By Professor Bryce C. Tingle, LL.B, LL.M
Since the introduction of universal registration with National Instrument 31-103 in 2011, there has been a lot of anxiety on the part of finance professionals and others active in the private market. For one thing, the introduction of universal registration meant the beginning of intrusions by securities regulators into a market that had grown significantly over the previous decade – and increasing regulatory activity is not always good news.
Contrary to what one might think, the evidence is that the 2011 reforms did not materially harm the exempt market. In a recent paper, University of Ottawa professor, Vijay Jog, determined that between 2010 and 2012 (a period that encompasses the introduction of universal registration system) the exempt market in Canada grew from $115.73 billion to $138.90 billion. The growth in monies raised under the Offering Memorandum exemption grew by even more than the market as a whole, rising approximately 50%, from $650 million to almost $1 billion.
It is useful to remember when considering statistics like these that in financial markets, regulation itself is nothing to be feared – the problem is bad regulation. Indeed, finance academics have observed for years that regulation is actually necessary to create and extend markets. Good securities regulation has been shown to increase individual participation in capital markets, facilitate the flows of capital to productive enterprises, and reduce the cost of capital to businesses. One of the most interesting features in the period since the end of communism has been the way companies from countries with weak legal institutions and poorly designed regulatory systems have gone public in Toronto, London, or New York, with the goal of ‘borrowing’ an effective securities regime and thus maximizing their value. Quite literally, a company is worth more if it is regulated in Canada, for example, than if it is regulated in its home country.
In contrast, the influence of poorly-designed regulations is equally easy to see. Since the Enron-era frauds, the public markets have also been the recipients of unprecedented regulatory attention, particularly in connection with corporate governance arrangements. Most of this formal and informal regulation has occurred based on conventional wisdom and political populism, without regard to the empirical literature. As a result, the public markets in Canada and the United States are in bad shape. In the United States, the number of public companies has declined by almost half since 1997. Various stock market indices such as the Wilshire 5000 or the Russell Micro-Cap Index can’t even find enough companies to fill out their roster. (The Wilshire has only 3,600 names, for example).
In Canada, the rates of new listings have followed a similar trajectory, as my co-authors and I found in research published last year. Between 1993 and 2000 there were an average of 42.6 IPOs on the TSX each year; following 2000 the average was 18.2 IPOs a year – less than half. Even when the markets were awash in liquidity and commodity prices climbed sharply, TSX IPOs in the best years of this century never exceeded the average rate of the previous decade and only amounted to 40% of its best year.
The decline becomes even more visible when the inflation-adjusted proceeds of IPOs over the past two decades are examined. Both in absolute terms and as a percentage of GDP, the IPO market of the 1990s was in significantly better health than at any time in the years since then. The best year this century for IPOs was 2010, which generated proceeds equal to 0.28% of GDP – or just over half of the proceeds generated during any one of several years in the 1990s.
Reference to the dot-com boom and bust, and then the 2008 financial crisis, provide little assistance in explaining these statistics. The Canadian market is largely resource-driven, not particularly oriented towards technology stocks. Low commodity prices in the second half of the 1990s likely explains why this country’s IPO rates actually declined during these years, even as the U.S. IPO market developed a bubble. Similarly, Canada’s IPO market was only comparatively briefly impacted by the 2008 crisis, with 2010 being the best year for IPOs in the past decade.
There has been no effective regulatory response to the problems in the public market and the main beneficiary has been the exempt market. This is the second reason for optimism among those who work with exempt issuers: the ongoing weakness of the public markets means that the exempt markets are likely to continue their rise in importance in this country.
Multiple economic trends have been pulling resources out of the public markets and into exempt issuers. The increasing correlation of public markets across the world has meant that it is much more difficult to build a properly diversified portfolio without participating in the market for private investments. A recent survey of pension fund managers by State Street this past November, found 60% were planning to increase their private equity allocations. 54% were planning on allocating more into direct loans and 46% were planning on acquiring more real estate. These are some of the most sophisticated investors in the world and they are moving into the kinds of investments that have always characterized Canada’s exempt market.
The demand is not just on buy side. As the IPO market statistics suggest, business executives are increasingly interested in raising capital in the exempt market. Spend any time in Canada’s boardrooms these days and you will hear the same message. Whereas there were once incentives to management teams to take their companies public, there are now incentives to avoid the public markets if at all possible. Corporation’s business investment as a percentage of GDP has been declining since 2000 and observers have tended to put the blame on public market’s focus on short-term results. R&D spending has also been declining over the same period and probably for the same reason. In response to the government-commissioned Kay Report on short-termism in the public markets, the UK and EU lawmakers are poised to scrap quarterly reporting for large public issuers. Many executives believe that if you want to build a business or asset that will take time, you need to raise the capital in the exempt market.
That brings us to the final, and best, reason to be optimistic about the state of the exempt market: by and large Canada’s regulators get it. As the exempt market has increased in importance, Canadian regulators have been trying to foster the market’s development. This is a point that gets lost in quite a few discussions one hears among exempt market professionals. While some of the proposed regulatory changes have been controversial, their over-all direction has been to remove barriers in the exempt market.
Last month the Canadian Securities Administrators announced they were going to keep the accredited investor exemption without increasing the net income or net asset tests for eligibility. The SEC originally set these thresholds in 1982, and various constituencies had proposed they be increased dramatically. For example, the $200,000 annual income threshold would be over $443,000 in today’s dollars. But the Canadian regulators left the thresholds alone. Indeed, the only really material change they made was to expand issuers’ responsibility to ensure investors are accredited. That arguably makes registered financial advisors and their Know-Your-Client obligations even more valuable in an exempt distribution.
The February amendments even keep the difficult-to-defend $150,000 minimum amount exemption (though it remains only for institutions). As well, effective in May, Ontario is adopting the Family, Friends and Business Associates exemption in the form available elsewhere in Canada.
More activity will be coming this year. Ontario is expecting (after several years of consultations and work) to adopt offering memorandum and crowdfunding exemptions. While the last public release of a draft offering memorandum exemption imposed limits on the amounts that individuals could invest under that exemption, a largely critical reaction from exempt market participants has prompted a review of the proposal. Lost in some of the rhetoric around the draft exemption, though, was acknowledgement the OSC is about to create an offering memorandum exemption in that province. That represents a massive liberalization of the private placement regime in Canada’s most populous and financially important province.
Taken as a whole, the securities commissions’ activities of the past year can only be understood as arising from a desire to support the exempt market. In light of the economic trends discussed earlier, how could they do otherwise? Even the corporate group that runs the TSX has jumped into the world of private issuers by launching a platform late last year to provide purchasers of exempt products with a secondary market.
At its fundamental level, finance is how society allocates its resources. Because finance is a precondition for any business activity, finance becomes the organizing principle of that activity. Professor Shiller at Yale puts it this way: “at its broadest level, finance is the science of goal architecture—of the structuring of the broadest arrangements necessary to achieve a set of goals and of the stewardship of the assets needed for that achievement.” The exempt market is an increasingly important part of this process. In 2012, $7.05 billion of equity (not including debt) was issued in the exempt market by operating businesses (not investment funds). In contrast, only $1.2 billion was raised in IPOs and less than $2 billion was invested by venture capital funds. The exempt market is important, and all the evidence suggests it will only become more so.