Ronald Woessner This is a reprint of an article of mine originally published by equities.com at the link here.
+++++++++++++++++++++++++++++++++++++++++++++++++
Public Policy is Killing Stock Markets for Smaller-Cap Companies
US Public policy has caused the well-publicized and alarming decrease in the number of US publicly-listed companies and is poisoning the public markets for smaller-cap companies.[1]
The number of US publicly-listed companies decreased over the last two decades by about 44%, from 8,823 in 1997 to 4,916 in 2012, according to the World Federation of Exchanges. A 2018 academic study from the Harvard Kennedy School reveals similar numbers.[2]
Other countries are lapping the US in the number of their public company listings versus our public company listings. During the comparable period in other developed countries, public listings increased by about 48%.[3]
The US “should have” approximately 10,000 public companies today, resulting in an estimated “listing gap” of approximately 6,000 companies.[4]
This decrease should be shocking and frightening to all Americans, regardless of party affiliation, particularly when one considers that real GDP has grown by over 60% in that time frame. Why, when our economy is growing strongly, has our public listing machine come to a grinding halt?
This decrease has cost America tens of millions of jobs,[5] reduced to a mere trickle the queue of future “Fortune 500” larger-cap companies for Fidelity, CalPERS and hundreds of pension plans to invest in,[6] and puts the US on the vector of falling behind China in China’s quest to dominate the US technologically.[7]
Here’s the chain of causation that’s created the US Listing Gap:
Step 1: The introduction of electronic trading execution, order handling rules, and smaller tick sizes collapsed buy/sell trading spreads to $.01 from $.25 per share and collapsed retail sales commissions to $5.00 per trade from $250 per trade.[8]
Step 2: These smaller bankable spreads and reduced retail sales commissions DRASTICALLY reduced the profitability (i.e., ability to make money) of smaller and mid-size broker dealers. This drove 74% of IPO bookrunners out of business[9] and drove 29% of broker-dealers out of business.[10] Those remaining eliminated the investment banking, research, retail sales, and capital committed to market making (i.e., creating stock trading liquidity) they previously provided for smaller-cap companies.[11]
Step 3: Lack of this “after-market” support from smaller and mid-size broker dealers has left thousands of smaller-cap companies as public-company “orphans,” with no broker-dealer or investment-banking sponsorship, and poisoned the public markets for smaller-cap companies.[12]
Step 4: This in-hospitability deters smaller-cap companies from conducting IPOs and going public. The big investment banks discourage these smaller deals with smaller stock trading “floats,” as they are difficult to market to their most actively trading institutional clients. They are also difficult transactions purely from an ROI and opportunity cost perspective of allocated resources.
Step 5: This disappearance of the smaller-cap company IPO (< $50M) is predominantly responsible for the US Listing Gap according to academic research and as stated by former SEC Commissioner Michael Piwowar during his opening remarks at an SEC – NYU conference on IPOs in May 2017: “The substantial drop in the number of IPOs in the United States is primarily driven by the disappearance of small IPOs.”
