Is Crowdfunding to Blame for the Decline of IPOs?
A frequent lament these days is the decline in the number of IPOs and public companies generally, with much of the discussion — particularly at the agency and Congressional levels — focused on the adverse impact of increased regulatory burden. (See this PubCo post.) In December 2015, Congress directed the SEC’s Division of Economic and Risk Analysis to assess the impact of Dodd-Frank and other financial regulations on access to capital for consumers, investors and businesses and market liquidity, including U.S. Treasury and corporate debt markets. The staff of DERA has now issued its report to Congress on Access to Capital and Market Liquidity. The report begins with a gigantic caveat: it’s really challenging to determine the effects of changes in regulations. At the end of the day, DERA did not pinpoint any “causal relationship” between Dodd-Frank and developments in the capital markets, emphasizing instead that the volume of IPOs has historically ebbed and flowed, with many contributing factors influencing IPO dynamics.
Why such a challenge? According to DERA, establishing causality with respect to Dodd-Frank or the JOBS Act was difficult “because so many other factors could affect the primary capital markets — factors for which we cannot control.” For example, post-reform macroeconomic conditions, such as the economic recovery and low interest rates, were different from those leading up to and right after the financial crisis. The report also recognized the possibility that “many of the observed changes in market participant behaviors would have occurred absent the reforms.” Utimately, with regard to Dodd-Frank and the JOBS Act, DERA found it
“difficult to pinpoint any causal relationship between the passage of either regulation as a whole or the implementation of different provisions, and developments in the capital markets. More generally, it is important to note that issuers will choose the type of offering that is optimal from their point of view in terms of costs and benefits. Those costs and benefits may depend on the current regulatory environment but will also depend on various other factors such as the general state of the economy, interest rate cycles, etc. For example, prior economic studies document the presence of hot and cold markets for registered equity offerings. These hot and cold markets are driven by macroeconomic factors, changes in the level of information asymmetry between investors and issuers, and changes in investor sentiment. It is also possible that registered and exempt capital markets will respond differently to these factors, and may function as either substitutes or complements. For example, it is possible that when registered markets are cold companies switch to exempt capital markets, and vice versa. Alternatively, a hot registered market could prompt companies to seek additional financing from exempt markets in preparation of future public offerings.”
With regard to the impact of Dodd-Frank, DERA could not determine whether Dodd-Frank “notably affected” IPO activity. DERA observed that several of the executive compensation disclosure provisions of Dodd-Frank were not even implemented in the sample period, and several of its other provisions did not apply to EGCs following the enactment of the JOBS Act. And, while the JOBS Act “may have had a positive effect on IPO activity,… the observed effects are also generally consistent with higher issuance in strong macroeconomic conditions.” Similarly, the decline in IPOs during 2015 and 2016 was “consistent with changes in investor demand, market saturation and the increased availability of private funding and other alternatives for exit.” Ultimately, with regard to IPOs, DERA recognized that capital raised through IPOs “ebbs and flows over time, reaching highs in 1999, 2007 and 2014, and lows in 2003, 2008, and 2016. It is difficult to disentangle the many contributing factors that influence IPO dynamics.”
DERA also reported that “[r]ecent years have seen an increase in the number of small company IPOs. IPOs with proceeds up to $30 million accounted for approximately 17% of the total number of IPOs in the period 2007–2011 and 22% in the period 2012–2016, following the passage of the JOBS Act in 2012.”
Curiously, others have reported a recent deep decline in the number of smaller IPOs. In remarks delivered in May, SEC Commissioner Michael Piwowar observed that the “substantial drop in the number of IPOs in the United States is primarily driven by the disappearance of small IPOs. In the 1980s and 1990s, IPOs with proceeds of less than $30 million constituted approximately 60 percent and 30 percent, respectively, of all IPOs. In fact, some of the most iconic and innovative U.S. companies… entered the public market as small IPOs. This trend reversed in the 2000s. IPOs with proceeds less than $30 million accounted for only 10 percent of all IPOs in the period 2000–2015. By comparison, large IPOs have increased from 13 percent in the 1990s to approximately 45 percent of all IPOs since then.”
