Solutions for Smallcap Markets: A roundtable discussion on liquidity, AIM and regulation

David O'Hara: The last two years have seen more damage done to smallcap valuations and liquidity than any period in ten years. The difficulties at this end of the market have hurt investors, companies and vital intermediaries such as brokers and the exchanges. To qualify the extent of these difficulties and draw out potential remedies, Blackthorn Focus assembled a panel of expert smallcap market practitioners in a roundtable discussion. Highlighted issues included the impact of both national and European regulation, the role of retail investors and the value of broker/independent research. We are delighted to bring you the proceedings of that discussion here. I hope this debate enhances understanding among all of us participating in the market and encourages future collaboration and cooperation.Finally, thank you to all our expert panelists, particulary BDO’s Chris Searle for hosting the discussion.

Chris Searle, Discussion Chair: AIM was disproportionately hit by the financial crisis. Has interaction with the financial markets become tougher for smallcap companies?

Andrew Tan: We listed in August 2006, during more buoyant times for the market. At the time of IPO we did not raise any new money but in 2007 we did two separate fundraisings. The process was extremely simple and valuations were favourable. This was great as we did not need to raise money in 2008, a really tough time in the market. For the 2007 fundraisings we already had institutional interest in the company and we just issued the shares. Less demands were made on management time through discussions with lawyers, brokers or roadshows. At the beginning of 2009 we raised £10 million. This was harder work and hugely timeconsuming from a management perspective. At the end of 2007 we raised funds at 280p, in May 2009 we got funds at 120p. It was much tougher, institutional shareholders were more questioning, the tone was very different to any previous fundraisings.

Chris Searle: Why do you think had to go through this when you didn’t the last time?

Andrew Tan: The biggest change that has occurred in the last couple of years is the amount of value destruction that has taken place. There was a time on AIM from what I could see, funds were getting involved at the IPO stage, there was a lot of press coverage and retail investor hunger — this was driving prices upward and funds could make a lot of money, exit and come back in again at the next opportunity. Less questions were asked then simply because there was the expectation that investments would perform well. A lot of funds have since seen that value destroyed and they don’t have an inflow of cash to invest back into the smallcap market.

Gavin Oldham: Was the latest issue done purely to institutions or did anyone suggest you should also approach private investors? Private investors complain frequently they cannot get access to primary issues.

Sandy Fleming: Why aren’t they buying ahead of placings — well they perhaps don’t realise these companies exist and they don’t get to see any research.

Andrew Tan: We work hard with private investors, doing four or five roadshows a year both in London and in the regions. The irony is that we can meet an institution that would like to invest, liquidity in the market deters them from buying there but they would be happier to invest via a placing. The problem is that your valuation is driven by the market and the marketmakers who won’t really hold stock. Private client trading drives the market volumes but in this instance we issued solely to institutions. The whole financial crisis has been a doubleedged sword for us as our sector, cleantech, has been put right in the middle of peoples’ agenda while at the same time smallcap valuations have been hit badly. Our placing was 100% institutional and oversubscribed. Following the placing volumes rose substantially. We started the week at around 100p, did the placing at 120p and finished the week trading at 150p.

Darron Preston: What was the reasoning behind a placing rather than an open-offer? Cost — obviously, but one thing private investors often express disappointment over is the fact companies will exclude them from placings and dilution results.

Andrew Tan: That’s absolutely true. From the company perspective a placing is more cost effective and less demanding on management time. In the most recent placing we issued at a premium to the market price, our shares had been trading below that level for some time, there was plenty of opportunity for investors to buy ahead of the placing.

Gavin Oldham: We did the same last year with an offer that was oversubscribed, going entirely to private investors. A private investor brings something more to the party as, for a company like ours, they can be a customer too whereas an institution cannot. Running an open offer is not a problem. A lot of brokers will go straight for a placing as it is the status quo and there is a culture within corporate brokers where they will not reach out to the retail investor market. This is an interested and approachable market and I am surprised we do not see more brokers go there.

