Escaping the Liquidity Trap - Small Cap Network Event Writeup, Part 2

Following on from Part One, this is Part Two of a summary of the Small Cap Network’s recent ‘Escaping the Liquidity Trap’ Forum Event at the London Chamber of Commerce. 

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 Two summarises the responses covering the following main questions:

1. Why aren’t more institutional investors more active in the SME space?
2. What can I do post-placing to diversify my shareholder register?
3. What actions can management take to increase access for retail investors?
4. Should I consider commissioning independent research?
5. How does London compare with overseas SME markets?
6. What are the advantages of an Order-driven vs. Quote Driven Market?
7. What impact does the tax environment have on liquidity?
8. Concluding Remarks

Why aren’t more institutional investors more active in the SME space? 

• There seems to be a growing lack of interest in small caps amongst institutional funds and advisers as the financial industry chases scale. 
• Gervais Williams has talked of the difficulties of managing the small-cap asset class, where the institutional and mutual fund outflows have been ongoing for a decade.
• Liquidity is a major concern for institutional investors in SMEs.  There’s a phenomenon which is referred to as a ‘lobster pot’, a lobster can swim into the pot but it’s extremely difficult to find its way out again. Perhaps that’s why a lot of institutions are wary about going into this space. Your shares are at the mercy of the market.
• Part of this may however be cyclical - we have had a period of credit expansion where large cap stocks leveraged up, paid very healthy dividends, so that’s where the money is starting to flow to and we‘re about to see a point in the cycle where that might change and we might revert back to a period that existed prior to the credit expansion. Asset managers are going to struggle to find decent returns in the liquid names and perhaps they’re going to start moving down the market cap chain.
• A further issue is that the institutions have an investment rather than an ownership mentality and, when faced with a problem, they will sell off, rather than deal with the issue. 
• You could be involved with a company along with quite a few other investors, you spot something you’re not happy about, you can go to management and tell them the problem. But if you go to institutions they’ll say ‘Oh we don’t get involved’ or they’ll say ‘Actually, you’re right, but we’re selling our holding, that’s our way of solving it’.  If they sell, and all institutions take that same approach, nothing will ever happen.  
• You can’t tar all institutional investors with that brush because there are some who are really dedicated. The rigour with which they go into the analysis, each company is really terribly impressive and certainly they do have a sense of ownership.  
• It’s a shame that many institutions don’t even send a representative to the annual general meeting. At the annual general meeting there are private investors there that know everything that’s gone on because they take a real interest in the company.  They’ll flag things up but, of course, the institutions are often blind to it because they don’t even have anybody at the meetings. If they’ve got over 10%, perhaps it should be enforced that they have to have a representative at the meeting so they know what’s going on at their company.
• On this note, the QCA have issued their governance guidelines, which is all about creating confidence between investors, institutional investors in particular, and management. 
• The Stewardship Code will be interesting to see as there will be more focus on how the institutional investors actually work and operate.
• Institutions who invest in SMEs can tend to get greedy for discounted stock simply because there’s too much evidence of weak valuations in the secondary market and they think that they can buy things on a single digit multiple with high expectations. People who run small businesses are just as entitled to have a reasonable valuation as people who run middle sized or larger businesses and they do need turnover to reduce risk.

What can a company do post-placing to diversify its shareholder register?

• If it’s a retail company then it can be easier because they’re already known amongst private investors but there’s lots of other ways it can be done.  Don’t, for example, cover employee schemes from the primary market from newly issued stock, but do buy in the secondary market. Covering a scheme with newly issued stock only results in diluting the existing shareholders and this process provides no support to the market at all.  Instead buy the shares in the secondary market, into an employee share trust, and cover a share incentive plan requirements from that source which carries the benefit of assisting the secondary market.  
• Monthly savings into ISAs or other schemes - there’s no reason why monthly savings and investment schemes can’t be made into the shares of a Director’s or employee’s own company.
• If a company is in the business of producing a product or service which the public enjoys using, then the introduction of a shareholder benefit such as offering a discount on the product to those who own a certain number of shares can help engage customers as shareholders.  This helps the client foster a sense of participation in the company.
• Evolving from a close company is not easy. It takes time and opportunities for diversification have to be found.  
• There’s no benefit of an entrepreneur remaining totally locked in to the majority shareholder position throughout their natural life because they will want the company to develop and mature into a fully balanced, listed company. 
• Opportunities such as acquisitions or further fundraisings are the sort of situations to make the most of to dilute existing majority positions thus allowing a company to mature.
• Companies can’t rely on the mainstream press and have got to get creative about their media making sure it’s disseminated as widely as possible if they want to attract a private investor audience.
• Institutions have got so much more access to management, understandably they’ve got a lot more capital, but it creates a worrying asymmetry, especially given that institutions are not particularly interested in SMEs.

What actions can management take to increase access for retail investors?

