Monday, 24 September 2018

Passive investment will kill IPOs

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  • Keith Mullin

Could the changing landscape around capital access and the seemingly unstoppable rise of passive investment strategies consign public floats to the history books, asks Keith Mullin

INVESTMENT BANKERS LOVE IPOs more than most. These days that’s largely because of the high fees such deals attract, rather than the kudos that comes with being a go-to adviser and underwriter (those bragging rights have been slipping away as the act of going public has lost its lustre as the highest-form corporate end-state).

The trend is more pronounced in the US, but the story is the same in other destinations.

Companies now often prefer to remain private - or at the very least will stay private for much longer.

The universe of publicly-listed US companies has fallen by around half over 20 years. M&A and take-privates have had an impact, but companies are clearly opting to avoid the glare of public scrutiny at the same time as dodging high banking and listing fees that add little value/liquidity for those that enjoy ready access to early and late-stage private capital.

Between 1980 and 2000, there was an average of 420 US IPOs per year. Since 2000, that has fallen to 130, according to Thomson Reuters data. That tells a story.

Corporates are now pursuing providers of alternative capital - or more likely mutual funds are joining alternatives in engaging at earlier phases of the corporate development cycle.

Pre-IPO finance is the new IPO market.

True, this year has seen something of a resurgence in activity, but given the record-breaking performance of US stock indices this year and their astonishing rise on a five-year view, a less than US$30bn US IPO market year-to-date in the kind of monetary policy environment we’ve been in suggests a distinct lack of interest.

And take a look at the US deal list: just 90-odd IPOs; only four above US$1bn, the vast majority sub-US$500m, and included among them a bunch of SPACs, REITs and other investment strategies. Take those and non-US companies out and the US corporate IPO market is a bust.

WHAT’S LIKELY TO kill any real resurgence is a fast-dwindling pool of active investors to conduct fundamental research and provide crucial price-discovery inputs. Mechanical investing is taking over. It’s not only dirt-cheap for end-users; it self-sustains equity market performance on a wall-of-money basis. It’s tough for stock-pickers who have nothing to show for their endeavour.

At the end of August, US ETF inflows hit US$300bn-plus in the year to-date. Academic studies and other research suggest the proportion of stock held in passive strategies will overtake active investment styles. By when? Some have suggested as soon as 2018.

We’re entering the realm of corporations with faceless owners (what one observer dubbed ownerless corporations) who don’t vote at shareholder meetings, and where buying and selling behaviour and order size are driven by hard-wired parameters such as index inclusion or other programmable metrics.

This thundering transformation of US stock ownership is destroying the fundamental links between supply, demand, price, value, performance and quality, and is quashing the art of price formation, a basic tenet of an efficient capital market.

There have been dark warnings that unbridled growth in passive investing will destroy capitalism. That may be overdone, but if it threatens capitalism’s soul of efficient capital allocation, those warnings may have some merit. Studies have suggested that lack of shareholder activism and mechanical ownership lead to poorer governance standards and less efficient competition - another fundamental tenet of capitalism.

If the likes of Vanguard, State Street, Blackrock and Invesco end up passively owning the same big proportions of the same stocks in the same industries regardless of product or balance-sheet differentiation, corporate strategy or quality of management, there’s less pressure on corporate executives to do the right thing.

This breeds anti-competitive or cartel-like behaviour, and in undermining fundamentally important differentiators like R&D it stifles innovation because any marginal positive differentiation goes unrecognised as an entry point ahead of potential stock price appreciation.

ANOTHER SUBSIDIARY IMPACT of passive strategies is the perpetuation of what might on a historical view be seen as unsustainable P/E and other valuation metrics. Passive index strategies don’t intrinsically recognise such quaint anachronisms. Or at worst if they mechanically hit valuation “sell” triggers, the likely result is potentially huge downswings driven by herd behaviour.

If regulation like MiFID II ends up damaging the investment research industry as some have suggested, the disappearance of research ideas will render the art of finding the next big riser or a reasonable buying point ever more elusive. The passive takeover is also breeding oligopolistic tendencies among increasingly gargantuan providers of passive products; which attract the bulk of inflows. Size begets size and garners them huge latent power.

Might future history books attribute the death of capitalism to ETFs? If so, they will have achieved what communism never could.

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