A SURVEY THROUGH THE EYES OF INSTITUTIONAL INVESTORS

Back to basics for equity markets

Are Londons equity markets failing the small cap sector?

Contents
Introduction Executive summary - Opportunities for growth lost to low valuations - Taking charge of the relationship with investors - Key questions Looking ahead, markets in the next 12 months - Factors affecting performance - Stock pickers, not sector specialists Seismic shifts as equity allocation keeps dropping - Changing character of the markets - The US experience - Is the UK following suit? Alternative strategies raising capital in tough times - Taking charge of fundraising Re-framing the debate how do we bring small caps back to the market? A view from Grant Thornton - Do we need a change in regulation? - A revived ecosystem for small caps - The source of future economic growth - Questions for debate Our approach 16 14 11 8 4 1 2

Introduction
Calm reflection is probably not an activity that is readily associated with stock markets in 2011. But in the interests of predicting how stock markets, and indeed the economy, will fare in the medium and long term, Grant Thornton commissioned Lighthouse Global to ask 50 of the most influential fund managers and institutional investors in the UK, who between them control funds valued at 43 billion, for their views on the current status of capital markets, particularly in regards to smaller companies. Their thoughts will be of interest to anyone concerned with the long term health of the UK economy.
The consensus among these experts is that there is a growing crisis in the small company sector. Management teams are looking for funds to grow and develop new ideas but they are being starved of capital. The experts point to regulatory, technological and commercial developments that have distorted aspects of the UK equity markets. These include the proliferation of high frequency trading and the apparently unrestricted growth of synthetic equity products, both of which can have unintended and potentially damaging consequences for smaller quoted companies. The conclusions of this survey point to challenges that we believe must be addressed if we are to maintain an efficient capital allocation system, able to meet the needs of both providers and users. This paper sets out the key issues and asks some core questions that we hope will stimulate the debate. Grant Thornton would like to thank everyone who took part in this survey. The time and care they took in answering our questions is a measure of the seriousness with which they view the problem.

Philip Secrett Partner, Head of AIM & Smaller Listed

Grant Thornton UK LLP

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Executive summary
Despite the global economic turmoil, and the rise of new economic powers looking to exert their influence over international commerce, the London stock markets are still among the best places in the world for investors and companies looking for capital.
There is, however, a clear danger that the next generation of UK companies is being starved of the capital necessary for growth, and that the future vibrancy and health of the UK economy is being placed at risk through market failure today. These are the key conclusions of this survey of 50 leading UK fund managers and institutional investors, who between them control funds valued at 43 billion. In detailed interviews carried out in August and September 2011, these experts gave their predictions for the future development of the London markets, explained how their own approach to investment is developing against the background of major economic change, and gave vent to their concerns over the problems being faced by smaller companies thinking of seeking a quote on a UK equity market. Their worries focused on small cap companies, including those on AIM, where the number of quoted companies has fallen by a third from the peak of 1694 achieved in 2007. They identified a significant decline in the support system of brokers and market makers which would once have identified and nurtured good prospects and interesting ideas, promoting them to the market as longer term growth stocks.
Opportunities for growth lost to low valuations

The decline in small cap listings has both immediate and longer term consequences for the economy. In a study of the economic consequences of AIM, published in 2010, Grant Thornton showed that AIM companies contributed around 12 billion in UK GDP in 2009, and supported around 250,000 jobs, more than those supported by the UK pharmaceuticals or defence industries.

Market inefficiencies have resulted in persistently low valuations for small cap companies, even those with a good record of profitable trading and growth, something that has led management teams to question the value of either seeking or retaining a quote on a public market. For a growing number, the lure of a sale to a larger competitor has proved hard to resist and companies which might have grown into the FTSE 250 stocks of tomorrow have been swallowed up by overseas rivals.

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Economic Impact of AIM and the role of fiscal incentives. Grant Thornton and London Stock Exchange, 2010.

Taking charge of the relationship with investors

Key questions

For AIM and smaller listed companies the advice from our investors was that management teams should take firm control of the process of promoting themselves to the market. Among the specific advice given was: frankness and openness is valued highly too few companies are prepared to be as honest as they should be provide the right amount of information in annual reports and avoid boiler plate disclosure direct access to senior management is very important investors want to look you in the eye dont overdo the company news provide non-financial data only when it matters company-commissioned research is useful, but it is no substitute for independent research.

