Securities Regulations Kill IPOs. Or Do They?
Kurt Schacht, CFA Institute
The script spelling out the importance of IPOs has not changed much over the years. It goes like this: the ability of companies to tap the public capital markets in a quest for growth and prosperity is a driving force for the economy at large. Corporate growth fuels jobs, the GDP and ensures America’s leadership position in the world. If only pesky regulations didn’t stand in the way.
Historically public capital markets have been the gateway to capital formation in the U.S. In a couple important ways this has changed however. Specifically, there is a very large and growing pool of available capital in the private investment markets that is often the precursor to companies seeking public listings. As a result, IPOs don’t attract new capital per se, but are often relegated to providing an exit strategy for venture and private equity investors. Accordingly, today’s IPO investors are much more discriminating in terms of the size, maturity and economic prospects of firms wanting to come public. IPOs are not as easy, more costly and again the harsh glare of regulation is blamed.
We see this as short sighted. First, regulation is just one of many influences on the IPO market. Other factors include: political elections, market conditions, market structure, investor demand and weak or unproven businesses. Taken together, these factors can limit IPOs, and intense competition from global exchanges can disperse IPOs to markets around the globe where they can’t been seen by investors here in the U.S.
It has been five years since the JOBS Act went into law, and U.S. issuers have experienced a two-tiered regulatory regime ever since, whether they’ve known it or not. There is one regime for larger companies with all the disclosure and governance protections investors expect, and another for small companies which are often exempt from many of these protections. Putting this latter group into specially chartered “venture exchanges” would make investors more aware of the higher risks they face when investing. Such exchanges would serve as the venues for development and experimentation and we encourage that approach.
In the meantime, our key global exchanges and the regulators who oversee them must be honest with the investing public about IPOs. When it is time for venture investors to cash out, what is typically left for the investing public are secondary interests being unloaded by the original owners. In a way, this is appropriate as the early investors assume much more risk. When their efforts bear fruit, these investments have less growth potential, but much less risk as well, and it’s appropriate that a new tranche of investors come in to take on these lower risks in exchange for the rewards they may offer. Surely, investing in Facebook’s 2012 IPO had much less risk than investing when the company was founded in a dorm room in 2004.
Still, it’s indisputable that this “changing of the guard” is not capital formation, but rather the replacement of investors with one risk profile by another set of investors with a different risk profile. Too often these new, less-connected public investors face an outcome where their IPO investments perform poorly. This is hardly the moment to end or diminish regulation, particularly on the fading evidence these are still the engine of economic growth.