A dramatic reversal occurred in the capital markets, beginning around 2000, and its causes and implications appear to have been widely misunderstood. From 1980 to 2000, an average of 310 operating companies did initial public offerings (IPOs) each year, but from 2001 to 2011, this number fell by over two-thirds to only 99 operating companies per year.¹  This decline cannot be explained by macro-economic conditions as Gross Domestic Product more than doubled over this period.

Moreover, this decline has been even more precipitous in the case of smaller IPOs (hereinafter defined to mean IPOs of companies with pre-issuance annual sales of less than $50 million²). This category of smaller IPOs crashed from an annual average of 166 IPOs per year during 1980 to 2000 to only 29 per year in 2000 to 2011—a drop of 83 percent.³  Indeed, the end may not yet be in sight, as in each of 2008 and 2009, there were only four such smaller IPOs, with the number rising modestly to 21 and 22 in 2010 and 2011.⁴

What caused this sudden decline? Congress thought it knew the answer last year when it passed the JOBS Act.  Persuaded by hasty research manufactured by task forces and bar groups that wanted to justify significant deregulation, Congress concluded that the costs of regulation, allegedly greatly enhanced by the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, deterred issuers (and smaller companies in particular) from becoming publicly held companies.

There were always serious problems with this explanation that regulatory costs chilled IPOs and decimated the smaller IPO. The usual culprit in the standard story was §404 of the Sarbanes-Oxley Act, which was initially interpreted to require an annual audit of accounting controls. But in 2007, the SEC relaxed this requirement with the adoption of Auditing Standard No. 5, and in 2010 the Dodd-Frank Act exempted issuers with a market capitalization of $75 million or less from §404.⁵  If the regulatory chill story works to explain the decline in the IPOs, these exemptions should have encouraged more smaller IPOs.

What actually happened? The number of smaller IPOs fell from 55 in 2007 to four in 2008,⁶ and following Dodd-Frank’s 2010 repeal of §404 for smaller issuers, the number of smaller IPOs rose only insignificantly from 21 in 2010 to 22 in 2011.⁷  Nor has the passage of the JOBS Act last year in 2012 produced any noticeable increase in smaller IPOs since then. In short, the claim that deregulation will produce an increase in IPOs (and consequent job creation) conspicuously lacks any confirming historical evidence.

Recently, new and better research has appeared, concluding that the proponents of deregulation have vastly overstated the impact of regulatory costs on IPOs.⁸  In December 2012, Professor Jay R. Ritter, probably the leading financial economist in the IPO field, and his colleagues released a new paper arguing that the number of IPOs has declined, not because of regulatory costs, but because for the privately-held firm “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.”⁹  Mergers and acquisitions, not regulation, are the forces eclipsing the smaller IPO.

This claim that economies of scale and scope explain the decline in IPOs (and particularly smaller IPOs) makes some obvious intuitive sense—at least in the high-tech context. A biotech start-up may not be viable as an independent company because it cannot afford the costs of drug testing and research, but it can still be very valuable as an acquisition to a large pharmaceutical company. But is this pattern generally true? Here, the surprising data presented by Ritter and his colleagues involves another dramatic change: There has been a marked increase in the percentage of recent smaller IPOs in which the issuer have been unprofitable (in terms of earnings per share) for the three years after the IPO. Back in the period between 1980 and 1999, the majority of companies involved in smaller IPOs earned at least a modest profit in the years following their IPOs.¹⁰  But since 1991, the majority of the companies doing smaller IPOs have proven unprofitable.¹¹  In short, small firm profitability has declined, and eventually this reduces the number of smaller IPOs. Ritter and his colleagues conclude that this phenomenon is rooted in the pace of technological change; the faster it moves, the more large firms are favored.