Some of DERA’s other findings are set forth below:
- The report did “not find that total primary market security issuance is lower after the enactment of the Dodd-Frank Act.” Total capital formation (primary issuances of debt, equity and asset-backed securities) from the signing into law of Dodd-Frank in 2010 through the end of 2016 was approximately $20.20 trillion, of which $8.8 trillion was raised through registered offerings, and $11.38 trillion was raised through unregistered offerings.
- In U.S. Treasury markets, DERA saw “no empirical evidence consistent with the hypothesis that liquidity has deteriorated after regulatory reforms.”
- In corporate bond markets, DERA found that “trading activity and average transaction costs have generally improved or remained flat. More corporate bond issues traded after regulatory changes than in any prior sample period.”
- In 2016, more than 75% of IPO issuers were classified as EGCs.
- Total registered issuances in the U.S. increased steadily from 2011 through 2016, from $1.42 trillion in 2015 to $1.49 trillion in 2016. In addition, the period 2013 to 2016 “witnessed the largest registered issuance in the U.S. for the last 11 years.
- Unregistered issuances of debt and equity increased from $1.16 trillion in 2009 to $1.87 trillion in 2015, falling to $1.68 trillion in 2016.
- Amounts raised through exempt securities offerings of debt and equity for 2012 through 2016 combined exceeded amounts raised through registered offerings of debt and equity over the same time period by approximately 26%. In comparison, the same figure for 2009 through 2011 was 21.6%.
- Amounts raised in reliance on the new general solicitation provisions (under Title II of the JOBS Act, implemented in September 2013) represented only 3% of total amounts raised pursuant to Rule 506.
- There was a large increase in Reg A offering activity over the first 18 months after the JOBS Act amendments to Reg A became effective, “with 97 qualified offerings seeking to raise $1.8 billion (compared with about 14 qualified offerings seeking to raise approximately $163.3 million in a typical year during 2005–2016). Issuer reports of amounts raised during 2005 to 2016 indicated that 56 issuers reported raising proceeds in Reg A offerings aggregating $314.6 million.
- Initial evidence on JOBS Act crowdfunding activity suggests that some very early-stage companies are beginning to use crowdfunding to conduct offerings. Between May 16, 2016, and December 31, 2016, there were 163 unique offerings by 156 issuers, 28 of which reported meeting their targets. The median offering during that period targeted approximately $53,000, with an average of $110,000. Of the offerings that reported having raised at least the target amount, the median amount reported raised was notably larger, at approximately $171,000, with an average of $290,000.
In a recent article published in the Hastings Law Journal (embedded below), Duke University School of Law Associate Professor Elisabeth de Fontenay discusses the relationship between the recent decline of IPOs and the deregulation of private capital. Professor Fontenay also spoke at the SEC’s recent Investor Advisory Committee on June 22 which discussed capital formation for smaller companies and the decline of IPOs.
Decline of IPOs?
Starting in the late 90’s, the number of IPOs per year has steadily dropped. During that same period, Congress and the SEC enacted several new regulations that were designed to open up private capital markets. Many of these new laws became and set the stage for what we now know as crowdfunding.
In her paper, Fontenay argues that the decline of IPOs can be attributed to the rise of private capital markets. That is, more companies are choosing to stay private rather than go public because recent crowdfunding laws, in part, have made it easier and cheaper. So is crowdfunding to blame for the decline of IPOs? No, that would be a mischaracterization and an oversimplification of an extremely complex system.
First, the paper mischaracterizes the decline in IPOs as do many publications that talk about how few IPOs there are compared to twenty years ago.
Yes, there was a sharp drop-off in the early late 90’s in the number of new IPOs each year, but that was a direct result of the dot-com bubble bursting. If you look at numbers pre-dot-com bubble, you’ll see that the number of IPOs today are not that much lower. If anything the dot-com bubble created an inflated number of IPOs and since that time numbers have readjusted themselves accordingly. There is a decline, but it is not as dramatic as some would have you believe.
