Anthony Cross, fund manager at Liontrust, shares his views below.
Over the last 10 years the combined number of companies listed on the UK Main Market and AIM has fallen every year bar one, dropping from 2,745 in December 2009 to 2,006 in December 2019.
The market value of these stocks has been more variable, reflecting fluctuations in stockmarkets over that time. But in recent years, this too has shown a downward trend. At the end of 2017 there were 2,221 companies with listings on the two markets, with a combined market value of around £5.5 trillion. This had declined to £4.9 trillion (across 2,006 companies) at the end of 2019. With the FTSE All-Share generating a capital return (excluding dividends) of 8% across the two-year period, we can’t blame falling markets for the decline of around 11% in equity market value.
Instead, we need explore the concept of de-equitisation. This is a trend that has garnered increasing attention in recent years and been the source of some concern.
If we start by looking at causes rather than consequences, there are a number of possible candidates for a reduced role for equity recently. Most obviously, equity finance isn’t necessarily the cheapest form of funding in a world of record low interest rates and bond yields – not to mention that debt interest payments can be paid from pre-tax income whereas shareholders’ dividends and earnings are subject to tax. This makes debt financing an attractive option for companies.
The growth of private equity investing – itself encouraged by low yields given its typically highly-leverage nature – also offers an alternative source of funds to companies. This might have stopped some companies from exploring a stockmarket listing. In addition, there have also been a number of private equity-backed buyouts of listed companies. In recent years, this has included high profile examples such as Inmarsat, Cobham and Zoopla.
Another possible cause of de-equitisation is share buybacks – historically more a feature of US markets, but now on the rise elsewhere.
One of the less visible factors behind this trend towards de-equitisation could be the costs of joining a stockmarket and maintaining a listing. All companies on the UK Main Market are subject to the same regulation standards and requirements around reporting to the stockmarket. They are also subject to the EU’s MIFID II (Markets in Financial Instruments Directive) regulations, which came into force in 2018.
This is a topic which UK corporate broker Peel Hunt has a vested interest in highlighting. Together with the Quoted Companies Alliance, Peel Hunt commissioned market research specialist YouGov to survey 155 fund managers and 110 small and mid-cap companies on the decline of UK equity market values. The results of one of its headline questions are presented below:
It goes on to state “MiFID II is blamed for reducing both the quantity and quality of coverage and research produced on mid and small-caps. The view is that this has had a direct effect of reducing appetite for private companies to list on UK public equity markets.”
MIFID II requires equity research to be provided on an “unbundled” basis. Whereas previously a fund manager could pay a commission in return for both share dealing and research, it is now necessary for research to be provided and charged on a stand-alone basis. The consequences have been the subject of much analysis and the consensus seems to be that less research will be produced.
It’s worth noting that for professional investors such as ourselves, this reduction in research can be viewed in different lights. A less smooth process of information dissemination and price discovery represents a risk to investors but can also provide opportunities to exploit perceived market inefficiencies. This dichotomy is illustrated well in the following question in the YouGov survey:
Whether regulatory costs have been a factor or not, we can unambiguously state that a process of de-equitisation is not a desirable trend. As equity investors, we want to have a broad range of companies we can access via shares and to facilitate this we need companies to see stockmarkets as an efficient source of inexpensive capital.
In this respect, we think the Covid-19 crisis has been a great reminder of the positive role of a stockmarket listing. In our view, equity will always have a substantial role to play in company financing regardless of the shorter-term cycles, such as the de-equitisation in recent years.
While equity may be more expensive relative to debt than it has been in the past, it still holds the substantial benefits of being an efficient and relatively immediate source of capital that, unlike debt, is not burdened by a fixed repayment schedule.
These attributes are key when seeking crisis funding and listed companies have been quick to take advantage this year. In 2019, the total from new equity issues (such as IPOs) and further equity issues (such as placings) came to £17 billion. But the Covid-19 crisis has led to a sharp spike in fundraising, with over £16 billion already raised in the first half of 2020 alone. January saw only £181 million in share issue but as the Covid-19 crisis worsened and the implications of lockdown restrictions on companies’ cashflow became clear, the monthly run-rate rose to £2.6 billion in April, £5.2 billion in May and £6.6 billion in June.
Research from Peel Hunt suggests that between 16 March and 21 June, there were 124 fundraisings attributed to Covid-19, raising an average of £125 million, equivalent to 27% of the issuing company, at a discount of 8% to the prior share price.
Debt financing’s inflexible repayment schedule relative to equity makes its less attractive for crisis fund raising. While equity investors receive their compensation in the form of dividends and earnings growth (via its impact on a share price) as and when they are achievable, debt holders require interest payments regardless of profitability and cash flow fluctuations. This is less than ideal during the Covid-19 crisis as lots of companies suffered enforced closures whilst lockdown measures were in place, putting huge pressure on working capital and ability to generate cash to service debt payments, rent, etc.
Equity investors who favour companies with conservative balance sheets have often been criticised for not embracing the earnings leverage potential of higher gearing. But the Covid-19 crisis has illustrated the flipside of this coin: higher risk. Leverage works both ways, and if cash flow drops away then interest repayments that previously seemed a cheap financing cost can quickly become unmanageable.
Perhaps the biggest advantage of equity financing is the speed at which a fresh cash injection can be arranged. Many companies have also issued bonds or negotiated new or amended banking facilities during the crisis, but issuing new shares is probably the quickest source of funds.
Under normal circumstances, a company listed on the UK main market can expect to be able to issue shares up to 10% of its total without triggering pre-emption rights [AIM market restrictions are looser]. This means it can sell or ‘place’ new shares to key large investors quickly, without the extra administration and time needed to offer shares to all existing holders. This timeframe could be as short as a couple of weeks, with investors only aware of the fund raise for the last day or two.
Pre-emption rights on larger share issues – which usually occur via a ‘rights issue’ to all investors – is a very important protection for smaller investors, enabling them to participate in fund raises and benefit from the discount at which such new shares are sold in the same proportion as larger investors. However, during times of stress, a placing to a specific group of larger investors is a very useful tool as a rights issue is conducted on a much longer timeframe due to more onerous requirements such as the publication of a prospectus. In April, the Pre-Emption Group suggested that issuances of up to 20% should be allowed without pre-emption on the main market, in recognition of the circumstances brought about by Covid-19.
While large swathes of the stockmarket have made use of this swift cash injection for ‘emergency’ circumstances brought about by Covid-19, others have seen the business environment evolve in a way that presents opportunities and have raised funds in order to target it.
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