Murder on the City Express – Who is Killing the London Stock Exchange’s Equity Market?

Brian Cheffins is the S. J. Berwin Professor of Corporate Law, and Bobby V. Reddy is an Associate Professor of Corporate Law at the University of Cambridge. This post is based on their recent paper, forthcoming in The Company Lawyer.

There has been much debate surrounding the decline of the U.S. public company.  As private corporations have found it easier in recent years to raise capital from the private markets, the number of public firms listed on U.S. exchanges has plummeted.  Why tap public investors for finance, and become exposed to burdensome regulation and the vicissitudes of the public markets, when growth can be sustained with private capital?

The U.K. has also seen a decline in the number of traded companies on the London Stock Exchange, alongside a similar rise in private capital.  However, the London Stock Exchange’s path differs markedly from its U.S. peers on at least one significant measure – the market capitalization to Gross Domestic Product (“GDP”) ratio.  As we underscored in a previous paper, while the U.S. exchanges have seen a consistent rise in the aggregate market capitalization to GDP ratio since at least 2017, the equivalent metric for the U.K. has remained stagnant at best.  A recent paper by Mark Roe and Charles Wang further notes that U.S. public firms have seen rising sales, profits, investment and employment as a proportion of GDP over the last thirty years.  One could correspondingly argue that the U.S. public firm has never been healthier.  That cannot be done with the U.K.  Whereas in the not too distant past, the U.K.’s market capitalization/GDP ratio consistently trended higher than the U.S.’s, it now lags far behind, with other countries, such as France, now catching-up.

In our new article, we seek to identify the factors causing the sharp decline in the London Stock Exchange’s equity market.  The divergence in fortunes between the U.S. and U.K. suggests that U.K.-specific factors are germane, and, accordingly, we focus primarily on those issues in our article.  In anticipation of a reform program the U.K. government has promised for this fall 2023, our article can serve as an aide memoire for those assessing whether the reforms are likely to reverse the London Stock Exchange’s fortunes.  Much like Poirot in Agatha Christie’s Murder on the Orient Express, we find numerous credible suspects potentially contributing to the London Stock Exchange’s travails and argue that no single factor is responsible.

An often heard frustration expressed by U.K. entrepreneurs is that the listing rules of the London Stock Exchange, to which all firms must adhere when seeking to list, are too restrictive, and that the governance requirements that apply to existing public firms are too burdensome.  That regulatory double whammy could conceivably lead to private companies shunning the London Stock Exchange, and can prompt existing listed firms to de-list and once again become private.  Indeed, in 2021, the U.K. Government and regulators targeted listing rule reforms and relaxed the exchange’s requirements on dual-class stock, free-floats and special purpose acquisition companies.  Further reforms have been touted to simplify the process of secondary capital raisings by existing public firms, and, presaged by the loss of Arm, a pre-eminent British-based tech company to Nasdaq, more radical initial public offering reforms have recently been proposed.

Easing the regulatory and governance burden on public firms could perhaps quell partly the U.K.’s equity market decline.  The point is not entirely clear, however.  The U.K.’s Alternative Investment Market (“AIM”), a lightly regulated exchange created to accommodate smaller firms, has suffered a decline similar to its bigger brother, the Main Market of the London Stock Exchange.  Additionally, the U.S. exchanges, which are increasingly attracting U.K. firms, such as Arm, have hardly engaged in a regulatory bonfire in recent times.  So, regulation of publicly traded firms may have had an impact on the health of UK equity markets, but deeper-seated market-oriented factors are also likely at play.

A dearth of investment research on existing and potential U.K. public firms could be one of the market-oriented factors responsible for the London Stock Exchange’s struggles.  Analyst coverage levels can plausibly affect share trading and pricing.  More precisely, substantial investment research can increase liquidity and decrease share price volatility by reducing the risk of unwelcome surprises.  Poor analyst coverage may have additionally contributed to the perception that firms listed on the London Stock Exchange are undervalued compared to their contemporaries on the U.S. exchanges.  So, thin analyst coverage could well prompt companies traded on the London Stock Exchange to list elsewhere or leave the stock market entirely.