There are regular calls for market reforms, especially a lightening of the burden of regulation. But we believe that these are missing the point. The current regulatory framework is a good one and yet, despite all the efforts being made by Government and the London Stock Exchange to encourage investment in small caps, the market is still failing to provide the necessary support. This study, along with our regular work in the London markets, leads us to ask the following core questions about the future direction of small cap investment in the UK: Have UK equity markets moved too far from their core function, which is to allocate capital? What are the systemic forces that are depriving small caps of the capital they need, and what can be done to counteract them? Are the economics of the small cap sector sufficient to drive the economic support system it needs to thrive and grow? If not, what can we do to re-shape them? How do we rebalance the movement of money out of equities and into bonds and synthetic investments? Is this movement irreversible?

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Looking ahead markets in the next 12 months

Despite the steady flow of bad economic news, most of the investors who took part in this research are moderately optimistic about prospects for the year ahead. Asked where they thought the AIM All Share, FTSE 250 and FTSE Small Cap indices would be at the beginning of September 2012, compared with September 2011, those fund managers prepared to offer a view were predicting growth of around 3.5 percent, on average, in each index (see Figure 1).
Figure 1: Where do fund managers think the markets will be in September 2012? Points on 1 September 2011
FTSE 250 FTSE Small Cap AIM All Share 10100 2900 740

Average points in 1 years time

10450 3008 765

Fund managers are predicting growth of around 3.5 percent in the small and medium cap indices for the year to September 2012.

A third of participants preferred not to offer a prediction. But for most of these people this was a reaction to uncertainty rather than a conviction that things are going to get worse. A common view is that profitable, cash generative businesses are still reporting growth, and that while most are cautious about their prospects, there is little reason to expect that they will not do well in the coming year.

In terms of corporate PLC, our experience with the companies we tend to invest in - profitable, cash generative, established businesses that operate in specific niches - is that the majority have been reporting solid growth and recovery. Now - to a man - while they are expressing caution on the outlook, there is little evidence yet of any significant change in the buying patterns of their major customers. Reassuringly, most have also now taken appropriate action to ensure that they are better prepared to withstand another significant economic downturn should such a scenario develop.
Chris Hutchinson Director Unicorn Asset Management

Even among the pessimists, no-one is predicting a widespread deterioration in performance. For most, the outlook is a continuation of the patchy, sporadic recovery in particular sectors that they have been seeing for the past 12 months, with a more general improvement expected in 18 months to two years time.

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The London markets are retaining their attraction for investors, despite their difficulties (see Figure 2). Two thirds say that London is holding its own against international competition from other exchanges, and for many the City remains a leading place to do business. One fund manager was adamant that London still stands alongside New York as the best place to have a dealing operation. It has enormous kudos he said.

Figure 2: Is London retaining its attractiveness for investors?

Compared to other exchanges London is a less attractive place to invest than 6 months ago
80% 70% 60%

Neither agree nor disagree 16%

Dont know 4%

34%

34%

8%

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40% Slightly disagree

30%

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Strongly agree

London is still one of the best places in the world for investors.

Factors affecting performance

In the minds of our fund managers, the importance of the key macroeconomic factors likely to affect investment decision making and asset allocation in the next three years is evenly spread, with no single factor particularly dominant (see Figure 3). However, the Eurozone sovereign debt crisis is causing a great deal of concern. The consensus view is that this is predominantly a political crisis, and that the politicians know what they must do to solve it. They are being prevented from taking decisive action by concerns over the possible reaction of their electorates, but this can only go on for so long.

We need to stop postponing the issue and actually address it. Thats going to be painful and some pretty tough political decisions need to be taken to get us there. The political risk that goes with chucking one country out is substantial, but the bigger problem is that no-ones taking the decision.
Paul Lee Director Hermes Equity Ownership Services Ltd

Increased regulation is also a source of concern, but while the effects of some kinds of regulation remain uncertain (for example, one fund manager said it was obvious that London should not participate in any financial transaction tax that is being considered in Europe), others are expected to have a significant impact. Perhaps the best example of this is the Dodd-Frank Act in the US, where the detailed regulations implementing the Act are still being drawn up, and several investors are keeping a close watch on the process in the firm belief that the US regulations will have a clear impact on businesses in the UK.

