I submitted the following letter to the editor of The Wall Street Journal in response to an article  published January 5, 2011, titled “Friending Private Capital.”  Although the letter was not published in The Wall Street Journal, here is my response.

To the editor:

Your editorial “Friending Private Capital” raises a good question – why are so few companies going public today?

Up until the previous decade, low cost and efficient capital formation was a hallmark of the U.S financial markets.  Individual investors at all income levels have been able to participate in exciting growth companies by buying shares of publicly traded stock.

Goldman’s creation of a special purpose vehicle to buy shares in Facebook speaks loudly to everything that is broken with capital formation in the U.S. today.  Facebook is in no rush to go public because they likely perceive being public as burdensome in many ways.  Shares of Facebook “trade” on private exchanges to which the general public has zero access.  Goldman’s lawyers create a clever special purpose vehicle such that a group of investors (each with a purported minimum investment of $2 million) can be treated as one investor and thereby help Facebook avoid violating arcane securities laws.  How did it all come to this?

Jobs are created by growing companies, which need efficient access to capital, which is most easily facilitated by selling shares of publicly traded common stock to institutional, high net worth and “mom-and-pop” investors, who in turn enjoy transparency and liquidity.

Going public and being public needn’t be complicated or burdensome.  Goldman’s “Friending” of Facebook shares should be a clarion call to all involved in the equity capital market ecosystem that it’s time to do a root and branch review of everything that is inhibiting exciting private companies from going public in the U.S.

It wasn’t so long ago that junk bonds were trading at a 2000 basis points spread to Treasurys.  That was then, this is now.

Junk bonds are in a raging bull market.  Spreads over Treasury have collapsed to 600 basis points.  And when the ducks are quacking, Wall Street will always be sure to find a way to feed them.  Consider hospital operator HCA Inc.’s announcement last week that it was issuing $1.5 billion in junk bonds and drawing down credit lines to pay a $2 billion dividend to KKR and Bain Capital, its private equity owners. According to Standard & Poor’s, HCA’s payout is the largest PE dividend recap since June 2005, when Fidelity National Financial Inc. issued a $2.7 billion dividend to its owners.  According to The Wall Street Journal, “This year is on track also to mirror total dividend-related financing in the 2005-2007 sales boom. According to S&P, companies have sold $40.3 billion in dividend-related financing loans and bonds this year. Companies issued $56.2 billion and $55 billion in 2006 and 2007, respectively.”

On the one hand, we know that short-term Treasurys basically yield zero and that investors are starved for yield.  On the other hand, one might think that after the 2008-2009 financial crisis that even high yield investors might be slightly chastened about lending money to already highly leveraged companies, especially for the sole and exclusive purpose of issuing dividends to PE owners.  The question is:  Why do these companies engage in these financing transactions?  The answer:  because they can.

Mortgage Rates Go Below Yields on Long Treasurys: “An Impossible Event”

As pre-IPO investors, we are always on the lookout for signs that “animal spirits” are on the rise.  Consider the following two interesting data points:

Exhibit A:  30-year fixed mortgage rates (4.17%) dropped below the yields on 30-year Treasury bonds (4.239%) for the first time—ever.  Credit for highlighting this freak event goes to Michael Shaoul, CEO of brokerage firm Oscar Gruss:  “You have, in theory, an impossible event, which is that the man in the street is paying less interest than the government is.”  Click here to link to the article in the November 11, 2010, edition of The Wall Street Journal. Mortgage Rates Go Below Yields on Long Treasurys

Exhibit B:  The private equity “dividend recap” is back in force.  More to come in our next posting….

Previously in this column, we had noted that in 2001 there was an average of 306 market makers quoting prices in stocks trading on the FINRA operated Over-the-Counter Bulletin Board (OTCBB). That number had dwindled to 199 at the end of 2008 and 160 at the end of 2009. As of April, the number stood at 135. There are now some 51,127 priced market maker quotes on Pink Quote vs. 9,615 on the OTCBB.

The OTCBB is now terminally ill; the faster that FINRA pulls the plug the better.

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Meanwhile, back in the land of free markets, Pink OTC Markets, Inc. (www.otcmarkets.com), the operator of the Pink Sheet quotation system, has been trail blazing a new model. Mind you, this is not your father’s Pink Sheets. Much has changed, and Pink OTC Markets is now the standard bearer for over-the-counter trading in the U.S. In fact, there are only 53 issues exclusively quoted on the OTCBB with the vast majority of over-the-counter securities (80%) being quoted on Pink OTC Markets.

