The Search for IPO Alternatives

David Weild and Edward Kim recently produced a report for Grant Thornton, titled IPOs in the ICU. The entire report is available here, but David has permitted us to reprint this conclusion about current and future alternatives to IPOs for private companies:

There has been no shortage of effort to find an alternative to an IPO for private U.S. companies. Among these are the NASDAQ Portal Alliance (144A PIPO), InsideVenture and Entrex markets.

To date, most of the major U.S. investment banking initiatives have been focused on the 144A PIPO market in efforts to create institutional-only markets for private placements of equity that would be issued to qualified institutional buyers (QIBs) and accredited investors subject to a Regulation D exemption from registration and a 144A safe harbor for aftermarket trading. These offerings are referred to by Wall Street as 144A PIPOs or “pre-IPOs.”

There were four credible marketplace entries in this niche: GSTrUE (Goldman Sachs Tradable Unregistered Equities), OPUS-5 (an alliance among five of the large investment banks), NASDAQ Portal and Friedman Billings Ramsey. Over the last year, participants in OPUS-5 and Goldman Sachs have thrown their hats in with NASDAQ to form the NASDAQ Portal Alliance. Friedman Billings Ramsey remains independent, as they were the market share leader.
These so-called 144A markets will come to the aid of some companies but not most companies. The reason is simple: The number of and type of investor is restricted. There is little liquidity. In fact, even the $880 million Oaktree offering that was run by Goldman Sachs is said to have attracted less than 50 investors.

One constructive structural element to the NASDAQ Portal Alliance is that it is quote driven and not electronic, which should create incentives for market makers to commit capital and provide liquidity (unlike current public market structure). The market will need to attract more institutional investors, market makers and research analysts if it is to have a chance of succeeding. However, the loss of individual investors from the market is likely to undercut its ability to support small offerings, because large populations of small (retail) investors are what historically support liquidity and valuations in small cap stocks. Smaller companies attract fewer institutional investors willing to participate due to liquidity constraints — a problem that does not afflict most individuals.

The United States needs an opt-in (by the issuer) capital market that provides the same structure that served the United States in good stead for so many years. This market — let’s call it “The Second Market” — would be:

Opt-in – Issuers would determine whether they wished to list in this marketplace or the traditional market.

Public – Unlike the 144A market, this market would be open to all investors. Thus, brokerage accounts and equity research could be processed in the ordinary way, keeping costs under control and leveraging currently available infrastructure.

Regulated – The market would be subject to the same SEC regulations and enforcement as existing markets.

Quote driven – The market would be a telephone market11 supported by market makers or specialists much like the markets of a decade ago. These individuals would commit capital. They could not be disintermediated by electronic communication networks or ECNs, as ECNs would not interact with the book.

Quote increments at 10 and 20 cents – 10 cents for stocks under $5.00 per share; 20 cents for stocks $5.00 per share and greater. These increments could be reviewed annually by the market and the SEC.

Broker intermediated – Investors could not execute trades in this market electronically. To buy stock, an investor would need to call a brokerage firm up on the phone. Brokers would earn higher commission rates and have an incentive to get on the phone and present stocks to potential investors.

This structure would lead to investment in the types of investment banks that once supported the IPO market in this country (e.g., Alex. Brown & Sons, Hambrecht & Quist, L.F. Rothschild & Company, Montgomery Securities, Robertson Stephens, etc.). This in turn would trigger rejuvenation in investment activity and innovation.