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Looking ahead markets in the next 12 months

Figure 3: What factors will affect asset allocation in the next three years?
International factors like the Euro crisis and growth of emerging markets are uppermost in investors minds. On the downside, worries persist about depressed consumer demand, risk and inflation, but on the upside, new technologies will create growth.

Stock pickers, not sector specialists

Euro crisis Growth of emerging markets De-risk strategies Fluctuating commodity Subdued consumer Emerging technologies Valuation Company evaluation/planning Economic improvement/optimism/growth Increased competition New regulations Public sector cuts Interest rates Dont know/refused Others 0% 5% 10% 15% 4% 6% 6% 8% 8% 8% 8% 10% 12% 12%

16% 16% 14%

14% 22% 20% 25%

On a positive note, continued strong growth in emerging markets, especially in the Asia Pacific countries, is providing good support for those companies able to do business in the region. Investors expressed some concerns about the possibility that the governments of emerging market economies might

choose to restrict investment in their countries to counteract soaring exchange rates. But whether through growth in emerging economies, or a rebalancing of existing benchmarks, the composition of the MSCI Global Index is shifting inexorably towards the emerging markets over the next three years.

It is clearly a difficult time for fund managers to decide where to invest, particularly for those, like the majority of participants in this research, who see themselves as stock pickers rather than sector specialists. The pharmaceuticals and oil and gas sectors are popular, but in very broad terms, companies expected to do well are those with specialist expertise in a particular market niche and some exposure to the markets of the Asia-Pacific region. The sector in which they find themselves is not thought to be particularly important. There is also a preference for investing in companies in the early stages of their development, in the expectation that they will grow more rapidly than their larger competitors and may, in time, move from the smaller markets onto the main market and benefit from a favourable revaluation. But the responses from investors suggested that this goal of achieving a main market listing is becoming progressively more difficult to achieve. On AIM, for example, the number of companies has fallen from 1694 in 2007 to 1156 in 2011. Investors report that while valuations remain stubbornly low, some small companies are finding it hard to justify the cost of maintaining a public listing (see Figure 4).

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Figure 4: Is AIM retaining its popularity among small companies?

600 519 500 462 Total AIM Delistings Number of Admissions on AIM

400

355 277 227 284 258 224 177 102 58 102 198 114 36 102 111 72 293

300

200

160 85

162 112 88

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0
99 00 01 02 03 04 05 06 07 08 09 10 19 20 20 20 20 20 20 20 20 20 20 20 to Se pt

AIM listings have declined significantly in the past four years. At the time this research was carried out, in September 2011, the total number of companies on AIM had fallen to 1156. This was down by nearly a third from the peak of 1694 in 2007. Asked to look ahead 12 months, fund managers predicted 138 delistings and only 85 admissions for the year to September 2012.

If the valuation is a derisory one, which it is once you get to a market cap below 50m, then some of these stocks fall into a black hole of lack of interest. Some stocks are so abysmally rated that managements say Whats the point? and take it private or de-list it.
Chris Rodgers Director Four Capital Partners

coming from companies themselves has increased in recent years, this is not seen as a satisfactory alternative to the broker research that many drew on in the past when making decisions.

There has also been a steep decline in the amount of independent research carried out on companies at the smaller end of the market. Fund managers frequently described their preferred investment targets as under-researched, and although the amount of information

It could be argued that the debundling regime, introduced in 2006 to force the buy side to separate the costs of research from those of trading, has had the unintended consequence of undermining the economics of the secondary market, resulting in a dearth of quality research for small caps.
Philip Secrett Partner Grant Thornton

20

(Source: London Stock Exchange)

In the absence of hard facts that include comparative performance measurement data, investors will perceive the small cap sector as more risky than larger businesses. The natural consequence is that they will demand a higher return, or offer a lower level of investment, to compensate for the additional risk. There are also problems caused by patchy illiquidity in the small cap markets. If asset prices do not reflect the true fundamental value of the underlying business and lack of investor interest leads to an illiquid market, the potential difficulty in achieving an exit will further reduce investor interest. This makes it particularly difficult for young, high growth firms to attract investment, because the number of investors willing to take on these risks, when there are less risky options available in the market, is relatively small. All these factors have combined, in the eyes of many small company management teams, to increase the cost and decrease the benefit of a listing. For some, the tipping point has been reached, and they have chosen to go private or sell. It is clear that the investment environment for small and mediumsized companies has become significantly more difficult in the past three to five years. But why did our fund managers think this has happened, and what did they think can be done to deal with the problem?

