London's Capital Conundrum
Bridging the Gap Between Global Finance and Local Growth in the UK's Market Landscape
By Elric Langton | 11 April 2024
The paradoxical nature of Britain's financial landscape presents a problem that is hard to overlook. On one hand, Britain stands as a global powerhouse, ranked as the fourth largest exporter in the world, outpacing other economic giants like France and Japan. This is a testament to the country's robust industrial and commercial capabilities, reflecting a strong, outward-facing economy with a global footprint. Moreover, London's preeminence as the world's largest exporter of financial services is undisputed, further solidifying the UK's stature on the international stage. Damn, Brexit!!
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Yet, this impressive facade belies a starkly different reality when it comes to the realm of capital formation for burgeoning enterprises. Despite its financial acumen and the global reach of its capital markets, London appears to falter in a critical area: nurturing and financing smaller, developing companies. This discrepancy is particularly glaring in the junior markets, where liquidity challenges and a dwindling number of listings have raised serious concerns about the efficacy of the UK's financial infrastructure in supporting growth-oriented ventures. I will come onto this shortly because I am betting this will or has already impacted your portfolio. If not, it is a matter of time.
This contradiction raises profound questions about the underlying mechanisms and policies governing capital allocation within the UK's financial ecosystem. How does a nation that commands such respect and authority in global finance and trade fall short in fostering its next generation of corporate leaders? The answer likely lies in a complex web of regulatory, structural, and market dynamics that inadvertently favour larger, established entities at the expense of emerging innovators. Oh, and, er, weak command of laws and regulations already in place by the authorities, seemingly asleep on the job.
Addressing this imbalance requires a concerted effort from policymakers, regulators, and industry stakeholders to reassess and recalibrate the support mechanisms for small to medium-sized enterprises (SMEs). Only through such more proactive interventions can the UK reconcile its global financial prowess with a thriving, dynamic domestic market for emerging companies, ensuring that the financial capital's tangible support for the innovators and entrepreneurs essential to economic renewal and growth.
We are now witnessing a shadow of scepticism looming large over the effectiveness and timeliness of regulatory interventions, casting a pall of concern for the private investors whose investments are increasingly precarious. I have felt doom unfolding within the AIM sector for some time, especially recently, among nascent enterprises, which demands a more vigilant consideration. The unmistakable trend towards convertible bonds provider’s role as a funding mechanism cannot be ignored. In an unforgiving market environment, where raising capital is Challenging for smaller entities, the allure of convertible bonds (CBs) expands, sweeping across the spectrum from the stalwarts of the FTSE100 to fledgling enterprises. CBs are being hoisted on PLCs indiscriminately, which is pure evil incarnate for the fledgling, small-cap Companies because they do not have the liquidity or the proper stewardship to broker the right deal for them; they accept the T&C, which often means a low floor on the conversion price, with minimal lock-in if there is one. Essentially, the converted bonds are sold into the market, but often not before the blaggards have forward sold the company stock, which means they can convert even more shares, thus flooding the market, and woe betide the PI if the Company shares are illiquid because the damage (downward pressure on the stock) will be exaggerated.
While industry giants can navigate these waters relatively easily, benefiting from more favourable terms due to their liquidity and cash reserves, the smaller caps find themselves at a crossroads. They often choose to withdraw from public listings in favour of private financing avenues that promise more congenial terms and do not suffer from moronic barbed comments from investors.
In a tone tinged with frustration and disappointment, it's imperative to scrutinise the regulatory oversight—or the apparent lack thereof—by the Financial Conduct Authority (FCA) and AIM, which seem to be steering the London markets, particularly the junior segments, toward a precarious future. This sentiment is further exacerbated by the palpable evaporation of liquidity, a stark contrast to bygone days. David Schwimmer, at the helm of the London Stock Exchange Group (LSEG), has openly acknowledged a significant shift in the investment landscape, with the allocation of UK pension funds to domestic equities plummeting from a robust 50% two decades ago to a meagre 5% today. This dramatic reallocation underscores a growing disenchantment with the local market, as even domestic investors seek greener pastures overseas. This is hopeful because it is acknowledged that London has a problem, but will it fix it?
The narrative of Ferguson Plc's transition to a primary US listing, which led to a noticeable surge in average daily trading volumes, exemplifies the allure of international markets. By July 2023, the London market witnessed an unsettling trend: a succession of de-listings, takeovers, and a notable absence of IPOs, culminating in a 40% reduction in listed entities since the zenith of 2007. This phenomenon, dubbed "de-equitisation," has left many pondering the root causes and potential remedies. However, the crux of the issue appears to be a diminishing interest in UK equities, as evidenced by 34 consecutive months of net outflows, rendering the UK the most undervalued significant market globally on a price-to-earnings basis.
This prevailing scepticism towards UK equities has prompted companies to reassess the viability of public listings, considering the substantial costs involved—approximately £300k for initial listing and £100k annually for maintenance. Redx Pharma's recent decision to relinquish its public status encapsulates this sentiment, citing the accessibility to a broader spectrum of specialised investors and capital in the private domain as a compelling rationale. As it happens, Redx and e-therapeutics are two entities I have researched but have not featured in the past couple of years. The latter I will come back to for reasons that will become obvious.
The burgeoning prominence of private capital, as sought by Redx, partly accounts for the public market's current malaise. The robust activity of private equity and unlisted trade buyers, exemplified by Shurgard Self Storage's acquisition of Lok’n Store at a premium, underscores the shifting dynamics. This trend highlights the dilution of the public market's appeal as a source of operating capital, with alternative funding avenues increasingly gaining traction.