Richard Feigen: Institutions give more certainty. As the various iterations of regulation have developed it has become increasingly difficult to address private clients. Unless you are raising less than e2.5m you have to put together a prospectus. It seems the government would much rather the regulators forced all private individuals into pooled investments.

Gavin Oldham: There are the regulatory issues and the operational issues. It has become much easier to reach private investors because they are using internet stockbroking sites now and decision making can happen within a couple of hours. I’ve been lobbying for private investors to have access to the rump part of rights issues. We can deal with certainty now but the regulation is certainly a problem and it needs to be tackled. The best way would be increasing that e2.5m limit up to about e10m.

Chris Searle: The European Union is reviewing the prospectus directive and a lot of the comments from the UK have suggested that or a cutdown prospectus that reduces those requirements.

Richard Feigen: If a broker is raising money in a primary issue it is clear throughout we are acting for that company and not anyone else. Dealing with private investors in any sense opens up whole series of regulatory issues.

Sandy Fleming: Should institutional shareholders be the only ones that matter? Unless there is liquidity in the secondary market, an institution is not likely to increase its stake substantially neither will they decrease if there is nobody to mop up the stock.

Andrew Tan: There is a distinction between raising funds in the most manageable and cost- effective way for the business and shareholder and saying ‘we don’t value the retail shareholders’. Retail shareholders play a huge part in governing a smallcap company’s daytoday valuation which will ultimately affect the price at which you can issue new shares and raise money. As a business you have to commit the time and I would say it is between a three and five year process of building liquidity in your company’s trading.

Darron Preston: In some instances you would not mind the spread being so large if you could buy a significant amount of stock. The spreads being quoted are a ridiculous degree of compensation for a risk position.

Gavin Oldham: Spreads are very wide. Continuous trading does not meet the needs of companies with little liquidity. With Sharemark, operating a periodic auction environment once a week or month helps narrow the spread and discipline marketmakers. The system has got to allow for a low liquidity market. If you want the luxury of being able to trade immediately you are going to have to pay a premium for it and that is the marketmaker spread but if you are prepared to be patient and allow orders to build up you can trade with sells on the other side without someone in the middle taking a slice. This is a great way to deal for people that are not driven by immediacy and that suits many institutions and private individuals. Dual trading on AIM and Sharemark is great — marketmakers can see the limit orders on Sharemark and it gives them something to work with, tightening the spread. There is a lot companies can do to nurture their own secondary market liquidity. Employee share purchase schemes should be executed through the secondary market, companies do not have to do this by issuing new shares. This provides a small but regular volume.

Paul Parker: One of the problems we have encountered is where trades are happening but are not being reported because they have been executed on another platform such as PLUS. You cannot see where trading is happening.

Ash Mehta: For a house broker isn’t it in their interests that there is a good aftermarket in their clients’ stock and wouldn’t research to the retail community help that?

Darron Preston: A broker doesn’t get the commission value from the man in the street but if brokers can stimulate retail investors by posting research on company websites, won’t the additional liquidity help bring the institutions in?

Richard Feigen: We would be very happy to distribute research to private investors but compliance tells us our research is written for the institutional audience, not private clients. The regulatory system makes a massive differentiation between institutional and retail investors.

Darron Preston: A number of companies carry broker research on their websites.

Richard Feigen: This is almost certainly in breach of regulations.

Gavin Oldham: I’ve been trying to make broker research available to private shareholders. Nearly all our register is private individuals and they cannot see the broker research, it is laughable. It is simply a matter of the regulators taking a more balanced look at it.

Sandy Fleming: If your shareholder base is made almost entirely from private shareholders, how do you get your broker to write research?

Gavin Oldham: We have to pay for independent research, and our broker also covers us.

Paul Parker: Most small companies only have one analyst producing research or none at all. Normally a smallcap analyst comes from the house broker, being cynical, can an investor believe the research that has been written?

Sandy Fleming: You can believe the research, but perhaps you should not be reading the recommendation!

