Rick A. Fleming, Investor Advocate

NASAA 2017 Public Policy Conference
Washington, D.C.

May 9, 2017

Thank you, Claire [McHenry], for the kind introduction, and for the invitation to speak at the NASAA spring conference. I’ve been away from the NASAA family long enough that I now see new faces in the crowd, but it’s easy to make new friends among people who are so committed to investor protection.

I was keenly interested in the topic of your first panel today: The Impact on Investors from Shrinking Public Markets. I have been giving some thought to that issue and, at the risk of repeating some of the comments of your earlier panelists, I welcome the opportunity to share a few of my preliminary observations. But, of course, I need to remind you that the views I express are my own and do not necessarily represent the views of the Commission, the Commissioners, or my colleagues on the Commission staff.

Overall, the public markets have been very good for investors. You don’t have to search very far to find examples of companies that have given average Americans an opportunity to participate in significant wealth creation. For example, Amazon was founded in 1994[1] and went public in 1997 at a valuation of $0.4 billion.[2]  It is now worth almost $440 billion, so it has grown an astounding 110,000 percent since its initial public offering (“IPO”).[3]

Now, consider the impact if Amazon had chosen—like Facebook[4]—to remain private until it reached a market capitalization of $80 billion. It would still be a huge success story, but its post-IPO price would have multiplied only 5.5 times, not 1100. This means that wealthy investors in the private markets would have captured a large share of the capital gains that would have otherwise gone to average households in the public markets.

Investors, then, and not just entrepreneurs, have a significant interest in vibrant public markets that foster IPOs.[5] Investors stand to gain most when successful growth companies go public as soon as possible. So we on the investor side should not automatically take a defensive posture against reforms that will improve the IPO marketplace. Rather, we should join the conversation so that policymakers are considering reforms that are good for investors as well as issuers.

Unfortunately, we are often forced into a defensive posture because most of the conversation about fixing the IPO market tends to focus on the supply side of the equation—namely, how to reduce regulatory burdens on issuers so that more of them are interested in becoming public companies.[6]But we need to bring some balance to the conversation by helping people understand the demand side of the equation. We need to continually remind policymakers that the IPO market cannot be revived in a one-sided fashion, by doing things like cutting back on disclosures that investors value or significantly altering the balance of power between shareholders and management.

Furthermore, by focusing on the demand side of the equation, I think we will find some important causes of the dwindling IPO market. And we need to understand the true causes of the downturn if we want to successfully address it.

In my view, there are some important macro trends that, when taken together, could be a significant impediment to IPOs.

First, the number of individual investors who invest directly in stocks is relatively small and getting smaller. The percentage of families with direct investments in stocks peaked in 2001 at 21 percent, and it has steadily drifted downward since the dot-com bubble burst and now stands at 13 percent.[7] If you drill down further, you find that, of the wealthiest ten percent of U.S. households, half of them own stocks, and they own substantial amounts (an average of more than $700,000). But stock ownership drops precipitously in less wealthy families. For example, for the third quartile of households—those with net worth between the 50th and 75th percentile of all U.S. households—only 11.4 percent own stock directly, and the median amount they own is only $10,000.[8] Overall, the proportion of stocks owned by individuals has fallen by a significant degree. In 1976, individuals directly owned 50 percent of the equities in the U.S. stock markets, but this has fallen to 21.5 percent in 2016.[9]

Instead of owning stocks directly, the average person now invests through various types of funds. Consequently, the assets under management (“AUM”) of institutional investors has grown substantially in recent decades, increasing from $6 trillion in 1998 to $19 trillion today.[10] Nearly 45 percent of U.S. households now invest in registered funds, and for those households who own mutual funds, the median asset size is $125,000.[11] Because of this shift to institutional accounts instead of individual ownership of shares, institutions now hold the majority of U.S. stocks, up from less than 20 percent in 1976.[12]

Curiously, at the same time that the AUM of funds has exploded, the number of IPOs has fallen. The average volume of IPOs fell from 310 per year during the period of 1980-2000 to only 99 per year during 2001-2012.[13] In 2016, only 74 operating companies went public in the U.S.—the lowest total since 2009.[14]

As bad as these numbers seem, they are even worse for smaller companies. Companies with annual sales less than $50 million (in constant 2009 dollars) had an average of 165 IPOs per year between 1980 and 2000, but that has fallen more than 80 percent to only 28 IPOs per year between 2001 and 2012.[15] Small company IPOs went from 53 percent of all IPOs in the earlier period to only 28 percent in the latter period.[16] Those small companies are also staying private longer. Between 1976 and 1996, the median age of a company going public was 7.8 years, but it has since grown to 10.7 years—a 37 percent increase.[17]

