Capital Markets

IPO “Crisis” Crushes Small-Caps, Grant Thornton Contends

On a career level, CFOs should worry about the collapse of the market for initial public offerings because it means "fewer attractive opportunities...
David KatzOctober 7, 2009

The market for initial public offerings — particularly among small-caps — is mired in a crisis, Grant Thornton capital-markets consultants contend. The debacle has been caused largely by wrong-footed regulatory and technological moves rather than the downturn in the economy, they say.

“Over the last several years, the IPO market in the United States has practically disappeared,” according to “Market Structure Is Causing the IPO Crisis,” a research paper issued by the accounting firm Tuesday. “While conventional wisdom may say the U.S. IPO market is going through a cyclical downturn exacerbated by the recent credit crisis, many experts are beginning to share the view of a new and much darker reality: The market for underwritten IPOs, given its current structure, is closed to 80% of the companies that need it.”

Citing figures from Dealogic and Capital Markets Advisory, the authors report that from 1991 to 1997, nearly 80% of IPOs were smaller than $50 million. By 2000 the number of IPOs smaller than $50 million had shrunk to 20% of the market. More recently, the first half of 2009 “represents the worst IPO market in 40 years,” according to the report, which adds that “[t]he trend that disfavors small IPOs and small companies has continued.”

Only 12 companies went public in the United States in the first six months of this year, and just 8 of those were U.S. companies, the authors note. The median IPO in the first half of 2009 was worth $135 million. “This contrasts to 20 years ago when it was common for Wall Street to do $10 million IPOs and have them succeed,” according to the report.

The authors contend that the loss of small-cap funding hurts the vitality of large companies as well. “We’ve killed the feeder system to the big leagues,” David Weild, a senior adviser at Grant Thornton Capital Markets and former vice chairman of Nasdaq, tells “You just don’t have major league baseball without kids going to Little League and then people in double A and triple A. They need training, and they need to grow up. And when you’ve got a public market that no longer allows companies to grow up, you have a crisis on your hands of epic proportions.”

In industries like pharmaceuticals, for instance, big companies face the risk of the loss of the cost-effective product pipeline represented by start-ups that bloom into IPOs, according to Weild. “A lot of innovation is acquired,” he notes.

The virtual elimination of underwritten IPOs — public offerings in which investment bankers, for example, at least temporarily have some money at risk in the deal — is hurting small businesses by wiping out a source of funding that represented more than 50% of all IPOs, the authors write. Instead, Weild argues, small-caps are relying on “a lot of desperation finance,” including reverse mergers and the private investments in public entities known as PIPEs. Such deals “tend to be very dilutive transactions” to shareholders. What’s more, they “don’t bring support and research” to companies that need them to grow, he adds.

The paucity of equity capital may also be hamstringing small-caps’ ability to attract other forms of funding. “Good credit starts with a layer of equity,” the paper’s authors note. “Companies are less able to attract debt capital or credit when they have inadequate equity capital.”

The CFOs of small companies, including private ones, have long been aware of the effects of the shrinkage of equity capital in the face of Sarbanes-Oxley rules that make it more costly to go public. “It’s become increasingly difficult to be a public company if you’re not of a substantial size because of the regulation and the lack of liquidity,” says John Kahn, CFO of Financial Asset Management Systems, an accounts-receivable advisory firm owned by private-equity investors. “The analysts don’t follow you to a significant degree, and it’s gotten worse over the years.”

Indeed, finance chiefs may have a personal stake in resuscitating underwritten IPOs, according to Weild. For CFOs, the demise of public offerings means “fewer attractive opportunities, and that demand for CFOs is going to go down,” says the consultant, who acknowledges that as a provider of audit, tax, and advisory services, Grant Thornton has a stake in the vitality of the IPO market.

Underlying the argument of the Grant Thornton report is the alarming notion that the collapse of the IPO market is a “market-structure” problem rather than an offshoot of the recession — suggesting that without regulatory and legislative change, the market won’t necessarily come back even if the economy improves.

The lack of public equity available for smaller companies stems from “the cumulative effects of uncoordinated regulatory changes and inevitable technology advances,” the consultants say, “all of which stripped away the economic model that once supported investors and small cap companies with capital commitment, sales support and high-quality research.”

A prime culprit is the rise of online trading in the late 1990s, according to the report. In that period, speedy transactions and short-term speculation began to replace a system of long-term, research-driven investing that nurtured corporations both large and small, according to the authors.

To solve the problem, they propose that “an opt-in capital market” be set up to foster small-cap IPOs, although big companies could choose to dip into it as well. Instead of online trading, the market, which would be overseen by the Securities and Exchange Commission, “would be a telephone market supported by market makers or specialists, much like the markets of a decade ago.”

Further, it would require broker mediation. “Investors could not execute direct electronic trades in this market; buying stock would require a call or electronic indication to a brokerage firm, thereby discouraging day-traders from this market,” the Grant Thornton consultants assert.