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Finance – Mid-caps squeezed out of the markets

As the FD of a mid-cap corporate, you probably feel rather unloved when you go to the capital markets to raise cash. “Small quoted companies struggle for visibility on the main market and don’t have the obvious strong management and growth prospects necessary to interest fund managers,” says Neil Austin, a partner in KPMG’s public company advisory group. His comments are supported by a recent KPMG report showing that 90% of these companies fall well below the ideal minimum market capitalisation sought by institutional investors.

Austin says this means mid-caps either have to get bigger and ensure that investors notice, or accept that their time as an independent listed company is limited. “The retail investor can help to some extent, particularly if the tax playing field is levelled, but, ultimately, many companies will have to leave the market by going private or getting taken over.”

Fund managers are coming under increasing pressure to invest larger sums of money in bigger, more liquid stocks. Most prefer to invest in companies with at least 52% of their shares freely available for trading. In value terms, they say that this ideal free float is more than #105m worth of shares, which suggests a desired minimum market capitalisation of about #200m. However, only 122 of 1,556 small quoted companies fit this profile, according to the KPMG survey.

Similar sentiments are being echoed elsewhere and consultants are increasingly taking the view that their clients’ needs might not be best served by remaining in the markets. This is especially true for a swathe of corporates outside the FTSE-350 index, which typically have market capitalisations between #10m and #500m. As for the major investment banks, most wouldn’t consider it worth mobilising their resources to underwrite a #1bn debt issue.

“We’re increasingly seeing people that say they don’t necessarily want to be listed, that it’s not the be-all-and-end-all of what they’re trying to achieve, but was merely done as a means to an end,” says David Maxwell, a partner at consultancy RSM Robson Rhodes and co-chairman of its Access to Capital team. “We are seeing a growing number of mid-size listed companies looking for alternative financing.”

Maxwell maintains that investors are looking to play at even higher stakes than the #200m minimum suggested in the KPMG survey. He believes the market cap cut-off needed to generate fund manager interest is closer to the #1bn level. The UK smaller companies sector, as measured by the FT small cap index, has fallen by 22% since last September, which compares with an 18% decline in the FT all-share index. The most annoying factor for corporate FDs is surely that this hammering is in most cases unrelated to company fundamentals. Fund managers are still licking their wounds from the pasting they took in the recent TMT debacle and they have become almost irrationally chary of companies’ growth claims, despite the fact that in most cases small companies have continued to meet or beat market expectations of profitability.

“We did a study of mid-cap companies that measured earnings over three years with a two-year forward perspective,” says Maxwell. “We looked at the prospect of that earnings growth compared with what price-to-earnings ratio each company was receiving. We took an average across the market and showed that the top 50 companies had broadly three times the growth and half the p/e. But the share price doesn’t allow a company to raise acquisition finance or capital for new technology.”

Almost no one is looking to join the stock market to raise capital. The IPO market has virtually dried up this year. The first quarter saw only two UK companies join the Official List and one of these, Orange, was an international enterprise that accounted for virtually all of the #3.99bn raised. The other was Caffe Nero, a coffee shop chain that raised #9m.

“This is the lowest level of activity we have seen for more than a decade and there is no evidence of a pick up,” says Austin. “The significant falls in stock markets and the continuing uncertainty have led to a paralysis in the flow of equity issues. No one is yet able to call the bottom of the slump and restore the degree of comfort that’s needed to encourage institutions to get their cheque books out.”

Maxwell even argues that some companies should consider coming off the market altogether. “A simple question for the board is why are you listed, what are the benefits and cost of getting those benefits? There is no panacea, but the solution lies in getting down to the objectives of the business strategy and how it should be financed. Many boards have not coldly looked at that for quite a while. Often they will say they are listed, they may have some bank borrowing, some of them might have some US financing, and that’s about it.”

For most, turning to the US markets is not an option. One international consultant says that the finance director of a mid-size UK company would not be familiar with the basics of going into the US market. The first question would be whether the company complies with US GAAP. “A lot of companies fall over that simple hurdle. If you want to go into the US market, where the SEC is involved, it’s quite important to be aware that you have to comply with this,” he says.

“If you talk to a UK mid-market chief executive, he doesn’t know anything about other markets. He may have heard that Nasdaq is coming to Europe, or that the London Stock Exchange is talking to South Africa, but he has no idea what opportunities that may offer. He needs someone to sit down with him and explain how it works if you tap those markets. This information is not readily available to a mid-size company. Only if you’re raising billions on a regular basis will the investment banks provide you with that service.”