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Seismic shifts as equity allocation keeps dropping

The move away from equities as a major constituent of institutional investor portfolios is not a particularly recent phenomenon. Research from UBS, for example, shows that among the big pension funds the proportion of assets allocated to UK equities has fallen from a high of just under 60 percent in 1994 to around 20 percent in 2010 (see Figure 5).

Figure 5: How have UK pension funds changed their asset allocation?

% share 60

UK equities Overseas equities and bonds UK bonds

50

Property Other

40

The process, which accelerated in the late 2000s, was accompanied by a widespread corresponding shift into bonds. This is explained by participants in our survey partly as a response to demographic changes in the UK population (creating an increased demand for steady income as pension schemes mature) and partly as a reaction from private investors against high levels of volatility, combined with uncertainty over the direction of the UK economy.

30

20

10

I think, with low values, there is a de-equitisation afoot. By any historical standards, equities would seem to be very cheap, but there is not the flow of new money coming in to the market. Pension funds are de-risking and private investors have been frightened away by volatility and scaremongering from the media on the economy.
1985 1990 1995 2000 2010 Chris Rodgers Director Four Capital Partners

1980

(Source: UBS Asset Management) Equities have lost their dominance in pension fund portfolios as managers have switched in search of income to meet demand from maturing pension schemes.

The overarching shift is away from equities into fixed income, driven by maturing pension schemes and fundamentals.
Paul Lee Director Hermes Equity Ownership Services Ltd

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Changing character of the markets

Alongside these factors, there seems to have been a more fundamental change in the way companies are assessed, valued and traded in the UK markets. Paul Lee, from Hermes Equity Ownership Services Ltd, thinks that the interests of the suppliers and users of capital are not being served as well as they once were. You see some activity - high frequency trading is just one example of it - where agents are frankly serving their own interests rather than the interests of end users. he says. That means that more companies feel frustrated and unloved, and see very little value in being on a public market.

Increasingly, investment institutions are seeking ways to disintermediate those intermediaries and invest more directly in companies. His concerns are echoed by other investors. Apart from the lack of independent research on smaller companies and poor liquidity in some smaller stocks they point to a clear decline in the number of market makers willing to put money into nurturing small cap companies. These are all seen as symptoms of a market that is focusing on the economics of trading in large quantities of large company stocks at the expense of investing in the smaller scale growth stocks.

You need to see more advisers who are going to suggest 5-10 percent of a portfolio is put into small cap stocks, preferably on a broad geographical basis to diversify the risks. Education is needed to encourage people not just to think about the FTSE100 but to look at under-researched companies.
Andrew Milligan Head of Global Strategy Standard Life Investments

The US experience

Figure 6: Does the US experience point the way for the UK? Online brokerage surges and Order Handling Rules are imposed, causing decline in small IPOs Online brokerage ranges from 1996 to 1999: Order Handling Rules are imposed in 1997; IPOs raising less than $25 million decline sharply from 1996 to 2000; Sarbanes-Oxley was not implemented until 2002.
400 350

A similar set of circumstances was identified in a study of the US markets published at the end of 2009 by Grant Thornton. This study asked why the number of Initial Public Offerings (IPOs) raising less than $25 million had fallen dramatically from around 250-350 per year in 1992 to 1996, to 25 or fewer per year from 2001 onwards (see Figure 6).

Number of U.S. IPOs raising less than $25 million

A Christie Schultz study* B First online brokerage C New Order Handling Rules D Regulation ATS (Alternative Trading Systems) E Online brokerage surges and stock bubble inflates; F Regulation FD G Decimaliztion H Sarbanes-Oxley Act I J Global Research Analyst Settlement Regulation NMS

300 250 200 150 100 50 0

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

YTD

Sources: Grant Thornton LLP, Capital Markets Advisory Partners and Dealogic. Data includes corporate IPOs as of 06/30/11, excluding funds, REITs, SPACs and LPs *Christie, William G., and Schultz, Paul H., Why do NASDAQ Market Makers Avoid Odd-Eighth Quotes? Journal of Finance, Vol.49, No.5, 1994.

