David Weild and Edward Kim, NASDAQ veterans and long-time equity market players, recently released a paper that is a must-read for anyone who cares about companies going public (or small companies that already are public) entitled “Market structure is causing the IPO crisis.” In the paper, they argue that we have been in an IPO crisis that began during the dot-com bubble. The crisis was obscured in its early years by the large number of Internet-related IPOs during the bubble, but the underlying causes of the crisis were operating even then. As evidence, the authors cite that IPOs of less than $50 million have essentially disappeared from the modern landscape even though they consistently exceeded 250 deals per year before the bubble era.
The paper does a good job laying out the causes of the decline in small IPOs, many of which will be unfamiliar to many readers. Unless you are a market structure wonk, you may be surprised to learn that things you may never have heard of such as the odd-eighths collusion settlement, the Manning rule, the order handling rules and decimalization have had such dramatic impacts and unintended consequences. I would also add that these same things that have led to the drought of smaller IPOs have also decimated market liquidity for small cap stocks generally. All of those changes, along with several others, have had the effect of making markets in small cap stocks uneconomical for the brokers that traditionally were responsible for maintaining a liquid market. The authors state that the potential consequences of this are many and severe:
Lower U.S. economic growth — U.S. economic growth will be lower as returns languish without a functioning IPO market and investors allocate less money to venture capital as an asset class. The venture-exit time frame currently exceeds eight years — an all-time high — extending the return horizon and lowering the internal rate of return.
Entrepreneurs take a beating — Investors are already cutting back funding to entrepreneurs in this country. Venture capitalists, in order to make up short-falls in returns, will dilute entrepreneurs even more. The incentive for Americans to leave well-paying jobs and risk everything will be less. Suffering from a lack of support, the IPO takes a beating.
U.S. vulnerable to outside threats — The U.S. will lose its competitive advantage in developing, incubating and applying new technologies. Technologists are already returning to foreign jurisdictions like China and India where government has devised an increasing array of economic and capital markets incentives to compete.
Loss of American prestige — The ability of the markets to support IPOs once made the U.S. stock markets the envy of the world. Our system was so effective that the French government, concerned that the United States would trump France in the then-emerging biotechnology industry, launched the “Second Marché” in 1983 as a feeder to the Paris Bourse.
Capital markets infrastructure continues to erode — The United States enjoyed an ecosystem replete with institutional investors that were focused on the IPO market — active individual investors supported by stockbrokers and a cadre of renowned investment banks, including L.F. Rothschild and Company, Alex. Brown & Sons, Hambrecht & Quist, Robertson Stephens and Montgomery Securities, that supported the growth company markets for many years. None of these firms survives today. Firms have attempted to fill the void and have found that the economic model supported by equity research, equity sales and equity trading no longer works.
Individual investors are left holding the bag — Traditional forms of capital formation (e.g., underwritten IPOs and marketed follow-on offerings) no longer work well for small cap issuers. As a result, investment banks have developed a series of financing structures that distribute shares exclusively to institutional investors (especially hedge funds) and generally dilute the ownership interests of individual shareholders disproportionately (e.g., PIPEs and Registered Directs) by placing discount-priced shares exclusively with institutional investors.
The solution proposed by the authors is to create a separate public equity market for smaller cap issuers that would look very much like the one that existed in the early 1990s. Most notably, electronic access would be limited and spreads would be maintained at 10 cents for stocks under $5.00 per share and 20 cents for those priced higher. Orderly liquidity would return to this market because there would be economic incentives to provide it.
While there is no doubt that such a market would represent an improvement, I don’t think that this is a viable solution. First of all, there does not seem to be any realization on the part of most politicians and regulators that the provision of liquidity is a legitimate service that should result in compensation. Narrow spreads are pretty much universally regarded as good things, not bad. Furthermore, many of the changes were put in place because the old market making structure was less than ideal in many respects. Cost of execution was difficult to determine and abuse was not uncommon. There will be major political resistance to any effort to throw out reforms that were ostensibly put in place to protect the small investor, even if the reforms in question did no such thing.
The changes that we have seen in equity market structure over the last several years have sparked tremendous amounts of innovation. Some of this innovation has resulted in good things and some in bad. To date, none of it has resulted in a better-functioning market for small cap stocks. Still, I think that the answer will come from new ideas rather than a return to old ones. For instance, a public execution venue could have a different pricing structure to provide larger rebates for providing liquidity in small cap stocks. Currently, this would be difficult to implement because there are low barriers to entry in the ECN/ATS space which leads to very low pricing power. Still, if one were able to devise some basis for differentiating the service, it would be possible within the context of today’s market environment.