Ash Mehta: Having a lowercost research offering is an opportunity for companies to engage better with investors. The challenge for the exchange is how do you get companies to start doing other things they really should?

Sandy Fleming: Every piece of research should add something. If you do not know anything about the company any information adds value. How did your company get twelve brokers covering you at one time or another?

Andrew Tan: We are very active in talking to the market. We don’t pay for any of it, much of the coverage is to do with our position in the cleantech sector. We make our staff available if analysts need some industry comment — you have to engage with the market. Sometimes brokers regard research as a lossleader in securing NOMAD mandates from companies.

Richard Feigen: Traditionally a lot of AIM-listed companies began as stocks dominated by retail investors and went on to recruit institutional investors. A good example of this is £ASOS , originally followed only by private clients, yearonyear profits and turnover increased and it became a company institutions invested in.

Paul Parker: That is a function of liquidity and freefloat. If you have retail investors in the first instance there will be a lot of liquidity.

Gavin Oldham: The fact spreadbetting is untaxed means a lot of people who were previously active in smallcap markets are taking their money to the place they can get leverage. That volume has come out of the cash market on AIM and has had a very marked effect on liquidity. If the government axed stamp duty on AIM shares or introduced more taxation on CFDs and spreadbetting turnover would improve hugely. Private investors are incredibly pricesensitive on dealing charges. There is huge scope for retail investors to play a bigger role. It is extremely difficult for a retail company to have a retail shareholder base, you have really got to work at it, whereas on the institutional side the entire track is welloiled. If turnover is inadequate spreads will widen and marketmakers will drop out. We need to nurture the full breadth of shareholder bases and that means the private shareholders as that is where the secondary market really comes from.

Andrew Tan: The credibility the market awards our statements is helped tremendously by us already having a considerable institutional shareholder base rather than a huge tailend of retail. Liquidity is an evolutionary process, it takes a long time. We are getting there but it is hard work.

Gavin Oldham: I believe the problems come from advisors focusing almost entirely on the primary market. Companies come through with the attitude that the secondary market is not important. One CEO once told me “I don’t care about the secondary market, I am really looking for a trade sale — the valuation in the secondary market does not interest me.” A lot of companies work that way and it undermines the market.

Paul Parker: When brokers can make 4% on a flotation and 0.2% on a trade in the secondary market, which business are they going to serve?

Ash Mehta: Many companies that have come to AIM over the last few years have been illprepared, whether that is their inability to execute good investor relations or to manage their shareholder register. The problem that creates for companies increasing profits and paying dividends is that it’s more difficult for those companies to get noticed.

Andrew Tan: How does a retail investor keep up with the large number of additional companies that have joined the AIM market? How many willing investors are there to provide liquidity for that many companies?

Sandy Fleming: In my experience if a company consistently grows profits and starts paying dividends it is surprising how the market capitalisation increases. Its like Gary Player said “the harder I practise, the luckier I seem to get”. If a company has a market cap of £20m and 60% is in institutional hands it isn’t going to get to £30m. The institutions who are not invested are unlikely to go into the market looking for stock.

Richard Feigen: One of the problems we get regularly is someone sells five thousands shares in a company for £2,500 and the share price falls 10%. It can take some CEOs and Chairmen a while before they stop taking it as a personal attack every time their share price falls.

Andrew Tan: The reputation of the junior market has taken a huge hit. We talk to a lot of European investors. On a number of occasions investors have been very interested until our listing comes up and they say ‘we are not going near AIM’. The bad reputation comes from the number of inappropriate businesses that got publicly listed. However, this was the cheapest form of capital available to them, so why wouldn’t they list? Investors were willing to invest because they had made money in the past. I cannot see how that could be addressed through regulation. 

