Escaping the Liquidity Trap - Small Cap Network Event Writeup, Part 1

This is Part One of a summary of the Small Cap Network’s recent ‘Escaping the Liquidity Trap’ Forum Event at the London Chamber of Commerce (see Part Two here). The event was an open forum discussion including a panel of industry experts and an audience of small and mid cap company managers and market participants such as SME advisers and investors. The discussion was conducted on the basis of Chatham House rules, so anonymity has been preserved in respect of specific comments made by participants. However, as it was a fascinating discussion, we have summarised the main comments in the attached PDF and also below. 

Given the breadth of the discussion and the number of participants, this summary has been produced on a best endeavours basis. As it was a lively debate between multiple participants, a number of the comments may be contradictory and – for the avoidance of doubt - the views expressed below obviously reflect those of the speaker in question, rather than the Small Cap Network as a whole.

Part One summarises the responses covering the following main questions:

1. What drives illiquidity for SMEs?
2. How important is it to have a balanced shareholder register?
3. Why are Placings used so often when they exclude retail investors?
4. Why aren’t Open Offers used instead?
5. How well is the SME market being regulated?
6. Is existing regulation being enforced?
7. What role do the NOMADS play in SME illiquidity?
8. What role do the Market Makers play in SME illiquidity?

What drives illiquidity for SMEs?

• There are serious problems in operating the primary market properly for an SME. The way a primary market is run can set up the secondary market for failure. One of the most interesting examples of the disconnection between primary and secondary markets is not actually in relation to SMEs but was evidenced in the recent float of Ocado. 
• When most companies go onto the SME markets, their first concern is understandably one of raising capital. The focus with their advisers is concentrated on due diligence, preparing documentation, and deciding on valuation. Part of that should be assessing where demand meets supply but the key concern is usually to attract institutional buyers for newly issued stock, and that’s because the chosen method is invariably a placing one.
• The method for primary valuation is looking at the business earnings and the prospects of that company, while obviously having an eye to what ratios are in the secondary market. However, unfortunately, the secondary market doesn’t always work that way. 
• Supply and demand basically make up the secondary market valuation. If you don’t have an eye to where supply and demand is coming from, then actually it’s not a great help in pricing the new issue in the first place or, in fact, designing the placing.  The secondary market has very different dynamics for valuation and advisers can seriously misjudge that process.
• Participation in primary market activity is currently restricted almost entirely to institutional investors. Placings are built around a discretionary environment, either an institutional decision or a discretionary broker decision; they’re not actually designed for marketing stock to private investors.  
• Often a company goes in for its new issue, the launch takes place, trading opens and the capital structure, post placing, is so thin that there’s very little turnover, institutions are locked in – the ‘lobster pot’ syndrome. 
• If there’s no turnover, the secondary market participants will lose interest.  Any small movements can impact on the price because the Market Maker wouldn’t risk actually holding a position overnight - why commit his capital if there’s no turnover?

How important is it to have a balanced shareholder register?

• It’s very important to target a balance of personal investors and institutions from the outset.  
• Companies should think creatively as to where the constituents of supply and demand are going to come from once the market is opened up and they should concentrate the minds of their corporate adviser upon those market dynamics. 
• A balance is important so that the turnover from personal investors, at least every month, should allow a moderate institution to be able to deal in a stock during that period - that’s about the right kind of balance to aim for.
• As far as this balance is concerned, it’s very difficult to adjust it post placing and quite difficult to achieve in the placing itself.  The mechanics of a placing are that you are only allowed to take that issue to so many people and obviously the time horizon of that is short and so there’s all sorts of issues about allowing that placing to become too wide.
• It’s not realistic to expect a corporate adviser to focus exclusively on the end market at the launch of a placing but if they don’t talk about how the secondary market is going to work, then they’ve missed a major trick.
• From the perspective of creating buzz around a company, there’s much more to play for when there’s an active retail investor base and so it’s very helpful for a smaller business to have a high level of interest and excitement on its register.
• Unfortunately too often, advice from the City is that companies should get rid of their private investors if they want to be taken seriously. That advice comes from brokers, and from some of the larger institutional investors, it comes hard and fast from PR firms and other market players, such as legal advisers. As a result, many AIM Chief Executives simply aren’t aware that it is actually quite a good thing to have a good balance. 
• It’s easier for the financial advisers to the company to execute a nice little placing to friendly institutions and it’s too much effort for them to go and stretch that extra mile to go out to private clients.

