Small-Cap IPO Specialists: The New Dodo Bird? OpEd
Today, the U.S. Securities and Exchange Commission will host a public meeting in Washington that should capture the attention of every entrepreneur, investor and job seeker facing the dismal consequences of the crippled U.S. IPO market of the past decade.
The meeting is about the destiny of the decimalization era.
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Spawned during the late 1990s market boom by two important events—the conversion to electronic markets and to penny-increment "tick sizes" (the primary increment by which stocks are bought or sold today)—decimalization replaced the fraction-based quote-driven system that sustained an efficient, functional IPO market for decades.
The old system not only brought thousands of small companies public, but created adequate incentives to sustain market interest and liquidity long after the first day of trading.
At the time, decimalization was sold as a way to save investors money while making stock markets more competitive with their international counterparts. Indeed, it spawned massive, speed-oriented trading systems around the world. But tragically, it's also the system that left America's most important job creators – entrepreneurs – out in the cold.
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Imagine a 10-year span where promising small-cap companies like Apple, Microsoft or Intel couldn't find an investment bank to take them public. Imagine that their only liquidity option would be selling out to a big corporation before their prime. Imagine the staggering potential job loss -- as Berkeley economist Enrico Moretti points out in his 2012 book "The New Geography of Jobs," every new tech job creates five more jobs in the service sector. Finally, imagine the history of American business if these bellwether names hadn't been able to fund, innovate, hire or grow independently in the public markets.
Now stop imagining. This is literally the decade we just lived through.
After years of discussion, it's finally time we rebuild the broken small-cap market and the IPO system with a ridiculously simple solution – putting investors, job seekers and entrepreneurs ahead of traders.
Real change could start today.
The meeting at the SEC is an outgrowth of the 2012 JOBS (Jumpstart Our Business Startups) Act enacted last April. The law created an "IPO on-ramp" by requiring the SEC to "…conduct a study examining the transition to trading and quoting in one penny increments, also known as decimalization…." The analysis is expected to examine the decline in the number of IPOs, aftermarket liquidity, and the ability of Wall Street to support small (below $2 billion in market value) and mid-cap (between $2 and $10 billion in market value) stocks. There's been ample criticism of the act since the signing, most notably for the SEC's tardiness in implementing new rules covering Regulation D and private markets, legalizing crowdfunding and to fix the poorly crafted and seldom-used Regulation A guidelines covering public offerings of $5 million or less.
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Those talks can and will continue. But penny-increment trading for small-cap companies needs to end right now.
At a time of protracted record-low interest rates and unprecedented modern government intervention to restart our economy, our greatest potential job creators – companies under $2 billion in market value – need a new stock market that welcomes back individual investors, institutional investors, corporate issuers and the value-added intermediaries needed to create liquidity through research, sales and capital committed to trading.
As the following chart shows, the small IPO market began a steep decline after 1996 that led to a near-collapse by 2001:
Decimalization is the chief culprit that's killed the aftermarket profit motive for investment banks that once specialized in small-cap companies during the go-go 80s and 90s. Abruptly and without understanding the long-term impact, effective tick sizes were cut as much as 96 percent – from a high of 25 cents in the early 1990s to 1 cent a share by 2001.
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But decimalization wasn't the only factor. In 1997 and 1998, respectively, the Order Handling Rules (OHR) and Regulation ATS (Alternative Trading Systems)—which revolutionized trading rules and technology on Wall Street—cut the economic incentives to investment banks that brought all small-cap companies to market. Small-cap companies represent less than 7 percent of total company market value but represents more than 80 percent of today's NYSE- and NASDAQ-listed companies.
Between 1991 and 1997—when the effective tick sizes were between 12.5 and 25 cents a share—there were 2,990 small-company IPOs representing nearly 80 percent of all U.S. IPOs (see chart, below). Fast-forward to the 2001-2007 timeframe after decimalization, couple it with the aforementioned regulatory changes, and you'll discover that small-company IPO volume tumbled by 92 percent. And that collapse came before the devastating credit crisis.
Where's the liquidity?
As a result of these regulatory changes, the trading operations of large investment banks have increased their domination while small-cap specialists have all but vanished. Tiny ticks created a super-efficient trading market for the largest, most naturally visible and liquid companies in the world. Yet all of this has been at the expense of a market environment that once created essential visibility and liquidity for smaller companies—far smaller than the Facebooks or Groupons of the world—to sustain aftermarket interest.
Recent research shows that high frequency traders (HFTs) that have grown up with decimalization have actually pulled liquidity out of the market. In particular, a 2012 paper by Matthew Barr of Princeton, Jonathan Brogaard of the University of Washington and Andre Kirilenko of the Commodity Futures Trading Commission notes that HFTs dominate the market with 47 percent of total trading volume and that some are almost complete "liquidity takers."
So small-IPO specialists have largely gone the way of the dodo bird, ceding their territory to large investment banks helping major corporations add small, innovative companies to their portfolio. Without access to capital, young companies can't grow, can't innovate and, most importantly, can't create new jobs as independent employers. Private funding and takeover-based deals can't remotely provide the job engine the U.S. economy needs right now.
The next step
Hopefully, the Feb. 5 discussion will cover the possibility of an SEC concept release that would address the following:
- •The need to increase the number of small IPOs,
- •The need to increase liquidity for small-cap (and smaller) stocks, and
- •The need to increase aftermarket interest in small public companies.
The 2012 update on the SEC Concept Release on Equity Markets failed to turn up significant thought and input on small-cap, micro-cap and nano-cap markets. It's time to shine a bright spotlight on this need now.
Industry leaders have begun to comment on the problem. Last June, Invesco's Kevin Cronin, testifying on behalf of the Investment Company Institute (the trade association for the mutual fund industry), told Congress it was time to look at ways to increase market liquidity and "…We recommend that a pilot program be established to examine wider spreads in certain stocks." Andy Brooks, head of equity trading at T. Rowe Price told Congress in September that it's time for a pilot program where there are higher minimum spreads for small companies.
These are investors speaking – not traders. Higher tick sizes will help investor confidence by improving stock price stability, increase liquidity to support investment activity by mutual funds (where 90 million consumers have money) and pension funds. Most important, they'll increase economic activity that will raise long-term returns for all investors.
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Public and industry representatives in attendance at the SEC's Feb. 5 roundtable need to advance serious discussion on an omnibus incentive structure (tick sizes, spreads and commissions) that will rebuild a compensation model for underwriters to stick with small-company stocks once they take them public. This will hold the IPO window open longer and allowing more growth companies to transition to public ownership successfully. Specifically, we'd like to see regulators and legislators:
•Give issuers the right to choose their own tick sizes between one and 25 cents. Market forces (investor input and underwriter input) exerted on issuers would lead them to pick an optimal tick size thus creating instant mass customization of productive stock markets. More capital would be raised by new businesses, which in turn would create jobs faster than established employers and drive economic growth and investment returns accordingly.
•Create a new stock market specifically for companies with market valuations under $2 billion (subject to a CPI escalator) and chartered to drive capital formation and economic growth.
The JOBS Act gave us an IPO on-ramp. Let's make sure it goes somewhere.
David Weild is a former vice chairman of NASDAQ and head of equity capital markets and investment banking at Prudential Securities. Weild currently overseas capital markets research and advisory work at Grant Thornton LLP and is the firm's acknowledged expert on how market structure impacts capital formation. He is founder of Weild & Co., the advisory firm that helps issuers succeed in capital markets.