WHAT HAPPENED TO OUR PUBLIC EQUITY MARKETS?
by James Angel, Associate Professor of Finance at Georgetown University, and is on the Board of Directors of DirectEdge.
The number of domestic U.S. companies listed on our exchanges has been dropping steadily for over a decade. At the end of 1997, there were approximately 8,000 domestic companies listed on the NYSE, AMEX, and NASDAQ markets. By the end of the 2010, the number had dropped to nearly 4,000. This decline has not been widely noticed by most market commentators, as total stock exchange trading volume has continued to grow. However, much of this growth in trading has been from derivative products such as exchange traded funds (ETFs).
This decline indicates a serious weakness in our capital markets. Public equity markets provide a vital source of liquidity to investors. Entrepreneurs and venture capitalists need to have an exit strategy for their investments or they won’t invest in the first place. No investor wants a “Roach Motel” investment where they can get in, but they can’t get out. If the public market is not available, entrepreneurs will have fewer choices for exiting their investments, resulting in lower returns. Lower returns to entrepreneurship imply less entrepreneurship and thus less economic growth.
The number of IPOs of U.S. companies on our public exchanges has not been enough to offset the attrition from bankruptcies, mergers, and voluntary delistings. One could argue that small companies are high-risk investments and that investors are better off without such speculative opportunities because they might lose money. But this would deprive investors—and our economy—of important growth opportunities.
There are three major contributors to this decline:
--SARBANES OXLEY-- Sarbanes Oxley §404 requires public companies to provide a disclosure about the “effectiveness” of their financial controls. This seemingly innocuous provision became a de facto requirement to maintain far more expensive controls than most companies had previously thought appropriate. As important as these increased compliance costs are for accelerating the decline in the U.S. markets, it is important to note that the decline in the U.S. markets started years before the passage of Sarbanes Oxley in 2002.
--SHAREHOLDER LITIGATION-- CEOs often cite the U.S. litigation environment as an important impediment to going public: “If you go public, you get sued.” This increases direct costs for legal fees and insurance as well as the indirect costs of management time and effort diverted by litigation issues rather than running the business.
--CHANGES IN MARKET STRUCTURE-- The United States made significant changes in equity market structure over the last 15 years. In the 1990s, smaller companies were traded in the old NASDAQ dealer market, which had a very different market structure (and higher trading costs) than the old NYSE auction market. A series of SEC-mandated changes gradually eliminated the differences between the two markets, and now small stocks trade in an environment much the same as for larger stocks. Although these changes have vastly improved the market for large-cap stocks, they have resulted in a market that is unreceptive to smaller companies.
Smaller companies have a difficult time getting noticed by investors, and investors are hesitant to invest in obscure companies. The high costs of the old NASDAQ system paid for a lot of information dissemination about smaller companies by the financial services industry. The combination of declining profit margins in brokerage and the research settlement greatly reduced the incentives for the industry to conduct research that improved the information environment for smaller companies.
Other factors have contributed less to the decline:
--DOT-COM BUBBLE-- Clearly the delisting of the failed remnants of the dot-com bubble has contributed to the decline, but the number of U.S. exchange-listed companies already had started to decline before the bubble really got under way, and declined during the peak years of the bubble. The total number of delisted dot-com companies accounts for less than one-fifth of the total drop in the number of companies.
--MARKET CONDITIONS-- Market conditions might explain the dearth of U.S. IPOs over the last 15 years. Overall, the first decade of the 21st century was a poor decade for the U.S. equity market as a whole. However, there was a strong recovery during the middle years of the decade, and during those years the number of U.S. exchange-listed companies continued to drop.
--PRIVATE EQUITY-- The increase in private equity activity over the last decade is more likely a reaction to the decline in the attractiveness of the public markets rather than a cause. Private equity firms ultimately need an exit for their investments, and they cannot just keep flipping companies between different private equity firms. Private equity investors generally expect higher returns than our available in the public markets due to the illiquidity of private equity investments, and this translates into higher costs of capital for firms accessing private equity.
What should we do?
Going back to the bad old days of trading small stocks in an over-the-counter telephone market is not an option. First, we need to have a broad public discussion to understand the nature and consequences of this decline. Without a good understanding of the nature of the problem, the public policy responses will be flawed. Second, because it is not clear what the best solutions are, our public policy decisions should promote innovation and experimentation with respect to trading models. Our regulators should not force a “one size fits all” market structure on all companies.
What might work?
There have been many failed experiments around the world in which exchanges tried to launch incubator markets for small companies that used almost the same market structure as the main market. These repeated failures imply that a successful market for smaller companies must have a different market structure than the large-cap market. Possibilities include:
--DIFFERENT TICK SIZES-- It is not clear that the optimal tick size (minimum difference between prices) for smaller companies is the same as for large companies. A larger tick size provides incentives for market participants to display more liquidity.
--ISSUER-PAID INCENTIVES FOR LIQUIDITY PROVISION-- Many European markets allow issuers to enter explicit agreements to subsidize liquidity providers in their stocks. U.S. companies should have the same freedom to experiment.
--MARKETING PAID FOR WITH TRANSACTIONS CHARGES-- Issuers should be permitted to experiment with a marketing charge on each transaction in their stock that would be collected just like the SEC fee by the exchanges and used for marketing expenses.
Market structure issues bring up a large number of complex questions. There is not now, nor will there likely ever be, universal agreement on the best way to answer them. We should promote experimentation to find the best models.