• SMEs suffer from both the media bias that exists in favour of larger companies and the lack of access to investment research given to retail investors. 
• 15% of private investors say that the lack of access to management is their biggest frustration about investing – in the same survey, one respondent said ‘it would be relatively easy to provide web casts of AGMs, analyst presentations, regular investor updates, project status reports and interviews with management but very few companies do any of the above’.
• In the circumstances, it’s very much up to companies to make themselves available and to have the investor relations functions in place to have their investment case heard and understood.
• Regular trading statements are important – if you can put out a quarterly trading statement it’s helpful but obviously management can’t spend all their time talking about prospects in the market. What investors really want to hear about is what is a particular company’s business, what chance of success does the business plan - how will the company be grown?
• Very often, management are only creating information in the more general sense in that they’re making presentations and undertaking analyst meetings. More often than not, it’s not actually being recorded and mediated. In so far as possible, this mediation should take place online, as long of course as there’s moderation as to what’s being said to make sure that potentially market sensitive comments are not made. 
• Pressure can be put upon management teams from private investors to stray beyond what’s in the public domain. People are being asked to comment outside of what’s in an RNS, so management teams need to guard against this. Instead, through regular and transparent news flow, it is much easier for private investors to understand what’s happening.
• It can be very time consuming for any executive to be trying to communicate with a retail audience. Companies’ lawyers will require them to check everything they’re saying and say that nominated advisers won’t like it very much. All of a sudden something which should have taken five minutes and would have been disseminated freely to everyone has lots of people crawling over it.
• There are a number of online IR functions (be it a Stockopedia type service or an interview with a management team on their website) which allow a company’s management to communicate with retail investors in a structured way. 
• One example is an oil and gas company with assets in Russia, which was relatively unique in using a PR firm to hold a conference call for private investors in the way that it’s normally done for analysts. It’s very hard for private investors to talk directly to the management teams so this is an approach that’s worth considering.
• For example, if a company does a presentation it should be recorded and webcast.  This is unfortunately a practice carried out by few UK companies. The practice is far more prevalent in the US. 
• It’s not just about adding a presentation to your website if there’s not much traffic to the site. Look at the trend of how people are using the internet.  Ten years ago there was only 35% of page views on the Top 10 websites, now it’s 75%. This is happening all the way down the tail of websites. More and more people are gravitating to social websites where they actually talk and discuss about stocks and, to be honest, most private investors get their ideas from each other.  Companies need to get on these sites and distribute presentations to these very large audiences.

Should I consider commissioning independent research?

• 60% of private investors say that the biggest concern stopping them from trading is lack of access to research about the stocks they’re interested in. 
• Brokers are talking to the management but, for commercial and regulatory reasons, the research isn’t ending up on the company websites mainly because it’s not required and the brokers are primarily concerned about protecting their client relationships.  
• Companies have to pay for SME research, there’s no choice because the independent research houses and, indeed, the corporate brokers will not voluntarily cover a company. Obviously if a company pays them for a corporate or advisory role, and they do provide research, then that will normally be included but it’s also helpful to carry out sponsored research although some would disagree in it’s value.
• Sponsored research is not biased, a lot of people think because you pay for it therefore it must be angled but it’s actually quite objective and neutral.  If it wasn’t, the provider would lose credibility. 
• Obviously they’re not going to give you a major thumbs down but on the other hand they will be honest about what your position is. 

How does London compare with overseas SME markets?

• It’s interesting though, where people are choosing to float these days as liquidity on AIM has suffered. Execs have been known to float in Toronto because there’s just no retail participation at float on AIM and because of that there’s no liquidity and no follow up brokering in the after market. That’s why so many companies are now choosing to float elsewhere.
• Edison has completed a research paper on the mining industry which involved putting all global mining companies onto a resource metric and they then worked out where they’re getting the ‘best bang for their market’. The answer, for an exploration company, was that you want to be based in Australia followed by Toronto but if you’re a producing company, you want to be based here in London. The flavour that comes from this is that certainly the London market prefers cash flow and value cash flow more than other markets, but if you’re an ambitious company with blue sky hopes, perhaps one of the other markets might be of interest. 
• Anecdotally, people are talking a lot about Toronto because of the higher retail participation. Toronto doesn’t stop private client brokers from going out and promoting stocks to the retail audience. It seems that that’s the issue here in the UK. The message from the private client brokers I speak to, is that they feel like they can’t do their jobs.
• Australia and TSX are great if you’re in natural resources but it’s only a small part of the market, it’s not that relevant for many people who are listed on AIM.
• Regarding the issue as to why a share price can be depressed on a placing, one of the reasons why the TSX and ASX are more successful is because in those markets trading in stocks is halted whilst an offer takes place. If this procedure were introduced here, that could help solve this particular problem.  An offer takes a few days, trading is simply suspended in that period.

What are the advantages of an Order-driven vs. Quote driven market?