Richard Feigen: Smallcaps come into favour at a certain point in the cycle and AIM was, and indeed still is, the leading smallcap market in the world. Companies were raising capital in the most sensible way and that was via AIM. There comes another point in the cycle when smallcaps go out of fashion and we are coming out of that phase now. This is one of the key advantages of having NOMADs who are brokers as well, we have clients on both sides, we cannot just sell poor companies to institutions because they will stop dealing with us. We have to make sure our corporate clients are quality businesses because our livelihood depends on it.

Darron Preston: For a lot of the smaller companies out there, an open offer could easily be paired with a placing. This would improve the perceptions of the company in the private investors eyes. I have told companies in the past that have sounded me out about a placing they should open offer instead to their existing private investors.

Gavin Oldham: How about a corporate broker approaching thesharecentre with a view to distributing stock in a primary issue. No broker has ever said to us “I’ve a corporate client who would like to see 25% of this placing go to retail shareholders, can you help?”

Richard Feigen: Within an IPO we could perhaps do it but the attitude of policymakers is that private investors are not supposed to see our research etc. The prevailing view seems to be that private clients are not sophisticated enough and they won’t be able to understand what is being offered.

Chris Searle: In recent years the number of overseas companies joining AIM has increased. Is that expected to continue?

Paul Parker: Why would we take the risk of investing in, for instance, a Chinese company that has come to the UK but does not have a listing in China? Without knowing anything about their local markets or economy I’d be relying on broker research for an introduction.

Richard Feigen: Typically overseas companies that list are those with international exposure. As the LSE raises the number of overseas companies listed in London, the broker community should increase the number of overseas institutions that will invest here. When we brought a Vietnamese company to the UK market recently we operated in partnership with one of the leading Vietnamese houses that intimately understood the local market and most of the money was raised in Asia. The international aspects of the company’s business made it important they took a London listing. What would be different is raising money in London for a purely domestic overseas company. The goal for all of us should be to make London the international centre for growth companies. 

Paul Parker: The problem is how do you get people to write research or look into these companies when there are enough UK smallcaps to look at?

Richard Feigen: That’s one viewpoint but there are others. If a broker tried to raise money for such a company solely from UK-based smallcap funds that would not be wise.

Darron Preston: I’ve no problem buying a foreign company that is listed in the UK provided it has a domestic listing. If it doesn’t I become wary.

Richard Feigen: The view was often ‘if they could not raise money there, why come over here?’ but SarbanesOxley resulted in lots of perfectly good US businesses listing in London to avoid overly onerous regulations back home.

Sandy Fleming: Is there any difference between the turnover in international shares on AIM and the rest of the junior market?

Gavin Oldham: It has much more to do with the shareholder base and how it is nurtured.

Darron Preston: One of the key problems is the mess of regulation we have.

Chris Searle: Most of the regulation now comes from Europe, MiFID for example.

Gavin Oldham: I doubt we will see any change before the next election. Now is the time to be engaging with people that are in a position to change things.

Sandy Fleming: Why is it that even the politicians that have come out of the City fail to understand the issues?

Richard Feigen: You don’t win many votes by saying you will loosen regulation. Markets will sort themselves out but the thing that interferes with that is regulation. The biggest threat to this country is not recession or inflation, it is regulation coming in and stopping us operating properly.

 Gavin Oldham: When it comes to price consolidation and reporting trade volume if that isn’t aggregated across trading platforms that’s a serious failure. I’ve brought this up with the FSA and they seem to have little interest in tackling it. The problem is the financial media are not regulated.

Darron Preston: There is a feeling regulation needs to be adjusted, perhaps by redefining the roles of NOMADs and brokers. There needs to be a greater belief in the market that what companies are claiming is true and when it isn’t advisors get stamped on.

Gavin Oldham: NOMADs have become used to a comfortable lifestyle. There is not much competition within that sector of the market. When we first listed on AIM and got bids back for NOMAD services, they were all pretty much the same amount.

Andrew Tan: It would be good if there could be a requirement for marketmakers to run a larger book but no regulatory framework can prevent outright fraud.

