Event Report: Why Are Fewer Companies Going Public?
The fact that fewer companies are going public was undisputed at a recent ECGI Roundtable hosted by the Stockholm School of Economics Riga on 10th June, while noting that this is not a cyclical phenomenon. The question of why, however took a little longer to explore, whilst also taking into account the many implications that this and several other market developments could have.
Describing the market: mature, complex, fewer, stronger, more unchecked?
Reviewing the composition of the market, it was observed that listed firms tend, on average, to be much larger than they used to, given that the total market capitalization of US listed firms has increased sevenfold since 1975. Although in GDP per capita terms, the market value of these companies is the same as it was in 1999. Furthermore, small firms (as measured by a market capitalization smaller than $ 100 million) have virtually disappeared. The US listing gap since 1991 is currently estimated at about 5,000 and in this story, mergers between listed firms are more frequent than going private transactions. As a result, the mean US listed firm has become twice as old and 200 firms are delivering the large majority of earnings of all listed companies.
The roundtable highlighted the additional complexity of the present day market, particularly in relation to transparency, disclosure, share structures, control and independence. This included some of the complications that investors may encounter when attempting to determine the equity stake and/or voting power of controlling shareholders at dual class companies. It was further demonstrated that in Asia, determining actual ownership and control figures from the annual report can be quite a chore due to a dense network of cross-ownership blocks – let alone identifying personal relationships between directors. The session noted that there still exists a wide varience in compliance with disclosure obligations amongst companies and jurisdictions. It also observed that institutional investors act, by and large, in accordance with their express policies, which often principally reject dual class stocks and press for unification.
The roundtable also examined the rise in passive investing, noting that currently, passive funds hold 30% of US equities. Evidence was presented to show that the default policy of passive investors is to vote in accordance with management recommendations and it was argued that lower allocated resources, and a potential free-rider consequence leads to an even lower propensity to monitor. Furthermore, it was suggested that an exit strategy is not used in a strategic manner, and any evidence of engagement, behind the scenes or direct communication by index funds is absent. Freeze-out transactions, which remain a relatively rare phenomenon in the overall M&A context, were also discussed by the participants with specific focus on whether institutional investors step in to protect their interests and, in the process, those of retail investors.
Discussing the causes: mergers, delistings, advances in private equity, technology, regulation...
The dramatic increase in the importance of intangible assets was offered as one of the underlying factors in the reduction of listed companies, noting that companies with large intangible assets often choose to raise capital privately, in order to reduce the risk of losing one’s advantage to competitors. This is compounded by the notion that private equity has become more institutionalized and, consequently, the traditional liquidity advantage of the stock market has decreased, whilst institutional investors’ internal regulations often prohibit investments in small listed firms with a lower liquidity.
The argument that regulation is at fault for the drop in listings for small businesses, was somewhat dismissed by the participants, pointing out that the decrease began before many of the more recent regulatory burdens were introduced, however, the absence of any stimulus to address these trends remains a policy issue. Simultaneously, the point was made that there is prima facie evidence that the increase in concentration is a result of failing anti-trust enforcement.
Another interesting argument that was highlighted during the roundtable was how the impact of new technology has made scaling a business less capital-intensive, and therefore perhaps less reliant on traditional markets. Conversely however, the increased investment in technology by many industry leaders may have also created significant barriers to entry for small businesses that may find it more difficult, if not impossible to compete.
The potential implications: productivity, growth, innovation, return of capital, shadow market, freeze-out, profitability, influence...
Several possible implications emerged from the roundtable discussion, noting that age and concentration could adversely affect productivity growth and innovation, with the stock market essentially becoming a place to return (rather than to raise) capital. It was offered that if public markets continue to shrink in size, many investors will simply not be able to participate, resulting in a freeze-out on an unprecedented scale. Although private equity could intermediate, this would create a shadow market economy, which may find it difficult to obtain societal support on a long-term basis. A further suggestion was that market prices could become more opaque if smaller firms are hampered by barriers to entry. Evidence was also presented to show that the market concentration has significant economic consequences in terms of profitability, while noting that there is no evidence of increased efficiency that can justify the associated increase in profitability.
It was recognised that the opacity of beneficial ownership structures can have many negative consequences for minority shareholders, including reduced accountability, heightened risks for the financial sector in respect of related party transactions, corruption and money laundering. The opposing arguments for increased disclosure requirements were offered to be the decreasing marginal value of information as institutional investors are inundated with information, and the superfluous nature of some disclosures as a consequence. These were noted as trade-offs by the participants.
Looking to the future
The roundtable raised a number of forward looking possibilities for the continued evolution of the market. It was suggested that as private equity markets develop and corporate governance expectations increase, the perceived magnitude of the step of becoming listed could somewhat diminish. One personal perspective on listing a company suggested that in some cases founders may be comfortable with ceding control and making the firm less dependent on a single individual, while allowing it transition to the next stage of maturity.
In referring to a recent initiative in the UK, it was suggested that the technology will be further developed to undress oligarchic structure and trace wealth derived from questionable sources, opening up a theoretical avenue for using data on an unprecedented scale to trace beneficial ownership globally.
In relation to the impact of passive funds and their monitoring propensity, it was offered that firstly, index funds could be obliged by means of legislation to pursue higher governance standards. However, this approach assumes active behaviour, and is therefore broadly inconsistent with the concept of passive investing. Secondly, the option of total democracy was raised, allowing beneficial owners to vote directly. Given the large number of companies index funds typically hold shares in, registering these votes may give rise to all sorts of practical issues. Thirdly, investors could be requested to state their default preferences on a number of frequently arising topics, and fourthly, passive investors could be prohibited by law from voting, leaving the voting process to investors who actively decide to invest in a company and rendering passive investors truly passive. However, the legislative changes required could take some time to enact.
Under the last scenario, the influence of activists could increase, also noting that under an efficient market hypothesis, an increase in the value of control should attract more competition for control and, therefore, swing the needle back toward active investing. The differences between retail and institutional passive investors was also added as a point of consideration.
On share structures, the question was raised as to how a dual class structure should be defined, noting that sometimes, deviations in cash flow rights coincide with deviations in control rights, as is for instance the case regarding non-voting preference dividend shares prevalent in Brazil and Germany.
The roundtable also offered suggestions for new avenues of research while discussing all of the above themes in greater detail. To read the full report, prepared by Titiaan Keijzer (PhD Candidate, Erasmus School of Law), click on the link below.
Click here to access the full report.