The Failure of Follow-On Offerings

Raising equity capital after an IPO would be easier if there was a two-way flow of information between the issuer and potential investors.
Vincent RyanNovember 19, 2012

While IPOs and equities trading get lots of attention, there’s a large part of being a public company no one talks about, according to Miranda Mizen, director of equities research at TABB Group: how a company will continually raise capital after it goes public.

I recently came across a report Mizen wrote on the subject this year, and if CFOs want to know why the follow-on equity offering process can be lengthy and expensive, they will find the answers here.

At the root of the problem, somewhat ironically in this age of electronic trading and general interconnectedness, is the inability of supply and demand to find each other in the stock market, says Mizen.

“The way the market works now and due to fragmentation, putting the issuers and investors together has actually become incredibly difficult,” says the author of “Follow-On Offerings: The New Face of Natural Liquidity.”

For example, one of the problems Mizen explores is the decline in block trading and the commensurate rise in high-frequency trading (HFT). Block trades – defined in the United States as at least 10,000 shares of stock – now account for less than 4% of daily trading volume, compared with 23% in 2004.

Asset managers and hedge funds still have sizable orders they would like to trade in blocks, but they can’t find the liquidity to do so and therefore are more likely to transact, say, 1,000 shares at a time. That causes problems.

“When you slice these orders up and trade them it’s like stepping outside – every time you step outside you may be seen by someone,” Mizen tells CFO. High-frequency traders look for active buyers or sellers so they can profit off their trading. “HFTs are watching and are trying to trade on the back of you and make money out of you.”

Stock prices tend to move more dramatically during a secondary offering when high-frequency traders get involved. HFT firms provide trading volume and take profits out of the markets, but they don’t provide liquidity for the shares, according to Mizen,” he says. “The ease of entry and exit is a major factor in the portfolio manager’s investment decision.”om

For the most part, companies are blind to the demand from investors to trade in blocks. Issuers “may be unaware of pent-up liquidity if it is outside the circle of their investment bank’s clientele,” says Mizen. Consequently, issuers may not be optimizing their use of secondary offering tools such as shelf registrations.

The problem is that such capital raising – as currently constructed – is a one-way street. “Institutional investors … do not typically contact the company to signal interest or tap an existing shelf, because they want to trade immediately and do not want to be privy to material, nonpublic information, which triggers trading restrictions,” Mizen wrote in the report.

In the absence of an electronic reverse-inquiry mechanism or a request-for-quote that is commonplace in the bond markets, it is hard for institutions to source liquidity from primary issuers.

That leaves a lot of the connecting of buyers and sellers in secondary offerings to the investment banks. Median bank fees for underwriting follow-ons have remained steady since 2003, while equities trading commissions have plummeted, Mizen points out.

But a company’s bank may not have relationships with the right buyers nor the capital-raising products that suit the issuer. “I’m not saying replace [these methods], but I am saying, ‘Is the issuer getting the best bang for its buck?’ ” she says.

There is “creeping progress” in follow-on offerings, Mizen admits. The first is Instinet’s Meet the Street product, which “streamlines the nondeal roadshow process by giving issuers the ability and control to plan road shows and visit investors who have the issuer on a watch list.” The second tool, Liquidnet’s Infrared, helps corporate officers “gauge aggregated buy and sell demand for their stock based on liquidity information from participating institutions in the Liquidnet trading network.” (Liquidnet says it connects top asset managers to large-scale trading opportunities, with an average trade size in the United States of 44,000 shares.)

Mizen envisions a “more straightforward, efficient, and low-cost capital-raising process that incorporates a two-way flow of liquidity information within the confines of Securities and Exchange Commission rules.” That may seem idealistic, but it also seems like a natural development.

While investment banks may initially be resistant to changes in follow-on offering processes, Mizen says, when it is easier and quicker for companies to raise capital, banks benefit.

What can CFOs do to move the evolution along? “Ask questions [of their banks], probe for change, question costs, and explore different avenues,” says Mizen. “When the ultimate consumer becomes more savvy, that often starts to break down the walls.”

However, issuers themselves may be reluctant – at least early on ­– to deviate from the tried and true. “Sticking with the familiar bank or process is the least risky path. After all, CFOs are not paid to take risks with the corporate coffers,” says Mizen.