In the US, a Perfect Storm of new regulation and market changes has all but killed off the small scale IPO.
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Seismic shifts as equity allocation keeps dropping

The report concluded that a Perfect Storm, consisting of: steep cuts in trading commissions a dramatic narrowing of spreads from $0.025 per share to $0.01 per share the switch from advice-based trading to online trading, and regulations designed to separate investment banking from research; had severely damaged the economic support systems that had nurtured and sustained investment in small companies. The study also concluded that in a market where the profit on promoting smaller companies has been severely curtailed, there is no-one left to promote the smaller stocks. This is not seen as a major problem for the larger companies, who have simply taken on the role of promoting themselves directly to investors. But for smaller companies and start-ups, it presents a real barrier to further growth. This has created two key problems. The first is that, today, very few US companies make it public. Instead, the exit workhorse of venture capital is now the sale to mostly large corporate acquirors, which means that the true potential of many of these start-ups will never be known.

The second is the adverse effect on financial support for the more far-reaching and risky ideas that have no obvious buyer. Today, the study said, the first question most venture capitalists ask of a potential investment is, Who are the natural strategic buyers for your company or idea?. If the answer is No-one as it might have been in 1983 when Genentech was the first biotech company to go public, the likelihood is that the Genentechs of our world might never be funded.
Is the UK following suit?

For those management teams and shareholders who are happy to follow this route, this is probably good news. But it is hard to discount the effect of the US scenario on the long-term health of the UK economy and the development of new ideas. If smaller companies are determined to grow on their own, but need capital and support to do so in a tough market, what strategies are open to them?

This is a scenario that many of the fund managers in our survey would recognise from the UK. Chris Hutchinson from Unicorn Asset Management says that much of the delisting by small cap companies has been due to them being acquired, often by cash-rich US businesses looking for good opportunities resulting from low valuations.

Whilst equity valuation multiples remain low, cash-rich foreign businesses are increasingly likely to make opportunistic bids to acquire businesses at bargain basement prices and enter Europe via the UK. Pharmaceutical businesses, medical device companies, engineering firms and software specialists are all currently vulnerable.
Chris Hutchinson Director Unicorn Asset Management

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Market Structure is causing the IPO crisis, published by Grant Thornton LLP in October 2009

Alternative strategies raising capital in tough times

Several of the fund managers who took part in this survey were keen to point out that the traditional markets are not the only source of capital available to smaller companies. Alternative forms of finance such as corporate bonds or convertibles are increasingly popular with institutions trying to find ways to invest directly in companies.
One fund manager urged management teams to find ways of tapping into the capital held in the communities around them, citing share clubs as a possible source. Although these alternatives can help, for companies needing serious quantities of growth capital there is really little option but to use established equity markets. Despite the problems outlined above, there is still a keen appetite among investors for opportunities to invest in sound companies with good growth prospects, if only they can find them (see Figure 7). If the normal market mechanisms for bringing together people with capital and those who need it are not working, then it falls on the companies themselves to take on the role of broker and more actively promote their stock to the market.
Taking charge of the relationship with shareholders
Figure 7: What prevents fund managers from investing?
40% 35% 30% 25% 20% 15% 10% 5% 0%

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Fund managers are looking for well-managed companies with strong balance sheets and good prospects for growth.

A good starting point is to identify those investors whose aims most closely match the needs of the company. All investors are looking for a strong balance sheet and demonstrably good management, but beyond this priorities may differ and a little research can prove invaluable if it is to identify a group of shareholders prepared to become medium to long term business partners for a growing business.

Were heavily allocated to companies with strong asset bases, strong cash flow and those with good and growing income.
Gervais Williams Managing Director MAM Funds plc

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However finding a suitable investor is only the start. Maintaining and deepening the relationship is a project that demands careful management. Some of the fund managers key concerns when they are looking for an investment opportunity, and their expectations of management, are set out in the table and in Figure 8 on the following page.

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Alternative strategies raising capital in tough times

Fund managers key concerns when looking for an investment opportunity Issue
High gearing falling out of favour

Fund manager comment

The rubbish we were spun in the previous cycle about efficient balance sheets and gearing up to the maximum possible levels to improve the returns on equity is now seen as complete garbage. But if a company is very, very cash generative, with a reliable, stable business, it still makes sense, especially when debt is cheap, to have a degree of gearing on the balance sheet. Telling the story in a convincing way requires telling the bad as well as the good, and too few companies are prepared to be as honest as they ought to be. There is a culture, certainly at the smaller end of the market, where short-termism seems to be more important. Id much rather see a culture whereby people are more realistic about prospects and build on a solid platform. If I look at our most successful investments, there is a common theme: management teams that understand the need for constant delivery to expectations. We dont like hearing bad news, but youve got to know about it. What you dont want to do is lose trust.

