The SEC’s focus on capital formation gives a perennial rush to commercial interests, mainly lawyers and investment banks who make lots of revenue from the IPO-underwriting business.
The notion is that our economic engine is turbocharged by companies’ ability to access public capital markets in their own quest for growth and prosperity, and that translates into jobs and, ultimately, overall economic prosperity. The only thing holding us back is too much regulation, these people say.
In some sense, it is true that our public markets are the gateway to capital formation. Yet, in many ways this has changed over the years, and IPOs have often become mainly an exit strategy for private equity investors. Capital formation in these circumstances occurs much earlier in the investment food chain, where skilled private equity and venture capital players fund the initial and later stages of a company’s march toward public-market access.
Even so, when there are fewer IPOs, it is argued, it’s a detriment to capital formation and closes out public investors, including moms and pops, from many of the best, long-term growth opportunities. Again, the culprit cited is broad and confusing regulation, so much so that it is just easier to remain private and find capital elsewhere.
We see it another way. First, after a down year in 2016, IPOs have recovered through the first half of this year, raising $26.5 billion in 111 offerings. That raises a second important point: there are many more things that affect the volume of IPOs than regulation. Political elections, market conditions, market structure, investor demand, weak or unproven businesses, and intense competition from among global exchanges are all major factors.
These factors both limit and disperse the crop of viable IPOs more than was the case as recently as the early and mid-1990s. Simply dialing back on important investor-protection rules and reporting obligations will not lead to a resurgence of the U.S. IPO market to the halcyon days of the late 1990s.
At the same time, the rush to satisfy issuers and allow public investors access to the “next big thing” for their investment portfolio is worrisome. According to Statistic Brain Research Institute, more than half of all startups fail within the first five years. It is the odd public offering that goes “Facebook,” and typical post-IPO returns are quite meager for investors.
It has been five years since the JOBS Act went into law, and U.S. market participants have experienced a two-tiered regulatory structure ever since, regardless whether they’ve known it. There is one for larger companies with all the disclosure and governance protections investors expect, and another for small companies who 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.
In the meantime, exchanges and the regulators who oversee them must be honest with the investing public. High-profile IPOs are primarily an opportunity for the venture crowd to cash out and the commercial service providers to cash in. What are typically left for the investing public are secondary interests that the original owners have unloaded, leaving little more than the hope there is some future growth remaining.
This isn’t capital formation but rather replacing one capital provider with another, less-informed and more vulnerable public investor. Is that the outcome we really want in the name of economic growth?
Kurt Schacht is managing director, standards and advocacy, for the CFA Institute.