Former Commissioner Piwowar is correct. The number of IPOs raising less than $100 million collapsed starting in 2000. The number of these small IPOs averaged 401 annually in the 1990s, but then dropped to only 105 annually in the 18 years since. In the 1990s, small IPOs represented 27% of all capital raised in the public markets, whereas in the period from 2000 to present they have represented only 7% of all capital raised.[13] Moreover, according to an OECD study, during 2008 – 2012 on a GDP weighted basis the US was third from the bottom for small IPOs among 26 countries studied — ahead of only Mexico and Brazil.[14]
The electronic execution, order handling rules and $.01 tick size trading rules created the salutary benefit of reducing stock trading transaction costs. Nevertheless, they also had the unintended negative consequence of killing the small-cap IPO and creating the currently poisoned US public markets for smaller-cap companies. As eloquently stated by David Weild, former NASDAQ Vice-Chairman, Wall Street investment banker, father of JOBS Act 1.0, and tireless advocate for the health of the US capital markets:
“Why have smaller-cap company IPOs disappeared? Because the profitability of the investment banking-focused broker-dealers — which previously sponsored and fostered a habitable environment for smaller-cap companies through underwriting, distributing and supporting them in the after-market via sales, research, and market-making (capital commitment) — has been destroyed by electronic-order execution, small-tick-size markets, that make it easy for predatory short-sellers to collapse trading spreads (especially in advance of offerings) and spread lies to drive down stock prices that cannot be countered because the investment banks that remain can no longer afford to provide research and sales coverage to counteract the lies.”[15]
Through the “butterfly effect,”[16] the electronic execution, order handling rules and $.01 tick size trading rules had the unintended consequences[17] of:
- killing the smaller-company IPO market,
- causing the loss of tens of millions of US jobs,
- forcing businesses to close because of lack of capital,
- discouraging entrepreneurship,
- hindering upward mobility for all Americans, especially minorities
- destroying the efficacy of the US capital markets, and
- creating an opportunity for the Chinese to technologically dominate the US.[18]
Who would have thought that the lack of a few pennies in tick size would have poisoned the US public capital markets, once the envy of the world?[19]
So, what is to be done to remedy the current in-hospitability of the public markets to smaller-cap issuers, which is causing them to avoid the US public market?
Let’s use our common sense to intuit the policy solution. Since the $.01 bid/ask tick size is a root cause of the current inhospitably of the public markets to smaller-cap companies, then one would naturally think that increasing the tick size to some larger number would remedy the issue.
And, indeed, academic research demonstrates this to be precisely the case!
The academic research of Mr. Weild and his colleagues demonstrates that widening tick sizes for smaller-cap illiquid stocks results in more smaller-cap companies going public. In other countries where there are higher tick-sizes-as-a-percent-of-share price (which in turn leads to higher bid-ask spreads) their smaller-cap IPOs are booming. There is a nearly 70% correlation between tick-sizes greater than 1% of an issuer’s trading price and a robust IPO market for companies under $500 million in market value, according to the research.[20]
Now, a word about the two year 2016 – 2018 SEC tick pilot study.[21] The study increased the tick size from $.01 to $.05 for the pilot stocks. It has been reported that the study was a “failure” because it cost investors approximately $350M more to trade the pilot stocks during the study period and did not produce the hoped-for and anticipated increase in the trading liquidity of the pilot stocks.[22] Commentators have incorrectly concluded from these reports that larger tick sizes and larger bid-ask spreads do not increase trading liquidity.
These commentators are incorrect. The failure of the tick pilot study to produce the hoped-for and anticipated increases in trading liquidity of the pilot stocks is 100% attributable to the inherently flawed design of the study.[23] The study design was inherently flawed in that that there was a null set (i.e., ZERO) of stocks in the pilot that could benefit from the tick pilot. The explanation appears below.
Recall that the academic research says the tick size must be > 1% of the stock share price. The $.05 tick was not > 1% for those stocks priced > $5.00 per share. The $.05 tick was > 1% for those stocks priced < $5.00 per share … but broker-dealers cannot recommend them for purchase because of brokerage firm policies[24] and such stocks cannot be purchased on margin.
Since the study design was inherently flawed to benefit ZERO issuers, it’s not surprising that ZERO issuers benefitted.
In conclusion, it is clear what needs to be done from a policy perspective to remedy the poisoned and collapsing US public capital markets: create a special exchange with special trading rules for smaller-cap issuers that permit higher bid-ask spreads.[25]
These higher bid-ask spreads will then create the profitability broker-dealers need to begin again providing after-market “sponsorship” and support for smaller-cap companies in the form of:
- investment banking,
- investment analyst research,
- providing retail sales persons to solicit customer buy orders, and
- committing capital to make a trading market in the issuer’s stock
These activities would in turn make the public capital markets more hospitable to smaller-cap companies, which in turn would motivate more of them to go public, and would enable those that are already public to thrive.
