Recently, Faegre & Benson LLP, one of the 100 largest law firms headquartered in the U.S., and Baker Tilly Virchow Krause, a full-service accounting and advisory firm, sponsored an informative seminar and panel discussion regarding alternative going public strategies. Faegre speakers included Michael Coddington, Jason Day, David Miller, Donald Stewart and Jonathan Zimmerman.  Also included in the panel discussion was Rick Schweiger, Chief Operating Officer at Keating Investments; Octavio Cabral, Partner at Collins Barrow; Janis Koyanagi, Director of Business Development at the Toronto Stock Exchange; Rick Hartfiel, Head of Investment Banking at Craig-Hallum Capital Group; and Mike McKee, Partner at Baker Tilly.

Topics included the TSX and AIM stock exchange alternatives; OTC and Pink Sheet market alternatives; senior exchange listing requirements; corporate governance; current state of the equity capital markets; and more.  For those CEOs considering going public, or for advisers to high growth private companies, I recommend you view the panel discussion at http://faegreandbensonllp.mediasite.com/mediasite/Viewer/?peid=7f57c16212ee4c2d82c8580c8ae56e9c1d, as the panelists provide some very interesting data.

The opinions set forth in the foregoing article do not necessarily represent the opinions of Keating Capital, Inc. or Keating Investments, LLC.

Now that President Obama has signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”), publicly reporting companies with a public float below $75 million are permanently exempt from the auditor attestation requirements under Section 404(b) of the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley Act”). Under the Section 404(a) of the Sarbanes-Oxley Act, all public companies are required to assess the effectiveness of their internal control over financial reporting, while Section 404(b) required the company’s independent auditors to report on management’s assessment.

Since enactment, the provisions of Section 404(b) have been the source of much controversy, especially the anticipated compliance burdens on smaller reporting companies.  This led the SEC to delay the compliance date for Section 404(b) for smaller reporting companies several times.  While smaller reporting companies are still required to disclose management’s assessment of its internal control over financial reporting, the permanent exemption from the auditor attestation requirement is a significant victory for small public companies and for the future prospects of small business capital formation in the U.S.  And as an interesting aside, the Act also requires the SEC to study ways to reduce the burdens of compliance with Section 404(b) on companies with $75 million to $250 million in market capitalization.  Let’s hope this is only the beginning of much-needed small business regulatory reform.

The opinions set forth in the foregoing article do not necessarily represent the opinions of Keating Capital, Inc. or Keating Investments, LLC.

I found the new information provided by Grant Thornton LLP’s Capital Markets Group in its updated U.S. IPO Market Study, released on June 21st, to be very interesting in light of the current condition of the traditional IPO market.  The release of Market structure is causing the IPO crisis – and more provides new and updated data that analyzes how the IPO market structure drives job losses.  The White Paper also addresses misconceptions about the impact of private equity, penny stocks and inflation on new public equity offerings.

Building upon Grant Thornton’s original 2008 study, Why are IPOs in the ICU?, the White Paper proposes a new investor and issuer opt-in market that would be subject to full regulatory oversight from the SEC and would bring choice in market structure back to the U.S. equities markets.

Authors of the White Paper are David Weild and Edward Kim, both Senior Capital Markets Advisors at Grant Thornton.  The full article can be found at www.GrantThornton.com/IPO.

The opinions set forth in the foregoing article do not necessarily represent the opinions of Keating Capital, Inc. or Keating Investments, LLC.

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.

For many years, the Ivy League has been known for its traditions, its gothic buildings, and, until recently, the mystique of its mammoth-sized endowments that consistently generated incredibly high returns in bull and bear markets alike. Ivy League and other large endowments, weighing in at billions of dollars, were able to achieve these extraordinary results by following what is often called the “Yale Model” for endowments developed by Yale University’s Chief Investment Officer, David Swensen, under which they invested heavily in alternatives such as private equity and hedge funds.  Until very recently, it seemed to some that the Yale Model was invincible.

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This all came to a grinding halt, however, in the past year when the largest university endowments—those of Harvard and Yale—stunned the investment world when they announced losses of 27% and 25%, respectively, for the fiscal year ended June 30, 2009.  This shocking news led many to declare that modern portfolio theory, the intellectual underpinning of the Yale Model, was dead.  Upon closer inspection, however, it becomes clear that the problem is with neither modern portfolio theory nor asset allocation, but rather with the endowments’ policies of holding shockingly small amounts of cash in their portfolios relative to the amounts needed to finance the day-to-day operations of their respective universities.

This white paper will argue that the melt down at certain endowments had nothing to do with purported flaws in modern portfolio theory.  Instead, the breakdown was caused by a failure to model for truly extreme events.  Given the enormous obligations of many Ivy League endowments to fund general university operations, their portfolios were positioned on the wrong point of the efficient frontier.  In other words, given their liabilities, they simply invested far too little in cash and liquid assets rather than too much in alternatives like private equity.

Conclusion

Given the immense and ongoing cash needs of the large university endowments, it is shocking how little cash they actually had in their portfolios.  The fault, however, is not that the endowments invested too much in alternatives like private equity, but that they invested far too little in cash and liquid assets.

Modern portfolio theory and asset allocation are not dead, and alternatives can and do play an important role in a well-constructed and well-diversified portfolio.  The difficulties the large endowments faced this past fiscal year do not reflect a breakdown of the principles of asset allocation, but rather a failure on the part of the endowment managers to properly diversify their portfolios and plan for extreme events.  In the future, the endowments must model and prepare for extreme events, evaluate whether the classification of their assets genuinely reflect true diversification, and perhaps most importantly, appropriate a much larger portion of their portfolios to cash and other liquid assets.

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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.

Shortly after the Sarbanes-Oxley Act of 2002 was implemented, it suddenly became very unfashionable to be public—particularly for smaller companies.  Out went the emerging growth underwriters of the 1990s (Montgomery, Robertson Stephens, Hambrecht & Quist, to name a few), and in came the leveraged buyout artists to take companies to the promised land of being private…before going public again.  So now that enough time has passed, how has it all worked out?  That depends.  If you were a private company or a limited partner in a private equity fund, the track record has been mixed, at best.  If, however, you were a private equity sponsor, chances are that in the era of cheap money that recently ended (and by charging fees for every activity imaginable) you probably did pretty well.

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Because of the enormous amounts of leverage associated with private equity investments, along with the lack of a benchmark index for comparison purposes, it can be extremely difficult to accurately evaluate investment performance.  The goal of this white paper is to provide financial advisers and their investor clients with a framework to effectively assess potential private equity fund investment opportunities that can play a valuable, return-enhancing role in a well-constructed portfolio. We believe that a value-added private equity fund should possess the following three key characteristics: (i) an identifiable source of “alpha” [see related white paper on this subject]; (ii) the ability to add value to portfolio companies in ways other than through pure financial engineering; and (iii) the use of little or no leverage. There are gems to be found in the world of private equity—the trick is knowing what to look for and where to mine.

Conclusion

Properly selected investments in private equity do generate superior returns relative to other equity alternatives, though often with higher levels of risk and illiquidity.  As with any mutual fund or other actively managed financial product, the challenge for advisers is how to identify these top-quartile funds.  The three key characteristics that a top-quartile fund should possess are:  (i) an identifiable source of “alpha”; (ii) the ability to add value to portfolio companies in ways other than purely through financial engineering; and (iii) the use of little or no leverage.  To the extent that an investor can participate in a publicly traded private equity vehicle, the illiquidity risk can be either mitigated or eliminated.  There are gems to be found in the world of private equity—the trick is knowing what to look for and where to mine.

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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.