Don’t die of shock, but a new study suggests that the bright idea from Congress five years ago to goose the IPO market by relaxing governance standards for new public companies hasn’t accomplished much.
Those filers, Emerging Growth Companies, were created by the JOBS Act of 2012. A study released by the Public Company Accounting Oversight Board this week finds that “EGCs” are more likely to have material weaknesses in financial reporting, and more likely to get going concern warnings from their auditors.
Oh yeah—and the number of publicly traded companies hasn’t revived either.
Kudos to the PCAOB for releasing this report, since we’re going to hear much more about relaxing governance and financial reporting standards so more companies can go public. That was one of the only themes voiced by Jay Clayton, nominee to run the Securities & Exchange Commission, during his Senate confirmation hearing last week. He’ll find support from Michael Piwowar, acting chair of the SEC; and lord knows how much President Trump likes to complain about regulation.
First, a few statistics from the PCAOB report. The study examined 1,951 filers that have identified themselves as EGCs since the creation of that category in 2012—but only 742 of those filers (38 percent of the total) are “real” businesses with common stock traded on U.S. national exchanges.
Of those 742 EGCs…
- 13 percent disclosed a material weakness in internal control over financial reporting, compared to only 7 percent of all other exchange-listed filers.
- 12 percent had a paragraph from their audit firm warning about the company’s ability to continue as a going concern, compared to 3 percent for all other exchange-listed filers;
- Median revenue was $37.7 million and median assets $161.5 million, compared to $635 million and $1.42 billion, respectively, for all other exchange-listed filers;
- 20 percent reported zero revenue in their most recent annual report, compared to only 2 percent for all other exchange-listed filers.
All that is to say that EGCs aren’t terribly good companies compared to other filers. Their financial reporting is more risky, their business operations are more risky, and more of them don’t even have any revenue.
Some will say that’s fine, because the higher risk means investors can get a higher return. Well, the PCAOB study found that as a class, EGCs aren’t all that impressive either. Their market cap did appreciate rapidly in early years as more EGC filers emerged, but since 2014 total market cap has puttered around $350 billion even as the number of EGC filers kept going up. (See chart lifted from PCAOB report, below.) So where’s my higher return for more risk?
The only redeeming point, if we can call it such, is that EGCs aren’t a large part of the capital markets: the 742 exchange-listed EGCs are only 15 percent of all exchange-listed companies, and account for only 1 percent of total market cap.
In other words, for most retail investors whose exposure to the markets is primarily a 401(k) account or a mutual fund, EGCs are harmless. But that’s precisely the irritating point about them.
What Comes Next
The JOBS Act was never intended to help more companies go public and bring investors their supposedly rich returns. It was only intended to let more companies go public, and enrich the investment banks and law firms that help them go public. That’s why it won the support of Sen. Chuck Schumer, D-NY, who normally favors tough regulation. Easier regulation here was a big favor to his politically important supporters on Wall Street.
Also worth remembering is that the supposed goal of the JOBS Act—helping more companies go public—hasn’t happened either. The number of publicly traded businesses on U.S. stock exchanges has fallen steadily since the 2000s, JOBS Act or not.
Republicans will say that’s because the rules for being a public company are still too onerous. That’s wrong. Those rules may indeed be too onerous, but they’re not why small companies aren’t going public. Small companies aren’t going public because they don’t have to.
Don’t take my word for it; read the materials from a meeting in February of the SEC Small & Emerging Companies Advisory Committee. As one speaker plainly put it, “Small companies are staying private because they can.” Private equity is in abundance, deals can be closed more quickly, and company employees can get a liquidity event that consists of cash rather than publicly traded stock. In that world, why bother with an IPO at all?
Those tempting conditions aren’t going to change any time soon. And therein lie clues about how the SEC might try to relax capital markets in the future.
If Clayton and fellow Republican commissioner Piwowar truly want small investors to participate in the high-growth investment opportunities percolating in the private world, then the way to go is by loosening restrictions on investors’ eligibility for those private offerings. Piwowar alluded to that idea in a speech last month, arguing for the SEC to revisit (or even repeal) the “accredited investor threshold”—the standard that restricts hedge funds and other swanky investment vehicles to hitting up high net worth individuals.
Loosen that standard, and more people can invest in those lucrative private opportunities like Uber circa 2010 or Facebook circa 2005. Sure, the average investor could also face more exposure to scams, but we tend to overlook details like that in Deregulatory World. And in fairness, giving small retail investors access to early opportunities with lots of upside is a good thing.
Just understand that shoving more filers through the EGC pipeline won’t really accomplish that. It will simply make more bankers, lawyers, and deep-pocket investors wealthier as they churn companies through that pipeline.