Not only have smaller firms that have gone public been generally unprofitable after their IPO (in the sense of negative earnings per share), but their IPOs, themselves, have significantly underperformed the market. Ritter and his colleagues find that smaller IPOs in the 2001-2009 period have “underperformed by an average of 30.2%” on an adjusted basis.¹²  Over time, investors learn from their disappointment, and the demand for smaller IPOs necessarily shrinks.  The Ritter research is also highly skeptical of the job-creating capacity of IPOs. Although Congress was told last year that the drop in IPO activity resulted in as many as 22 million “lost” jobs, Ritter concludes that if IPO activity had continued at the same pace as in 1980-2000 until today, only 1.87 million jobs would have been created—a 90 percent reduction.¹³

Provocative as the Ritter “economies of scope and scale” thesis may be, its pessimistic claims about the future unprofitability of smaller firms are still far from proven. In addition, it is at least arguable that the unprofitability of smaller firms could be driven, in part, by regulatory costs. More importantly, still other explanations exist (which economists tend to undervalue) for why IPOs have declined in number. Thus, rather than debate the standard “regulatory cost” thesis versus Ritter’s “economies of scope” hypothesis, this column will suggest that there are at least five alternative explanations that could each explain some of the decline in the number of IPOs and the pending extinction of smaller IPOs:

1. The Loss of Investor Confidence. American investors have lost confidence in the market (and financial regulators as well) as the result of a variety of shocks: e.g., the IPO Bubble of 2000, Enron and WorldCom in 2002, market timing at mutual funds in 2003-2004, and the financial industry’s collapse in 2008. In 2012, U.S. IPOs raised about $41.2 billion, well below the $57 billion in pre-crash 2007.¹⁴  Although stock prices have risen all year, the percentage of U.S. households owning stock mutual funds has fallen, declining every year since 2008.¹⁵  The result is self-reinforcing, because as money flows out of mutual funds, the demand for IPOs is reduced, and underwriters postpone offerings.  Public opinion polls and other surveys leave little doubt on this question. The Chicago Booth/Kellogg Financial Trust Index for 2012 finds that 79 percent of investors have “no trust in the financial system,” and the Center for Audit Quality’s Sixth Annual Main Street Investor Survey reports that the majority of investors “have no confidence” in either the management or the board of directors at public companies.¹⁶

The loss of investor confidence has not been slow and gradual, but has come in sudden, punctuated bursts. For example, there were 381 IPOs in 2000, but only 79 in 2001 after the IPO Bubble burst. Similarly, there were 160 IPOs in 2007, but only 21 in 2008 after the Lehman bankruptcy.¹⁷  Although investor confidence can be restored to a degree, the 81 IPOs conducted in 2011 represents only 12 percent of the 675 IPOs conducted in 1996. Overall, the loss in investor confidence has been cumulative, because since 2000, the number of IPOs has never recovered to more than 25 percent of that 1996 level.

Of course, financial economists could respond by claiming that this vague factor of “investor confidence” simply reflects the general unprofitability of IPOs, which investors have slowly come to recognize. But this is too simple. The 2000-2001 IPO Bubble was not the product of a sudden discovery that IPOs were generally unprofitable, but rather of the much more focused recognition that the market had overvalued the capacity of the Internet. Older readers will recall Pets.com and the extraordinary valuations that underwriters were able to justify for some Internet IPOs. Similarly, in 2012, investors came to realize that “social media” stocks had been overhyped.

Moreover, the fact that IPOs are generally unprofitable (if true) should still not logically lead investors to spurn IPOs.  Rational investors could happily accept investing in five IPOs, four of which flopped, to obtain cheap stock early in an Apple or Microsoft. Investor confidence then may be in part a function of whether investors perceive that they were treated fairly. Last year’s most discussed and disputed offering—Facebook—is an example of a flawed offering process, in which retail investors (and others) believe that material information and forecasts were selectively disclosed by underwriters to favored clients. This sense that the game is rigged can produce a negative reaction independent of the overall success or failure of IPOs, as it leads at least a portion of the market to withdraw.

2. The Economies of Scope and Scale Hypothesis. Ritter and his colleagues argue that the post-issuance profitability of IPO issuers has declined not only in the United States, but on a worldwide basis. The universality of this phenomenon undercuts the alternative hypothesis that high regulatory costs in the United States have deterred IPOs. For the years 2001-2011, they find that 73 percent of the post-IPO fiscal years of the issuers who conducted smaller IPOs in this period were unprofitable; in contrast, for larger companies, only 24 percent of their post-IPO years were unprofitable over the same period.¹⁸  Although negative earnings per share were most pronounced in the high-tech and biotech sectors, they find a trend in the direction of negative earnings for all smaller issuers.

