Small- and mid-cap stocks (SMIDs) are currently more vulnerable to the COVID shock than markets have already priced in. A capital chasm is set to emerge as the unprecedented conditions have left many businesses in need of re-capitalisation that institutions and other pools of capital have insufficient resources to deliver.
This means the Bank of England, other central banks and governments should focus significantly more of their ‘firepower’ on the sector to head-off economic calamity.
These are the main findings of Edison Group’s latest report “Racing Covid’s Capital Chasm”.
There are two key factors behind the lack of capital supply. First is the 31.5% year-on-year decline in private equity sector activity in Q2 2020, which has significantly reduced the funding available from PE houses. Edison’s analysis suggests that this lull in activity is likely to persist, given the amount of leverage in the private equity industry.
Second, the report points to the historic decline in the amount of new equity capital being raised in public markets over the last decade. In Europe, the rates of raising fresh capital have fallen by nearly 50%, from 380 annually between 1997 and 2007 to 220 per year between 2008 and 2018. In the US, the average number of IPOs annually has exactly halved from 300 IPOs 20 years ago to 150 IPOs today.
As any further shocks are likely to drive investors towards large-cap stocks and be more severely felt since emergency fiscal measures have already been used, the report stresses that many SMIDs, which deliver up to 33% of revenues and employment, may be unable to recapitalise. This would likely spell economic disaster.
Public markets may help avoid this scenario
Edison suggests that if the capital chasm does not emerge it will likely be due to government intervention, or a continued upward trend in the use of public equity markets to raise funds. The report indicates that COVID-19 appears to have increased investor appetite for public equities, as £55bn was raised in Europe through IPOs and follow-ons in H120.
London accounted for £23.7bn, or 43%, of this total – 15% more than the total raised across the whole of 2019. According to the report, since 1 March, £17.4bn was raised in 249 follow-ons in the London market as companies raced to recapitalise. The report also underlines the sizeable $136bn raised by US public equity markets in H120, which is a $109bn increase on the same period in 2019.
Smaller-cap companies need to prepare
However, even in a more benign scenario, the report suggests the flow of capital may be restricted to a smaller cohort than usual. Investors are expected to be more exacting when picking smaller cap stocks relative to larger ones. As a result, companies need to prepare to compete for funding and should make themselves as attractive as possible.
Edison stresses that strong balance sheets will be fundamental to this. It advises smaller-cap companies to emphasise, where possible, that funds will be used to consolidate and improve pricing power in their markets and that, by being larger and more powerful, their stock liquidity will improve as well.
Governments need to act
The report then makes a number of policy recommendations. One is that governments should further extend QE to buying equities, a measure already being openly discussed in the US, and an approach the Bank of Japan has pioneered. A second is that the Bank of England’s ‘firepower’ – and that of the Federal Reserve and other central banks – be more specifically focused on small- and mid-cap stocks.
Edison also supports the Government creating a patient capital fund of significantly more than the £30bn that has been previously suggested – larger starting sums are likely to reduce the fund’s total capital requirements over time by demonstrating complete commitment. This in turn will reduce the risk of under-supply from elsewhere in the capital ecosystem.
Other benefits include the possibility of the fund returning more money to taxpayers, over the long term.
Aside from further capital provided by central banks, the report also recommends incentivising the provision of equity capital to SMIDs. Tax regimes that currently favour loan capital should come under scrutiny while incentives for the provision of new equity capital – either at IPO or for subsequent raises – should be improved. To level the environment for SMIDs, rather than fuel demand for larger-cap issuances, the report recommends these incentives be tapered, with investors benefitting most from fresh capital injected into micro-cap stocks.
The report also recommends tax benefits could be conditional or proportional to the period over which the newly released equity is held to protect against short term investments, and that measures remain flexible so they can be carefully calibrated on an ongoing basis to respond to changes in the capital ecosystem.
Neil Shah, report author and Director of Research at Edison Investment Research, comments:
“Broadly speaking, the overarching recommendation of the report is that investors, companies and governments start considering now the likely impact of a capital chasm emerging, and that they begin to make preparations to limit its effects as quickly as possible.
“Whilst we don’t think the emergence of a capital chasm is a certainty, we do think it is important that market participants, constituents and policymakers take the risks involved seriously as in the worst-case scenario the chasm could see many smaller caps affected. And, if bankruptcies multiply and jobs are lost, the effect on the economy could be devastating so much so that it becomes a black hole rather than a chasm.”