Why the deficit in analyst coverage for firms traded on the London Stock Exchange?  Regulatory rules, including the EU-wide MiFID II Directive which the U.K. adopted prior to leaving the EU, have been blamed for asset managers cutting research budgets.  However, empirical evidence on point is mixed.  It is possible that investment research is deficient for particular types of firms for practical reasons, with tech and other innovative, high-growth sectors bearing the brunt.  For instance, investors may well be reluctant to pay for investment research in sectors underrepresented on the London Stock Exchange.  Tech firms stand out here as being in the minority, with, instead, mature, “old economy” sectors such as mining, energy, finance and retail featuring more prominently.  Similarly, investors will not fund research on firms in which they have little appetite to invest, which brings us to another market-oriented factor, “buy-side” investor deficiencies.

“Buy side” deficiencies potentially manifest themselves in two related ways in the U.K.  First, domestic investors have little interest in owning shares in U.K. public firms.  Second, investors in U.K. equity markets appear to prefer reliable, mature, dividend generating companies over riskier, innovative, high growth firms.

With the first investor deficiency concern, the evidence is stark.  The proportion of shares in publicly traded U.K. firms held by domestically based pension funds and insurance companies fell precipitously from 52% in 1993 to under 5% by 2020.  A series of regulatory and policy reforms intended to shore-up pension fund and insurance company solvency prompted these domestic institutional investors to seek out interest-generating investments, such as bonds, at the expense of equities.  A desire to diversify investments globally also hit domestic investment in U.K. public firms hard.  In relation to the second investor deficiency concern, even if domestic pension funds and insurance companies were attracted back to U.K. equities, the “buy side” may still be compromised because the bias in favor of income-producing shares will mean promising but riskier companies will remain unpopular.

A corollary to a weak investor demand for innovative firms is the hampering of the development of dominant industry players.  A “winner take all” culture in the U.S. potentially explains why the market capitalization of U.S. exchanges is growing while the number of U.S. public firms is shrinking: the firms that are listed on the U.S. exchanges are becoming substantially bigger.  A key reason for greater size, as noted in a recent U.S. study, is that U.S. public firms are prolific acquirors of other public firms and private companies as well.  With publicly traded firms adopting this “winner take all” approach the stock market continues to thrive despite sporadic IPO activity and numerous stock market exits.

The same “winner take all” culture that arguably has helped to sustain the US stock market does not appear to operate in the U.K.  The Main Market of the London Stock Exchange and AIM have suffered from numerous firms de-listing due to being acquired.  This is not the result of a “winner take all” pattern.  Instead, as we note in our article, only a small minority of those exits are occurring as a result of acquisitions by other U.K. public firms.  To be sure, U.K. public firms are becoming larger, but, unlike the U.S., that rate of growth is not sufficient to overcome the secular decline in the number of public firms.

Why the lack of a “winner take all” mentality in U.K. public companies?  As well as an investor base wary of high growth companies, managerial shortcomings may be relevant here.  U.K. executives may lack the entrepreneurial verve to create truly dominant, world class public firms.  Similarly, at the private company level, concerns have been raised that founders of successful businesses are more inclined to sell out earlier than their U.S. peers, rather than enter the public markets with a view to growing into industry titans.

So what are the key takeaways assuming we are correct that numerous culprits are complicit in the London Stock Exchange’s equity market predicament?  For the U.K, policymakers need to bear in mind when proposing reforms that changes are unlikely to be effective unless the multiple issues involved are addressed in a coherent manner.  As for the U.S. and other jurisdictions, to the extent that having a vibrant stock market is a priority, vigilance is essential.  Britain has a distinguished stock market history, but for various reasons, probably including policymaker neglect, that legacy is in danger.  A stock exchange and the public markets must evolve nimbly with the times to avoid, reverting to the Agatha Christie analogy, having to call in Poirot further down the line.  Sometimes you don’t know what you’ve got ‘til it’s gone.

The complete paper is available here.

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