FirstPreviousNextLast

Initial Public Offerings: Status, Flaws and Dysfunctions

Summary

Access to public financing is a key factor in the development and growth of businesses. This stage enables a business to benefit from a permanent source of capital and reduce its equity costs. This is especially important in a knowledge economy where the intangible nature of major assets limits the use of debt financing. The development of a method of exit for venture capital investors and a dynamic stock market are other arguments favouring the stimulation of primary offerings. The primary issues market is thus essential for businesses mature enough to make use of it, but also for more junior businesses because it helps to improve early-stage financing conditions. Over the past two decades, various initiatives have been launched by governments and self-regulating agencies to facilitate public financing of new businesses in Canada. The Quebec Stock Saving Plan, stimulation of the venture capital supply, the gradual relaxing of minimum standards for stock market listings and the Capital Pool Companies program all flow from this desire to facilitate the public financing of growth businesses.

Despite the importance of this type of financing for businesses and the efforts made to develop it, there are very few recent studies on the various forms of access to public financing in Canada, and what research there is, is limited to share offerings followed by listings on the Toronto Stock Exchange. This makes it difficult to gauge the outcomes of the various initiatives and redirect public policy in this area. To partly fill this gap, this study offers a complete picture of primary offerings in Canada by operating companies and CPCs from 1991 to 2000, based on the identification and analysis of 1,891 share issues. The short- and medium-term behaviour of the securities and issuing costs are evaluated for traditional issues. We also draw a comparison with the activity in this area in the United States and attempt to establish the connection between venture capital and primary issues.

In the first part of the paper, we show that primary issues are proportionally fewer in Canada than in the United States and that the capital raised is appreciably less after standardization by GDP. Canada is a market of very small issues. However, including issues arising from privatization and demutualization in figures can partially obscure this phenomenon, as such issues account for a major percentage of the total gross proceeds raised in the 1990s. Issues by subsidiaries of already listed companies also account for major amounts, further reducing the measurable issuing activity of completely new businesses. Paradoxically, big corporations do not seem to make frequent use of the primary issues market.

The gap between primary issues in Canada and those in the US is even more pronounced in the field of technology. And it is even wider than first appears in that the main Canadian technology stock offerings are by subsidiaries (Bell, AT&T) and not by new companies.

We go on to review a number of possible explanations for the deficiency in Canadian primary issues, including high costs, medium-term performance and regulation.

The second part of the study looks at direct and indirect issuing expenses, including initial underpricing. Size being equal, direct issuing costs are lower in Canada than the general rule in the United States. However, primary issue costs seem to be very high for small businesses, which may have a significant impact on their competitiveness.

The performance of primary issues in Canada is disappointing. In this respect, it is no different from issues in other developed markets. However, the medium-term return on small issues is about -50% over the first five years following the offering, and the five-year survival rate is around 60%, for issues from the early 1990s. It seems plausible to associate the mediocre performance of IPOs in Canada with the fact that they are made by small companies that often have very short track records. These companies have not been able to develop and build up a competitive edge, which is the key factor for creating wealth and increasing value. In many cases, these issues are too small to command a sufficiently liquid market and adequate coverage by financial analysts.

In the final part of this paper, we get into the implications of these observations in terms of government action and market regulation. The operation of the primary issues market seems to be hampered by a number of major problems, the main one being the low survival and growth rate of small businesses making initial public offerings. We estimate that 5.9% of small issues lead to a business that can claim big business status within five to ten years. The policy of stimulating the listing of small businesses should be re-evaluated. The emphasis should be on mechanisms that would allow IPOs to be deferred until businesses have had a reasonable chance to ensure they can survive. Stress should be placed on developing a capital supply prior to the issue.

The arguments in favour of lightening the regulatory burden for small issues should also be reviewed in the light of these findings. The success rates of primary issues are similar to those of venture capital. However, this form of financing is handled by experts, which is not the case with primary issues, which are bought by institutional but also individual investors. There would seem to be no justification for relaxing the conditions for primary issues. Lastly, small primary issues in all likelihood have a negative effect on the market. They perform poorly and hamper liquidity.

Primary issues nonetheless remain few in number compared with those in the US, which may seem paradoxical given the efforts made by the different governments to increase the venture capital supply. It may be that the fragmentation of this supply is one of the factors accounting for the relative rarity of IPOs involving venture capital firms. The role of government in the area of venture capital supply needs to be revisited.

FirstPreviousNextLast