To explore whether there is a link between the shift to institutional investing and the decrease in IPO activity, I have begun to ask asset managers about their investments in IPOs and, more generally, in smaller public companies. In those conversations, I have discovered that, in general, institutional investors who engage in active management seem to have little interest in shares of micro- or small-cap public companies. This is largely due to liquidity concerns,[18] which means that it is difficult to do trades of institutional size because there may not be enough buyers or sellers on the other side of the trade. In that environment, if a trade can be done at all, it may significantly impact the price of the security. In addition, there are certain regulatory barriers that prevent funds from holding large positions in small companies,[19] and it may not be economical to track and analyze numerous small companies in which the asset manager would hold small positions. The scaled-back disclosure requirements for smaller public companies can also make them less attractive to sophisticated institutions who carefully scrutinize the data.[20]

For institutional investors who are interested in smaller companies, private alternatives such as venture capital and private equity have become more accessible.[21] This could be considered good for investors who may otherwise miss out on the early growth potential of a successful start-up, but it also means that the illiquidity of smaller companies in the public markets is exacerbated as more investment dollars flow into the private markets.

These observations from informal conversations with asset managers are borne out by the data. A recent study revealed that mutual fund investments in small IPOs have experienced a significant decline since 1990, with an especially big drop-off in the late 1990s.[22] In 2010, only 0.7 percent of funds disclosed an investment in a small IPO issuer, as compared to 10.6 percent of funds in 1990.[23] Another recent report shows that institutional ownership of small-cap companies has fallen 8 percent between 2014 and 2016, and that institutions own a significantly larger share of mid and large cap companies.[24]

Unfortunately, illiquidity in the smaller end of the markets can feed on itself, as illiquidity deters investment by the largest potential investors.[25] And this, in turn, can damage the IPO markets. Companies may not want to go public into an illiquid market because it negatively impacts the value of their shares,[26] and it also sets them on a course in which their subsequent offerings into the public markets may be less attractive. Thus, companies may consider it advantageous to stay private until they are much larger and have a market capitalization that will support robust trading, which results in fewer small-company IPOs.

In my view, the impact of these macro trends deserves much greater study, and we should give more thought to potential reforms that could make institutional investors more interested in smaller public companies. By boosting the demand for smaller company shares, I believe policymakers could do far more to invigorate the IPO market than they are likely to accomplish by focusing on the supply side of the equation and whittling away at disclosure requirements or shareholder rights in an effort to attract more companies to the public markets.[27]

Thank you, again, for the invitation to speak. As a person who spent the majority of my career as a state regulator, I know the day-to-day challenges you face back home, and I want to thank you for your dedicated public service.

[1] Amazon.com, Inc. was founded in July 1994 and began selling books on its Web site in July 1995.  Amazon.com, Inc., Prospectus (Form 424B1), at 39 (May 14, 1997), https://www.sec.gov/Archives/edgar/data/1018724/0000891020-97-000868.txt.

[2] Nasdaq, “The Promise of Market Reform: Reigniting America’s Economic Engine,” at 4, available at http://business.nasdaq.com/revitalize .

[3] Id.

[4] Id.

[5] “I think companies should be going public earlier in their life cycle so the broader public can be shareholders. I think it’s not good for society for all of the gains in these, you know, game-changing companies to be held between a very, very small group of shareholders….[A]ll of the gains are captured among a very small cohort of people. It’s just not good public policy.” Jeff Bercovici, “Fred Wilson: Startups Are Staying Private Too Long and That’s Bad For Society,” Inc., https://www.inc.com/jeff-bercovici/fred-wilson-startups-staying-private-too-long.html (quoting Fred Wilson).

[6] For example, the Wall Street Journal editorial board has cited the regulatory burdens of going public as the chief reason why entrepreneurial firms have chosen to remain private.  See “Where Are the IPOs?,” The Wall Street Journal, Dec. 31, 2016, at A10.  See also R. Bartlett, et al., “What Happened in 1998? The Demise of the Small IPO and the Investing Preferences of Mutual Funds, at 2, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2718862 (“Ranging from the formation in 2011 of the SEC’s Advisory Committee on Small and Emerging Companies and the IPO Task Force at the prompting of the U.S. Treasury Department, to the Congressional enactment of the JOBS Act of 2012, the past decade has witnessed a multitude of approaches to reinvigorating the small IPO market.  A common theme in all of these efforts has been a near exclusive focus on altering the cost-benefit calculation of smaller firms considering a public equity offering in hopes of increasing the supply of smaller firms conducting an IPO.”)

[7] 2013 U.S. Federal Reserve Survey of Consumer Finances, at 291, https://www.federalreserve.gov/econres/files/bulletincharts.pdf.

[8] Id. at 324-25.

[9] Credit Suisse, “The Incredible Shrinking Universe of Stocks: The Causes and Consequences of Fewer U.S. Equities,” Mar. 22, 2017, at 8.

