State of Innovation

Grant Thornton has prepare a paper entitled Market Structure is Causing the IPO Crisis .  Here is my understanding oftheir position.  The IPO market, especially for small IPOs started to decline before Sarbanes Oxley.  The Manning Rule and Order Handling Rule and decimalization decreased the margin for handling illiquid securities by brokerage houses.  Finally, online brokerage accounts have killed quality research and encouraged speculation.

The things that effect the IPO market are the cost of going public, the return for going public, the alternatives to going public, and the willingness of an investment bank to take you public (might be part of the cost).  While not stated explicitly in the report, they seem to imply that there is little incentive for investment banks to take small companies public or to create a market in their securities after the fact.  If true, I think this would contribute to the IPO downturn, but I do not think they have stated their case very strongly.

It is common for a small company thinking about an IPO to compare going public to private equity (including venture capital), bank loans, and strategic partnerships.  At any given time the advantage of one type of financing method varies compared to other modes of financing.  It is my opinion (unsubstantiated) that in the late 90s venture capital was a better choice than going public for a small IPO.  So I do not buy their argument that the IPO market for small public offerings were necessarily falling off for the reasons they state.  I think there were more attractive alternatives for small IPOs at that point in time.

In general, I do not think a great alternative to going public has been developed in the last decade.  The report does not mention any new alternatives.  I do not think the decline in IPOs is due to a competing source of financing or just the normal fluctuations between types of financing.  This is not a small decline in the number of IPOs it is cataclysmic change.

The speculation, lack of quality research and online brokerage argument seem like red herrings, especially speculation.  This is always a favorite whipping boy of all populist since the beginning of stock markets, maybe markets generally.  The other factors only seem relevant if they have decreased the value of an investment bank’s participation in taking a company public.  I do not have enough information here but the points they list do not appear large enough to result in a cataclysmic change.

By process of elimination it appears that the most relevant factor is the cost of going public or more broadly the return for going public.  SOX has clearly increased the cost of going public and reduced the return of being a public company.  I am not saying that it is only factor, but it appears to me that it probably is the major factor.  A weak patent system has also inhibit small company creation and growth.  There are probably other factors, but they fail to met Occam’s razor in my opinion.  SOX is the simplest explanation for the decline in IPOs that is consistent with the facts.

In 1996 60% of worldwide IPOs went public in the US.  In 2005 only 20% of worldwide IPOs were in the US.  The US is the only major country to have fewer public companies today than a decade ago.  As far as I know online trading is available in all these other countries.  There is no reason to suggest that the amount of speculation is different between the US market and other foreign markets.  All these facts seem consistent with SOX being the major factor for the decline in IPOs.