Market Structure Is Causing The IPO Crisis

This post was written by David Weild and Edward Kim, both of whom are capital markets senior advisors with Grant Thornton LLP.

As Congress battles over the shape of financial reform, will it address the lack of a properly functioning market structure? The market for underwritten IPOs, given its current structure, is closed to 80% of the companies that need it. In fact, since 2001 the U.S. has averaged only 126 IPOs per year, with only 38 in 2008 and 61 in 2009 — this compared to the headiness of 1991–2000 with averages of 530 IPOs per year.

Companies can no longer rely on the U.S. capital markets for an infusion of capital, nor can they turn to credit-strapped banks. The result? Companies are unable to expand and grow — they are unable to innovate and compete — so they are left to wither and die, contributing to today’s high unemployment rate.

During the time since our first studies were released, Grant Thornton has received a number of intriguing questions. This post (and the report posted below) addresses them and presents updated data through December 2009, while examining the continued lack of a properly functioning IPO and small cap stock market. The systemic failure of the U.S. capital markets to support healthy IPO and robust small cap markets inhibits our economy’s ability to innovate, create jobs and grow. At a time when America is struggling with double-digit unemployment, the failure of the U.S. capital markets structure can no longer be ignored.


1. IPO Crisis worsens: Calendar year 2009 represented one of the worst IPO markets in 40 years. Given that the size of the U.S. economy, in real GDP terms, is over three times what it was 40 years ago, this is a remarkable and frightening state of affairs.

Only 61 companies went public in the United States in 2009, and the trend that disfavors small IPOs and small companies has continued. The median IPO in 2009 was $140 million in size — quite a contrast to 20 years ago when Wall Street commonly executed $10 million IPOs that succeeded.

2. Small business impact: The ramifications of the IPO Crisis extend well beyond the venture capital industry and affect “mom and pop” businesses as well. The non-venture capital and non-private equity segment of the market historically (over more than 20 years) has represented more than 50 percent of all IPOs. The lack of an IPO market is thus hurting small business by cutting off a source of capital (capital realized from going public) that in turn would drive reinvestment and entrepreneurship in the United States. We heard this repeatedly in our discussions.

3. Market structure is at fault — The IPO Crisis is primarily a market-structure-caused crisis, the roots of which date back at least to 1997. The erosion in the U.S. IPO market can be seen as the perfect storm of unintended consequences from the cumulative effects of uncoordinated regulatory changes and inevitable technology advances — all of which stripped away the economic model that once supported investors and small cap companies with capital commitment, sales support and high quality research.

4. Casino capitalism: We have interacted with management and portfolio managers of a number of classic, long-term investment firms, including Capital Guardian, Delaware Asset Management, Kaufman Funds, T. Rowe Price and Wasatch Advisors, that invest in small cap companies. These investors confirm that the current stock market model forces Wall Street to cater to high-frequency trading accounts at the expense of long-term investors, and that Wall Street is increasingly out of touch with the interests and needs of long-term equity investors. Specifically, we have heard that the quality of research on Wall Street has deteriorated dramatically while, in comparison, institutional investors’ quality of in-house research is now “much better.” We also have heard that more investment-oriented portfolio managers are more likely to be treated as “C” accounts (Wall Street may rank accounts as “A,” “B” or “C”; most resources are given to the so-called “A” accounts).

5. Crisis started before Sarbanes-Oxley (2002): The IPO Crisis was not induced by Sarbanes-Oxley, Regulation Fair Disclosure or NASD Rule 2711 (separation of banking and research). Each of these changes occurred well after the IPO Crisis was underway. While we believe these well-intentioned investor protections may have raised the costs of going public (and taking companies public), they did not cause the abandonment of the investment-centric Wall Street model (that also supported small cap companies and thus IPOs) in favor of a high-frequency trading model.

6. Origins of crisis obscured by Dot-Com Bubble (1997): The IPO Crisis began during, but was hidden by, the Dotcom Bubble. We see a clear decline in the number of smaller IPOs beginning in the 1996/1997 time frame, which aligns perfectly with the introduction of the Manning and Order Handling Rules. In addition, we spoke with the CEO of a firm that was active in small cap IPOs in the heart of that time frame. He shared that “the handwriting was on the wall that the combination of trading changes that were being contemplated was going to destroy support for small cap stocks.”

7. This equity crisis exacerbates the credit crisis: Good credit starts with a layer of equity. Companies are less able to attract debt capital or credit when they have inadequate equity capital. The IPO Crisis is creating an equity crisis companion that is exacerbating the credit crisis.

8. A dysfunctional IPO market fuels unemployment: In addition to negatively impacting the number of publicly listed companies in the United States, our current market structure is having a deleterious effect on job creation. When companies cannot raise capital efficiently — or at all — they are deprived of their ability to acquire the assets and human resources they need to grow their businesses. If we want to stop this vicious cycle of rising unemployment and its devastating impact on U.S. citizens, we must take steps now to revive our IPO markets.

You can download the entire report by clicking here