Outlook: Stock market fails smaller companies

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The Independent Online
JUST three short years into life at the head of a publicly quoted company, Peter Presland, chief executive of Rebus Group, an IT company specialising in the insurance sector, has had enough and is selling out to venture capitalists. Rebus is only the latest in a growing number of so-called "public to private" transactions, and as such it is symptomatic of the deep disillusionment many smaller companies have begun to feel with the stock market.

In recent years there has been a growing polarisation in the quoted sector between big and small companies, and between perceived sunset and sunrise sectors. If your company happens to be a small or medium sized enterprise in an out of favour sector, then your chances of using the equity markets to fund expansion at a reasonable rate are virtually nil. Plainly it is much worse than this, however. Rebus is in a glamourous sector, IT, but it is also small so it is still being afforded a stock market rating so low that its advisers cannot recommend use of equity to fund growth.

What's the point of being subjected to the disciplines of a publicly quoted company, many managements are asking themselves, if we cannot avail ourselves of the benefits of the capital markets? This sort of question is now being posed with such regularity by smaller companies that it is no longer possible to write these complaints off as the whinging of underperforming executives.

Many smaller companies feel themselves trapped in a vicious circle of decline; if they don't achieve a reasonable stock market rating, they don't get access to capital and will for ever remain small. So they have to adopt a strategy consistent with generating good short term growth and delivering on budgets set by others - namely the short term earnings forecasts of City analysts. This in turn necessitates a short term investment strategy within the company, which tends to mean it can never break free of whichever narrow business perspective it is locked into.

In such circumstances, the attractions of venture capital are obvious. Ironically, most buyout capital comes from the very institutions that in their stock market dealings are applying these short termist pressures; there is, however, a small part of each portfolio which is allocated to longer term, more illiquid investment.

As a consequence, there is a certain amount of robbing Peter to pay Paul going on here. In the past, the big institutions were reluctant to accept venture capital bids on the grounds that any company buying itself must be worth more than it is paying. In the last year or two that perception has changed. The underperformance of smaller company shares has made many keen to sell at almost any price, further depressing the value of these companies.

For big institutions with an interest in the venture capital industry, the process is a zero sum game, since they can expect a share of the higher returns these companies might earn as privately owned entities. The venture capitalist also has the opportunity much more effectively to bring about consolidation and management change than would have been possible in the quoted sector.

Unfortunately, this is a process in which the retail investor can rarely participate. All too often small private investors are being forced out at an undervaluation. Later, on the other hand, they are asked to participate in the inflated valuations at which these companies return to the stock market. The capital markets are not meant to work in this discriminatory and unfair manner.