by CHRISTINE R. QUILLIAN, CFA, CFP®, MONTAG Portfolio Manager
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Whether you manage investments on your own or on behalf of others, deciding what to buy or sell, much less when or how much, can be a daunting task. Just as the process of investing has become more accessible with advances in technology, the resulting explosion of available information reveals an endless array of choices and risks available to investors. One consideration is whether an investment is a public or a private security.
The reason why we have investment choices to begin with is that companies need capital to grow and develop; they may need money to expand production capacity, to embark on new research, launch a new marketing approach, or to add more staff.
Companies may choose to use past profits, i.e. retained earnings, to pay for these corporate-investment related costs. Or, they may raise money (“raise capital”) by issuing securities through the capital markets.
Capital comes in two basic forms: debt and equity. Companies that raise money through debt financing borrow money temporarily; they are required to pay the lender back on an agreed-to schedule, including interest. In contrast, when companies raise capital through equity financing, the company gets to keep the money permanently. In exchange, existing owners relinquish a portion of their ownership holdings to new owners or to existing ones who choose to increase their stake.
Equity and debt financing can be facilitated through the issuance of public or private securities. From the investor’s perspective, much of the difference comes down to transparency of information, pricing and liquidity.
What are the Differences Between Public and Private Securities?
Public Securities
Companies that raise funds through exchanges or markets that are accessible to ordinary people commit to disclose, in standardized form, extensive financial and operational results to those people – and potential competitors – on a regular basis. The Securities and Exchange Commission (SEC) provides free access to corporate financial records on its EDGAR database. The result for investors in public securities is an ongoing flow of information about a company’s financial health.
Private Securities
Conversely, private companies are permitted much more leniency around financial disclosures. Reduced transparency is beneficial from a competitive point of view but is less desirable for potential investors. Privately issued securities are designed to be exempt from federal securities registration requirements and the compliance hurdles incumbent upon public offerings. This flexibility may free management to focus more on operating the business, but less disclosure may also limit the ability for investors to assess risks in a timely manner.
Advantages & Disadvantages of Each
Accessibility – buying or selling publicly traded securities is a relatively simple process with many platforms available to facilitate the direct purchase and sale of equity shares and debt instruments. Owning private securities, whether debt or equity, is most often done through funds or fund-of-funds.
All investors have an interest in knowing what their investments are worth. For public equity and debt securities, price discovery is not theoretical; it is available every day, in real-time. Public securities’ prices are based on actual transactions. Conversely, price discovery is poorer in private markets, with a higher potential for mis-valuation. Just as the algorithms behind Zillow or Realtor.com will estimate a home’s value, the price of a private market security is entirely theoretical until money changes hands between buyer and seller.
Related to pricing is liquidity – the ability to sell something in exchange for cash when the owner chooses. Public markets are open weekdays from 9:30am to 4pm ET for equities and 8am to 5pm ET for bonds. They are designed to attract a broad population of potential investors, facilitating connection between buyers and sellers, and enabling them to transact at will. In contrast, investors in private securities are typically restricted to transacting only during pre-set trading windows, such as a few days each quarter. In times of market stress, some fund managers may exercise a right to temporarily “close the window” and restrict investors from redeeming holdings.
There is a perception that private securities are less volatile than publicly traded ones, but that is not a fair comparison. The view is a direct result of illiquidity and the limited signals that come from infrequent pricing. The value of 5-year bank Certificate of Deposit (CD) is just as volatile as a 5-year corporate bond. Both are debt securities whose valuations are equally affected by credit-quality concerns and changes in market interest rates. The bank CD appears more stable only because holders do not see its value marked-to-market daily.
Profitability is every company’s goal, but public and private companies have reasons to differ in how they present profitability. With a big and diverse equity shareholder base, public companies aim to please owners by maximizing after-tax profitability. However, when corporate expenses are tax deductible, a private company with a limited shareholder base may have incentive to generate unnecessary expenses in order to reduce tax liability.
The past decade+ of near-zero interest rates and good economic growth, on the back of key legislation enacted in the first decade or so of the 2000s*, fueled a boom in private markets, especially private debt. However, the current and very new era of higher interest rates is upending the business models of public and private companies alike to a degree not seen in decades. This important shift, in combination with opaque private market information and lack of accessible secondary markets for trading, suggests particular caution and skepticism should be applied when considering private securities.
*Memo*
With sincere apologies to Soren Kierkegaard: life must be lived forward, but Congress often legislates backward:
- In response to the bursting of the tech bubble, the 2002 Sarbanes-Oxley Act substantially increased financial reporting requirements (and compliance expenses) for public companies.
- In response to the Great Financial Crisis, the 2010 Dodd-Frank Act aimed to constrain banks’ ability to take risks.
- The 2012 Jumpstart Our Business Startups Act (JOBS Act) enabled non-bank firms to raise money via crowdfunding and exempted “emerging growth companies” (EGCs) from a range of compliance burdens, giving EGC issuers and insiders a freer hand on governance structure, disclosure requirements and shareholder-rights responsibilities.
The information provided is accurate to the best of our knowledge as of the date of publication. The information provided is for illustration purposes only. It is not, and should not be regarded as “investment advice” or as a “recommendation” regarding a course of action to be taken. MONTAG employees do not provide legal or tax advice. For specific legal or tax matters, you should consult with your own legal and/or tax advisors.