Apparently then, larger firms do better after an IPO, either because they can realize economies of scale or scope or because the regulatory costs associated with becoming a public company are less significant to them. Still, the implications of this finding do not point unambiguously towards only one future course of action. Smaller firms could decide to sell themselves to, or merge with, larger firms (as Ritter suggests they are increasingly doing). Alternatively, smaller firms could decide to delay their IPO until they were larger in the belief that the equity market would be more receptive to offerings by larger firms. This possibility of deferred IPOs leads to the next hypothesis for why the number of IPOs has declined.

3. The Substitution of Private Placements for IPOs. Issuers conduct IPOs for multiple reasons: (1) to raise capital; (2) to create a public market and give their founders liquidity; and (3) to generate the highest valuation for their firm through the efforts of underwriters. If the principal goal is to raise capital, there are obvious alternatives to an IPO, including, of course, a private placement. If the goal is liquidity and the creation of a trading market, no true substitute exists for the IPO, but, even if this is the end goal, it may still be advisable to defer the IPO until the market would be more receptive to it—and rely on private placements for capital in the interim.

Whether, as a practical matter, a smaller issuer can use private placements to finance itself until it grew to a size more attractive to the equity market depends in turn on how easily private placement may be used as a substitute for public offerings. Historically, the private placement was an imperfect substitute for a public offering because the securities purchased in it were illiquid and legally restricted from resale. From 1972 (the year in which Rule 144 was adopted) up until 1997 (when the Rule was amended, as next described), securities purchased in a private placement could not be sold until a two year holding period had run,¹⁹ and, even after this 2-year period, all purchasers were subject to a ceiling on the amount they could resell in any three-month period equal to 1 percent of the class.²⁰  These rules restricted liquidity and implied that stock sold in a private placement was subject to a substantial liquidity discount. But beginning in 1997, the SEC began to liberalize the rules applicable to the resale of privately placed securities. First, the two year holding period was reduced to one year in 1997, and later in 2007 this period was further reduced to six months (for “reporting” companies).²¹ Similarly, the volume restrictions on non-affiliates were repealed as part of the 2007 reforms.²²  Further, the adoption of Rule 144A in 1990 meant that large institutional investors (known as “Qualified Institutional Buyers”) could immediately resell privately placed securities of smaller non-reporting issuers to each other,
without any requisite holding period.²³  Cumulatively, these changes made private placements much more attractive, particularly to smaller issuers, because private placements always had lower transaction costs and now were also subject to less of a discount because of the increased liquidity associated with them.

The data on IPO volume supports this hypothesis that the number of IPOs should go down as the rules on private placements were relaxed to make the latter offering technique a more competitive alternative. The SEC halved the holding period under Rule 144 from two years to one year in early 1997, and the total number of IPOs declined sharply from 675 in 1996 to 473 in 1997 to 283 in 1998.²⁴  Some of this decline could be attributable to the greater ability of privately held firms to postpone their IPOs and rely on private placements in the interim.

More recently, the development of trading markets for privately placed stock by firms such as SecondMarket has further reduced the pressure on issuers to conduct an early IPO. Because shareholders needing to sell can now find an exit through these markets, management of the smaller issuer can wait longer for the most propitious time to conduct its IPO. Few issuers intend to remain private forever, but they today have greater control over, and flexibility as to, timing.  As delay of the IPO becomes more feasible, the total number each year has dropped.

4. The Overregulation Hypothesis. Underlying the JOBS Act was the explicit premise that the costs of becoming a public company had become prohibitive for smaller issuers. Thus, the JOBS Act (1) exempted “emerging growth companies” from many of these requirements, (2) raised the threshold at which companies must become “reporting companies” to 2,000 shareholders of record, and (3) preempted a variety of SEC and FINRA rules applicable to securities analysts so as to give them greater ability to publish research reports about IPO firms at all stages of the IPO offering process.

From the perspective of Ritter and his colleagues, all these reforms will accomplish little, because small firms will still find it more profitable to merge with larger firms than to do an IPO. Indeed, they are particularly skeptical of the claim that preempting the rules applicable to analysts will produce more IPOs. Based on other research that finds that analyst coverage boosts an IPO issuer’s stock by around 5 percent, they estimate that higher stock valuations from more analyst coverage “would result in approximately 10 more IPOs a year.”²⁵  Not a big deal!