A big-tent, bi-partisan advocacy effort is now being organized in Washington, DC, to present this initiative to Congress and to the SEC. If you want to help:
- restore America’s capital markets to their former health,
- create millions of US jobs,
- help America’s entrepreneurs succeed,
- promote upward mobility and bring millions of Americans, especially minorities and others last hired during an economic recovery, to the metaphorical “mountain top,” and
- assure the US maintains its worldwide technological dominance
— please contact me through Linked In.
© Ronald A. Woessner, February 25, 2019
[1] There are approximately 5,500 “publicly-listed” companies listed on the NYSE and NASDAQ. There are another approximately 10,500 “OTC-traded” companies. The term “public markets” as used in this article refers collectively to both publicly-listed and publicly-traded companies.
[2] “Hunting High and Low: The Decline of the Small IPO and What to Do About It,” Lux and Pead, Mossavar-Rahmani Center for Business and Government, Harvard Kennedy School (April 2018),
https://www.hks.harvard.edu/centers/mrcbg/publications/awp/awp86 (hereinafter cited as “Lux & Pead”). The World Federation of Exchanges number of publicly-listed companies as of December 2018 is 5,343. There appears to have been a modest uptick resulting from JOBS Act 1.0 and JOBS Act 2.0 and the robust economy.
[3] 9,538 is the estimated “should have” number as of 2012 according to the study. “The U.S. Listing Gap,” Doidge, Karolyi, and Stulz, December 2015, at p. 8.
[4] The author extrapolates to an estimated 10,000 “should have” number in 2019. Other commentators peg the “should have” number of public companies as > 13,000.
[5] It is estimated that 22M jobs were lost between 1997 and 2010 because of the reduced level of IPO activity. “A Wake-Up Call for America,” Weild & Kim, November 2009 (hereinafter cited as “Weild & Kim”), at p. 27.
[6] Today’s Fortune 500 companies were smaller-cap companies at one time. It’s necessary to have a public market ecosystem that enables smaller-cap companies to thrive so that those smaller-cap companies who have the potential to become a Fortune 500 company – have a fighting chance to do so. Today’s public market ecosystem is so inhospitable to smaller-cap companies that many who have the potential to become a Fortune 500 company will never achieve their potential.
[7] See, e.g., Dodwell, “Be Afraid: China is on the path to global technology dominance.” March 24, 2017. https://www.scmp.com/business/global-economy/article/2081771/be-afraid-china-path-global-technology-dominance. If American firms are starved for capital, they will not grow, innovate, or create new technologies for the world.
[8] “Hearing on Legislation to Further Reduce Impediments to Capital Formation,” Financial Services Committee, on October 23, 2013, Statement of David Weild, at 15 – 16.
[9] As of 2012, there were only 44 IPO bookrunners still in business, down from 167 in 1994. Id.
[10] FINRA Member Statistical Review, 2003- 2017.
[11] The $.01 bid/ask trading spreads have (a) decimated the ranks of the small-to-mid size broker dealers/investment banks who formerly provided after-market support for smaller-cap companies, (b) eliminated virtually 100% of the retail salesmen who previously phoned retail investors and solicited buy orders for a small-cap issuer’s shares of stock, and (c) decimated the ranks of the sell-side investment analysts who left the industry in droves to work for hedge funds and the like.
[12] Manifestations of this market in-hospitability vis-a-vis smaller-cap issuers are: (a) little-to-no investment analyst coverage; (b) crushed stock valuations; (c) little-to-no stock trading liquidity; (d) “bear raids” and short-sale attacks; and (e) no retail sales people on the phone soliciting buy orders to purchase the issuer’s stock in the open market. These concepts are discussed in the following articles: https://www.equities.com/news/dodd-frank-death-spiral-how-small-cap-access-to-capital-got-crushed; https://www.equities.com/news/harvard-kennedy-schools-recommendations-to-encourage-companies-to-go-public; https://www.equities.com/news/why-do-investment-analysts-ignore-smaller-cap-companies; https://www.equities.com/news/smaller-cap-companies-beware-the-short-seller; Weild & Kim at p. 19 – 28.