Yes, there are fewer IPOs today than compared to 20 years ago and more and more companies are choosing to remain private for longer, but to infer a causal relationship between the two would be incorrect. Correlation does not equal causation. In fact, it could very well be that the deregulation of private capital markets was a symptom of the declining IPO market. That is, market forces could have made it less desirable to go public, thus pressuring companies to remain private longer. These private companies could have lobbied for less regulation to make it easier for them to raise capital without going public. In order to know with certainty what caused the decline of IPOs, one must look at real world situations and not academic theory.
Fewer IPOs but More Mature Capital
The overall landscape of public offerings is shifting. According to a report created by Cowen, there are fewer individual investors who purchase stocks for themselves as more and more brokerage firms migrate towards business models with asset allocation and management fees. Additionally, institutional investors, which are becoming larger and larger, are seeing increasing pressure to outperform their benchmarks. Investors, both retail and institutional, are less incentivized in purchasing stocks of small cap companies.
Investment banks are also seeing more profitability from alternatives to IPOs. Mergers and Acquisitions is becoming more profitable for investment banks as well as lending/debt financing given the current environment of low interest rates. It doesn’t make sense for investment banks to underwrite an IPO from a small cap company if they can make more money from an M&A deal or debt financing.
This all contributes to less demand for small cap public offerings as they provide less compelling returns for investors and other stakeholders compared to large cap stocks.
Issuers are also facing more reasons to stay private for longer as well. The increasing regulatory costs of going public imposed by Dodd-Frank for example, lack of liquidity in small cap markets, and a growing trend of the desire to maintain control all place pressure on private companies to remain private.
These are only a few of the reasons why the landscape of public offerings is shifting and why fewer private companies are going public.
However, according to a report published by Ernst & Young, even though there are fewer IPOs today, the amount of capital being raised by IPOs is actually steadily increasing. That means larger more mature firms are opting to go public which in turn creates more stability.
With fewer small cap companies going public too early, there are less boom-bust cycles. Not only that, but more and more foreign companies are being publicly listed in the US while the number of US companies being listed in other countries has remained few and far between.
This all paints a picture of a relatively healthy public capital market. Yes, the number of IPOs are down but that is only one metric and doesn’t tell the whole story.
Private vs Public is Wrong
Finally, is there anything inherently wrong with
IPO numbers declining?
Instead of focusing on private vs public, policy makers should be asking how to make capital markets as a whole better.
You have to look at capital markets as a whole to determine whether or not changes need to be made. Yes, there are fewer IPOs and more companies are choosing to stay private for longer, but dividing it into private vs public misses the point:
Easing access to capital for emerging companies is good. So is providing more opportunities to investors.
Making it easier for private companies to raise capital may actually have a beneficial effect on public markets as can be seen by the current make-up of IPOs: more mature companies are conducting IPOs and are raising much larger amounts of capital.
Furthermore, some reports estimate that 2017 is shaping up to be a very good year for IPOs. If IPO numbers do in fact rebound this year, it would give credence to the fact that healthy private markets are good for healthy public markets.
Regulating private capital more is not a solution to the problem of declining IPOs because declining IPO numbers is not necessarily a problem.
The confirmation hearing last week for Jay Clayton, who has been nominated to head the Securities and Exchange Commission, focused on the continued sluggishness of the market for initial public offerings. Senators pushed the nominee to do something, anything, to revive it.
The problem is that there is no magic wand — including deregulation — that can fix the decline.
The problems were recently documented in a research note by Credit Suisse titled “The Incredible Shrinking Universe of Stocks.” The bank documented that the total number of companies listed on the United States stock market plummeted by nearly half, to 3,671 last year from 7,322 in 1996.
Companies get bought or go out of business, but new companies are not replacing them. In 1996 there were 706 initial public offerings, but in 2016 there were only 105. The downturn affects all sectors, and last year there were only 30 new private equity offerings, the “lowest level since 2009,” according to Credit Suisse.
Such shrinkage has prompted hand-wringing for over a decade. At Mr. Clayton’s hearing, at least five senators brought it up, pointing to the regulatory burdens on companies going public.
There’s only one problem with casting regulation as the villain: There’s not much evidence for it.
In 2012, Congress took a stab at fixing the regulatory issues in the Jump-Start Our Business Start-Ups Act. The changes have been well-received by entrepreneurs. Some provisions, like the one allowing for confidential review with the Securities and Exchange Commission, have been particularly popular.
