Columbia Law School
Sky Blog
In the policy-oriented paper, “Re-energizing the IPO Market,”which will be published in the 2013 Brookings Press book Restructuring to Speed Economic Recovery, I summarize results from a number of my related co-authored papers and address why IPO volume, and especially small company IPO volume, has been so depressed for more than a decade.
From 1980-2000, an annual average of 310 operating companies went public in the U.S. During 2001-2011, on average only 99 operating companies went public. This decline occurred in spite of the doubling of real gross domestic product (GDP) during this 32-year period. The decline has been even more severe for small company initial public offerings (IPOs), for which the average volume has dropped from 166 IPOs per year during 1980-2000 to only 29 per year during 2001-2011, a drop of 83%. Partly in response to this prolonged lack of small company IPO activity, in April of 2012 the JOBS Act was signed into law.
The low IPO volume this decade is usually attributed to a combination of heavy-handed regulation, especially the Sarbanes-Oxley Act of 2002, a decline in analyst coverage of small firms, and lower stock prices since the 2000 technology bubble burst. In “Where Have All the IPOs Gone?”, Xiaohui Gao, Zhongyan Zhu, and I present an alternative explanation, the economies of scope hypothesis, that has very different policy implications. Our hypothesis is that getting big fast is more important than it used to be, due to many of the same forces that have driven the increase in the right-skewness of the income distribution. Thus, for many young firms, especially in the technology industry, the value-maximizing growth strategy is to sell out to a larger company that can quickly integrate a new technology into its related products and realize economies of scope and scale. We argue that the lack of IPOs is because of this big firm vs small firm choice rather than a private markets vs public markets choice. We present related evidence that is consistent with our hypothesis, such as an increase in merger activity among small firms that started long before the technology bubble burst in 2000.
Estimates from other studies suggest that analyst coverage boosts a company’s stock price by 5%. In “Where Have All the IPOs Gone?”, we compute that the higher valuations from more analyst coverage would result in approximately 10 more IPOs per year. I point out that reducing the high direct and indirect cost of going public in the U.S., due to high investment banking fees and the underpricing of IPOs, would have just as large a quantitative effect on IPO activity as a lack of analyst coverage creates. Almost all moderate-size IPOs pay investment banking fees of 7% of proceeds. In the last decade, the average U.S. IPO has had a first-day return of 11%, measured from the offer price to the first-day closing price. For a moderate size IPO with an offer price of $10 per share, the firm thus nets $9.30 for a share that on average trades at $11.10 in the market. This $1.80 gap is 16% of the expected market price of $11.10. Since a typical IPO sells 30% of the shares to be outstanding, at least 0.16×30% = 4.8% of the post-issue market value of the firm is lost in the process of going public.
The paper also addresses the number of jobs “created” by IPOs. In the run-up to the passage of the JOBS Act, two numbers that were cited in congressional testimony and repeated in a number of Wall Street Journal articles were that the drop in IPO activity since 1997 has resulted in as many as 22 million “lost” jobs, and that 92% of job creation by companies that have gone public occurs after the IPO. The paper tracks down where these numbers come from, and finds that the 92% number is from a consulting report that compiled employment numbers for 25 successful venture capital-backed IPOs such as eBay and Google. Another report then applied these highly conditional numbers to all IPOs, and assumed that the peak year of IPO activity, 1996, was the normal level of activity.
In a report that Martin Kenney, Donald Patton, and I did for the Kauffman Foundation, we tracked down the post-IPO employment growth of all of the companies that went public from 1996-2000, and found that the average company created far fewer jobs. Although we caution that it is a mechanical calculation, we report that if IPO activity in 2001-2011 had maintained the pace of 1980-2000 activity, 1.87 million jobs would have been “created.”
Lastly, my paper offers a few suggestions for reforms that would boost IPO activity, but I caution that if the economies of scope hypothesis is correct, small company IPO activity has permanently disappeared.
The full text of the current draft of the article can be found here.
It seems to me that no study of the demise of the small company IPO market can be complete without considering the cause and effect on intermediaries. At one time there was a proliferation of small broker dealers, law firms and accounting firms who would help small companies go public and the resulting competition kept costs low. Any consideration of the rising costs of going public must take into account legal and accounting costs in addition to underwriting discounts and commissions (and in that regard such costs must also include continuing compliance costs associated with periodic reporting). Apart from the effects of SOX and other regulatory initiatives, it would appear reasonable to take into account that negotiated commission rates helped consolidate the brokerage industry, increasing malpractice insurance rates eliminated small law firms’ willingness to handle securities matters and the effects of litigation and increasing regulatory burdens (most recently the creation of the PCAOB) helped eliminate the role of small accounting firms in the process and the effect of these developments on the costs of going public. It could be argued that all that consolidation and increase in regulatory burdens effectively raised costs to the point that a few years ago there were more IPOs done abroad than in the United States including several of the largest IPOs (despite the vaunted depth and breadth of US capital markets). In my view, it is open to question whether reliance on bulge bracket underwriters, AM LAW 100 law firms and the now few remaining big four accounting firms has necessarily improved the product given that the preponderance of the major securities fraud cases of the last 10-15 years involved the participation of one or more members of an increasingly small club. This leads one to question the cost benefit associated with these developments and it would appear that the JOBS Act is a reaction to this increasingly limited access to public capital. Ironically, I would argue that it should be the goal to increase the number of publicly reporting companies thereby fostering transparency in the capital markets rather than incentivising funding through various private capital raising mechanisms facilitated by the liberalization of Rule 144, the creation of the institutional Rule 144A market and Regulations D and S all of which which lead to even greater institutionalization of the capital markets, risk reducing the breadth and depth of our capital markets by driving out individual investors and introducing ever greater volatility. While I would never advocate reverting to the statutory 4(2) exemptive regime with all its arcane dogma, it would appear that some measure of balance should be acheived to make it less costly for small companies to go public and to provide some added protection to the participants in the process.