Tuesday, February 12, 2008

Are They Killing the US Capital Markets?

I have been very concerned about the state of the US capital markets of late. The market’s gyrations aside, we have seen a marked decline in initial public offerings over the recent years. I discussed this matter with Mitch Gross, the founder and former CEO of Mobius Management Systems, Inc., a publicly-traded company which was acquired last year and was formerly a Makovsky Investor Relations client.

Q: Why the lack of IPOs?

A: There are three things that are killing the public markets: 1) government regulation; 2) Reg. FD; and 3) overly aggressive shareholder activism.

Q: What about shareholder activism?

A: Today, corporate boards and managers live in fear of activists. Boards and corporate managers are afraid to invest to build their businesses or make acquisitions for fear of things not working out leading to loss of market value making it easier for activists to launch an attack to oust management. As a result, market and growth opportunities are missed as well as efficiencies given the curtailed investment in capital improvements. This is particularly problematic for small cap growth companies that lack easy access to the capital markets.

Q: What happens to these companies? They can’t continue to operate this way, can they?

A: Ultimately, these companies wind up selling out in an attempt to realize some measure of value. Studies have shown that most boards and managers act both in the companies’ and perhaps more important, their own interests. When attacked by outside forces they react accordingly. Typically, the price is not optimal as managers grow weary of the glare of public scrutiny. Oftentimes, the acquiring company “guts” the business hoping to realize some economies of scale, resulting in a loss of jobs and perhaps market position for the products acquired.

Q: What about the regulatory environment particularly Reg. FD and Sarbanes-Oxley?

A: I believe that Reg. FD - which curbs the practice of selective disclosure of material nonpublic information - has had a very profound impact both on companies and investors. Reg. FD has instilled a disclosure muzzle on management because of the simultaneous release requirement and has severely inhibited the flow of information and the ability of corporate management and boards to communicate with shareholders. To greater or lesser extent (probably greater), this has exacerbated the problem of shareholder activism. You can’t make investment decisions without information. Other regulations pertaining to the disclosure of executive compensation and corporate governance (particularly in the area of proxy voting) will place additional stress on corporate managers and make being public less appealing.

When it comes to Sarbanes-Oxley - which came into force in July 2002 and introduced major changes to the regulation of corporate governance and financial practice - I look at it simply as a “poor man’s tax.” You have to comply and you have to spend the money to comply. So, like a tax on bread, Sarbanes-Oxley effects smaller, less well financed companies dramatically more than the larger entities. These rules and their associated costs are pushing companies to either stay private or sell out. As a result less companies go public and the investing public has less good opportunities in which to invest. The end result? The current growth in “private equity” funds that enable the wealthy investor to take private stakes in growing, innovative companies.

Q:What can be done to change things?

A: That’s a tough one. It would help if shareholders were better educated so as to understand the difference between corruption and bad business decisions. Years ago, people understood the risks. You invested based upon a wealth of information and if you were smart you stood to make a reasonable return. Now only the rich benefit from the future of America through their participation in private equity vehicles.

Q: Is there a chance for legal changes?

A: Perhaps, we might move toward a more prudent system. I think boards and legislators should resist the recent trend toward changing proxy voting rules such as requiring minimum votes to elect board members. These regulations tend to take the control of companies away from boards and management and turn it over to the “voting public.” Companies just cannot be expected to take advantage of opportunities and perhaps risks if they are continually worrying about the next proxy and the next vote.

In their zeal, regulators have opted for more laws in stead of efficiency. It would be better if Corporate America asked itself: “Is this right” as opposed to “Is it legal.” Ours is now a class action culture with the lawyers being the chief beneficiaries. There might be some changes to Sarbanes-Oxley based on a company’s size which could lessen the burden on smaller companies. However, I don’t believe there will be changes in the near future.


Technorati Tags: US Capital Markets, Mitch Gross, Mobius Management Systems, Inc., shareholder activism, Reg. FD, Sarbanes-Oxley, business, communications, public relations

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