Capital Formation: Same as it ever was?

Yesterday was a good day for our markets for several reasons, none more so than the large amount of attention that capital formation garnered throughout the trading day. As CNBC’s Bob Pisani put it, “Wall Street is excited that a major part of the capital markets business is finally starting to function after a bitter four-month hiatus.” Amen, Bob, and yes, we are excited.

It is great to watch capital formation play out before our eyes and based on reports, we are only at the beginning of an IPO wave. Assuming markets remain stable, an estimated 200+ companies will seek to go public in 2019 with the hopes of raising more than $100 billion in capital. If the experts are correct and their predictions come to fruition, 2019 will be a record year for capital raising, passing Y2K.

Even if the prognostics are wrong, Levi’s return to the public markets serves as an example of how differently our markets perform this function compared to 20, or 220, years ago. In other words, while our markets have been facilitating capital formation for over two centuries, it is constantly evolving how it does. This is after all, not our Father’s Buttonwood Tree.

Players are Bigger

In April 2018 SEC Chairman Jay Clayton laid out three primary objectives for equity market structure, one of which was creating a better ecosystem for thinly traded securities. As the industry engages in debate and decision making on what that ecosystem will look like, it is imperative that all parties understand today’s markets and the changes, both major and nuanced to its structure, that have occurred more recently. So what are some examples? First, participants who play major roles in capital formation are much bigger today. Consolidation among the asset management and broker dealer industries have led to fewer, but much larger players in the marketplace. Moving the needle of profitability at these companies requires sizable deals and transactions. Additionally, while the number of listing exchange families has remained roughly the same over the past 20 years, today’s Nasdaq and NYSE are multiple times larger than they were at the turn of the century due to globalization, new product lines and other reasons. As these participants have grown, the size of an IPO has also had to grow in order to attract their interest.

For the small to mid-size players who provide innovation and wealth creation, Congress and the SEC have drafted bills, and held hearings and roundtables, all with the goal of improving the ability of our one-size-fits-all marketplace to facilitate capital formation for smaller issuers. Most of us would agree that our markets need to improve in this area, and that will require decisions based on empirical data and consensus building.

“The raising of equity capital by corporations is the cornerstone of our economy. However, given the recent regulatory events surrounding research and investment banking and market structure changes affecting trading, the raising of capital has become exceeding more difficult. That, in turn, is impacting the U.S. economy and its ability to create jobs. Action must be taken soon to remedy what could soon be a capital formation crisis.”

Letter to Senate Banking, March 2012

Shift of Influence

The amount of influence that exchanges, asset managers and banks have with companies has shifted over the past two decades. For banks, research coverage was a means to build relationships with companies void of an investment banking service. As we read on a regular basis, the research model is experiencing a major disruption that is resulting in fewer companies receiving coverage. Less coverage translates to less relationships between banks and issuers. For asset managers, the rise of dual share class structures has diminished their ability to influence the decision making of corporate boards. On the other side, exchanges have increased their levels of influence due to the range of services they provide to issuers like: investor relations, shareholder ID and industry research. None of this is necessarily bad or good, it’s just different than it used to be. Therefore, decisions on designing a market structure for thinly traded securities needs to take into account that exchanges have more influence with issuers today compared to banks and asset managers 20 years ago. With this shift of influence, new conflicts arise.

Loss of Liquidity Providers

STA continues to be of the opinion that the loss of liquidity providers and its potential impact on investors is of major concern. We believe those less active securities (the overwhelming number of publicly traded securities) and their shareholders do in fact benefit by the presence of market makers and enhanced liquidity providers. We believe both market makers and other liquidity providers dampen market volatility to the benefit of the marketplace and investor confidence. While we are not advocating a return to the past, we believe in the benefits of enhanced liquidity, and regulators need to find a modern way to incentivize its existence

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