Diagnosing London’s listing miasma

Craig Coben is a former global head of equity capital markets at Bank of America and now a managing director at Seda Experts, an expert witness firm specialising in financial services.

Last week, UK-based semiconductor chip designer Arm announced that it would pursue a “US-only listing” in 2023. For a country anxious about its financial standing after Brexit, the decision felt like losing an arm (sorry). 

The FT described the decision as a “personal blow to prime minister Rishi Sunak”, while one Conservative MP said it was a “big blow”. The Guardian said it was a “blow to Rishi Sunak’s ambitions for London”; the Telegraph said it was a “blow to the prime minister”. Meanwhile, Reuters called it a “blow to London”, and according to CNBC it “deal[t] a blow to the UK’s post-Brexit vision.” “London suffers new blow,” headlined Bloomberg, and City AM said it was a “blow to the UK tech industry” and a “blow to the UK markets.”

So everyone agrees: This blows.

But the reaction is both overblown (no pun intended) and misdirected. For all the garment-rending, Arm has not rendered a verdict on London. Yes, it had been listed on the London Stock Exchange (LSE) until Japanese conglomerate SoftBank acquired it in 2016, but Arm’s decision makes a lot of sense. As I wrote last January in an FTAV post entitled “A farewell to Arm”:

Arm should float in the US not because London has any particular flaws as a listing location, but rather because the scale, scope and depth of American capital markets make it a more compelling venue . . . [A] Nasdaq-only flotation offers the broadest access to investors without the complications of two primary listings.

The UK government and LSE had argued for a dual-primary listing as a “win-win”, but it is hard to be the third wheel in any relationship.

The scapegoating has started. According to the FT, the UK regulator FCA has been blamed for sticking to its rules on related-party transactions, but this is hard to believe: in over two decades in the City I never heard a single company cite this as a reason not to list in London. As mainFT’s Arash Massoudi tweeted, this looks like desperate misdirection.

Total red herring
https://t.co/2lpUsZRpyA

— Arash Massoudi (@ArashMassoudi) March 4, 2023

Arm’s decision is the exception that proves the rule that a company should list in its home market. London remains the appropriate forum for nearly every British company contemplating an IPO, especially mid-cap names. It also offers an appealing venue for many emerging markets companies.

London is also the default choice of companies who want to IPO on a global exchange without wading into the US. Some companies shy away from NYSE or Nasdaq due to litigation risk — in 2022 alone, 208 securities class action suits were filed in the US, including 34 against non-US issuers — and the penchant of US authorities to apply federal laws extraterritorially to SEC-reporting companies. Underwriting fees are also a lot higher in the US.

Moreover, the direct economic impact of losing a listing to the US is de minimis. If Arm’s decision forces policymakers to confront — with urgency — the challenges facing London as a financial centre and to stop taking the City for granted, then Arm’s choice of a US-only list could mark a positive turning point.

Should we even care?

At one level, it doesn’t matter too much if companies eschew London as an IPO venue. After all, the purpose of an IPO has changed. It used to be for raising growth capital, but nowadays companies can tap the ever-growing private pools of capital, such as venture capital, private equity, family offices and sovereign wealth funds.

Today, IPOs are designed as much to enable pre-IPO investors to take money off the table as to raise new money. This means that IPOs don’t offer the same public benefit that they used to. Why should the public care how a private equity firm exits its investment?

Moreover, you can have a robust financial sector without a bevy of IPOs. Singapore is growing its market share and burnishing its credentials as a financial centre, but its stock market is an IPO backwater. Australia has a robust equity culture with nearly half of superannuation (retirement) funds invested in stocks, and yet there are very few IPOs of significant size. It’s hard to imagine that losing a flotation to New York would trigger in those countries the neuralgia that Arm’s decision has caused in the UK.

And the reality is that the IPO market is small beer. In the UK and elsewhere the debt, commodities and foreign currency markets dwarf the size of the equity market. Although the stock exchange has an evocative origin story of traders swapping shares and gossip in coffee houses in the late 17th century, historians will tell you that the City achieved its post-WWII primacy through the Eurodollar and the Eurobond markets in the 1950s and 1960s, respectively.