• One of the things that distinguishes AIM from Toronto and Australia is the Market Maker driven system – is liquidity really assisted by the Market Maker system as they would claim, or whether it’s actually a deterrent to liquidity.
• The long tail of companies on AIM needs to have an order driven market, not necessarily exclusively but maybe having the two working together (dual-trading), and complementing each other to try and increase liquidity. Effectively it provides companies with an additional route to settlement.  
• Order-driven trading is not the perfect solution to all the issues under discussion. But if you take dual trading as one element, and put it alongside some of the other elements touched on – it’s about bringing those two different markets alongside effective research, effective investor relations, bringing that package together to try and create a facility where we can potentially solve this.
• The market making system worked for small caps in a way but that was when there was market making in the large caps because the one subsidised the other.  The moment order books come in you start to see that capital disappearing from the large caps and it has that huge impact on the small caps.
• Can a mix of order and market making systems actually work if a Market Maker doesn’t see all the order flow, then it just becomes a pure order book?
• The problem is that Market Makers are not seeing the limit orders.  If you dual trade a stock on Sharemark as well as on AIM the Market Makers can see where the limit orders are and if they want to job and pick up some of those limits they’re very welcome to do so.
• In relation to liquidity of AIM stocks, should there be a rule whereby if a company falls below a minimum trading volume mark, it automatically gets delisted, possibly to an alternative trading platform like Sharemark?
• Market Maker driven secondary markets are not always the best way for SMEs.  Basically the Market Maker spread, the bid-ask spread, is an insurance premium that the Market Maker takes for holding stock for either longer or larger than they need and the thing is they need to take on that position because it’s a continuous market and their obligations to deal immediately on that price but if you, as an investor, are prepared to be a bit patient and wait for your order to be filled then it is possible to run on a periodic auction market
• It’s much more applicable to companies which don’t have such high turnover to have a periodic auction market where basically you can find a direct price, or a single price, between buyer and seller.
• If shareholders aren’t happy with the spreads they see in stocks then they should talk to the Company Secretary of the company they’re invested in, say that they’re not satisfied with the market and request that they look at additional options. It’s up to shareholders to ask their company to ensure that they also provide order driven trading.  

How significant a driver of illiquidity is the tax environment?

• Tax is very significant because the structure is currently unfriendly towards SME investing and has encouraged the rise of spread betting and speculation amongst retail investors.
• Capital Gains Tax is much too high for SMEs.  It’s interesting to note that at 28% it’s actually higher than the effective 25% that a higher rate taxpayer who’s on 40% normally will actually pay and yet they’re the people actually taking the risks in an SME. 
• We need a new regime for business assets and we need to look at a structure for early stage investors which is separate from the Entrepreneur’s Rate
• Regarding Entrepreneur’s Rate the government is extremely generous in increasing it but actually for somebody who’s serious about starting up new companies, and actually has a good track record, it doesn’t really meet the bill
• Entrepreneur’s Relief has this lifetime element too so that if you have somebody who’s a successful serial entrepreneur and actually keep on building new businesses which create employment then basically they’ve got to wrap it all inside this lifetime allowance.  
• An ability to hold AIM shares within ISAs would be very important.  The bulk of personal investors’ money these days is actually held in ISAs.  SMEs AIM stocks can be held in a self invested personal pension plan, why not in an ISA?  I know that it’s extremely important that we don’t lose Business Assets Relief, particularly for people in terms of Inheritance Tax, but it’s also possible to preserve that status, and still allow the shares to be traded in an ISA.  There’s plenty of material on the Web following a major debate in the House of Lords in February
• All companies with a market cap of less than £100m should be exempt from Stamp Duty, it probably only generates £5m or £6m in total for the government.  The QCA application is that all AIM companies should be exempt but actually the revenue forgone is considerably more in that case.  The sub-£100m market caps would be a good start.
• In respect of Capital Gains Tax, the QCA’s proposal is, that instead of entrepreneur’s relief, having stakeholders relief. So if somebody holds shares for say five years, then there should be an appropriate relief against Capital Gains Tax. The QCA have suggested this should be for any company with a market capitalisation, on the day of investment, below £100m.
• Entrepreneurs of successful listed companies looking to undertake an exit should have three potential exit potential routes: 1) selling to the market, 2) a buyback and 3) a trade sale. 
• In reality, because of the market structure there’s no fundraising market. The buyback doesn’t work either because of labyrinthine 40 year old HMRC rules which mean that if an entrepreneur is undertaking a buy back into his own company, he actually ends up paying the highest rate of Income Tax as opposed to the Entrepreneur’s Rate, which will mean that you’re treated as distributing income rather than actually selling your shares. 
• As a result, there’s only one option left and that’s the trade sale and so many, many companies which come onto AIM end up going for a trade sale.  It can’t make sense for the country as often it leads to unemployment through restructuring or offshoring.

Concluding Remarks

• The Junior market unfortunately no longer has the attractive tax environment to improve liquidity, it no longer has the attractive regulatory environment to improve liquidity – perhaps we just need to wind the clock back to 1996, 1995, when AIM was first launched to reinvigorate the market?
• If the government believes that SMEs must drive the private sector recovery then it’s really, really important that we get this right.  If you have a larger company and you incentivise that to raise capital and build a new business, most of that employment, nowadays, will go overseas because people outsource their operations to the Far East, whereas an SME will tend to be grounded in the UK and build its employment in the UK and that’s what we need to look at.  
• We’re actually talking about much more than liquidity and valuations for SMEs from the secondary market.  What is at stake here is the ability of the private sector to pick up from the public sector with the private sector here being the SMEs.  Really what we’re talking about is the whole future of the British economy.