One of the recurring themes of financial commentators has been the decline in the number of IPOs compared to prior years. Articles about the dearth of IPOs are something of a staple in the financial press. The decline in the number of IPOs has also drawn the attention of Congress. One of the intended purposes of the Jumpstart Our Business Startups Act of 2012 was to try to encourage more companies to go public. A number of other initiatives to try to encourage more IPOs are currently circulating through Congress. The premise behind these various legislative initiatives is that if the regulatory burdens can be eliminated and costs reduced, more companies will go public. Columbia Law School Professor John Coffee recently testified before a Congressional committee about these latest initiatives. His testimony is set out in a May 29, 2018 CLS Blue Sky Blog article entitled “The Irrepresssible Myth That SEC Overregulation Has Chilled IPOs” (here), reflecting his skepticism that further deregulation alone will result in increased numbers of IPOs.
Coffee notes at the outset that the “common premise” behind both the JOBS Act and the more recent legislative initiatives is that “high regulatory costs and burdensome SEC rules discourage many private companies that would otherwise go public from doing so.” This premise, Coffee says, “is a myth” that is “persistently asserted by industry groups seeking to enact a wish list of deregulatory reforms.” Other considerations, Coffee contends, explain the decline in the number of IPOs.
Before reviewing the causes that Coffee contends explain the dearth in IPOs, he reviews some preliminary considerations. First, he notes that the flood of IPOs in late 1990s and early 2000s ultimately led to a bubble that, when it burst, destroyed investor confidence, which Coffee suggests shows that “underregulation can be as serious a problem as overregulation. “ Coffee also notes that the regulatory reforms instituted in the JOBS Act did nothing to turn this problem around; indeed, in the years following the enactment of the JOBS Act, there were fewer IPOS than in the years immediately before the JOBS Act.
Coffee also notes that if overregulation were indeed the cause in the drop in the number of IPOs, this problem would be specific to the U.S. However, the decline in the number of IPOs is not limited just to the U.S.; rather, IPO volume has declined throughout the developed world, including in Europe and China, and has declined even more dramatically in Canada. Since Canada has no national securities regulator, the decline in the number of IPOs in Canada cannot be blamed on an overregulating national regulator.
What then is the cause in the decline in the number of IPOs? Coffee suggests there are two explanations: first, private companies now find it “easier, quicker, and often cheaper to raise capital in robust private equity markets” where the litigation risk is lower and less executive time is diverted; and second, that “IPOs for smaller firms have been consistently unsuccessful for a sustained period, losing money for all concerned.” On this latter point, Coffee notes academic research showing that “a high majority of small offerings have had negative earnings per share for years after the offering and poor first day returns.” Research show further that reasons these smaller companies struggle after going public is because “such firms cannot gain the economies of scale that are increasingly necessary to compete in a globalizing marketplace.”
While the JOBS Act was intended to encourage more companies to go public, it was based on a “core fallacy” – that is, that reducing regulatory and legal costs would encourage more companies to go public. However, as a percentage of overall costs of going public, the legal and regulatory costs are “trivial.” The most significant component of IPO costs is the underwriter’s discount, which is not going to be reduced or eliminated by trying to reduce regulatory costs. Because the current legislative proposals are built on a similar premise that companies can be encouraged to go public by trying to even further reduce legal and regulatory costs, these initiatives are premised on a “futility.”
An even deeper consideration is the question of whether the lower number of IPOs is actually problem. Coffee rejects the suggestion that the low number of IPOs represents some kind of a crisis. He notes that private companies “are tapping ready sources of capital in venture capital and private equity markets.” Some high tech companies are pursuing IPOs but that is primarily motivated by a desire to provide liquidity for their employees, while Spotify pursued a “direct listing” without completing an IPO. The fact is that companies are spurning the classic IPO format. Not only that, by many smaller firms can achieve a higher price/earnings multiple in the M&A market, which could afford the acquired companies to achieve the scale to compete in a global marketplace.
In light of all of this, Coffee argues that “relaxing disclosure and transparency rules and downsizing important governance …represents a dubious policy for Congress to follow,” particularly as some of the proposed regulatory revisions amount to “micro-managing the SEC.” It would make far more sense, Coffee argues, Congress would be better served, rather than mandating specific regulatory changes, to ask the SEC to study proposed rule changes and report back to Congress.
Coffee concludes by saying that the various reforms Congress is currently considering start from a “false premise” and proceed to “unfortunate conclusion by proposing major retreats in disclosure and governance in order to encourage some additional IPOs,” even though the concessions in the JOBS Act did not produce increased numbers of IPOs. The proposed Congressional revisions have not been “vetted adequately by the SEC or other concerned constituencies” but could result in “major retreats in corporate governance,” even though there is “no crisis demanding deregulation. In short, the costs of the proposed reforms “seem real,” but the benefits “may be illusory.”
I think Coffee’s analysis, which is bolstered by some interesting statistical analysis presented in graphical form, is on target. It doesn’t make sense to even further lower regulatory requirements for smaller companies if there isn’t some kind of crisis necessitating the changes and if the changes are unlikely to produce the desired result.
There is one aspect of Coffee’s analysis that in my mind warrants further consideration. In discussing the advantages for smaller companies of raising money through venture capital or private equity rather than by going public, he notes that in the private markets “litigation risk is lower.” In a later section of his paper, Coffee notes that many of the costs of going public are “hidden,” noting, for example, the concerns small companies considering an IPO may have that when public “a stock price drop might spur litigation.” Coffee does not further elaborate on the possible impact that litigation fears could be having on smaller companies’ decisions to go public, nor does he suggest what might be done to address these concerns. However, it is noteworthy (and to me it rings true) that litigation fears could be among the reasons holding back smaller companies from going public.
There is of course the question that Coffee himself asks in a number of other contexts in his paper; that is, is it a problem that smaller companies are holding back from going public because of litigation concerns? Other information in Coffee’s paper suggests that it might not be a problem that these smaller companies are staying private. His paper emphatically shows that IPOs for smaller firms have been consistently unsuccessful for a sustained period, losing money for all concerned. It could be argued that perhaps overall the markets are better off if companies that can’t withstand the scrutiny that comes with an IPO refrain from going public.
That said, I still the impact of litigation risk is an interesting question, one that I would be interested in hearing more about. For example, how significant is the impact of this concern, by comparison to other factors that might be restraining companies from going public? Are there things that companies themselves can do in the run-up to their IPOs to lessen this risk and the related concerns? Are there legal or regulatory reforms that could address these concerns?
In any event, the recurring questions about the number of IPOs are interesting. It seems almost inevitable that these issues will continue to be debated. The question will remain about how worried we should be that there are fewer IPOs than there used to be.