But the JOBS Act has not spurred initial public offerings in any meaningful way. One study found that it may — may — have resulted in 21 more new offerings a year, but given the small numbers in the analysis, that is questionable.
Moreover, the JOBS Act has done nothing to revive the market for small companies, those with a market capitalization of under $75 million. They still number less than a handful each year.
And while fingers get pointed at regulation like Sarbanes-Oxley and Dodd-Frank, the number of initial public offerings fell off the cliff in 1996 — years before either bill was passed. So there must be something more here.
Those who have examined this issue have come up with a number of possible reasons.
The first theory is that the decline is a result of structural changes in the market ecosystem. Jay Ritter, a professor at the University of Florida, has argued that the dearth of initial public offerings has been caused by companies selling out quicker.
The Credit Suisse paper also brings up this theory, noting that mergers are the major cause for companies to be delisted from a stock exchange. It appears that this deal activity has spread to the private markets, co-opting the process of taking companies public.
For example, Cisco Systems purchased AppDynamics on the eve of its market debut. And acquirers seem willing to pay top dollar in these instances, as research and development by many large corporations now consists largely of acquiring smaller, usually private, companies.
This is aptly illustrated by the buying sprees of Google and Facebook, which took candidates to go public — like Instagram, Nest, Waze and WhatsApp — out of contention.
Another possibility involves demand. In a paper that I wrote with Robert Bartlett and Paul Rose, we explore this theory. The drop-off in activity is largely attributed to the disappearance of the small offering.
In 1996, average proceeds for an initial public offering were $85.7 million, and 54 percent of these offerings were considered small, with a market capitalization below $75 million in inflation-adjusted dollars. In 2014, however, average proceeds were $186.4 million and only 4 percent of offerings were small.
The market for new issues has moved toward liquidity and bigger stocks. Mutual funds prefer making big investments rather than small ones for liquidity and administrative purposes — lots of small investments simply require more people and more monitoring.
A third possibility is that companies simply no longer need the public market. The private markets are more efficient, and financing is readily available from venture capitalists and banks.
There are even markets and mechanisms that exist not only to allow for financing, but to allow for selling employees’ and founders’ shares in private markets. In addition, the JOBS Act allowed companies to expand the number of shareholders and still be private, a change that encouraged companies to remain private.
There are other theories. One of these notes that the 1990s saw a surge in I.P.O. activity and that we are just back to what the activity was in the 1970s and ’80s. Who is to say what is a normal market?
Another possible reason is that companies are shying away from the public markets to avoid shareholder activism, short-termism and the glare of public scrutiny.
Yet the growing use of dual class shares and staggered boards by new companies, measures that help founders retain control, argues against this need. And they are tools that can be used by any company — even Shake Shack went public with dual-class stock.
The bottom line is that while there might be rational reasons to reduce regulation on capital raising — to make it easier and less expensive — we are kidding ourselves if we think that simply deregulating will bring back initial public offerings.
The task is much harder. The Securities and Exchange Commission, for one, could help build an infrastructure for buying small company offerings. Allowing mutual funds more latitude to buy illiquid small investments and to change their compensation structures if they do would be a big step.
In addition, we could explore more novel ways of bringing companies to the public markets. Special purpose acquisitions companies — those created to buy a private company and bring it public — have attracted criticism, including from me. Yet a recent $900 million deal in the energy business shows one possible way to take more companies public, provided there are investor protections.
Then there is the argument that maybe we shouldn’t do anything, given how hard it will be. The idea behind the public markets is to provide capital funding. But if the private markets are now efficient and capable of providing even less expensive capital at lower cost, maybe we should be fine with the current state of affairs.
Still, that overlooks the fact that for most of us, our retirement money is in the public markets. We should be worried about all of this money flowing into a smaller and smaller group of companies.
One answer is to allow mutual funds to invest more in private companies. Already 26 mutual fund groups had $11.5 billion invested in late-stage companies in 2016, according to Credit Suisse.
That’s one answer, but that will result in yet more intermediaries. The better solution is to push more companies to the public markets. Deregulating is one thing, but the real work will require more innovative thinking from market regulators.
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