The overarching narrative isn't merely a disinterest in UK entities but a broader strategic reallocation driven by the fear of missing out (FOMO) on the returns generated by the behemoths of US tech, notably the mythology around the “Magnificent 7.” This trend suggests not just a disenchantment with the UK but a strategic pivot towards the high-yielding tech sector in the US, buoyed by what some perceive as more proactive regulatory frameworks overseas.
This discourse, however, must be tempered with caution. The perceived premium of US-listed entities over their London counterparts often masks deeper systemic issues, potentially attributable to the sophisticated financial engineering and regulatory lobbying prevalent in the US—a stark contrast to the more conservative approach observed within the Bank of England's purview, even under the hapless pratt, Governor Andrew Bailey, who resided over a period when Chinese fraud resided in London was a matter of course.
Doom Loopmarket's phenomenon is notionally anecdotal but is evidenced by the growing list of small caps opting for de-listing, driven not by a capricious whim but by a calculated retreat from the onerous conditions imposed upon them. AIM, once the bastion for private investors to partake in the gSharepad'sies of smaller companies, now teeters on the brink of irrelevance, save for the few who thrive on the high stakes of speculative ventures. The case of Redx Pharma's proposed departure from AIM underscores a disheartening trend, as companies increasingly perceive a desolate landscape devoid of the liquidity necessary for their sustenance and growth.
One of the most recent de-listings was e-therapeutics. It has since successfully £28.9 million after de-listing. Why de-list? Ali Mortazavi is no mug; he has been the CEO of two UK-listed biotech companies and has had a long career in the London financial markets. He spells his decision for de-listing:
“To be clear, the UK markets are not just illiquid; they are completely broken and closed. The situation is worse for small growth companies (particularly biotech) and even sizeable companies such as Shell.”
A lengthy roster of companies in primary and secondary markets have utilised convertible bonds for their liquidity and working capital needs. As investors in SkinBioTherapeutics, we know the adverse effects these bonds can sometimes have on a company's value. While there have been some encouraging signs of improvement from SkinBioTherapeutics, sadly, many small-cap companies have not been as lucky and have been de-listed or taken over by the bondholders as a result.
Mortazavi continues: “We attempted a capital raise in February/March, and frankly, we couldn’t even secure a serious meeting, let alone have a shot at raising capital. We saw c. four funds, one of whom said they may (may) invest £100K. I am not exaggerating when I say that a consistent message has been a blanket refusal to invest in an AIM company and that a private company would be far more attractive.”
Similar decisions across the board, from Sopheon's exit to acquiring Arix Bioscience at a premium, further compound the narrative, signalling a broader disenchantment with the public markets. This disillusionment is not confined to AIM alone; the tale of Dispensa Group's voluntary de-listing, alongside others like Grand Fortune High Grade and Quarto Group, echoes a sentiment of seeking greener pastures beyond the stringent and sometimes unrewarding public market ecosystem.
Wael Sawan, Shell's CEO, has been complaining for some time about the company's value, to the point that he is prepared to move Shell’s main listing from London to the USA if its shares stay undervalued as they are currently.
Moreover, the movement of notable entities towards other financial havens, such as New York, further diminishes London's appeal despite its historic stature in the financial world. Companies like Flutter Entertainment and CRH's departure from the London Stock Exchange to pursue more lucrative listings elsewhere indicates a broader reevaluation of different markets' value propositions.
As companies like Hawkwing and Safestyle UK navigate through liquidation and administration, the narrative for private investors becomes increasingly grim, with diminishing prospects of returns. The saga of Revolution Bars Group's suspension and Unbound Group's de-listing further punctuates the narrative with tales of missed deadlines and unfulfilled regulatory obligations, leaving investors uncertain.
This unfolding drama is a stark reminder of private investors' precariousness in the current market milieu. Where regulatory safeguards seem perpetually a step behind, the allure of CBs or private financing becomes ever more enticing for companies disenchanted with the public market's vicissitudes.
Private investors face critical decisions regarding their strategies for navigating these turbulent waters. One viable path could involve leaning into actively managed funds, which promise the expertise of seasoned fund managers adept at manoeuvring through market volatility and identifying undervalued opportunities. Such funds could offer a semblance of reassurance in an environment where traditional market indicators may no longer suffice. However, news the FCA has decided to investigate Neil Woodford for his infamy suggests there are no guarantees your hard-earned will be looked after with care and consideration.
Alternatively, investors might consider specialised research services like Small Company Champion or our Lemming Investor Research Newsletter. The former, leveraging sophisticated software, sifts through the market to spotlight companies poised for growth, filtering out less promising entities. Meanwhile, The Lemming Investor Research Newsletter delves into the more speculative realm of fledgling growth companies, catering to those with a higher risk tolerance. Both services represent not just tools for financial analysis but a significant saving in time and effort, which many investors would prefer to dedicate to their personal lives.
For those with a penchant for independent analysis, the market offers advanced software solutions to replicate the depth of professional research. These tools can be invaluable for dissecting financial data, market trends, and growth indicators, effectively shouldering much of the analytical burden. However, this approach has its downsides, including the high cost of such software and the inherent risks that even the most sophisticated algorithms cannot fully mitigate. Investors must remain vigilant, continuously adapting their strategies to manage these risks effectively.
Given the broader context of dwindling liquidity and the scepticism surrounding UK equities, there's an emerging niche for what might be termed "bear research" — a focus on identifying growth opportunities and understanding the undercurrents that could lead to market contractions. This perspective anticipates a scenario where liquidity constraints could intensify, underscoring investors' need to be equipped with insights that can navigate both bull and bear markets. Such a paradigm shift in investment research reflects a growing pragmatism among investors, acknowledging the potential for further market challenges unless regulatory bodies step up to instil confidence and stability in the markets.
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