This year produced a bumper crop of initial public offerings (IPOs). New listings surged early in the year after Mifid ll forced stockbrokers to change their business models.
With less money from institutional investors for research, hopes were that fees from new issues would fill the gap. In the rush to bring companies to market, might standards have dropped?
In 2019, investors will learn the true quality of these new issues. But already, the signs are worrying.
The clues are not in the results themselves, which all seem very good, but in the presentation. Too many companies are flattering performance with generous management adjustments to the numbers.
If genuine business progress is being made, why not let normal audited results do the talking? Incentives do not seem to get enough attention in the field of behavioural finance, but do usually drive behaviour.
Evaluating these companies is challenging – new issues often have little history to guide. If private equity investors owned a company pre-IPO, significant financial restructuring may cloud the picture. And there may be board changes as better governance is introduced, or new management for the next stage in growth. Without continuity, current numbers take on greater importance.
This means a reliance by investors on the work done by the issuing broker, despite the obvious conflicts for analysts. Analysts in house brokers are notoriously optimistic about their corporate clients. Fees for new issues are lucrative, typically with competitive tendering for a sponsoring broker.
There may be little incentive to be a curious or cynical analyst. Yet, although institutional investors have opportunities to meet management, they find it difficult to research a business fully from a standing start. And it is particularly tough when a business is carving out a new niche, with no obvious peers or comparables.
This cocktail of conflicts and unhelpful incentives drives confusion on company performance. Even though accounts are audited, the headlines and much of the reporting of measures are typically created by the companies themselves.
Concern over earnings adjustments was recently highlighted in a Financial Reporting Council (FRC) report, which reviewed the accounts of a number of smaller listed and alternative investment market (AIM) companies. The FRC found a tendency to give undue prominence to alternative performance measures – that is, calculations that are not standard accounting practice.
Management might choose, for example, to remove goodwill components or lost customers from an earnings calculation. This is excused as an attempt to show what they believe is the underlying organic growth rate. Often part of executive pay is based on these adjusted non-standard measures, exacerbating the conflicts. It looks a lot like management marking their own homework.
And for AIM companies, there may not be the usual checks and balances – they do not need to present an audit committee report to shareholders. The funny numbers that can determine bonuses may not even be audited. The underlying growth rate can be crucial – as some argue that technology and e-commerce businesses will only list publicly when their rate of growth slows. Private equity investors like to hold on to the most rapidly growing businesses.
The Financial Conduct Authority (FCA) has forced investment managers to address conflicts. But investors are just one part of the system.
Across the market system, many conflicts remain – between management and shareholders, and within issuing brokers and their research. This makes it essential for investors to have scorecards they can rely on. The financial ecosystem can only be trusted if all parties are transparent in incentives and results.
With lower stock market liquidity and tightening credit markets, the pressure is on small and mid cap companies to now generate cash. External capital could prove expensive. Almost all metrics can be adjusted, but not cash in the bank.
Investors need to probe deeper to get to the truth about trading performance. This is an opportunity for active investors to show that their independent research can bring an edge. And more questioning is needed of alternative numbers and the incentives that encourage them.