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The monster that ate small-cap IPOs Print E-mail
Tuesday, 10 November 2009

By John Goff

The recent bankruptcy of CIT has plenty of folks worried about the fate of many of the company's smaller customers. There's good reason for concern. CIT is the nation's largest lender to small businesses, a recession-rocked group that has already been hammered by a pull back in commercial credit.

Not surprisingly, small businesses owners -- and their associations -- have been pleading for some time for financial help from Washington. Politicians on Capitol Hill are currently debating ways to pump up lending to small businesses. What gets lost in this discussion, however, is that another crucial source of capital to small companies has all but vanished.

A study released on Monday by accounting firm Grant Thornton shows that the rise of high-tech, high frequency stock market trading has effectively gutted the IPO market for smaller companies. "Our 'one-size-fits-all' market structure has added liquidity to large cap stocks, but has created a black hole for small cap listed companies," said David Weild, capital markets Advisor at Grant Thornton nd former vice chairman of NASDAQ. "Wall Street's very nature has been substantially transformed."

According to the study, SEC actions over recent decades have encouraged the development of markets that favor the most technologically sophisticated traders. The rise of high-frequency trading is the natural consequence of regulations designed to increase efficiency, but those same regulations have undermined market support for smaller companies.

Few lawmakers in Washington seem concerned that the small cap IPO is practically  an endangered species. One exception: said Senator Ted Kaufman, a Democrat from Delaware. "This important study demonstrates convincingly further cause for concern about rules that encourage high-frequency trading to thrive, but perhaps have undermined one of Wall Street's most important purposes: to provide the infrastructure for smaller, growing companies in the United States to gain access to the public markets to facilitate further growth and innovation."

Grant Thornton found that the decline in the number of new listings began well before the dotcom bubble burst a decade ago. It also pre-dates the enactment of the Sarbanes-Oxley Act, whose burdensome -- and costly -- financial reporting requirements are often blamed for the decline in the number of small businesses going public.

In fact, the decline in the overall number of U.S. listed companies commenced in the early Nineties with efforts to speed up trading. Since 1991, the number of IPOs has dropped by more than 22 percent - or 53 percent if you factor in inflation-adjusted GDP growth. Exchanges in Asia, meanwhile, are adding news listings faster than GDP growth rates.

Not surprisingly, underwriters have tended to focus on mega-deals and the mega-fees they throw off. Such offerings generally help catapult investment banks to the top of the underwriting lead tables -- and ensure bragging rights on Wall Street.

But small-cap deals still constitute the lion's share of initial public offerings. And the startling decrease in the overall number of IPOs points to a market that no longer welcomes those companies.

According to the study, the U.S. has averaged fewer than 166 IPOs per year since 2001, with only 54 in 2008. What's more, about 360 new listings per year - a number not approached since 2000 - would be required simply to replace the number of listed companies that are lost every year. About 520 new listings per year are needed to grow the U.S. listed markets roughly in line with GDP growth.

That's not likely to happen, given that Wall Street is now dominated by firms that use automated algorithms which are not tied to the fundamental valuations of underlying stocks. These market giants include proprietary traders, statistical arbitrage hedge funds, and automated market makers.

Investment banks, now firmly fixed on trading profits, have abandoned investments in quality sell-side analysis, underwriting and sales support -- the infrastructure some say is necessary to support and create value in small cap stocks.

"The inability for emerging growth companies to access U.S. public equity capital by completing IPOs below $50 million inhibits job creation and hurts American entrepreneurs more than any other group," said Pascal Levensohn, founder and managing partner of Levensohn Venture Partners. "

Levensohn believes that the U.S. must repair the "bridge into public markets." Otherwise, he claims, the next generation of innovative private enterprises will continue to move to cross-border exchanges.

Certainly, the recent growth in the London Stock Exchange's AIM, an alternative investment market geared for smaller businesses, does not bode well for the future of small cap IPOs in the U.S.

"Today, our stock markets are increasingly structured to favor computer-driven trading interests at the expense of long-term investors and the U.S. taxpayer," said Grant Thornton's Kim. "We need a regulatory framework that guides Wall Street to help small companies with their capital formation needs, not just build faster and more powerful trading algorithms."

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