Publicly traded corporations are arguably one of the key ingredients of modern capitalist societies and have been instrumental in facilitating economic growth. Yet, the number of listings has been decreasing in developed markets in recent years, driven by lower levels of IPO activity. Isaksson and Çelik (2013) show a global downward trend in IPOs from 1993 to 2012, concurrent with a shift in proceeds raised from OECD member countries to non-members. In the US, for example, Doidge et al. (2015) report that the number of listed companies peaked in 1996 at 8,025, and dropped nearly 50% to 4,102 in 2012. The authors provide evidence that composition- and flow-related explanations cannot fully account for the US ‘listings gap’.
Given the critical importance of the public listing process for companies and their founders, for investors, and for the growth of the economy at large, this listings gap is a concern. It is also somewhat surprising, given the historical resilience of the IPO market and its ability to adjust to changes in market participants’ interests and in market conditions.
Practitioners and academics have proposed a number of possible causes for this apparent decline – unintended consequences of regulations, lower capital needs, expansion of alternative funding sources, and changing market structure. We believe there is room for a more coordinated approach to tackling this apparent decline across the listings ecosystem. In this column, by NBIM analysts, we address these issues based on Norges Bank Investment Management (2016).
Listings activity as a function of stakeholder incentives
The level of listings activity is crucially dependent on the outcome of the adversarial game played between founders/early investors on the one hand, and public shareholders on the other, with underwriters, exchanges and index providers playing important supportive roles. The objective of the game is the distribution of the present value of future cash flows from the company. Pricing this too low will make founders hesitant to sell. Pricing it too high may make public equity investors hesitant to commit capital. Getting the balance right is a function of the market environment, and of the set of alternatives available to each player in the game – for founders, the option to stay private, and for public equity investors, the option to build up private equity investment expertise. We need to consider the incentive structure and the available alternatives for each of the key stakeholders in the listings ecosystem – founders/early investors, public equity investors, listing venues, underwriters and index providers – and how these might have changed in recent years.
The entrepreneurial founder’s objective function and incentive structure revolves around two variables: the need for capital to grow the company, and the desire for control and flexibility. Generally, there is tension between these two factors. The capital needs of many founders are considerably lower in generally services-oriented developed economies than they would have been in economies dominated by manufacturing. There is also a greater range of alternative capital sources available – from private equity to ‘crowd-sourcing’ to debt finance. This means that founders can bootstrap a greater proportion of their company’s growth potential while still private. IPOs become vehicles for cashing-out, rather than for capital-raising, and the equity risk premium may decline.
Households save and invest to facilitate inter-temporal consumption smoothing. This means they have two objectives. First, they want maintain purchasing power, and second they seek to participate in the earnings growth potential of the companies they invest in, enabling them to lower their savings rate. From the perspective of that second objective, the delay in listings is a concern – a greater proportion of the earnings growth potential will accrue to the founders. We believe that the growth in passively managed equity funds in recent years reflects this shift.
At the same time, the pooling of savings through institutional managers has broadened the set of feasible investment strategies such as the inclusion of pre-IPO equity in several US mutual funds in the last couple of years. We believe that this increased flexibility can lead to new strategies in the IPO game with founders, which may lead to a change in the distribution of gains from economic growth.
From a game theoretic perspective, underwriters are involved in a number of games. First, a game with their competitors and the founders to win the mandate to take the company public. This is followed by two simultaneous games with the founders on the one hand and with potential shareholders on the other hand to determine the IPO price. Crucially, while underwriters play a one-shot game with the founders, they play a repeated game with their competitors and with potential shareholders. This characteristic of the game has led to considerable complexity. In the one-shot game with founders, underwriters often do not compete purely on price (underwriting fees), but also on their distribution network, league table results, research coverage and other qualitative factors.
Underwriting has remained a relatively high-cost, manual process. Historically, much of this cost has been borne by the selling founders, both through underwriting fees and a tendency to under-price IPOs. The latter may be necessary to manage the conflict between founders and public shareholders. The former, however, is as much a function of historical custom as of necessity. For example, the process of collecting indications of interest (IOIs) from potential shareholders is still essentially a manual process, conducted over the phone.
We believe that there is scope to reduce these high costs – through automation (for example, of the IOI process) and through streamlining the due-diligence process. There is also room for advisory boutiques to step in and fill the apparent gap in the small-to-midcap market segment.
Listing agents and exchanges
The main exchanges may have become less welcoming to smaller firms given regulatory and other market structure changes. We encourage exchanges to develop new solutions here – be they in the form of new listing classes, or alternative trading platforms to enable smaller firms to go public at an earlier stage in their life cycle. We welcome the introduction of junior, secondary exchanges that aim to reduce barriers of entry for smaller firms. In particular, some eligibility criteria could be relaxed such as trading liquidity and reporting frequency, at least at the early stages of a newly listed company’s life cycle. Policymakers may also consider tax incentives for smaller firms to go public, again for a limited time horizon and size criteria.
Index providers are playing an increasingly important role in the asset management industry. Companies are now more incentivised to become index members in the major indices, as growth in passive funds have resulted in capital inflows. Index providers apply different eligibility rules including domicile, free float market capitalisation and tradability (liquidity) considerations. Smaller newly listed firms may not pass such inclusion tests. Index providers could revisit their rules. For example, a provider could consider ladder-based free float market capitalisation bands, where companies can enter with lower initial weights at the beginning of their life cycle, and their weights gradually increase if they grow in size or they provide more free float to the market.
The decline in the number of company listings is of concern not only for us as an investor, but also for companies and their founders, exchanges, regulators, and for the growth of the economy at large. Just as there is no single driver explaining the listings gap, there is no single solution for closing it. However, we believe that a number of steps can be taken by the various stakeholders, enabling more listings to come to market. There are encouraging signs in that direction. We welcome more proactive dialogue and research by practitioners, academics and policymakers in addressing this important topic.
Doidge, C, G A Karolyi, and R Stulz (2015), “The U.S. Listing Gap”, NBER Working Paper No. 21181, forthcoming in Journal of Financial Economics.
Isaksson, M, and S Çelik (2013), “Equity Markets, Corporate Governance and Value Creation”, OECD Journal: Financial Market Trends 2013/1
Norges Bank Investment Management (2016), “The Listings Ecosystem: Aligning Incentives”, Asset Manager Perspective, 2016-1