Public markets are shrinking. The number of publicly traded companies in the US peaked in 1996 at 7,300, and now sits 42 percent lower. This trend is alarming for public equity investors as it indicates that the opportunity set in public markets is not what it used to be. What happened in 1996 that caused the sharp reversal from a twenty-year period of rising public listings? A paper published by Michael Mauboussin and Dan Callahan in July 2023 titled “Birth, Death, and Wealth Creation: Why Investors Need to Understand Corporate Demographics” explores the academic research that explains the decline.^1, 2

Figure 1
Number of public companies in the U.S., 1976-2022

Declining birth rate

The number of initial public offerings (IPOs) sharply declined after US Congress passed the National Securities Markets Improvement Act (NSMIA) in 1996. This act exempted private companies from state-level securities regulations, making raising capital from out-of-state investors easier. For venture capital investors and private equity funds, NSMIA increased the minimum number of investors in the fund that would require them to register under the Investment Company Act, which mandates regular disclosure of investment portfolio holdings and imposes leverage and other restrictions. Together, these changes allowed investors more flexibility to invest in private companies irrespective of geography and increased private firms’ access to capital, allowing them to grow to a size that few firms reached when they were private.³

Although the passing of this act marked a turning point, it was not the only driver of the decline in public listings. The passing of the Sarbanes–Oxley Act (SOX) in 2002, in response to several high-profile financial scandals in corporate America, imposed more stringent disclosure requirements for public companies’ boards, management, and accounting firms, increasing the costs of being public. These fixed costs disproportionately impacted small firms, because, at the margin, it may be value-maximizing to go private when the SOX-imposed costs exceed the SOX-induced benefits to shareholders. This specifically led to a decline in publicly listed micro-cap companies.⁴ As shown in Figure 2, the mix of US public companies has changed significantly. From 1996 to 2022, mega-cap companies increased by 5 percentage points while micro-caps decreased by 23 percentage points.

Figure 2
Mix of mega-, mid-, small- and micro-cap U.S. public companies, 1976-2022

Death rate

If regulation is the leading cause of the declining birth rate of public companies, then mergers and acquisitions (M&A) are the leading cause of death. On average, about 4.6 percent of public companies are M&A targets yearly. M&A accounts for 58 percent of delistings since 1976, with sharp rises during periods of market disruption, such as the bursting of the dot-com bubble in 2000 and the global financial crisis in 2008/2009.

While M&A counts as a death, selling shareholders are typically well-compensated. Shareholders receive an average premium of 29 percent relative to the company’s price prior to the announcement of the deal. Most acquirers are other publicly traded companies, so the aggregate assets controlled by public companies has declined at a far lower rate. However, private equity buyers have been on the other side of a rising number of transactions since 2000. From 1977 to 2000, private equity accounted for less than 2 percent of M&A delistings. Since 2000, private equity has been the counterparty on 20 percent of M&A deals. Given that NSMIA lowered the regulatory burden for private investment, more capital flowed to private funds in search of opportunities for deployment. Shortly after NSMIA, SOX imposed a higher regulatory burden on public companies and changed the cost-benefit ratio of remaining public. It follows that private capital increasingly found a home in public companies looking to go private.

Figure 3
Private equity buyouts as a percent of M&A delistings, 1977-2022

Market composition

Because of the lower birth rate and consistent death rate, the composition of public markets has evolved in a few significant ways. On average, public companies are larger and older than they used to be, which implies a very different profile in terms of growth, profitability, and ability to return capital to shareholders through dividends and share buybacks. Markets are also more concentrated. A greater proportion of shareholder wealth is being created by a smaller number of companies.⁵ Research into the roughly 28,100 public companies in the US since 1926 found that 60 percent destroyed value through 2022. Over 90 percent of the total wealth creation was attributable to just 2 percent of public companies in the study.

Valuation and portfolio construction

When valuing public companies, investors must be mindful that projecting out terminal values forever is inconsistent with reality. Research on death rates and corporate longevity should inform assumptions of terminal value. Investors should also be aware of the concentration of wealth creation when going through the portfolio construction process. Investors can either take an active or passive approach to dealing with concentration. Active investors seek to build concentrated portfolios with a selection of companies that have the potential to generate high returns while avoiding those that do not. Researchers found that companies that created wealth had common characteristics identifiable from their fundamentals. They had large increases in net income, rapid internally generated asset and sales growth, rising return on assets, above-average research and development (R&D) spending, and cash accumulation. Alternatively, the passive approach can be employed, which includes stocks with poor returns along with the few companies that drive returns.

Diversification and risk

Because institutional investors have a fiduciary responsibility to put clients’ interests first, investment policy statements almost always include portfolio diversification and risk management guidelines designed to protect clients from the risk of loss. Stocks that generate most of the portfolio return inevitably exceed position limit thresholds and need to be trimmed. Portfolios subject to these position size limits are, therefore, at a relative disadvantage to their benchmarks or index fund alternatives that are not subject to the same guidelines.

Accessibility of private markets

Lastly, while private markets are more accessible than ever, not all investors have access to private markets. With more early-stage wealth creation shifting to private markets, it is more essential than ever for the investment industry to offer solutions that level the playing field and bridge the gap for investors to private markets. There are significant benefits to adding private exposure to their portfolios.⁶ Research shows that adding private equity to a 60/40 portfolio improves returns and provides diversification benefits.⁷ In Canada, early-stage efforts are underway by industry players to make private assets accessible for retail investors while addressing their specific liquidity constraints, time horizon, and tax considerations. 

¹Mauboussin, Michael. J., and Dan Callahan. “Birth, Death, and Wealth Creation: Why Investors Need to Understand Corporate Demographics.” Consilient Observer (July 25, 2023), Morgan Stanley Investment Management. 

² All figures are from Mauboussin and Callahan’s report (refer to Note 1).