Why are Institutional Placings used so often when they exclude retail investors? 

• The placing problem is so endemic. Why do companies raising finance adopt institutional placings?  Partly it’s now the convention that as an SME managers go to a corporate adviser and are almost invariably told ‘A placing is the easiest, the cheapest, it’s the way we normally do it’ and the regulations do lead companies down that route. 
• Small and mid-cap quoted companies do not see public fundraisings, which involve retail investors, as a cost-effective or efficient way of raising money.
• The QCA have analysed all the costs of going for flotation and if you add it all together it comes up to about £0.75m. As such, companies seek to do fundraisings, e.g. placings, that only involve institutional investors so as to avoid the prospectus. This has the knock-on effect of cutting off retail investors from the small and mid-cap quoted sector.
• The QCA has lobbied the EU directly about the Prospectus Directive and obtained changes which will help companies, including raising the threshold at which a prospectus is required, the number of persons to whom a document can be sent before a prospectus needs to be published and obtaining a proportionate prospectus for companies of less than €100m market cap and on secondary issues to existing shareholders, but the fundamental issue remains. 
• As a private investor in a company, sometimes out of the blue a big placing is announced, with a big discount and you are left thinking ‘There you go, I’ve been supportive all these years, I’ve just been ignored whilst x, y, z fund managers have picked up shares at a 25% discount of the share price’.  That’s why I think it’s important to tell companies ‘You’ve got to make an open offer alongside this to at least give some sort of private client participation if they want it’.
• There’s not a level playing field and it’s something that’s got to be addressed. Unfortunately, the way the industry is organised at the moment, private clients are seen as just an annoyance.
• Requests to the London Stock Exchange that a 25% open market obligation be brought back have been rebuffed because it’s felt that the market will simply lose business to other markets. The issue seems to be one of international competitiveness.

Why aren’t Open Offers used instead?

• Often a company requires certainty that it’s going to raise the money; it also doesn’t want its share price to suffer while the money is being raised and thirdly, an open offer is more expensive. 
• The risks are higher and the adviser’s going to say ‘The only way you’ve got a great chance of doing this, is to do a placing’.  Do a placing, get it underwritten and put it out to market but risk paying the price… Institutions no longer want to do that, if they do they want a big discount.  
• As soon as you let it out to the market place that you’re doing one, then the share price very rarely goes up.  So the cost of doing an offer is a lot more than just the fees.
• Despite what may be believed, three weeks are no longer required to complete a retail offer and this idea about cost is one that goes back to the days when we used to use paper to do all this, sending an application form, getting it back in, having it processed by receiving agents, completing all the checks and the rest.  The process is much faster these days.  Investors can open an account online within two minutes, get verified, put their money in, enter their order, that’s it, the costs are extremely low.
• There are those of us who would be delighted to market stock to a private investor, within the UK and within the current regulations, but the fact is that if nobody will actually bring us primary issue stock to be offered in that way, then we can’t do it. 
• Bear in mind that few corporate advisers have much knowledge or experience of a retail market.  There’s not been any requirement for an open market float for many years, and that’s a considerable pity.
• As far as corporate advisers are concerned, they’re obviously going to focus on the area where they make the most money.  The money comes from completing a range of new issues, not out of looking after companies which have already floated. Unfortunately there’s continually a need to badger the corporate adviser to take notice of a company once it’s actually in the market. The pressure has to be kept on so they don’t always concentrate on the next new company but instead do something about servicing companies which have already entered.  
• The large investment banks advise companies not to go anywhere near the personal investor market. It’s this ethos which is deeply embedded in the corporate adviser environment - it goes right through the AIM company advisers too. This tendency needs to change because the retail broking environment can handle it, it can market stock like they do in Toronto, give the industry a chance.
• We’re arguably not far off where we were in 1986 when together they led the way to the bust of the secondary market. If enough people would get together and actually say ‘We will write to the Office of Fair Trading and ask them to investigate the primary market of SMEs as a cartel system’, it might have an interesting result. 

How well is the SME market being regulated?

