifford between our private company specialists and the public market teams. Indeed, our core team of seven private investment specialists is joined by over 30 other Baillie Gifford investment managers who split their time between private and public investing. Each of those 30 has individually led a private investment within Baillie Gifford. The research that this group generates is then shared within our central research hub, which it is accessible to all the 120-plus Baillie Gifford investors, wherever they are based in the world. The result is that Baillie Gifford has a seamless relationship with the management of private holdings when the companies eventually move into public markets. This lets us forge deep relationships and thus understanding of them while they are private – and reassures founders that in Baillie Gifford they have a potential public market investor who truly knows them.
Finally, these relationships allow us to work closely with founders and their management teams. As one of the few investors in the world that walks with companies through multiple private rounds with the intention of being a long-term public markets holder, we stand out as an obvious source of advice on how to prepare for listing. Whether it is engaging on individual corporate governance policies or discussing how to behave at IPO to attract good long-term public markets funds, we frequently find ourselves engaging with the companies we invest in to help them think about their future on a multi-year time period. We continue to work hard at improving this offering, doubling down on making sure we remain the investor of choice for long-term oriented private company founders.
We believe that the world of capital provision is changing in ways that have not been seen since the early 20th century. With over $1.8tn of value now found in private company unicorns, we believe that late stage private companies can no longer be considered as an afterthought. This is a new space, and it requires a new kind of private investor.
At Baillie Gifford, we are striving to be that investor.
IMPORTANT INFORMATION AND RISK FACTORS
The views expressed in this article are those of Robert Natzler and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect personal opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.
This communication was produced and approved in December 2020 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
Any stock examples and images used in this article are not intended to represent recommendations to buy or sell, neither is it implied that they will prove profitable in the future. It is not known whether they will feature in any future portfolio produced by us. Any individual examples will represent only a small part of the overall portfolio and are inserted purely to help illustrate our investment style.
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The images used in this article are for illustrative purposes only.
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Robert Natzler Investment Manager
Robert is a member of the Private Companies Team at Baillie Gifford.
He joined the firm in 2015 and worked on our Emerging Markets and UK Equity Teams before moving to Long Term Global Growth. There he focused on finding stocks for a set of highly concentrated long-term international growth portfolios. He also began working on private companies, in the context of both private founding rounds and existing holdings approaching IPO.
In 2018 he moved to our Private Companies Team to work full-time on identifying high growth late-stage private companies. He has led research on private companies including Tanium, Niantic, Sana, Flixbus and Away, as well as doing follow-up work on pre-existing portfolio holdings. He is working to develop a best-in-class research culture and company support strategy on the team.
Robert graduated with a BA (Hons) in Philosophy, Politics and Economics from the University of Oxford in 2014.
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