Solution
Gearing strategies should reflect the revised attitude many fund managers have towards risk.

Frankness and openness is valued highly

Careful, well-constructed market briefings. Clear guidance on appropriate performance expectations. Keep up to date with market views on the company/ sector.

Provide the right amount of information in annual reports, and avoid boiler plate disclosure

Annual reports have gone from 5 to 50 to 150 pages, but am I any better informed on business philosophy or performance? The general view is that most of the information out today is pro forma because someone decided ten years ago that it was a good idea, and we cant take it out. Now, the vast amount of information amounts to information overload. Its hard to build trust unless you have looked people in the eye. With one of our companies, one of my colleagues went to see them early in the year, they came to see us in London before a fund-raising, and we have seen them again recently. So weve seen them three times over the summer and have enhanced confidence in what they are doing and how they are doing it. There is too much noise out there. Telling the story clearly and cleanly and then waiting for genuine news is much the best way. There are companies that are forever issuing notes about the tiniest things that have happened. It just gets frustrating and annoying, and you miss the interesting stuff because you are so used to deleting all their emails. Soft information, like environmental reports, can be very important for certain groups of investors who look at the hard and soft aspects of companies side-by-side. If its material, absolutely, lets have it. If its not material, dont give it to us.

Thorough review of formal reporting to eliminate unnecessary data. Key information presented clearly and succinctly. Additional data well signposted for those who might want/need to see it.

Direct access to senior management is very important

Hold regular meetings with shareholders. Provide easy access to senior management. Honest, informative personal interactions.

Dont overdo the company news

Eliminate frequent corporate news emails. Use the so what? test to filter out unnecessary news. Senior oversight of news management process.

Provide non-financial data only when it matters

Establish clear purpose for non-financial data. Use the so what? test.

Company-commissioned research useful, but no substitute for independent research

Clearly, youd prefer there to be independent sources of research that arent driven by commission. If thats not there, it is a sign that the market is not working properly. Commissioned research is a sticking plaster rather than a real cure. In the interim it is helpful but it is depressing that its needed at all.

Encourage independent research.

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Figure 8: How effective do fund managers believe these strategies are in enhancing liquidity in a companys shares?
Dont know Being more frank with investors about the challenges they face

14% 6%

38% 40% 46% 38% 40% 24% 2%

20% 40%

34% 26% 20% 24% 10%

8%

Providing more detailed financial data 14% 14% (e.g. Split down by division, region or markets) Providing more one-on-one access to senior management More regular updates of company news Provide more non-financial data in company report Provide more company commissioned research 80%

6%

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8%

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8% 60% 80%

Not at all effective

Not effective

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A frank, open exchange and good quality data will pay real dividends with investors.

For companies able to take a greater role in actions targeted at developing greater liquidity in the secondary market, this is good advice which will help them develop a valuable, supportive relationship with their investors. But this is little help if investors prepared to nurture small companies with good prospects are thin on the ground. There seems to be a more fundamental problem in the markets, which is forcing small caps to look for alternative ways to fund growth. How can they be brought back in to the mainstream?

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13

Re-framing the debate how do we bring small caps back into the market? A view from Grant Thornton
There is a strong consensus among the fund managers and institutional investors who took part in this research that small cap companies are not being wellserved by the UK equity markets. They agree that liquidity in smaller stocks is low, and that factors contributing to this problem include a lack of good quality independent research into the smaller caps, and a tendency for trading to focus on high volume, large company stocks. What is less clear is why the markets have moved in this direction, and what can be done to reignite interest in small companies (see Figure 9).
Figure 9: Is AIM still popular for fund managers?
Neither agree Dont know nor disagree 8% 32% 12% 24% 16% 8%

40%

30% Strongly disagree

20%

10% Slightly disagree

0% Slightly agree

10%

20%

30%

Strongly agree

Although 24 percent of fund managers say AIM and Smaller Listed is a good place to invest now, the majority are cautious or neutral on prospects for small caps.

Do we need a change in regulation?