• Policymakers, lawmakers and regulators have concentrated too long on the secondary trading markets. They seem to have forgotten that markets were, and should be designed to, enable companies to raise finance effectively and in an environment which enables investors to find those companies and vice versa. 
• We exist in a state of overprotection of retail investors. There seems to be more of a buccaneering spirit about the Australian and Toronto exchanges, unlike here where the regulations required of smaller companies are strangling them.
• If you look at the treatment of personal investors getting involved in the primary market when a company’s shares are first issued vs. the secondary market, it’s completely different. 
• The secondary market has been only quite successful about keeping this investor protection process at a sensible level, so it means people can go in and buy AIM stocks in the secondary market but if you go in the primary market we’re completely surrounded by all these suitability requirements and prospectus rules and that’s the thing which creates the problem. 
• Suitability requirements on intermediaries are too draconian. An awful lot of private client brokers are scared stiff of introducing their clients into very small companies. This seems wrong – in many cases small companies are better known than larger companies, and their risks are better known too. 
• By analogy, you’d think that if you’re sent a credit card through the post that there would be an obligation on the bank to check that you’re suitable to receive that credit card, but there isn’t and there’s no way that the bank’s going to be held responsible for the scale of debts that you run up on that credit card, and yet that credit card could be a major risk for you in terms of suitability.  
• Surely an investor who habitually yields in small company stocks is actually going to be much better informed about the kind of risks that they will have onboard.  Pragmatism is required and the suitability rules need to be looked at again.  
• There is a nanny state environment but a large part of it actually comes from Europe and not within the UK. 
• The Prospectus directive is too tight; it should be significantly larger than the €5m which it’s now being raised to.  Why have a limit of 150 investors? It’s very arbitrary. A large part of these rules seem to have been put in place in order to satisfy the need for some effect in Eastern European countries. There’s a worry that smaller SME companies in this country are being held back in terms of their capital raising because of the profile of the European Union.  
• There’s supposed to be an alternative to preparing a full prospectus, which is called a registration document. However, it’s flawed – in theory it sounds fine, and involves adding a few notices on the end of your annual report but, in fact, it doesn’t cut the mustard.  

Is existing regulation being enforced?

• One concern is a lack of effective enforcement of existing regulations. It’s unclear who polices the market and looks at companies that are on it, e.g. threatening an official reprimand if rules aren’t followed, thus protecting the investors looking in from the outside. 
• Corporate governance and the lack of quality control is a big fear amongst investors. With a lot of investors, if you mention an AIM company, they just fall away, they say ‘We’re not interested, we don’t do AIM’.
• AIM, and other markets, have their problems and regulation is obviously an issue.  But at the same time there’s too much regulation which drives companies away. There is something like a 100,000 SMEs in this country, only 2000 of them are actually on public markets.  That’s a relatively poor market share for the public market.
• When a company goes to the wall and you see falsehoods contained in RNS or dubious accounting practices, where is the blame? Who puts up their hand and says ‘I’m to blame’, or points the finger and says ‘You’re to blame, you get fined’?
• The FSA have got to get down and stamp on abuses to ensure that people can trust the market - ultimately somebody is going to have to be held up to account. Until that situation’s addressed, a large proportion of the smaller market is going to be seen by investors as… somewhere not to go.
• There’s also a broader question, who’s actually in charge of the primary markets, who is responsible for the welfare of primary markets in the UK and, indeed, across Europe?  
• Back when the London Stock Exchange was a mutual, it was responsible for the primary market and it had a set of rules which said that if you were raising over a certain amount of money you couldn’t do a placing, you had to do an intermediaries offer. If you were raising above a further set amount of money, you had to do a full offer for sale and put your advert in two national newspapers. There was no competition so the rules were the rules and it provided for investor enablement. It enabled investors to get in at the right time. 
• The regulator is actually the Listing Authority, which is under the FSA. The London Stock Exchange is a commercial business plying its wares, to think of it as some sort of regulator in the old way that we considered the London Stock Exchange pre-1986, is not an option these days. 
• Why is the UKLA under the FSA? It would be preferable to put it under BIS because then you’d have a dynamic whereby the regulator of markets is actually looking at the efficiency of markets to generate new capital for businesses. The FSA is about investor protection and the investor protection rules are there to cover both main market and SMEs as well and to cover a secondary market and they’ll continue doing that whether the Listing Authority’s in the FSA or not.  
• We’ve had a whole raft of directives which have been borne out of the Financial Services’ action plan, which was there to encourage competition amongst the investment banks, order flow etc, but all the directives, and the Commission are now trying to change these directives to make them more small cap friendly, they’re nothing to do with the primary markets, they’re all to do with secondary markets 
• A study by Grant Thornton last year showed that if you look over a 10 year period the number of listings in America adjusted the GDP, before adjusting for GDP fell, over a 10 year period, by about I think it was 10% or 15%, something like that.  If you just look at the GDP it’s fallen by 55% and by looking and studying and making broad assumptions about how companies have not been able to raise finance because they weren’t joining those markets, they reckon that accounts for the loss of potential or actual jobs of 22 million jobs, which suggests that primary markets are quite important.

