IPO rules on unconnected parties haven’t worked: investors are suffering

The dangers to a growing company of having an unsuccessful IPO can be serious, affecting investor confidence, customer relations and staff morale. Fraser Thorne suggests the new FCA rules have not helped.

A year since new rules were introduced by the Financial Conduct Authority (FCA) to reform initial public offerings (IPO) it is not entirely clear they are achieving what was intended. 

Regulators and stock exchange officials should therefore be far more concerned about the decline in market efficiency for IPOs in the UK and across Europe than they are. There were at least 14 new listings across Europe worth upwards of $250m that were pulled last year. Some actual stock market debuts have been spectacularly unsuccessful, particularly those of Aston Martin and Funding Circle, whose shares have recovered only somewhat from the lows of reaching half their issue price. 
Part of the problem lies in the fact that the broker market has experienced years of consolidation, which has shrunk the choice of advisers to run an IPO considerably. This has left a void into which bulge bracket banks have stepped, despite not necessarily having local market franchises outside the larger, liquid stocks. 

While the regulations set out by the FCA were a step in the right direction, without further support, companies and investors alike will lack the protection they deserve.

Regulations designed to protect investors
The new rules introduced last year were designed to encourage greater engagement with independent parties – analysts and investors – ahead of an IPO. Previously, investors relied on a draft ‘pathfinder’ prospectus and connected research to educate themselves ahead of meeting management, with a price range announcement made prior to final investment decisions. Other than an ‘intention to float’ (ITF) announcement, the entire IPO was run by investment banks and offered only to their existing institutional clients.

The new process brings the publication of the admission document/prospectus significantly earlier in the IPO process and before the ITF. This gives the public earlier access to the prospectus, meaning the education phase ahead of the management roadshow takes place on more of a level playing field.

Issuers/advisers will decide whether to invite unconnected analysts to the analyst presentation and this will trigger either a one-day window between prospectus and ITF, in the event that unconnected analysts get identical access to management as connected analysts; or a seven-day window between prospectus and ITF, in the event unconnected analysts do not get access to management at the same time. This would potentially extend the overall process to nine weeks from the analyst presentation.
In doing this the regulator sought to level the playing field for investors by widening market access to the pathfinder and to comprehensive equity research, so that investors could access research that is not produced by a party that will be paid out of the success of the deal. 

Consolidation has limited choice 
But years of consolidation in the brokerage market have reduced the number of advisers to manage an IPO considerably. The larger investment banks have stepped into this void but many do not have local market franchises outside of the larger liquid stocks. While all of the banks are plugged into the relevant investment houses that is not the same as having a trusted broker/fund manager relationship in the right sector, geography or market-cap range. The dominance of the international banks is skewing allocation away from the right investors.

Moreover, how banks are incentivised and how they win business can push an IPO price higher than it ought to be. When supply is limited, bankers will come under pressure and are often criticised for being too enthusiastic with regard to valuation in order to win a mandate.

One company that suffered particularly as a result was Aston Martin. Its share price fell 5% on its Stock Exchange debut and never recovered. Its market cap is now less than half of its IPO valuation.  Aston Martin’s problems stemmed from the fact that it hired no less than 14 banks to raise just £900m, none of which was new money to fund growth. It has subsequently found insufficient support in the aftermarket.

Funding Circle similarly was forced to call upon banking stalwarts Morgan Stanley, Bank of America Merrill Lynch, Numis Corp and Goldman Sachs Group to raise £300m from its IPO. Apart from Numis none of the other banks had a speciality in UK mid-cap companies. 

Naturally those selling the stock will give a very good hearing to the bank offering the highest price, even though this is not the only criterion they take into account. Banks have to bid for an IPO months in advance of the deal going live. That leaves plenty of time for other factors to affect value and for lots to go wrong with an inflated debut price leaving investors exposed to arguably avoidable losses. 

Both Aston Martin and Funding Circle were hit by what bankers and investors describe as a ‘Marmite effect’, drawing enthusiastic doubters of their business models, as well as backers. Funding Circle, in particular, also suffered from the new rules by not engaging with unconnected parties forcing the publication of its prospectus back by seven days at a time when equity markets were beginning a slide that would continue until Christmas, wiping billions off company valuations. 

It is also no surprise that private-equity backed IPOs are viewed with greater scepticism than those of companies looking to secure new capital to support future growth. The former is seen as an exit for the current investors, while the latter is viewed as the start of a new journey.

Incentives continue to distort the IPO process 
An IPO should go to a premium in its first week, not just because advisers need to look after their buyers but because a premium needs to be justified. A stock is re-rated as it transfers from a private company into a quoted company and the company, management and staff feel the brunt of an overpriced IPO. If an IPO stock goes to discount the consequences can be punishing, setting a company back years and stunting growth. 

The prevailing view among advisers is that the IPO reforms are a distraction from the ultimate goal of raising money as simply and quickly as possible. Their interests lie in the initial order size, in stock allocations and have been known to take the view that extra marketing to smaller, less prominent institutions will not add significant value or even might lengthen the IPO window causing reputational damage for the company.  

So far the intended effects of IPO reforms have not yielded the results that were hoped for or properly addressed the problems discussed. They have had little effect on deterring inflated valuations and protecting investor’s interests for long-term growth. Better preparation and foresight is needed for the post-IPO life of an organisation, based on further widening the window for independent equity research. 

Fraser Thorne is chief executive of Edison Investment Research.

Published 29 July, 2019

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