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AmericasSeptember 3 2012

Can Europe emulate US small-cap sweet spot?

While some of the largest initial public offerings have attracted the wrong kind of headlines recently, investors can find value among genuine US growth companies but the UK is struggling to match this success.
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The top-tier investment banks may view the past year as a particularly stagnant one for equity capital markets (ECM), but in the US, there is one part of the market that is still definitely active. New York-based investment bank Jefferies used the previous ECM lull after Lehman Brothers in mid-2009 to make some key hires from the bulge bracket firms and build a broad growth companies franchise. Three years on, the bank was bookrunner on four initial public offerings (IPOs) in less than three weeks in July 2012.

“That’s a high run rate for us – or for anybody at the moment. When secondary markets are grim, everyone flees from the elevated end of the risk spectrum. But at the moment, Nasdaq is up about 12% this year, deals are getting done and done well. We’ve even seen two homebuilders raise money in the same week for the first time since 2003,” says Mark Connelly, global head of equity capital markets at Jefferies.

Peter Kies, co-head of equity capital markets at Robert W Baird & Co, agrees that the IPO market will welcome companies with a great growth story. In July, Jefferies and Baird were lead underwriters on an $87m offering for US restaurant concept Chuy’s, which was over eight times subscribed despite volatility in equity markets. However, Mr Kies adds that investors can be quite specific in their definition of a growth company.
 
“If the company can show growth well into double digits, then a deal for up to $150m or $200m can get away in pretty much any market. But it needs to be top-line revenue growth, not just acquisitions or margin expansion,” he says.

A further sign of the market’s dynamism is the string of follow-on offerings after IPO, sometimes even within the six-month lock-up period for investors in the original offering. Research by Baird shows that in 2011 and 2012, 44 companies returned to the market within a year of their IPO, on average 187 days later, and with an average price rise of 63% from the initial to the secondary offering. This is certainly a stark contrast to the poor after-market performance of many large IPOs over the past 12 months.

“Private equity sponsors in particular are opting for smaller than normal IPOs as a proportion of the company, in part responding to IPO discounts that are higher than the generic 10% to 15%. The smaller IPO creates scarcity value and a better price, they sell less of the stock at the IPO discount, and can then come with an aggressive follow-on if the stock has done well,” says Mr Connelly.

Competing for business

Traditionally, small-cap equities trade at a discount to the blue-chips, as liquidity is more limited and research coverage among the largest investment banks and fund managers is sparse. This should leave good opportunities for specialist funds to buy undervalued stocks with a longer investment horizon of three to five years, so that the lower liquidity is less important. But with the global economic outlook uncertain, finding value can be difficult, according to John Bichelmeyer, portfolio manager of the Buffalo US small- and micro-cap funds.

“At a time of slow growth in the wider economy, some growth companies are trading at a premium because investors are ready to take the valuation risk in the expectation that these companies can grow into their multiples and outperform larger stocks,” he says.

When secondary markets are grim, everyone flees from the elevated end of the risk spectrum. But at the moment, Nasdaq is up about 12% this year, deals are getting done and done well

Mark Connelly

With the pipeline for growth company IPOs and follow-ons much healthier than for large caps, specialist investment banks are facing an increasing challenge from the bulge bracket who would not regard such mandates as cost effective in a boom market. Mr Connelly says even the largest banks are ready to look at follow-on offerings down to $30m at the moment. Naturally, investment bankers who focus on the growth company sector believe they offer a better quality of service.

“What we provide is a more stable platform that delivers the right mix of investors, with fund manager relationships that have not been devalued by the balance sheet-led, mega-cap strategy of the largest investment banks,” says Kent Nelson, head of global equity syndicate at financial services holding company Raymond James in Florida.

Mr Kies at Baird says the larger investment banks may be tempted to take the easy route on execution for a deal that is low-value by their standards. That means distributing to hedge fund clients rather than winning over the long-only value investors who are a better fit for the strategy of most growth companies. And investors tend to agree with this analysis.

“Research coverage of small caps is less profitable for the bulge bracket, and that creates an opportunity for us to find companies that are not well covered. We have to keep a very large broker panel with multiple brokers in every market. For many of our investee companies, we are one of only two or three large institutional investors,” says Nick Hamilton, the head of global equities for Invesco Perpetual and a manager of the firm’s global small-caps fund.