The company now operates the leading electronic interdealer quotation and trading system in over 9,000 securities not listed on a U.S. stock exchange. Pink OTC Markets segments these securities into three tiers: the quality controlled OTCQX marketplace, the U.S. registered and reporting OTCQB marketplace, where nearly all reporting issuers are now quoted, and the speculative Pink Sheets marketplace, where non-reporting companies are quoted. These three tiers constitute the third largest liquidity pool for trading public company shares, after the Nasdaq Stock Market and the New York Stock Exchange.

We embrace and support this model for the simple reason that we are unqualified advocates of free markets, including and especially markets for equity securities.

Pink OTC Markets is to be commended for its transparency and rational segmentation of its diverse market place. For example, in the Pink Sheets segment of the company’s Web site, comprised of non-reporting companies, there is:

• A “Yield sign to warn investors that limited information is available for 737 securities;
• A “Stop” sign to warn that no information is available for an additional 3,514 securities; and
• A skull and cross bones to further identify those 26 securities for which the display of quotes has been discontinued because of a range of questionable or suspicious activities.

Surely in this era of failed regulation and ubiquitous access to information, that is all the information necessary to help investors understand the risk profile of certain categories of publicly traded stocks.

Capital formation can only occur when investors are willing to provide speculative “risk” capital to fund new ideas and businesses. Liquidity is the grease that makes markets work efficiently and which, in the case of public issuers, can lower the cost of capital by as much as 50%.

The “flash” crash of May 6 demonstrated that there can never be enough liquidity in the marketplace. This is especially true for the world of micro- and small-cap stocks, which provide investors with the opportunity to participate in the exciting, albeit risky, world of growth investing.

Pink OTC Markets has demonstrated clearly that its market-based approach to equity trading can and does work and is superior to any scheme crafted by regulators. As two obvious next steps, we need to get the regulators out of the world of equity research and credit ratings so that these markets can also evolve and thrive.

“Toto, I’ve a feeling we’re not in Kansas any more. We must be over the rainbow!”

If the Tech Bubble of 1999-2000 was the Kansas of the IPO market, then no, Toto, we’re definitely not in Kansas any more. But is where we are today really all that is on the other side of the rainbow? No, and here are a number of important silver linings that provide hope for a more robust and vibrant IPO market—particularly for small issuers.

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Priced IPOs.  The critics point to a currently difficult IPO market. Yes, it’s true that there were only nine IPOs priced through February of this year. But that is an 800% improvement over the one IPO that was priced in the first two months of 2009. Admittedly, an easy comparison period, but progress nonetheless.

New Filings. Through February, 30 companies filed S-1 registration statements to do an IPO—a 900% improvement over the three that filed in the same period last year. (See chart on page 3.) On February 16th, a total of six companies filed new IPO registration statements—the highest one day total since July 2007.

IPO Withdrawals. Through February, only three companies had withdrawn their IPO registration statements—a 70% improvement over the 10 withdrawals in the same period last year.

Average Deal Size. Now this one is counterintuitive. As of the end of February, the mean market cap for companies trading on Nasdaq was approximately $1.4 billion. Yet the median market cap was $171 million, and a full 69% of all companies on Nasdaq had market caps below $1 billion. Smaller is better, because it means that more new, promising companies are able to come to market. Here are the deal size data: In 2008, the average gross proceeds raised in an IPO was $650 million (skewed by Visa). Without Visa, the average was $240 million. In 2009, the average deal size jumped to $348 million. This year, the average deal size thus far is $158 million. Whether this is a trend that continues remains to be seen, but it is encouraging.

Small IPOs. In 2009, 13 of the 51 priced IPOs (we exclude REITs, funds and reverse mergers from our calculations)—or 25% of all deals—raised gross proceeds of under $100 million. This year, three of the nine priced IPOs—or 33%—have been transactions for under $100 million. Last year only one company raised less than $50 million. Through February, there has already been one sub-$50 million IPO.

Underwriter Hegemony. Last year, the “Final 4 Underwriters” (Goldman Sachs, Morgan Stanley, J.P. Morgan and Bank of America Merrill Lynch) either lead or co-managed an astonishing 80% of all IPOs (40 out of 51). In 2010, this hegemony has given way to a new crop of emerging underwriters such as Rodman & Renshaw, Merriman Curhan Ford and Broadband Capital.

Appetite for Risk. Of the nine IPOs that successfully priced through February, three of the companies were loss making. The mean net income of all priced IPOs was $3 million, while the median net income of the universe was –$2 million. While there have been no pre-revenue companies, the revenue for the three smallest companies was $32 million, $35 million and $74 million. Clearly, there is a re-emerging appetite for risk on the part of equity investors.

To be sure, there is still a litany of challenges standing in the way of a humming, vibrant IPO market including: Sarbanes-Oxley, Regulation FD, the Spitzer “global settlement” on equity research and other critical aftermarket support issues.