The bond markets are similarly problematic. Tony Assender, a director at rating agency Standard & Poor’s Corporate Ratings Europe, says that companies with a market capitalisation of up to #300m are likely to rated sub-investment grade. They would therefore be looking at the high yield European bond market, which has has suffered 12 months of falling yields and declining values for bonds outstanding in the market place.

“Most of the mid-cap corporates we would analyse have sales at least in the #150m to #200m range,” he says. “The capital markets may be open to them, but investors would be looking for segments that diversify away from telecommunications to more traditional, stable cash-flow manufacturing companies.”

The attractiveness of the sector is a key issue for the bond markets. KPMG has found that engineering and machinery businesses are back in vogue. On the other hand, the software and computer sector has lost its dominance, with only 20% of fund managers planning to increase investment in this area. This compares with nearly 70% just one year ago.

Yet, even if the IPO market does stabilise, bonds may remain the best option for mid caps. “Ratings are low, and as funding adds to your cost of capital, a company has to work out convincingly what the capital is needed for,” says Austin. “If you are buying another quoted company and paying a 40% premium, you are paying a price that is earnings dilutive. Even if there are synergies it might get you back to earnings neutral, and that is not good enough for the market, so we are talking about using debt. But UK corporates can be inexperienced in the use of different types of debt.”

The trend to debt as opposed to equity is reflected in the figures of corporate bond sales in the first quarter of this year. Issues worldwide rose to $126bn, or 24.6%, of the total market, in the first three months of this year, compared with $83.1bn, or 19.2%, last year.

One difficulty mid-cap companies face in this market is competition from jumbo-size bonds, which force corporate bond yield premiums to widen significantly, meaning that any company wanting to raise money faces a higher cost of capital. Just now, a $10bn bond from France Telecom and a proposed EUR5bn-EUR7bn issue by DaimlerChrysler, are forcing smaller companies out of the market. In this scenario, less needy companies tend to stand back from the market, among them Northumbrian Water, which pulled a #200m bond issue rather than face extra financing costs in excess of #1m. Small companies that have to raise money, whether to re-finance short-term bank debt or to pay for acquisitions, are having to fork out a significant premium to secondary bond prices.

Once a company has exhausted the non-equity route and finds it is still in need of capital, it should bear in mind that the equity market has not shut its doors. However, an FD will need to have a convincing story. The investor appetite is still there and a few brave souls are going into the market, albeit at a deeply discounted price. Even if you are a company with a #50m or #100m capitalisation, wanting to raise only #5m, the City will have to be convinced of the quality of your management and it will be looking for a convincing explanation that your proposal is earnings enhancing.

“We see increasing trends of companies looking to access capital by not going the normal route,” says Maxwell. “Traditionally, they have gone to venture capital, the local equity market and then perhaps they’ve gone for a secondary listing. But a lot of mid-cap companies complain that they don’t get the recognition they deserve, having performed well.”

RSM set up Access to Capital as an international serviced aimed primarily at mid-cap corporates, defined as those capitalised at #10m to #300m. “We looked at how we could help them,” says Maxwell. “The clear answer was that no FD sitting in one location knows enough about different markets around the world. We have an international team connected by a proprietary IT system whose job it is to access the most appropriate source of capital for a mid-size company.”

This search might entail looking at regional US investment banks to underwrite a bond issue, a private placement, going to the venture capital market, or even to Nasdaq, for instance. Maxwell says that once a company’s strategy and capital requirements are assessed, it can advise on market appetite, how the company would be valued in a given market and what obligations it would have to take on.

“There is appetite out there for smaller deals amongst institutional investors in regional markets, particularly in North America,” says Maxwell. “The issue for mid-cap corporates is that if they need financing now, they may be looking at further rounds of venture capital or private placements. The venture capital market is currently less active than it was but there is still a lot of capital out there. The public-to-private transaction trend is growing and venture capitalists are targeting listed companies to take them private. Basically, they’re putting forward an alternative source of capital that is better suited to funding growth without the restrictions of being in the public eye. If a company is owner-managed with a controlling or substantial owner shareholding, institutions don’t rate them highly. So it may be beneficial to de-merge out aspects of the business.”

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