In their view, the IPO process is too costly (particularly for smaller issuers) because of the relatively fixed underwriting fee of 7 percent plus the universal practice of underpricing IPOs. In contrast, median underwriting fees appear to be around 3.3 percent on the London Stock Exchange, 3.6 percent on Euronext, and only 2.5 percent on the Hong Kong Stock Exchange.²⁶

Accurate as this critique is, the fact remains that IPOs have high fixed costs that make smaller IPOs in particular an inefficient way to raise capital. Lobbyists could thus argue that, by mandating more disclosure and auditing, SOX and related SEC rules aggravated this high fixed cost problem. Thus, the more relevant issue becomes whether the costs of disclosure and auditing that are associated with becoming a public company add much to the total costs of an IPO. As just noted, underwriting fees are probably the largest cost, and the costs associated with SOX’s §404 simply do not apply to smaller issuers with a market capitalization below $75 million.²⁷  Of the remaining costs, the largest are probably (1) the cost of D&O insurance for public companies, and (2) the increased costs that auditors will charge to audit a publicly held firm. There are costs associated with the greater risk of litigation in the United States and have little to do with SEC rules or requirements.

But are the costs of an IPO particularly high in the United States as compared to other countries? Few global comparative studies of the IPO underwriting process have been done, but one such study finds that the average aggregate IPO floatation costs, as a percentage of the offering proceeds, varied among markets as follows: Euronext (7.6 percent); NYSE (7.7 percent); Deutsche Borse (8.3 percent); Nasdaq (9.5 percent); LSE (12.6 percent); Hong Kong Stock Exchange (14.6 percent).²⁸  On this basis, the United States does not look particularly high. However, for smaller IPOs, the average aggregate flotation costs were 10.1 percent on both the NYSE and Nasdaq—but still below London!²⁹

Moreover, if one subdivides these costs into underwriting and non-underwriting costs, the United States is particularly cheap in terms of the non-underwriting costs (i.e., chiefly the costs of professionals, such as lawyers and auditors). In this same study, those costs were estimated at 1.2 percent on the NYSE, 2.6 percent on Nasdaq, 4.9 percent on the LSE, and 10 percent on the Hong Kong Stock Exchange.³⁰  In short, the JOBS Act is largely a solution to a non-problem if we are concerned about the non-underwriting costs of an IPO.

5. Investor Demand and the Ecosystem for IPOs. Institutional investors are the largest purchasers of IPOs, and they tend to strongly disfavor smaller IPOs because they want high liquidity. The level of liquidity desired by them is hard to pinpoint, but some investment bankers have told me that any issuer with a public float of below $500 million will be avoided. Hence, underwriters probably know that they cannot market smaller IPOs to institutions.

Although the desire for liquidity is not a new phenomenon, the composition of traders in the market has changed significantly over recent decades. Back when smaller IPOs were viable, retail investors constituted a larger portion of this market. Classically, they are “buy and hold” investors who do not trade frequently or in large volume and so do not need much liquidity. In contrast, hedge funds are active traders and might be reluctant to invest in a stock where a dozen or so similar institutions will dominate trading (with all likely wanting high liquidity at the same time). Given this transition, the barrier to smaller IPOs has probably grown in recent years.

Further, even if analyst research can build the demand for an IPO below this $500 million level, someone has to pay for that research. In an environment where spreads and brokerage commissions are now razor thin, underwriters will likely be reluctant to bear such a cost.

Conclusion
For all that the JOBS Act does to roll back the federal securities laws, it will probably do little to encourage the smaller IPO. Large IPOs should remain viable, and iconic names, (such as Twitter) should have easy access to the equity market (when they decide to do an IPO).

From a policy perspective, the most important debate over the securities laws is between those who would give a priority to restoring investor confidence and those who wish to push deregulation even further. The latter have weak arguments, but strong lobbyists.

If one truly wanted to encourage smaller IPOs, the reforms that might do the most good would seek to (1) restrict selective disclosure at roadshows (by amending Regulation FD’s overbroad current exemptions³¹⁾, and (2) encourage Dutch Auctions to reduce the total underwriting costs to the issuer (which costs include the first day runup in price).

