SEC commissioner Robert Jackson gave a speech last week exploring possible reasons why middle market companies aren’t going public as often as they did in decades prior. Given that the decline of mid-market and small-cap IPOs is the principal reason critics give for repealing compliance obligations (SOX compliance, proxy disclosures; you name it), Jackson’s remarks are worth a closer look.
His fundamental point was that the relative cost to take a mid-market company public hasn’t changed in decades. On the contrary, those relative costs have become more inflexible over the years — practically fixed at exactly 7 percent of total proceeds raised in the IPO. That conclusion holds true regardless of the mid-market company’s industry, and regardless of how much money the IPO seeks to raise. (Jackson defined “mid-market IPO” as raising $20 million to $100 million.)
Some history here. In 2000, a finance professor studied mid-market IPOs that happened from 1985 to 1998. More than 90 percent of them had investment banking fees exactly equal to 7 percent of the IPOs total value.
Jackson — who was a newbie investment banker in the 1990s, and helped DrKoop.com go public in the dot-com craze — decided to repeat that original research using more current IPO data. His staff examined 700 IPOs mid-market IPOs that happened from 2001 through 2016, and found that an even higher concentration of companies (96.6 percent) now pay the 7 percent fee.
The chart below shows the pattern. The thick black line on the left are all the mid-market IPOs, almost uniformly priced at 7 percent. And as IPO values get larger, the relative cost trends downward. (Jackson’s staff found that half of large IPOs pay less than 7 percent in fees.)
By now you may be thinking, “Cool story, bro — but what does it actually mean?” For those tasked with helping a company prepare to go public, Jackson’s finding can mean a few things.
The Great IPO and Compliance Debate
Above all, as Jackson noted in his speech — if the costs of taking a mid-market public company haven’t changed in decades, nobody should be surprised that private equity has emerged as an alternative exit strategy for entrepreneurs. Why wouldn’t it? The investment banking community hasn’t found any innovative way to take companies public at lower costs.
Meanwhile, nearly 20 years of low interest rates means the private equity and M&A markets could provide better exits for those mid-market entrepreneurs. Instead of the rigormarole of preparing to go public; and paying 7 percent of the proceeds to some investment bankers; and then fighting all the short-term activists who want to bleed profits from the business you built — you can just sell quickly and simply, and walk away with a pile of cash or stock. It has appeal.
That’s the real issue in our great debate about declining IPOs, and whether compliance and disclosure burdens are the cause of that decline. The question isn’t so much, “Why aren’t more companies going public?” as it is, “Why are so many companies staying private?”
So many companies are staying private because they can, thanks to gobs of cash in private equity and larger companies with CEOs looking to grow quickly through acquisitions. Those factors aren’t likely to change any time soon, no matter how much the Trump Administration blames the Sarbanes-Oxley Act, the Dodd-Frank Act, SEC disclosure rules, or any other of the usual targets of Republican ire.
Repealing “social disclosures” under the Dodd-Frank Act, reducing proxy disclosures, increasing exemptions for internal control testing under Section 404(b) of SOX — that’s all equivalent to pushing on a string; it won’t move much.
The real issue about declining IPOs isn’t so much, “Why aren’t more companies going public?” as it is, “Why are so many companies staying private?” Because they can.
Relaxing 404(b) will increase the risk of financial restatements or fraud at exempt companies; we’ve seen research proving that point, too. The question is whether the marginal benefit of that relaxation to some pre-IPO companies will exceed the increased risk that investors would have to shoulder.
One could also note that since 2015, small companies have been allowed to raise as much as $50 million in crowd-funding under Regulation A+. Well, $50 million is smack in the middle of these mid-market IPOs that have been evaporating for years. Emerging growth companies as defined under the JOBS Act are exempt from Section 404(b), and have been for much of the decade.
In other words, the SEC has already shot its quest for more mid-market and small cap IPOs in the foot. Now we’re surprised those numbers are bleeding out?
Jackson, a Democratic appointee, offered few specific ideas on how to remedy the IPO drought for mid-market companies. He did offer some words that might almost warm a Republican’s heart: “If lawmakers do nothing to level the playing field for middle-market IPOs, the trend that is taking small American businesses out of our public markets will likely continue.”
That said, remember the part where Jackson was a budding investment banker in the dot-com boom. He saw the wreckage caused by loose IPO standards in the 1990s. We should also note that when SEC chairman Jay Clayton, congressional Republicans, and the Trump Administration say the number of public companies in the United States has fallen by more than half since 1997, three-quarters of that decline happened from 1997 to 2004 — before SOX went into effect.
Jackson did float the idea that underwriters should disclose more (to both entrepreneurs and investors) about the total costs of going public. That would include how much money mid-market companies lose by “underpricing,” where the bank deliberately prices pre-IPO shares low and gives them to favored clients, who then reap a bundle when the stock immediately pops on the first day of trading.
I don’t know who’s wrong or right here. But Jackson does give this question of compliance and IPOs the thoughtful treatment it deserves.