Previously, I said that no one had offered me a coherent explanation of how larger tick sizes would create jobs (outside of Wall Street). I’ve just finished reading the latest in a series of Grant Thornton whitepapers on this subject. Let’s talk about it, because while it is an explanation, it is less than coherent.
If I can summarize the GT argument, rules put in place in the late ’90s that dropped the tick size in just a few years from $0.25 to $0.01 gutted the IPO market in the US. Since investment banks cannot turn a profit on small IPOs any more, they are simply unwilling to take these companies public. As a result, these small dynamic companies are starved of capital, can’t grow, and our economy as a whole suffers. Further, the Wall Street ‘ecosystem’ of small investment banks, dealers, market makers, retail brokers, etc. suffers from not having a continuous supply of new small companies to market, and market at a profit to themselves.
The GT authors are former NASDAQ execs, not professional researchers. The white paper is often emotional, repetitive and prescriptive. That doesn’t make it wrong. It is also illogical and incoherent. That makes it wrong.
The clearest problem of the GT whitepaper is the post hoc, ergo proper hoc fallacy. If your Latin is a bit rusty, that means ‘after this, therefore because of this.’ The falloff in the number and size of IPOs after 2000 is laid at the feet of rules changes in 1997, ’98, and 2001.
There is no awareness that there might be competing secular reasons for the falloff in IPOs, reasons such as the Dot Com bubble bursting, 9/11 changing the risk appetite of investors, or huge amounts of capital being used to fund the war in Iraq instead of new economic growth. None of those things apparently happened in the Grant Thornton alternative universe. Certainly, they had no effect on the IPO market, which was driven to its knees by Reg ATS.
If GT had wanted to make the first part of their argument in a solid way, they would have needed to do a few things more than they did. For example, they assume that the IPO pace of the ’90s is the natural economic status of the US. They present no evidence for time periods prior to the ’90s of how many IPOs normally come to market, and at what level of capitalization.
The reason this is problematic is that the ’90s were a long bull market, and not necessarily reflective of the full business cycle. GT’s Exhibit 2 says that 539 IPOs came to market every year during the bubble years – more than 2 every business day. But in the prior years of the decade, 520 IPOs per year came to market, less than a 4% difference. A bubble is not a 4% difference.
What we really need to see is an inflation adjusted distribution of IPO size vs. time for a period longer than one bull market and the subsequent lateral movements.
Stepping back from the market, we also really need to examine the belief, the blind assertion, that very small IPOs represent a huge driver of the US economy. Comparing the pro-forma balance sheet of the prospectus to the first 10-K is not going to do that. You need to look at GDP-wide statistics of job growth and compare those to the IPO over a few years, taking into account companies that do not survive.
The GT whitepaper continues to make problems for itself by creating its own metric, the ‘bankable spread.’ The authors then complain when no one else references their pet metric, and uses that as a reason to ignore the actual academic research compiled by the SEC in the JOBS Act required decimalization study.
The study does not make clear whether it is really interested in more jobs on Wall Street or more jobs on Main Street. The authors, ex-market execs, clearly believe that the old ways were better than the current system. Eliminate automated trading by bringing back big ticks. More sales people selling individual stocks to retail investors!
Yes, they really say they want that. After all the research that says people can’t pick stocks and are better off in index funds. They really think the individual investor is better served by a cold call flogging PetFood.com than a lifestage appropriate index fund.
The paper is long on why small ticks hurt the business we used to be in when we used to be in it, and short on evidence that the rule changes actually hurt the economy. Growing companies have multiple exit strategies available today, and going public is only one of them. Companies can be bought by market leaders in their industry, hedge funds and other kinds of investors.
Looking at the IPO data, today IPOs are fewer, older and bigger than previously. Is that a bad thing? Is the total value of the IPO market larger or smaller? Is the total number of employees larger or smaller? If the VC or the hedge fund killed off the poor performers, or merged companies together before bringing them to market, have I been harmed?
A final nail in the coffin of GT’s credibility is their Appendix F, charts of IPO success rates. Now IPO success rate is another one of their own metrics, so you have to take the charts with a big grain of salt right up front. The first chart shows the the metric for all IPOs has fallen from around 55% in ’93 to about 27% in 2012. The second chart shows that a subclass of IPOs, valued greater than $500 million, has performed even worse. These IPOs have gone from 87% to 25% (looking at the trend line).
The problem here is that the whole paper up until this point has focused on IPOs less than $50 million in size, not greater than $500 million. If the big IPOs are doing worse than average on this metric, someone has to be doing better than average for the average to be, well, average. That someone must be the small IPOs, and that is a chart they don’t want to show you, because it undercuts their entire argument.
Bottom line, I still haven’t seen a coherent argument that big ticks create jobs. What this paper does show is simple nostalgia for another era on Wall Street and a lot of hand waving.