[13] Lux and Pead at p. 8. A delta of 296 (401 – 105) * 18 years = 5,328, which predominantly accounts for the Listing Gap.
[14] “Making Stock Markets Work to Support Economic Growth,” Weild, Kim & Newport for the OECD, July 11, 2013 at p. 54.
[15] “Fixing America’s IPO Markets, Why this is Essential for US National Interests, Ideas for JUMMP Act 1.0,” D. Weild, unpublished paper, February 2019.
[16] The butterfly effect is the phenomenon whereby a minute localized change in a complex system can have large effects elsewhere.
[17] Weild & Kim at p. 19 – 28.
[18] Id. There is an additional network effect that magnifies the extent of this damage. Enrico Moretti at Berkeley in his book. “The New Geography of Jobs,” wrote about the “multiplier effect” of how a single high-tech job in an “innovation hub” like Boston, San Francisco, or Raleigh-Durham creates five new jobs in the surrounding service sector. Hence, all those IPOs that didn’t happen didn’t create a successful company that then didn’t hire people that then resulted in the communities not flourishing.
[19] This is reminiscent of the nail proverb:
For want of a nail the shoe was lost.
For want of a shoe the horse was lost.
For want of a horse the rider was lost.
For want of a rider the message was lost.
For want of a message the battle was lost.
For want of a battle the kingdom was lost.
And all for the want of a horseshoe nail.
[20] “Making Stock Markets Work to Support Economic Growth,” Weild, Kim & Newport for the OECD, July 11, 2013, at p. 54. For the period from 2008-2012 the U.S. had a disastrous “Efficiency Ratio” of GDP-weighted output of small IPOs — at only 0.4 IPOs per $100 billion of GDP (ahead of only Mexico and Brazil). Why? Because the US has the lowest tick-sizes-as-a-percent-of-share price of any of the 26 countries studied. A number of countries enjoy 50x the GDP-weighted output of the number of small IPOs in the US. Id.
One may ask: “How do we know this is causation and not merely correlation?” Answer: because we have seen from our experience here in the US how the lower bid/ask spreads created the loss of after-market support for smaller-cap issuers. See note 12 above and the articles cited therein.
[21] The SEC studied for two years the effects on the trading liquidity of 1,200 NMS pilot stocks of widening the tick size from a penny ($.01) to a nickel ($.05).
[22] Trading liquidity is necessary for a public issuer to attract investment firm capital. As noted by Weild & Kim and in earlier articles of mine: without trading liquidity a public issuer has virtually zero chance of attracting non-toxic investment firm capital. See, e.g., https://www.equities.com/news/why-do-investment-analysts-ignore-smaller-cap-companies.
[23] Early proponents of the SEC study criticized the proposed study design at the time it was being designed. At the time, Mr. Weild and others stated that the study design was flawed and not remotely close to the tick size pilot they had advocated for. The Carney – Duffy legislation, which would have required the SEC to conduct the pilot according to certain parameters, called for a 5- year pilot (not 2 years) and a $.10-cent tick size (not $.05). The legislation never became law and hence the SEC did not follow these parameters in designing the study.
[24] Brokerage firm policies prohibit brokers from calling customers to solicit a buy order for stocks priced at <$5.00 per share.
[25] This is the fundamental requirement. Obviously, there are hundreds of other details as well that would be necessary for such a trading venue to function properly.
+++++++++++++++++++++++++++++++++++++++++++++++++
Mr. Woessner mentors, advises, and helps companies in the start-up and smaller-cap company ecosphere raises capital through Regulation Crowdfunding (CF) and other means. He also advocates in Washington DC for policies that create a more hospitable public company environment for smaller-cap companies, enhance capital formation, support small business, promote entrepreneurship, and increase upward mobility for all Americans, particularly minorities. See here for more information on Mr. Woessner’s background.