The 1986 Big Bang transformed the equity market, but FICC (fixed income, commodities and currencies) still dominates the City. In one sense, then, the Arm decision and the health of the UK IPO market are utterly immaterial to the public interest.

But in another sense, it matters deeply, almost uniquely to the UK, in a way that it doesn’t for other countries, especially its European neighbours.

Vibes matter

The stock market is the most visible part of finance, and sometimes “image is everything”. London’s pre-eminence stems from its centrality in transactions often not involving the UK; it sits as a lucrative toll booth collecting fees on the financial motorway.

Companies and counterparties must have confidence that London has a critical mass of capital, expertise, and institutional legitimacy to transact there. Listings validate the competence and importance of London as a financial centre. Like The Dude’s rug in “The Big Lebowski”, they really tie the City together.

And London feels like it’s haemorrhaging listings at the moment. At around the same time as Arm’s announcement, Irish building materials company CRH announced it was changing its primary listing from the LSE to the US in what the BBC described as — you guessed it — a “further blow to the London market.”

This comes a few weeks after Irish betting firm Flutter said it was consulting with shareholders about a similar move to the US. Last year, plumbing firm Ferguson moved its listing from London to New York after selling its UK business to private equity.

Each of these companies has compelling operational reasons to migrate their listings to the US. CRH earns 75 per cent of its ebitda from North America; Flutter’s biggest revenue stream comes from US-based sports bookie FanDuel; and Ferguson’s operations are now “100 per cent North America”.

Nevertheless, the announcements have shaken confidence. Rumours abound of investment banks pitching to other UK-listed corporates the benefits of migrating their listings to the US.

Why has London lost its mojo?

It’s therefore important to understand why — despite its advantages — London has become a laggard in attracting and retaining companies on its stock exchange.

UK investors, we’re told, are hidebound: they shy away from risk, crave their dividend coupons, don’t understand growth, and are pessimistic on life. “Domestic UK investors have not evolved with the times,” a senior banker told the FT. The story, then, is that UK fund managers are miserable old gits holding back the London market from supporting high-growth companies.

But the real problem is less psychological and more structural: there’s not much money to invest and the markets lack liquidity. Over the last three decades, the UK has enacted regulatory measures that have forced fund managers to redirect money from stocks to bonds, purportedly because it’s safer.

Only 19 per cent of assets in defined benefit schemes are invested in equities, down from 61 per cent in 2006. (The safety of piling into fixed income proved illusory last autumn when several UK pension funds were hours away from financial Ragnarök, but that’s another long story.)

In fact, these days pension funds and insurance companies barely figure on UK shareholder registries, respectively holding only 1.8 per cent and 2.5 per cent of the London market as of the end of 2020.

If equity fund managers don’t have a lot of money, they will have low risk tolerance and search for income-producing stocks. This is rational behaviour from investors operating in an irrational regime. In any case, these investors are not especially relevant anymore and that is a big part of the problem.

Oversexed, overpaid and over here

As the domestic fund industry has hollowed out, the UK market has had to rely on the kindness of strangers, with the rest of the world holding a record high of 56.3 per cent of quoted UK equities as at the end of 2020. The London IPO market heats up when American investors and overseas hedge funds increase their allocations to the region.

For example, in 2014 US funds turned positive about UK retail and supported flotations such as AO World, Pets At Home and Poundland. But attitudes change, and the trade winds of investment can shift suddenly. These investors have no attachment to London and will find the best opportunities globally. And Britain does not have a captive audience to fall back on if sentiment cools.

The effects of this show up in secondary market liquidity. The number one complaint I used to hear from investors in Europe revolved around IPO liquidity. Not price. Not company quality. Liquidity. Frequently, by the third day of trading post-IPO, volumes normalise at low levels, and the stock trades “by appointment”, meaning investors can’t adjust their positions without moving the share price against them.

