Tag: private equity

Back to the IPO Doldrums?

After initial public offerings (IPOs) had a robust 2014, it looks like 2015 has been a bit quieter, according to a recent article in the Wall Street Journal.  But not because companies aren’t growing.  The companies are doing fine; they’re just not going public, opting instead to court buyers and quietly sell themselves.  The trend away from IPOs isn’t a new one; it’s been in the works at least since the late 1990s.  While some celebrated 2014 as a return to vibrant public capital markets in the United States, it may be that the year was simply an anomaly. 

The question, of course, is whether this trend is a bad one.  The answer depends on the cause.  For any one company, the decision to sell may be exactly the right one, no matter what the IPO environment.  Some business models may work better as a business line within a larger organization, or the two companies may be able to exploit synergies and create a new company that is greater than the sum of its parts.  But it’s not clear that these motives are what’s driving the current trend. 

The Journal found that at least 18 companies that had filed papers with the SEC abandoned their IPOs due to acquisition.  This suggests that companies that are otherwise interested in going public nonetheless find acquisition the more attractive option.  The process of going public and maintaining good standing as a public company has been increasingly difficult (and expensive) over the last several years, due to increasing the regulatory requirements imposed by Sarbanes-Oxley and other follow-on regulation.  Increased regulatory compliance imposes both direct and indirect costs.  Direct costs include the expense of paying internal and external experts (mostly accountants and lawyers) to provide guidance and prepare disclosures.  Indirect costs include the risk of facing either litigation or an enforcement action (or both) due to a misstep in the compliance process. 

Who Wants To Be ‘Too-Big-To-Fail’?

I’ve argued that the Dodd-Frank financial reform bill does not end “too-big-to-fail”, that is the belief that certain companies are implicitly backed by the government because policy-makers are unlikely to let said institutions actually fail. By naming some companies as ”systemically important” – as required by Dodd-Frank – the government is actually sending a signal as to who is likely to be bailed out.

As evidenced by regulators’ behavior during the financial crisis, the prime beneficiaries would be the creditors of these companies, as even when shareholders and management suffered, creditors generally did not. This should allow such firms to borrow at a cost lower than firms not deemed systemically important.

Given this funding advantage, it would seem natural that firms would want to be included as systemically important. Sure they might be examined by bank regulators more often, but that’s hardly a large cost compared to the funding advantage.

Congressman Frank has attempted to refute that there are any benefits from being deemed “systemically important” by the fact that ”so many financial institutions have lobbied against being designated in this way.” What his argument misses, or chooses to ignore, is that these benefits are not the same for all institutions. It is companies that rely heavily on debt market financing, such as banks, that have the most to gain. And under Dodd-Frank, the largest banks are automatically included. They have no opportunity to lobby to be in or out. The firms that are not automatically in, the most important of which are insurance companies, do not fund themselves primarily via the debt markets. Insurance companies get most of their funding from the premiums paid by their policyholders. And those premiums must be sufficient to cover expected losses, which have little to do with funding costs in the debt markets. Other non-bank financial companies, such as hedge funds and private equity, do not gain to the same extent that banks do because they have traditionally been a lot less leveraged than banks.

So the answer to Mr. Frank’s point is that those who have the most to gain from being ”systemically important” are already included, those with the least the gain are the very ones lobbying against being included. The real perversity is that once they are included, they will have a strong incentive to shift their business models toward more debt funding, making them riskier and more likely to fail (debt markets are far more fickle than insurance policy-holders). We are left relying solely on the judgment of the regulators to avoid this outcome, the same regulators who were asleep at the wheel as the housing bubble expanded.