Stimulating activity

Despite the resilient short-term picture, the longer-term story for small caps is not so positive. Baird research shows that total companies listed in the US fell from a peak of 8823 in 1997 to 4970 by mid-2012, while the average market capitalisation of those listed rose from less than $1bn to more than $3bn. Both strategic buyers and private equity are draining the supply of small-cap issuance.

“The forward earnings multiples used to price a public offering should represent a premium to private equity valuations based on historic cashflow. But private equity is raising very cheap money right now, which narrows the discount to perhaps 10% or 20%, without entrepreneurs having to run the execution risk of an IPO,” says Mr Kies.

While investment banks cannot do much about ultra-low interest rates and volatile markets, they can urge the government to tackle another deterrent to small cap IPOs – excessive compliance costs. The Jumpstart Our Business Startups (JOBS) Act, passed in March 2012, is intended to ease some of the regulatory burdens for smaller companies, stimulating access to public capital.

IPO conditions have been tough for the past two years

Oliver Hemsley

“The consideration process for IPOs can be multi-year, so it is early days to know if the JOBS Act will work. But there are already signs among companies that had started pondering IPOs prior to the JOBS Act that its private filing provisions help them to see if fund managers will like the company and give them a better price than a strategic buyer,” says Mr Nelson.

European woes

The decline in small-cap listings is even more marked in the UK, despite the presence of the Alternative Investment Market (AIM) specifically focused on the growth companies sector. The number of companies listed on AIM has fallen from just under 1700 in 2007 to 1114 in June 2012, of which fewer than 900 were UK-based companies.

“IPO conditions have been tough for the past two years, there has been limited recycling of cash via merger and acquisitions, while fund inflows have focused on emerging markets, with institutional money exiting smaller company mandates,” says Oliver Hemsley, founder and chief executive of UK stockbroker Numis.

Mr Hemsley remains optimistic, arguing that the shrinking of European bank balance sheets will ultimately encourage companies that previously relied on bank loans to turn to equity capital markets. But Donald Stewart, a corporate finance partner at law firm Faegre Baker Daniels and a director of the Quoted Companies Alliance, worries there are more profound structural difficulties facing the AIM. The 2005 EU Prospectus Directive has restricted the AIM’s ability to reduce the compliance burden on small caps.

In addition, the Markets in Financial Instruments Directive (MiFID) has prompted a fragmentation of trading venues. The World Federation of Exchanges warned in a MiFID consultation in February 2011 that, faced with higher competition and tighter margins, trading venues were focusing on large-cap stocks with the highest turnover, and neglecting the provision of small cap liquidity.

ESMA to the rescue?

Time for a European answer to the US JOBS Act? That decision rests not with the AIM alone, but with the European Securities and Markets Authority (ESMA).

“I have spoken to officials at ESMA, and my conclusion is that there will never be a European JOBS Act. That would involve rolling back aspects of the Prospectus Directive and MiFID that make it very difficult and costly for small companies to carry out a broad public offering. But the view at ESMA is that small companies are inherently risky, and investor protection takes priority over access to capital,” says Mr Stewart.

A spokesman for ESMA says the regulator is aware of the difficulties small and medium-sized enterprises (SMEs) face in accessing capital markets, and the proportionate disclosure rules in the amended Prospectus Directive are intended to help address this challenge. The Securities Markets Stakeholders Group (ESMA’s advisory body of industry representatives) is finalising a strategic paper on the subject to be presented in September, which could result in several initiatives in the area of facilitating SME access to equity capital.

“While I would reject the assertion that ESMA views small companies as being inherently risky, ESMA is of the view that facilitating easier access for SMEs to capital markets should not be done to the detriment of investor protection,” says the spokesman.

As the debate rumbles on in Europe, the US could take advantage by presenting itself as a suitable destination for foreign small-cap listings. Mr Hemsley says Numis already organises about 50 to 100 roadshows for UK companies in the US every year.

“The JOBS Act is a good start, and if the policy environment after the next elections [in November 2012] is supportive, then the US could be set up to re-establish itself as the undisputed leading capital markets platform in the world,” says Mr Kies at Baird.

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