The key investors in IPOs are often long-short hedge funds. They may not be the long-term shareholders that every company craves, but they provide the incremental liquidity and demand to make a deal work. Their strategies vary enormously but usually involve leverage and careful hedging aimed at generating good risk-adjusted returns. Risk management remains a paramount concern for hedge funds. Even if they like a stock and think it is cheap, portfolio managers cannot afford to be trapped in it in case they need to get out to take down the risk in a portfolio.

As one hedge fund manager wrote about European IPOs on Acuris:

Low liquidity means low trading volume and fewer buyers to lift the stock when it’s down. Selling over-concentrated stocks causes big price swings. And convincing risk managers in institutional firms that buying underpriced but volatile and illiquid stocks is a tall order. All of which creates a vicious circle whereby holders become tempted to sell as they don’t see where the buy pressure will come from.

A stock that grinds down amid dwindling liquidity wreaks havoc for these kinds of investors.

This problem isn’t unique to London. It afflicts other bourses all over the world, especially on the European continent. The average daily trading volume in London and elsewhere in Europe averages around 0.2 per cent of overall free float, while in the US the figure is closer to 1 per cent. According to the New Financial think tank, Europe has a “complex patchwork” of 33 stock exchanges for listing, resulting in a “fragmented landscape” of subscale markets, and this adversely affects liquidity and deal flow.

Absent the rocket fuel of extreme positivity, most European IPOs — including in London — must come at a substantial discount to their fair value to entice an investor who has no reasonable prospect of exiting from a sizeable position. Ironically, this isn’t so much the case with a jumbo asset like Arm, because its size will mean good aftermarket liquidity anyway. But it hampers the appeal of listing for the sort of mid-cap names who make up the bulk of the IPO pipeline.

And unless they’re high-tech or biotech or have the overwhelming majority of their operations in North America, most of these companies don’t really have the option of listing in the US; they would likely be orphaned with no sponsorship in their home market or their listing market.

No more half-measures, Walter

So what can the UK authorities do to inject some dynamism back into the London equity markets?

To its credit, the government has taken measures to improve listing procedures, enacting most of the reforms proposed in Lord Jonathan Hill’s UK Listing Review in 2021 and adopting the recommendations set out in the Secondary Capital Raising Report it commissioned in 2022. They will make a discernible difference. More broadly, the government has announced a wide-ranging series of “broadly sensible … but mainly evolutionary” measures, dubbed the Edinburgh Reforms, to promote growth and competitiveness in the financial sector.

But on the big questions the government has often done more harm than good. When it was an EU member, the UK had championed Mifid II rules, which by unbundling execution from advice has eviscerated sell-side research and sapped small and mid-cap stocks of liquidity. The government is reviewing these rules as part of the Edinburgh Reforms, but the damage may already have been done.

And in the biggest act of policy vandalism, the UK signed the Trade and Cooperation Agreement with the EU without so much as an equivalence arrangement for financial services in its rush to get Brexit done.

If the government really wants to restore London’s lustre as a venue for share listing and trading, it must implement wide-ranging tax and regulatory policies to encourage equity investment. Policy thinking should be oriented around incentivising pensions, insurance companies and retail investors (12 per cent owners of UK equities) to allocate a greater part of their portfolios to equities.

Yes, it entails the risk of loss of capital, but as the baseball saying goes, “you can’t steal second base with a foot on first.” Otherwise, the London market will be dependent on the vagaries of American money for its success, and British investors will be deprived of the capital appreciation gained from long-term equity exposure.

In other words, policymakers should think big. They need to bring capital and liquidity back into the equity market and take some chances. Anything less means incremental improvement at best. No more half-measures, Walter.

On its own terms, Arm’s decision doesn’t mean much. Even in an ideal world, Arm would likely have chosen to list only in the US at IPO. But correctly or not, it is seen as a vote of no-confidence in London.

“Never let a good crisis go to waste,” said Winston Churchill. The UK should use this “blow” as a catalyst to create an investment culture capable of supporting public equity investment.