It is common to hear that regulation is too onerous and costly for small companies, and that the authorities should cut back on the rules that companies seeking a listing have to follow. But, looking objectively at the AIM platform developed by the London Stock Exchange for small cap companies, we believe it strikes a good balance between the interests of capital provider and capital user. It is hard to see how regulation could be reduced without encouraging companies to come to the market too soon something which professional investors regularly deplore.

We need to get back to a market that works more efficiently in the interests of the users and providers of capital. Thats one thats much less about trading activity and much more about underlying companies; investing in companies as if they were companies rather than providers of share chips in a casino.
Paul Lee Director Hermes Equity Ownership Services Ltd

Many market participants do, however, feel a sense of unease about the shape of the markets that seek to serve AIM and Smaller Listed companies. They are concerned about the extent to which regulatory, technological and commercial developments have distorted aspects of the UK equity market. They point to the proliferation of high frequency trading and the apparently unrestricted growth of synthetic equity products, both of which have resulted in unintended and potentially damaging consequences for smaller quoted companies.

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A revived ecosystem for small caps

The source of future economic growth

Questions for debate

At a more fundamental level, a key reason for the problems afflicting small caps is a slow strangulation of the economic ecosystem that had grown up to support them. It looks as if the experience of the US equity markets, set out in the October 2009 study from Grant Thornton, is of considerable relevance for the UK. This can be summarised as a progressive decline in interest in dealing in small company stocks, as the revenue that can be earned from doing so is driven down. In the interests of cutting transaction costs and speeding up trading, spreads and commissions have been progressively reduced, to the point where there is little option for traders but to focus on the high volume end of the market in order to make money. In past years it was the revenue that could be earned from trading in small stocks that allowed brokers to fund research, which in turn fuelled greater levels of interest, thereby underpinning liquidity. This system may have looked costly and inefficient at the time, but it provided a much-needed route into the capital markets that helped many small companies grow into todays corporate giants.

The implications of the decline of this system are that small companies can no longer develop into the economic powerhouses of tomorrow. Entrepreneurial, dynamic companies are finding it extremely hard to get the backing they need to become mainstream, to the detriment of economic growth and prosperity. It is already rare to find a private equity firm or venture capitalist in the small and mid cap market whose aim is to take their portfolio companies public. The preference is to sell them on to a large corporate buyer. While debt markets continue to be a hostile environment for small and medium sized companies, we believe this commercial conservatism is squeezing out the entrepreneurial drive that is so important for the long term health of an economy. This is not a problem that can be solved by solely turning to the Government for further assistance. It is more an issue of market structure, one of changing economic priorities and the effects they have on market behaviour. As such, it is within the power of market participants to change the way that small cap companies are supported, in the long term interests both of the economy, and of the markets themselves.

If small companies are still not getting the support they need, this raises some important questions that we need to debate: Have the markets we have today moved too far from their core function, which is to allocate capital? What are the systemic forces that are depriving small caps of the capital they need, and what can be done to counteract them? Are the economics of the small cap sector sufficient to drive the economic support system it needs to thrive and grow? If not, what can we do to re-shape them? How do we rebalance the movement of money out of equities and into bonds and other synthetic investments? Is this movement irreversible?

Back to basics for equity markets

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Our approach:
Grant Thornton UK LLP commissioned Lighthouse Global, the business advisory specialists, to conduct an initial 50 quantitative interviews amongst top fund managers and pension fund managers. There then followed 10 in-depth interviews amongst the same audience to gain deeper insights and probe the issues uncovered in the initial quantitative phase. Organisations included - Unicorn Asset Management, Hermes Equity Ownership Services Ltd, Four Capital Partners, Standard Life Investments and MAM Funds plc. The total value of funds controlled by participants is 43 billion, a quarter of participants control a fund of 1bn or over organisations spanned the full spectrum of fund managers from specialist organisations to the very largest giving a good overview of the whole market. The research phase took place over a period of 4 weeks, from 26 August 2011 to 23 September 2011.

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Back to basics for equity markets

Back to basics for equity markets

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Contact us
For further information on any of the issues explored in this report contact: Philip Secrett Partner, Head of AIM & Smaller Listed T +44 (0)20 7728 2578 E Philip.j.secrett@uk.gt.com Kam Mattu Business Development Manager - AIM & Smaller Listed T +44 (0)20 7865 2336 E kam.k.mattu@uk.gt.com

For other queries please contact your local Grant Thornton office:
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EPI.776