The Kay Review, which spent several paragraphs discussing the utility of equity markets in raising money for small and medium sized companies, concluded that the equity markets are “no longer a significant source of funding for new investment by UK companies.”
Personally, I find this disconcerting. Equity markets are meant to help companies raise capital, to further their research and development. Through the process of purchases and sales, they ensure money is efficiently allocated. But, it now seems that most companies generate enough money internally to fund R&D, lessening the need for equity markets (especially for large companies). Beyond this, it has become more costly for companies to raise capital through equity issuance. This follows from an increasing number of intermediaries, who must be paid (lawyers, exchange personnel, etc).
What else has prompted this change? For one, modern businesses are less dependent on physical assets, and therefor tend to require less capital. This is, of course, quite ironic given technology companies’ ability to raise capital (see footnote below). Secondly, there has been an increase in private equity and venture capital funds funding small and medium sized companies (this includes angel investors, business incubators and even specialized banks). Tax policies have also had a role, as debt is a more tax efficient method of raising capital. At the same time, increasing regulation has made raising equity capital “burdensome.”
Does this mean that the fundamental reason for the stock market has changed? That instead of a place to raise capital, it has become a location primarily for easy transfer of ownership? Indeed, that is possible. Exchanges allow for mergers and acquisitions to occur with more ease, through the majority ownership of shares. While this transformation is possible, and seems likely, it is not desired - it turns out that acquisitions do not typically add value to a company.
A third reason exists, and that is the mismatch in expectations between companies raising capital and investors. Again according to Kay, there is a “wide gap between what banks expect to pay for new equity and what savers expect to receive from such an investment.” This makes investors and companies alike hesitant to raise equity.
So, what should companies do and how should exchanges be used? A focus on developing and maintaining the competitive advantages of British companies is one suggestion by Kay. We must also change our perceptions and see equity markets today “as a means of getting money out of companies rather than a means of putting it in.” While it is hard to fault these recommendations, one must wonder if something more drastic should be done.
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[1] Google, raised $1.67bn US at their IPO, and gave them a market capitalization of $23bn US. Google’s share price increased 18% on its first trading day. Other technology companies that have IPOd since Google have done even better – Linkedin, for example, gained 108% on its first trading day (closing at $94.25 US, up from its initial offering of $45 US). Let us not forget the Instagram purchase by Facebook for $1bn US. Given these prices, it also seems prudent to mention worries about a tech bubble.