IPOs – not coming back?

The market for initial public offerings is drier than a creek bed in Death Valley, but don’t wait around for spring rains to make IPOs start flowing again, two Grant Thornton advisors say in “The Slow Degradation of the IPO Market” in the September 2009 issue of Mergers & Acquisitions.

David Weild and Edward Kim of Grant Thornton write:

Recent signs of life in the IPO market have led some to believe that the worst is behind us and that we’re about to enjoy another bountiful period of IPOs. Don’t be fooled.

While conventional wisdom may say that we are merely experiencing a cyclical downturn in the IPO market, exacerbated by the credit crisis, we assert that the reality is much darker. In fact, we believe that, given its current structure, the market for underwritten IPOs is closed to most of the companies that need it.

Sorry to pass along this gloomy picture, but it’s useful for investor relations practitioners to have a perspective on the overall landscape of our profession.

Weild and Kim say the decline in IPOs arises from long-term causes in the US stock market and regulatory system, not the bear market or recession of 2007-09.

Among the structural factors are regulatory and legislative changes that contributed to a weaker sell side: repeal of Glass Steagall, which coincided with large firms swallowing up i-banks that used to focus on venture-backed IPOs; Regulation FD, which democratized information for investors but reduced the value of sell side research; legal restrictions on conflicts of interest between research and investment banking, which may be good but took more of the reward out of sell side research; a crackdown on use of one-eighth point spreads, which had given market makers an incentive to generate volume in small cap names; and decimalization, which cut spreads in most stocks to $0.01 and further hurt market making.

All this adds up to a structural and legal landscape that doesn’t favor IPOs, especially smaller companies that might want to emerge into the public markets. The market’s big second-quarter bounce brought only four venture-backed IPOs, and the authors don’t expect great things even if the stock market recovers further.

The guys from Grant Thornton do offer up a “solution” – creating a new capital market where stocks might trade in 10 or 20-cent increments, brokerage houses could earn improved commissions, and i-banks might stage a comeback. They propose allowing companies to opt-in for this “Back to the Future” marketplace.

Given the devastating impact of the recent bear market “scandals” on any kind of financial innovation, I wouldn’t wait around for this idea to gain political traction. Instead, I hope the pessimists are wrong and IPOs do recover. Access to capital markets through IPOs has been an important factor in US technological and economic progress, not to mention the growth of industries like tech and biotech.

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