Americans are highly aware that our middle class is failing to keep up economically. Everything is getting more expensive, and wage growth simply hasn’t kept pace. One major area is often overlooked as a possible contributor: the stock market or, more directly, how companies use it today in comparison to the recent past.
When I started my career in finance in the early 1990s, the stock market was the place most emerging companies went for growth capital. This allowed individual Americans to participate in the wealth creation of successful homegrown companies. I cannot tell you how many kids were put through college because of the growth of Home Depot or Waste Management stock, or too many other companies to count. There were several stock launches, or IPOs, a week, and an investor usually had a good chance of getting an allocation if he asked.
It’s astonishing to think about now, but if you reinvested the dividends, a $5,000 investment into Home Depot on its IPO would be worth $96,000,000 now. The same $5,000 invested into Facebook, however, would be worth $75,000.
The difference is that Facebook’s parabolic growth was enjoyed by private equity firms, not the public. This is even more confounding when you consider that the current market cap of Home Depot is $320 billion, and Facebook is a $1.4 trillion company. Clearly, the timing of when you are able to invest in a company is incredibly important.
By 1996, there were 8,090 domestic public companies with a median market cap of $300 million. Today the total number is around 3,600, with many being special-purpose acquisition companies (also known as a blank-check holding company) and listed funds that do not operate as businesses, while the median market cap is $2.4 billion. These numbers alone accent how consolidated the market has become.
Because of this, small and mid-cap funds are being starved of appropriately sized companies, diluting the quality of their holdings. There are no longer enough stocks to completely populate the Willshire 5000 index. Clearly, big things have changed.
More telling is that the average size of an IPO in 1990 was $37 million. Now, the average size is $419 million, with the 10 largest IPOs last year all pricing at over $1 billion.
Why did this happen? Federal regulations now make selling to a private-equity firm significantly more attractive than to the public markets. Audit costs because of the Sarbanes-Oxley Act of 2002 average $2.77 million a year, a huge number for an emerging business to absorb. This has had the unanticipated effect of moving companies away from public offerings and toward sales to private equity firms, denying regular investors access to shares.
Liquidity issues for founders create another major complication. Once you are deemed an affiliate of a public company, your sales are subject to incredibly strict rules (such as Sarbanes-Oxley section 409) that govern how much you can sell and when. Once a company goes public, deemed insiders have further restrictions on how much they can sell at any time, what price they can sell at, and a lengthy cooling-off period if they want to use an affirmative defense trading plan like 10b5(1). Further considerations include listing requirements that must be met, quarterly public filings, investor relations, and endless frivolous lawsuits.
Compare that to a more or less instant check from a private-equity firm, as well as access to their balance sheet (instead of constantly chasing lenders for capital), and liquidity for their own portfolios, it becomes clear what the prudent thing for a management team to do is (keeping in mind that their fiduciary responsibility is to their shareholders, not the public).
A vibrant small IPO market would help all investors. If people don’t want to buy individual stocks, they could buy small- and mid-cap funds that would undoubtedly get allocations, increasing their returns. These are the same funds we already use for retirement accounts.
This can be fixed, but it must be done with great care, because, sadly, the vast majority of securities regulations are in place due to bad actors. For example, Tyco, Worldcom, and Enron all defrauded us in the early 2000s and cost investors billions of dollars, leading to Sarbanes-Oxley.
Yet relaxing the audit requirements, while keeping the penalties for companies under, say, $1 billion in capitalization, would be an interesting place to start the discussions. Provisions allowing executives and affiliates to monetize holdings under less strict rules, or to hedge, would also help materially. You could look at forcing private equity firms to treat their carried interest differently as well, but that would meet severe pushback.
When there were conditions conducive to public offerings, there were dozens of tier two and three investment banks that managed the process for small companies. DLJ, AG Edwards, Morgan Keegan, and too many other companies to mention merged with big banks until only a few were left. Reinflating these markets would require many more full-service investment banks, which would create hundreds of high-paying jobs in investment banking, trading, research, equity capital markets, compliance, and many other areas, and that would be a wonderful thing.
One of the biggest impediments to reforming these markets is that the current rules favor a small group of people who happen to be among the largest contributors to the elected officials who directly influence the relevant regulations. This of course means they have less than no incentive to change things. You really don’t have to dig too hard to see the massive amount of campaign contributions from private equity firms and huge banks. Perhaps this should be addressed as well, but Congress and the Senate have always been reluctant to eliminate these financial perks for their jobs.
Just imagine for a moment how much it would help the middle class to enjoy access to these transactions again. It’s graduating from college with no debt. It’s down payments on houses. It’s secure retirements. Or, as it is now, it’s wealth concentrated in the hands of a very few fortunate investors. I know which I, and the vast majority of American voters, would prefer.