Needless to say, no bar association committee or stock exchange task force will ever make such a recommendation; rather, they will likely continue to recommend more deregulation. Why do they refuse to understand that such policy prescriptions are useless to counter-productive? Upton Sinclair answered this question long before the word “capture” was coined when he wrote: “It is difficult to get a man to understand something when his salary depends upon his not understanding it.”³²

John C. Coffee Jr. is the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.  This article was originally published in the New York Law Journal on January 17, 2013.

Endnotes:
1. See Xiaohui Gao, Jay R. Ritter, Zhongyan Zhu, “Where Have All the IPOs Gone?” (Dec. 17, 2012) at p. 1, available at http://ssrn.com/abstract=1954788. Their calculations include only IPOs of operating companies and exclude closed-end mutual funds, REITS, and special purpose acquisition companies.

2. This is the measure used by Gao, Ritter and Zhu, supra note 1. They use $50 million in annual sales, “expressed in 2009 purchasing power.” Id. at 6.

3. Id. at 6.

4. Id. at Table 1, p. 38.

5. See Securities Exchange Act Release No. 34-56152 (July 27, 2005) (adopting Auditing Standard No. 5); Dodd-Frank Act §989G (exempting issuers with a market capitalization of $75 million or less from §404).

6. Gao, Ritter, and Zhu, supra note 1, at Table 1, p. 38.

7. Id.

8. Ritter’s recent work appears in several articles. See Gao, Ritter, and Zhu, supra note 1; Jay Ritter, “Reenergizing the IPO Market,” Jan. 3, 2013, available at http://clsbluesky.law.columbia.edu; and Jay Ritter, “Reenergizing the IPO Market” (to appear in Restructuring to Speed Economic Recovery (Brookings Press) (2013)).

9. See Ritter, supra note 8, at 1.

10. See Gao, Ritter, and Zhu, supra note 1, at 7-11.

11. Id. at 8.

12. Id. at 27.

13. See Ritter, supra note 8, at p. 2.

14. See Whitney Kisling “Bull Market Soars Past Many U.S. Investors,” The Washington Post, Dec. 29, 2012

15. Id.

16. These surveys also show equal skepticism of government regulators. Sixty one percent of the investors responding to the Center for Audit Quality’s Sixth Annual Main Street Investor reported that they “have no confidence in governmental regulators.”

17 See Gao, Ritter, and Zhu, supra note 1, at Table 1, p. 38.

18. Id. at 11.

19. See Rule 144(d) 17 C.F.R. §230.144(d). The original holding period from 1972 to 1997 was two years. See Securities Act Release No. 5223 (Jan. 11, 1972). In 1997, this was shortened to one year. See Securities Act Release
No. 33-7390 (Feb. 20, 1997).

20. The volume limitation, which is still contained in Rule 144(e), formerly applied to all shareholders, but today applies only to affiliates. Technically, the ceiling is the larger of 1 percent or the average weekly trading volume (as defined).

21. For the 2007 reduction of the holding period to six months or one year, see Securities Act Release No. 8869 (Dec. 7, 2007).

22. Id.

23. See Securities Act Release No. 6862 (April 23, 1990).

24. See Gao, Ritter, and Zhu, supra note 1, at Table 1, p. 38.

25. See Ritter, supra note 8, at p. 2.

26. See Christoph Kaserer and Dirk Schiereck, “Going Public and Being Public—A Global Comparison of the Impact of the Listing Decision on the Cost of Capital” (2007) at p. 8.

27. See note 5 supra (noting §989G of the Dodd-Frank Act).

28. Kaserer and Schiereck, supra note 26, at pp. 7-8.

29. Id. at pp. 22-23. In this study, smaller IPOs were defined as offerings under $100 million.

30. Id. at p. 8.

31. Regulation FD applies neither to non-reporting companies nor to “oral communications made in connection with the registered securities offering after the filing of the registration statement.” See 17 C.F.R. §242.100(a)(2)(iii)(F). Thus, it does not apply to oral statements at a roadshow or to most IPOs by non-reporting issuers.

32. Upton Sinclair, “I, Candidate for Governor, and How I Got Licked,” at 109 (1935).