[10] Investment Company Institute 2017 Fact Book, at 9, https://www.ici.org/pdf/2017_factbook.pdf .

[11] Investment Company Institute 2017 Fact Book, at 2, https://www.ici.org/pdf/2017_factbook.pdf .

[12] Credit Suisse, supra note 10, at 8.

[13] X. Gao, at al., Where Have All the IPOs Gone?, Journal of Financial and Quantitative Analysis, Vol. 48, No. 9, 1663-1692, 1667 (Table 1 and Figure 1).

[15] Gao, et al. supra note 14, at 1667.

[16] Id. (Table 1). In addition, as the number of small IPOs has dropped, the size of “small” listed companies has grown. Using inflation-adjusted dollars, the size of firm at the 20th percentile of listed companies had $68.5 million in assets in 2012, as compared to $18.67 million in 1996. See C. Doidge, et al, “The U.S. listing gap,” NBER Working Paper No. 21181 (May 2015), https://www8.gsb.columbia.edu/faculty-research/sites/faculty-research/files/finance/Finance%20Seminar/Fall%202015/Doidge_Karolyi_Stulz_Listing_Gap_July2015.pdf.

[17] Credit Suisse, supra note 10, at 11.

[18] Seee.g., Bartlett, et al., supra note 7, at 10 (“[A] growing fund’s aversion for illiquid stocks can translate into an associated aversion for smaller firms.”).

[19] For example, under Section 5(b)(1) of the Investment Company Act of 1940, a mutual fund cannot qualify as diversified if it holds more than ten percent of the voting shares in any one company. Under Section 22(e), a mutual fund must redeem shares within seven days of a redemption request, which could elevate the price impact of a large redemption in a thinly traded security. In addition, mutual funds are often restricted from investing in securities that are not listed on an exchange, so mutual funds may be unable to participate in nearly 70 percent of small IPOs because they are traded on non-exchange venues. Bartlett, et al., supra note 7, at 18.

[20] The SEC’s Division of Economic and Risk Analysis (DERA), in its economic analysis of proposed amendments to the definition of a “smaller reporting company,” observed data that suggests scaled disclosures have a negative effect on institutional ownership. See SEC Release No. 33-10107, File No. S7-12-16, https://www.sec.gov/rules/proposed/2016/33-10107.pdf (page 44). Moreover, the OTC markets, because they offer varying levels of disclosure, offer unique insights into the trade-offs between disclosure and market integrity, particularly for small companies.  OTC tiers with the stricter disclosure requirements are healthier, have higher liquidity, and lower crash risk than the tiers with less disclosure. See Joshua T. White, “Outcomes of Investing in OTC Stocks,” DERA White Paper, Dec. 16, 2016, https://www.sec.gov/files/White_OutcomesOTCinvesting.pdf.

[21] For a list of mutual funds with stakes in late-stage venture capital, see Credit Suisse paper, supra note 10, at Exhibit 10.

[22] Bartlett, et al., supra note 7, at p. 1 and Table 1. In particular, “the largest quartile of mutual funds decreased their participation rate in small IPOs from 12.1 percent to 4.8 percent between 1990 and 2000.”  Id., at 19.

[23] Id. at Table II.

[24] Garnett Roach, “Institutional investment drops at small-cap companies,” IR Magazine, Mar. 1, 2017, https://www.irmagazine.com/articles/small-cap/21918/institutional-investment-drops-small-cap-companies/ .

[25] Bartlett, et al., supra note 7, at 11-12 (“[G]iven that liquidity itself is a function of investor demand, any drop in demand for small IPOs among the largest funds would itself be expected to further enhance the illiquidity of these transactions, potentially creating a vicious cycle of illiquidity-begets-illiquidity.”)

[26] See J. Schwartz, The Twilight of Equity Liquidity, 34 Cardozo L. Rev. 531, 548 (2012) (“Diminished prospects for [analyst] coverage make going public less attractive, particularly for smaller firms. This is because less analyst coverage means less liquidity, and less liquidity makes shares less attractive for public investors. To make up for this, smaller firms have to discount IPO shares, which in turn reduces the value of joining the public markets.”).

[27] For example, the JOBS Act created a new category of  issuer known as an “emerging growth company” (EGC) and mandated  certain accommodations, including scaled disclosure requirements, for those companies. A recent study found that about 88 percent of IPOs from January 2010 to April 2012—before the JOBS Act—would have been EGCs had that designation existed. Since the JOBS Act, that proportion has actually declined to 85 percent, which suggests that the EGC benefits have not incentivized smaller companies to go public. See Carlos Berdejo, Going Public After the JOBS Act, 76 Ohio St. L. Rev. 1, 37 (2015).

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