Weekend Question 2: When Will the US Initial Public Offering Market Dry Up?

ANSWER: Sooner than you might think, if something isn’t done about excessive regulation.

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From an editorial at today’s OpinionJournal.com:

It won’t be news to readers of these columns that increased regulatory burdens and litigation costs are undermining the competitive position of America’s capital markets. But this week’s interim report from the blue-ribbon Committee on Capital Markets Regulation performs a public service by marshaling evidence of the decline that is hard to refute. (Indeed it does. Go here to find PDFs of the “Interim Report” [very big file] and “Interim Report Summary” — Ed.)

The committee, directed by Hal Scott of Harvard Law School and co-chaired by Glenn Hubbard and the Brookings Institution’s John Thornton, is a privately funded, bipartisan group of executives and academics who have put their heads together to assess the state of our capital markets. Its first report is detailed and analytical, which may explain why Eliot Spitzer immediately attacked it.

It’s well known that more large global IPOs are happening outside the United States, and the report notes this fact. But most regulators have chosen to explain away this trend rather than confront it.

….. Another warning sign is venture capital, long an engine of American economic growth. Traditionally, VC firms have used the U.S. IPO market as their exit strategy; in the 1990s, IPOs accounted for 90% of VC investment “exits.” Today, however, nearly 90% of those venture-capital-backed startups are sold to strategic buyers in private transactions.

….. U.S. capital costs are lower than elsewhere. But as the new report documents, that premium has been shrinking. What’s more, it’s been shrinking faster vis-à-vis other developed countries–such as Japan and the U.K.–than it has against developing-world markets.

This suggests that it is stiff competition from relatively well-regulated markets, not from shifty, nontransparent Third World markets, that is taking the biggest toll. This could mean that overseas regulation is improving, not that U.S. regulation is getting more onerous. But even if this were the case, it would not change the main point: Global capital markets are becoming more competitive, and the U.S. is now more likely to be punished for over-regulation than it was in the past.

….. the report’s best contribution is the seriousness with which it examines the evidence of U.S. competitive decline–evidence that defenders of the status quo should now be obliged to answer.

If the venture capitalists conclude that the IPO option is being closed off, they will fund fewer deals, either because:

• They don’t believe they will be able to achieve their targeted rate of return by selling out to another company when exit time comes.
• Some start-ups are only viable if going public is a viable exit strategy (i.e., there is no realistic chance that another company or group of private buyers would want it when the time comes).

The negative implications for future economic growth if deserving start-ups can’t get funded should be obvious. Not that Eliot Spitzer cares.