Whatever happened to the small-cap IPO? Capital Markets and the Impact on Community Banks

For decades in this country, the vast majority of Initial Public Offerings (IPOs) were for companies raising $50 million or less.  Smaller public companies, including community banks, could thrive in the public markets, with equity research coverage and retail brokers driving investor interest in growth-stage companies.  However, in recent years, the market structure changed and the public markets became inhospitable to smaller public companies.

Today, thousands of public companies—including many community banks—are simply ignored by investors in the public markets.  Investors in these companies have discovered that the stock rarely trades or simply does not trade.  These companies essentially endure all of the costs and burdens associated with the public markets without experiencing the benefits. 

So what happened?  Industry observers point to a series of events over the past 15 years that have effectively killed the small company IPO:   

Sarbanes-Oxley Act – The legislation is a popular punching bag in Washington and often blamed for the lack of IPOs; however, many observers believe it is not the most significant factor in companies electing to remain private.  Nonetheless, corporate compliance with the Sarbanes-Oxley Act has certainly increased costs for public companies, particularly smaller ones. 

Online Brokers – Although the introduction of online brokerages helped to make trading less expensive, these online brokers replaced retail brokers who helped buy, sell and market small-cap public companies to investors.  Stockbrokers collectively made hundreds of thousands of calls per day to their clients to discuss under-the-radar small-cap equity opportunities.    

Decimalization – Stock prices used to be quoted in fractions (e.g., the price of Company A was 10¼ or 10½).  The difference between fractions created profit for firms providing market making, research and sales support.  When the markets began quoting prices in dollars and cents, trading spreads were reduced and profits were significantly cut.  It became unprofitable to cover small-cap equity because there was inadequate trading volume in the small-cap companies. 

Global Research Settlement – After decimalization began, in an effort to continue writing research reports, Wall Street began funding research with investment banking profits.  Not surprisingly, conflicts of interest emerged and positive equity reports began to be written for undesirable companies.  State attorneys general got involved and ruled that investment banking divisions could not pay research analysts.  The result was that it once again became unprofitable to cover small-cap companies and research reports stopped being written.

High-Frequency Trading – Although high-frequency traders bring significant liquidity to the public markets, they require the volume and velocity that can only be found in trading stock of larger public companies.  As a result, high-frequency traders essentially ignore small-cap companies because there is insufficient liquidity in small companies to support high-frequency trading objectives. This trend is particularly damaging as a recent report stated that high-frequency traders conduct nearly 75 percent of the trades in the U.S. equity market– thus three-quarters of the public markets ignore small-cap companies.  

Taken in the aggregate, these (and other) factors have made the public markets undesirable, even hostile, for small companies. 

As a result, the public markets no longer provide the solution for investors who need liquidity, and the systemic failure of the U.S. capital markets to support healthy IPOs inhibits our economy’s ability to create jobs, innovate and grow.  For community banks, it has a significant impact on their ability to attract capital and lend money to small businesses which, over time, will disadvantage these banks and damage their local communities.   

Clearly, a new, stronger growth market must emerge.