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Capital Famine Relief

A stock exchange listing used to be an ambition for many an eager entrepreneur growing a private company. Today that ambition doesn’t seem quite the glittering prize that it once did. Step inside the boardrooms of Britain’s 2,000 smaller quoted companies (SQCs) and there are long faces and gloom about the difficulty – impossibility in the worst cases – of raising external finance.

And the situation looks set to get worse, according to the Quoted Companies Alliance (QCA), the body that represents the interests of SQCs. It has just produced a detailed research report that suggests the main institutional investors are turning away from SQCs. The QCA argues that a “two-tier” market is emerging “with specialist small cap funds and the specialist arms of the large investment houses on one side and the bulk of the industry focused on larger companies and international markets on the other”.

The QCA neatly points out that institutional and retail investors’ aversion to small caps makes no sense from a money-making standpoint. John Pierce, QCA chief executive, points out: “We’ve recently calculated that investors in Abbey National, Vodafone and Marconi have lost as much money as they would have done if they had been 100% owners of 771 smaller quoted companies which had then gone into liquidation.”

Pierce’s figures are a neat way of putting the scale of different parts of the market in perspective. In 2001, 96% of the £3,958bn traded on the London Stock Exchange was in the FTSE-350 leaving just 4% for the 2,100 companies on the rest of the main market and AIM.

All this should be of considerable concern to FDs of small caps and their boards. Pierce says: “The effect filters right through and affects enterprise. The result is that the cost of capital becomes more expensive and so companies are deterred from enlarging their businesses, investing in new factories and plant and taking on more people.”

You might think a major problem affecting 2,000 British companies employing two million people – and with £9bn of tax and national insurance contributions at stake – might be high on the government’s business agenda. After all, Chancellor Gordon Brown has championed the idea of “enterprise Britain”.

But Brown is apparently too busy to meet the QCA to discuss the problem, and the organisation has been waiting weeks to find out whether economic secretary Ruth Kelly will grant them an audience.

The QCA has drawn up a shopping list of actions it would like the government to take. These include creating a minister for SQCs, reforming the structure of the investment industry and SQC markets, removing stamp duty on trades in SQC equities and making both listing and delisting easier.

It’s an ambitious wish list and it seems unlikely that the SQC will get more than a fraction of what it wants in the foreseeable future – which means that if small caps are to tackle the capital famine they will be forced back on their own resources. Getting a clear understanding of what’s going on out there is the first step to finding a solution.

One key factor is the growth of the institutions as drivers of investment. Between 1994 and 2001, funds managed by institutions leapt from £51bn to £230bn. Yet a QCA poll of institution investors suggests that 83% believe that the number of their colleagues willing to invest in small caps is either static or falling.

The QCA finding is supported by the latest statistics from KPMG’s “investing in SQCs” bi-annual survey. The number of institutional investors who think funds available for small caps are decreasing has doubled to 14%, compared with when the survey was last conducted in 2000. The same survey shows a sharp fall in those thinking small cap investment is increasing (from 39% down to 27%).

Neil Austin, a partner at KPMG Corporate Finance, says: “I reckon that smaller companies’ funds have had a decrease in money going into them in the past few years. But that could be true of larger company funds as well because of a move away from equities.” That may be true, but if there’s an historic switch from equities – certainly the case in some pension funds – then small caps will find it harder to handle the move than the corporates.

In fact, figures produced by Standard & Poor’s show that the proportion of equity funding going into small caps has fallen from a recent high point of 8% in 1995 to just over 5% in 2001. Had the figure remained at its peak, small cap holdings would have been £17.7bn in 2001 instead of the £12.3bn they were that year. That missing £5.4bn is the key reason why small caps are now finding it so much harder to raise capital.

So is it possible for small caps to attract greater interest from institutions? Pierce agrees that many could do more by improving the way they present themselves to the market. Even so, he also points out there are trends that make it less likely that institutions will want to invest in small caps in the future. He says: “The economics of the fund management industry mean that the ability to deal in large volumes is a key driver of investment decisions.” PricewaterhouseCoopers carried out a study a couple of years ago which showed that a typical institutional fund consists of eight portfolios, each worth around £55m, totalling £440m. Typically, there are around 50-to-120 stocks in each portfolio with 80-to-90 representing a balance between diversifying risk and handling the practical side of fund management.