Notwithstanding these challenges, both the economy and the financial markets are continuing to recover—in spite of obscene, misguided attempts from Washington to interfere with this otherwise self-correcting process. With zero percent interest rates continuing for as far as the eye can see, and the specter of (hyper?) inflation lingering on the horizon, the prospects for fixed income investments are uninspiring, to say the least. The IPO market seems to be telling us—at least for the moment—that in the absence of more compelling alternatives, risk taking in new equity issuance is beginning to make a comeback.

Of course, continued economic recovery, falling unemployment rates, more robust corporate earnings and an increase in bank lending will all positively influence the overall equity markets, which always tends to be a key barometer for the IPO market. But even in the absence of these, there appears to be a ground swell of interest by institutionally-backed private companies to pursue $100 million or less IPOs. More importantly, an increased appetite is developing among investors to participate in these opportunities for selective technologies and innovative products which have demonstrated high growth potential and a path to profitability.

Perhaps, just maybe, there is at last reason to hope that we may find those silver linings somewhere over the IPO rainbow.

We have written in the past about the many factors that have conspired to compromise the traditional, underwritten IPO, particularly for smaller issuers that raise less than $50 million in a public offering. The causes of the extinction of the small IPO include: Sarbanes-Oxley, Regulation FD and the Spitzer “global settlement” on equity research. But it’s not only the primary market that has been affected. Although less headline grabbing, the knock-on effects of these ill-conceived “reforms” have also had insidious impacts on the pillars of the aftermarket, namely research and trading.

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Consider research first. According to a recent study, a full 40% of all stocks traded on Nasdaq had no research coverage. You read that right—not a single analyst following the stock. A further 20% of Nasdaq companies had only one analyst. Now let’s take a look at trading. In 2001, there were an average of 306 market-makers quoting prices in stocks trading on the Over-the-Counter Bulletin Board. That number has declined steadily each year through 2008, when only 199 firms made markets. Looking at the rather grim data for the past 12 months, the number of market-makers has declined steadily from 188 in November 2008 to 149 in November 2009. The charts below tell the story with alarming clarity.

According to data from SIFMA (Securities Industry and Financial Markets Association), as recently as 1990, nearly one quarter of all broker-dealer net revenue was attributable to trading gains. That number has alsosteadily eroded to approximately 9% this decade, with 2007 (a good year) showing a negative 3% contribution—the first loss in the last two decades. While “decimalization” has surely played a part in declining spreads, it has also served to dramatically increase volumes—but only in the largest, most liquid stocks.

As if the perception of the difficulty and cost of complying with Sarbanes-Oxley were not enough to deter private companies from seeking to obtain public company status, now there is an eviscerated aftermarket— with vanishing research coverage and market-making—to finish the job. Talk about a one-two punch.

A rational and free market for small business capital formation will create more new companies, innovation and jobs than any stimulus from Washington ever can. In addition to making it easier for companies to go public in the first place, genuine reform is needed in the aftermarket to dramatically lighten the burden on broker-dealers who would otherwise be willing to provide research coverage and make markets in these stocks.

The National Venture Capital Association recently published a 4-pillar plan to restore liquidity to the U.S. venture capital industry. The four pillars in the plan are: Ecosystem Partners, Enhanced Liquidity Paths, Tax Incentives and Regulation.

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And while we support not only the framework but also most of the specific plan recommendations, it is abundantly clear that the unintended consequences of regulation (Sarbanes-Oxley, Regulation FD, and the Spitzer “global settlement” on research) have brought small IPOs to a grinding halt. Indeed, the NVCA called for nothing less than a “full SEC review of recent laws to streamline [the] small company IPO process.”

The charts below really capture the story in a nutshell: While 46% of VC respondents to a survey preferred an IPO exit route, only 19% believed that an IPO was a likely path (with 81% indicating that M&A was the more likely route). And of the top three barriers to going public identified, it should come as no surprise that compliance requirements (i.e. Sarbanes-Oxley) was #1 on the list.

Venture capital has enabled the United States to support its entrepreneurial talent and appetite by turning ideas and basic science into products and services that are the envy of the world. While the death of the small cap IPO translates into lower returns for venture capitalists, it has more profound downstream implications for the economy at large. Specifically, it ultimately results in less innovation, less company creation and less job growth in the United States.

In the context of such a convoluted and disgraceful federal tax code, it’s hard to put much hope that tinkering around the edges of something that is so fundamentally broken would have much real impact. Of the four pillars in the NVCA’s plan, regulation is really the game changer. We believe that the number of ecosystem partners would expand naturally and that enhanced liquidity paths would be less important if the small IPO market were allowed to “re-open” by means of a rational regulatory framework. We echo the NVCA’s call for a full SEC review of the recent laws that have done so much damage to small business capital formation.

