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The Economist has an article, High-speed slide, which discusses a recent study by Grant Thornton about the disappearance of the initial public offering (IPO) market in the U.S., and, in particular, the death of the small IPO. In the October 2009 study, Market structure is causing the IPO crisis, authors David Weild and Edward Kim argue that the recent paucity of U.S. IPOs is a result of the “market structure” failing the IPO, rather than a cyclical downturn. That may seem unlikely at first blush, but the data are compelling:

The first six months of 2009 represents the worst IPO market in 40 years. Given that the size of the U.S. economy, in real GDP terms, is over 3x what it was 40 years ago, this is a remarkable and frightening state of affairs. Only 12 companies went public in the United States in the first half of 2009, and only eight of them were U.S. companies. The trend that disfavors small IPOs and small companies has continued. The median IPO in the first half of 2009 was $135 million in size. This contrasts to 20 years ago when it was common for Wall Street to do $10 million IPOs and have them succeed.

The implication, say the authors of the study, is that the market is closed to most small companies:

From 1991 to 1997 nearly 80% of the IPOs were smaller than $50 million. By 2000 the number of sub-$50 million IPOs had declined to only 20% of the market. The market for underwritten IPOs, given its current structure, is closed to 80% of the companies that need it.

From page 8 the study, a graph showing the decline in the number of small IPOs (<$50M) relative to large IPOs ($50M+):

The Economist points out that the “50 or so” new companies to list this year is just “one-seventh of the level needed to offset the average annual loss of listed companies in recent years.”

The study discusses a number of possible causes of the decline, including the introduction of low-cost brokerages and new regulations and legislation. From page 4 of the study, a graph showing the decline in the number of IPOs and the timing of regulatory changes:

The Economist focuses on the impact of low-cost brokerages:

An accidental victim of this technological revolution, the report says, was the ecosystem that helped bring small firms to market and then nourished them once there. “It’s a bargain-basement market today,” says David Weild, a co-author of the report. “You get what you pay for, and that’s nothing but trade execution.”

The “high-frequency” traders who have come to dominate stockmarkets with their computer-driven strategies pay less attention to small firms, preferring to jump in and out of larger, more liquid shares. Institutional investors, wary of being stuck in an illiquid part of the market, are increasingly following them.

Another factor is the near-evaporation of research on small firms, which has been undone by the rise of passive index investing and by rules that banned the use of investment-banking revenues to subsidise analysts. With less funding to go around, analysts are increasingly concentrating on large, frequently traded shares, says Larry Tabb of TABB Group, a consultancy. The centre of gravity in research has shifted to “buy-side” firms, like hedge funds, which do not generally disseminate their work.

The authors of the study point to other regulatory and legislative acts, including the “order precedence rule,” commonly known as the “Manning Rule” after a legal case against Charles Schwab, the Gramm-Leach-Bliley Act, which saw the end of the Glass-Steagall Act of 1933 and formally allowed the combination of commercial banks, securities firms and insurance companies, Regulation Fair Disclosure, which devalued stock research, and the Global Settlement ruling, which has made research coverage tougher for issuers to secure. Sarbannes-Oxley was simply the final nail in the coffin.

The authors suggest two changes to reinvigorate the market, neither of which I find particularly palatable. They are the establishment of a new market segment without automated trade execution but with fixed trading commissions used to fund research and looser rules governing institutional investment in pre-IPO companies. These are band-aids that won’t get to the root cause of the problem. If the regulatory and legislative changes backfired on the U.S. IPO market, as the authors claim, perhaps winding back some that legislation would help it. The list of regulation and legislation detailed in the appendix of the study, stretching over the last three pages, is enough to choke a donkey. SarbOx has not received its fair share of the blame, possibly because the market was already an ex-market by 2002, the year Sarbannes-Oxley was enacted. The authors write that SarbOx was “a bit of a red herring” because “[online] brokerage and decimalization were significantly more damaging to the IPO market.” That’s all well and good, but it’s also plain that – bubble years aside – the smaller end of the market has further declined since the enactment of SarbOx. SarbOx has created an enormous regulatory and compliance burden on listed companies, and the corollary is not true: Fraud is as endemic as ever, and people still lose money to sheisters. The additional SarbOx regulatory burden cannot do anything other than reduce the number of companies for which being public is a worthwhile exercise. Smaller companies will incur proportionately higher costs in meeting the burden than their larger brethren and that means the additional regulatory burden will only ever be observable at the margin – the smaller end of the market. If we wish to see the IPO market back in health, we need to reduce the regulatory burden on all companies.

Update

The net effect of the decline in listings is striking (via BusinessWire):

The number of U.S. listed companies has fallen by more than 22 percent since 1991, or 53 percent when calculating in inflation-adjusted GDP growth. In contrast, exchanges in Asia are adding new listings faster than GDP growth rates.

According to the study, 360 new listings per year — a number not approached since 2000 — are required by the United States simply to replace the number of listed companies that are lost every year. Moreover, 520 new listings per year are needed to grow the U.S. listed markets roughly in line with GDP growth. In reality, the U.S. has averaged fewer than 166 IPOs per year since 2001, with only 54 in 2008.

Hat tip Jules.

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