So the arithmetic isn’t hard to work out. If a fund manager is handling 90 stocks, each investment unit represents 1.1% of his or her holdings.

So in a £440m fund, each investment unit averages £4.88m. As Pierce points out: “Such an investment would represent an illiquid 20-to-25% stake in about half of all listed companies.” And some funds play with even larger stakes. M&G’s £1.5bn Recovery Fund works with investment units of about £17m.

This raises another issue. Is it too easy to be listed? To gain admission to the LSE’s main market a company needs a minimum capitalisation of £700,000 and a shares free float of 25%. Critically, once on the market, the company doesn’t have to maintain those levels. By contrast, smaller companies on Nasdaq’s Small Cap Market must meet tougher market capitalisation rules and maintain at least two market makers – so the mechanisms are in place to encourage liquidity.

The QCA addresses this market quality issue head-on in its report. It argues that “the perception of the market would benefit from a reduction in the numbers of dormant or historic listings.” It quotes one fund manager who says that in too many small caps “the wheel may be turning but the hamster is dead”.

Perhaps it would help to improve market perceptions if some of the dross was cleared out. The trouble is that without some radical changes, it isn’t going to happen in the short-term. Although the market does see public to private transactions, taking a public company private is fraught with difficulty and expense. It’s not unknown for investors to pay a premium of as much as 40% on the share price to complete the transaction.

Moreover, the private equity industry, which would have to stump up most of the cash to fund a new wave of publics-to-privates, will not be interested in ploughing its money into a long list of under-performing turkeys. So publics-to-privates are going to remain the exception rather than the rule.

But it’s possible that private funds could help some small caps. Private investment in public equity (Pipe) deals have had something of a chequered history in the US. There are a few voices in the venture capital community who believe they could become more common in the UK, especially while stock prices are depressed. “I wouldn’t be at all surprised to see a slight increase in the number of Pipe deals in 2003,” says Martin Jenkins, a partner in Deloitte & Touche’s corporate finance practice.

Under a Pipe, a venture capitalist invests new money into a company usually in some form of preference shares or convertible loan stock. Huntsworth, the #12m-cap public relations company run by Lord Chadlington, raised #3.8m in November to fund two acquisitions, with the aid of a Pipe supported by venture capitalist 3i. But, again, Pipes are not going to be the answer for most small caps, not least because they won’t offer the kind of returns venture capitalists are looking for.

So what’s left? One option – and the only option for most small caps – is to try to make themselves more attractive to both institutional and private investors by improving the quality of their investor relations.

“It’s something that we keep on about to our members,” says the QCA’s Pierce. “There’s so much that companies can do to assist themselves. I keep saying they should adopt the same principles they use in marketing their products – look at the main attributes and ask themselves: who are our customers?”

But Austin wonders whether the indifferent quality of management in some small caps will mean that doesn’t happen. “You get boards of directors who are just sitting there and nobody is going to mount a friendly or hostile takeover bid,” he says. “They are relatively small and off the radar screens of the institutions.”

He talks of boards of forty and fiftysomethings marking time on comfortable salaries and with little incentive to change the status quo. They may run companies where only a small proportion of the capital is actively traded. In that situation, their only realistic prospect of raising new capital to move forward is to seek a merger or sale into a larger group.

“And why should they do that?” asks Austin. “It would be like turkeys voting for Christmas.”

If small caps remain, as Pierce believes, under-valued because of market perceptions, floating could become a much less attractive option for entrepreneurs building the fast-growth companies of the future. And that could cause a serious dislocation in what the Centre for the Study of Financial Innovation has called the “finance escalator” – the financing shift from family and friends through business angels to venture capitalists into capital markets as the natural funding progression of a growing company.

In fact, it’s already started to happen and it’s harming some of Britain’s most innovative small businesses. It’s about time Gordon Brown cleared a slot in his diary and started talking about what can be done about it.

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