What role do the NOMADS play in SME illiquidity?

• There seems to be no-one there to pick up the blame or to do any quality control and you have to look at the brokers, the sponsoring brokers and the NOMADs.  
• NOMADs have multiple functions - they are supposed to look after the quality of the market, their clients and their institutional investors, so it can be unclear who a NOMAD is actually representing. In a sense, that versatility of function has been part of the success of AIM but it’s also an issue too that people need to recognise and constantly question/challenge these potential conflicts. 
• Perhaps NOMADs should have to define their investment template, i.e. what businesses they’re going to focus on.  Does one really want somebody who’s spanning the whole gamut in say restaurants to high tech to mining stocks?  There ought to be a degree of specialisation, rather than being all things to all people because you can never have knowledge in depth to try to cover all those different areas.
• There are cosy relationships within the adviser community. A lot of accountants and bankers who will just reel off one or two names.  People then go into those relationships, they don’t really know who they’re talking to and so they’re not really prepared for the process.
• The QCA has looked to assist in answering the question of ‘Are You Ready’ by producing a guide of the same name for a company aspiring to go public. If every company read this before they went to see a corporate adviser it would significantly help. As in so many things, time spent on reconnaissance is rarely wasted but, unfortunately, many people just rush in where angels fear to tread.
• You could rightly ask should we be assessing the NOMAD community and ranking them via performance tables not just according to money but also according to the longer term performance of the clients they bring to market? 
• Assessing the NOMAD market has the potential to increase liquidity on the same way that a fund manager who is AAA rated will attract, one assumes, many more people who want to be part of that fund.
• The issue is that performance tables tend to be based on one year, how much of any blame during such a short period can be attributed to the NOMAD? 
• Companies have been known to float, make significant progress but then the management changes and the progress was experienced disappears.  At what point do you attribute blame to the NOMAD?

What role do the Market Makers play in SME illiquidity?

• The problem is we simply can’t buy any stock. Sure an offer can be made for 10% or 15% above the current offer price, it might get filled. But the next day somebody offloads £1000 worth of stock and buys it back down 20%.  How can that be reported to clients? 
• There’s no depth, there’s no size being held, how can they justify the spreads when they’re holding, say, £3000 worth of stock? I think it’s got to go across to an order driven system. If they can’t do it, then it’s up to the private clients and the institutions to sort out the price amongst themselves.  
• The whole point about a Market Maker is he assesses what scale of position he can afford to hold by looking at the amount of time it might take him to get out of it. If it’s completely indeterminate, he really doesn’t want that position in the first place, so he’ll only take very small deals, and neglect will obviously result in the price wilting.
• A financial firm starts with various different gradations of quality of revenue. At the lowest level of quality of revenue is market making revenue, it’s the only element of revenue on which you can lose money before you even start paying your overheads and it is volatile.  That is why suppliers of capital into Market Makers actually require a very high IRR to make it work.
• Winterfloods have had some pretty rough periods in the past.  If you look back through their accounts you’ll find periods, certainly around 2003 and 2002, when it was a pretty rotten time for them and that’s the reason why the margins are so big.
• If market-making is easy and the margins are that high, and they are at the moment, then it should attract new entrants. But why isn’t it happening?
• If you go back to the days of the late ‘80s, early ‘90s when the market was trading on 14/15 times, Smith Brothers, you bought on a 5x multiple, so it was a third of the market multiple basically because it was so risky.