Richard Feigen: It is not just down to AIM to improve the situation for smallcap markets. AIM and Marcus’ team have done as good as job as anybody could. There is a fundamental direction from big regulators to say private investors should not be investing. I am more concerned that policymakers will clamp down on private clients investing into smallcap companies, as direct investment becomes ever harder for individuals.

Gavin Oldham: This government’s argument forbidding AIM shares in an ISA is centred on the inheritance tax breaks on business assets which are completely irrelevant. If AIM shares can be held in a pension they should be allowed in an ISA.

Tony VineLott: There is no appetite at the Treasury or HMRC to do more for AIM stocks than is already in place, even though a lot of the tax benefits of AIM shares disappeared when the capital gains tax rules changed.

Summary

Shane Smith - Markets thrive on information and liquidity. At the core of this debate is the question: what policy, regulatory and commercial framework best fosters these attributes? Creating a vibrant shareholder community around a company’s stock is a process rather than event, and one requires constant attention. It is a perennial frustration for smallcaps that price formation often occurs on small trading volumes. Yet it is these small volumes that perpetuate the vicious circle of low broking revenues and, across the industry, structurally diminishing budgets for research.

There is a delicate regulatory balance to be struck. Retail investors desire greater participation in primary markets but are often excluded by the additional burden this would place on issuers. Ironically, to participate at all these investors might need to be involved ahead of a formal offer, consequently losing the protection the regulatory framework is designed to provide.

Without a retail element in the share register, the full potential of the public market is not realised. Smaller issuers tend to work with smaller brokers whose commensurately small client base restricts the distribution of research. With over 1300 companies on AIM, it is no surprise that many companies are invisible to investors. Smallcap issuers must devote time to investor relations. The London Stock Exchange is helping, notably with its PSQ Analytics initiative. Further industry roundtables are essential to explore fresh initiatives for policy, regulation and commercial innovation.

Participants

David O’Hara is Founder of Blackthorn Focus.

Chris Searle is a partner in Chris Searle BDO Stoy Hayward’s Transaction Services team and specialises in advising companies seeking to list on AIM. He has 20 years experience of this type of work. He also leads the firms corporate finance technical and prospectus committees and is chairman on the technical committee of the ICAEWs Corporate Finance Faculty.

Andrew Tanheads up investor relations and business development at AIM quoted Zenergy Power Plc (LON:ZEN) — a leading clean technology business focussed on the development of superconductor technology for efficient power generation, distribution and use.

Gavin Oldham is Chief Executive Office of Share (LON:SHRE) . Founder of The Share Centre, having previously established Barclayshare (now Barclays Stockbrokers) for Barclays Bank, Gavin plays an active role in business affairs and is a regular contributor to radio and TV

Tony VineLottbecame Director General of the Tax Incentivised Savings Association (TISA) in September 2001. Tony is a Fellow of the Securities & Investment Institute; is Chair of the National Skills Academy for Financial Services and has served on a number of Committees and working parties for the London Stock Exchange.

Richard Feigen is the Managing Director of Seymour Pierce and is responsible for all of Seymour Pierce’s activities encompassing investment banking, stockbroking and corporate finance.

Ash Mehta is Chief Executive of Ash Mehta Orchard Growth Partners, a professional firm providing parttime Finance Director services, and is also parttime FD of Northbridge Industrial Services plc, an AIM-quoted industrial hire company.

Sandy Fleming is an elected Sandy Fleming Trustee of the F&C Pension Scheme. From 2000 he was the manager of F&C Smaller Companies plc, the largest quoted global smaller companies investment trust. In 2005 he retired from F&C.

Paul Parker is an investment Paul Parker manager with Collins Stewart Fund Management. He is the deputy manager of the Collins Stewart UK Catalyst Fund and a Fellow of the Securities & Investment Institute.

Darron Preston joined Aventus Capital Management from one of the largest private banking groups in the UK and has been managing investment portfolios since 1987. His speciality is in investment research and applying that knowledge to clients individual circumstances. 

Shane Smith is Chairman and Chief Executive Officer, Independent International Investment Research plc.