EUROPE
New-style stock exchanges are a window of opportunity for Europe
Spring 2007
With their US competitors struggling to cope wth the regulatory burden if Sarbanes-Oxley, European companies large and small have a chance to improve their access to capital. Leif Beck Fallesen, Editor of the Danish business newspaper Børsen explains the stock market revolution that is within their grasp
Everyone agrees that Europe needs to become more competitive in global financial markets, but the tricky part is doing so in a way that actually benefits the smaller companies that are the lifeblood of our economies. Neither stock exchange mergers, nor the setting up by major investment banks of their own trading platform will have much impact on Europe’s fastest growing sector, our unlisted small and medium-sized companies (SME’s).
If Europe’s priority is the job creation and higher growth rates targeted in the Lisbon Agenda, then we in Europe need to take the global lead in developing alternative exchanges and markets that can provide easier and lower cost access to capital. In all business sectors and industries, SME’s tend to be the only net creators of jobs. Big companies provide most private sector R&D in the EU, but job creation, too, is an essential part of our response to globalisation.
For once, the European Union has a strong hand to play. The Sarbanes-Oxley corporate governance rules in the US have imposed such an onerous burden on companies that they are taking their listings elswehere, or they’re selling themselves to private equity firms who then de-list them. Not to copy paste Sarbanes-Oxley has been a virtuous European non-decision that is now paying off.
For smaller US companies, the regulatory weight of Sarbanes-Oxley has made Europe an attractive alternative to a US listing. In 2005, 19 US-based companies went public and raised $2.1bn by listing on the AIM, the Alternative Investment Market owned by the London Stock Exchange. AIM has attracted companies from eastern Europe, Russia, Australia and China, and its very wide distribution of sectors, as opposed to the high-tech bias of the Nasdaq in the US, has been a strong point in the market’s contribution to growth. Companies do not just raise money at entry with an Initial Public Offering; many go on to raise further substantial amounts, and that has added up to a sound health certificate for the exchange itself and a testimonial to the strong growth genes of the companies it lists.
With more than 1,500 companies now listed, three quarters of them with a market value of less than ₤50m, AIM is a template or at least a strong benchmark for similarly organised but unregulated new European markets. Many of these withered or were closed in the tough years after the IT bubble burst back in 2001; Euronext closed its New Markets, but has instead launched Alternext to cater for the needs of small- and mid-cap firms. Competition at the regulated level is thus mirrored at the unregulated level.
The European Private Equity and Venture Capital Association (EVCA) is a strong advocate of a pan-European trading platform and quoted market for small and medium-sized growth companies. A first effort, Easdaq, failed and so did the US Nasdaq’s own attempt in Europe. EVCA rightly identifies a chicken-and-egg problem in which no pan-European platform can be established without a critical mass of companies, which is unlikely to exist until any new pan-European platform has proven that it can generate new money.Rather than wait for this problem to be somehow resolved, the EVCA is now proposing a cross-exchange platform with sector indices that could be marketed across Europe.
Harmonisation of listing criteria across the exchanges, streamlining of regulatory procedures for IPO filings on the ”light touch” model of AIM and Alternext and the involvement of more non-domestic market makers are all very good practical proposals included in the EVCA paper. Yet the end of the day, success will be determined by investor demand for shares in growth companies with a return on investment that, compared to the regular stock markets, is high enough to compensate for the lower liquidity and perceived higher risk.
Investor demand will also depend on the supply of interesting growth companies. Although encouraging entrepreneurship is now high on the agendas of virtually all European countries, the EU still lags well behind the US. Comparatively fewer new companies are started up in Europe, and their access to venture capital is more restricted than that of their US counterparts. A cardinal reason for this is that they are often less profitable; US venture capitalists had a 10-year return on investment of 26%, while in the EU the return in the same decade up to 2004 was only 6.3%. This means that in Europe there are relatively fewer companies than in the US to send down the financial food chain to the alternative and regular stock markets, or to private equity buyers.
From a European perspective, the globalisation of stock exchanges can be seen as a levelling of the financial playing field. For many years, the much larger capitalisation of US stock exchanges compared to European stock exchanges, benchmarked against GDP, has been seen as a disadvantage. American companies have had greater access to the cheapest form of money available – capital raised on the stock exchange.
Conversely, European companies have had a higher debt-to-equity ratio, along with the added growth constraint of higher interest payments. Lenders have to be paid in bad times as well as in good, whereas shareholders may protest and unload their shares, but they do not have to be paid dividends at all times. Reducing their debt by issuing stock would give European companies much greater scope for growth, and many large European companies have already globalised their acquisition of capital. But this has not been an option for the great majority of small and medium-sized enterprises (SMEs).
The cost of capital includes transaction costs, the expense of an initial and subsequent public offerings and other charges. Although globalisation should exert downward pressure on these parameters, a stock exchange must set a market price that is accepted as fair by both sellers and buyers, so it must be possible to trade large numbers of shares without moving the price. In other words, the market must be as liquid, which can be defined as the price per share multiplied by the daily turnover. Major investors need to buy and sell fairly large numbers of shares at a time, and will therefore be biased in favour of more liquid stock exchanges. Less liquid shares tend to be traded at a discount, to the detriment of the companies, their shareholders and the stock exchanges on which they are listed.
This is not a critical issue for Europe’s largest companies. A mid-2006 report commissioned by the City of London and the London Stock Exchange claimed that the London markets are cheaper than the New York Stock Exchange (NYSE) and Nasdaq at both the Initial Public Offering stage and beyond. A merged NYSE and Euronext is now to offer the world’s largest pool of liquidity, with an aggregate market capitalisation of $18,700bn ($3,600bn from Euronext). which is greater than that of the next four exchanges, London, Tokyo, Nasdaq and Deutsche Börse combined. And if the newest challenge to the world’s established stock exchanges – the trading platform codenamed The Tourquoise Project that is being fathered by Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, Merrill Lynch and UBS – comes on stream in 2007, global trading costs for big companies can be expected to drop further.
Private equity in recent years has been a boom industry. To the extent that companies have been bought at a premium to the market price by private equity investors and then de-listed, this is a challenge to the business and to the fundamental pricing mechanisms of stock exchanges. But if successful, and their track record has been good, private equity investors will at some point need to exit, so these companies may return to the stock market with higher trading volumes. Growth in the private equity market has been driven by extremely low interest rates, and that should slow as short-term interest rates continue to rise both in the US and in the EU.
The profitability of listed non-financial corporations in the eurozone, measured as a percentage of sales turnover, reached a 20-year high in 2005, which bodies well for the future of regulated stock exhanges in Europe, irrespective of their ownership. The challenge for Europe is to take the lead in alternative growth markets by creating a pan-European platform or bringing about much closer co-operation between existing markets. US Treasury Secretary Hank Paulson has initiated a revision of the Sarbanes-Oxley rules to help smaller American companies, but for Europe there is still a window of opportunity that must be fully exploited if business in the EU is to benefit from the easier access to capital that has done so much to fuel America’s economy.