In his opening remarks to the 2007 Government-Business Forum on Small Business Capital Formation, former SEC Chairman Christopher Cox acknowledged the critical importance of small business to the U.S. economy:

• “Small firms represent…99.7% of all the employer firms in the United States.They employ half of the entire labor force in the private sector.”
• “Of all the net new jobs created in our country, small business generated between 60 percent and 80 percent in every year during the last decade.”

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So, one might reasonably ask, if small business capital formation is so important to the U.S. economy, why is it now nearly impossible for small businesses to go public? The answer: one ill-conceived government regulation piled on top of another in the past decade, which collectively have brought public company capital formation to a grinding halt.

The lack of new public companies matters greatly to a capitalist society because the vast majority of value creation, and hence new jobs, occurs after these entrepreneurial companies have gone public. To deny access to the public markets for the most promising of private enterprises seeking growth capital is the moral equivalent of eating one’s offspring before they have a chance to thrive.  Regrettably, we believe the most effective way to revive small business capital formation, i.e. reverse the damage already inflicted by regulatory and legislative malfeasance, is to work through the SEC and Congress.

The blame surely begins with the infamous Sarbanes-Oxley Act of 2002. Originally designed to cover the 1,000 largest public companies, in a wave of Congressional exuberance Sarbox was eagerly extended to cover all public companies. While we disagree with some of our peers in the small business community about the actual real cost of complying with Sarbox, in the end it doesn’t matter. The perception of $1 million compliance costs for smaller companies trumps the reality of closer to $100,000 and is enough to set less-informed companies running from public markets.

Next on the hit parade came former New York Attorney General Eliot Spitzer’s $1.5 billion “Global Settlement” with Wall Street in 2003 aimed at combating tainted equity research. As part of the settlement, Spitzer forced Wall Street investment banks to spend $460 million on independent stock research. According to a recent article in The Wall Street Journal, it “turns out that many investors couldn’t have cared less.” The Journal goes on to report that in one recent year at Credit Suisse Group, “just 16 retail clients had retrieved reports from the bank’s Web site.” Spitzer’s massive initiative only directly affected a few investors, and perversely, actually decreased the amount of available equity research. Talk about the cure being worse than the disease.

The list goes on and on. For each capital markets “reform” (ahem, regulation) enacted in the past decade, there is a group decrying it as the root of all evil. Regulation Fair Disclosure, Decimalization, Regulation SHO…pick your poison.

Ayn Rand presciently warned about the consequences of government regulation in extremis in her 1957 novel Atlas Shrugged. The protagonist, Dagny Taggart, sees society collapse around her as the government asserts control over all industry, while society’s most productive citizens, led by the mysterious John Galt, progressively disappear. Galt describes the strike as “stopping the motor of the world” by withdrawing the “minds” that drive society’s growth and productivity.

The “minds” behind small business capital formation have increasingly gone on strike and are innovating new solutions.

Consider the following:

• Nasdaq OMX recently announced that it has entered into an agreement with Morningstar to provide a research profile targeted at retail investors for all of the more than 3,600 companies that trade on the exchange-including nearly 900 (25%) that have no analyst coverage at all. [See related article on page 2.]
• Fidelity Investments and Kohlberg Kravis Roberts & Co. recently announced that they have entered into an agreement to provide Fidelity’s brokerage customers to buy into KKR-sponsored IPOs.
• At least four new private exchanges (Second Market, Inside Ventures, SharesPost, and XChange) have sprung up in the past few years to fill the IPO void and satisfy investors seeking to participate in investment opportunities of emerging growth companies.

So while we generally applaud innovation in all of its forms, these developments all share one thing in common: they are Band-aids to a badly broken capital formation process. More insidiously, certain of these initiatives run counter to the most important function of an exchange, namely creating a centralized pool of liquidity. Fracturing liquidity serves neither investor nor issuer under any circumstance. In that regard, these liquidity-diffusing solutions are not the long-term fix that is required.

Instead, we think the better solution is to fix the root of the problem: bad and excessive regulation. The recommendations of the 2008 SEC Government-Business Forum on Small Business Capital Formation (http://sec.gov/info/smallbus/sbforum.shtml) include 22 securities law changes and a further 15 recommendations on tax issues. We support nearly all of these recommendations. Unfortunately, the very well-intentioned SEC’s Office of Small Business Policy headed by Gerry LaPorte seems to be impotent and lost in an otherwise disgraced and dysfunctional agency.

Nevertheless, given the pervasive and highly visible hand of government in the capital markets, we believe that working through the auspices of the Office of Small Business Policy is regrettably a Hobson’s choice for those who are serious about reviving small business capital formation. Thus, we encourage all who are involved in the micro-cap public market ecosystem to join the cause of working to agitate for the restoration of rational regulation to our capital markets sooner rather than later.