DAYS OF RECKONING: NEW EQUITY MARKETS AND ADDED VOLATILITY
Daniel Muzyka,
INSEAD
Benoît Leleux, Babson College
Christopher Zott, INSEAD
ABSTRACT
INTRODUCTION
METHODOLOGY
EVOLUTION OF
THE NEW EUROPEAN STOCK MARKETS
LISTING AND REPORTING
REQUIREMENTS
PORTFOLIOS
PERFORMANCES
SUMMARY AND CONCLUSIONS
NEXT STEPS
TABLE 1
TABLE 2
TABLE 3
TABLE 4
FIGURE 1
FIGURE 2
FIGURE 3
FIGURE 4
FIGURE 5
FIGURE 6
FIGURE 7
NOTES
CONTACT
REFERENCES
The Summer of 1998 brought new highs to European growth equity markets, soon followed by the devastating blows of the global economic crisis that followed through the Fall. The paper analyzes the behavior of the new European growth-oriented markets in that period of added volatility, comparing it to major markets and to NASDAQ. The hypothesis that liquidity and depth of market would disappear in times of shocks is generally not supported by the evidence, even though a correlation between number of firms listed and volatility is highlighted. Implications are drawn for the future of these markets.
After the stock market crash of 1987, many of the European secondary markets for new issues collapsed or “froze,” and, by the early 1990s, Europe reached a crisis in the evolution of its stock markets, which resulted in fewer opportunities for new firms to enter the markets through Initial Public Offerings (IPOs). The decline in IPO markets had several consequences. Most significantly, this affected the ability of entrepreneurs and venture capitalists to realise the value from successful, growing businesses and to ensure that their growth continued. The lack of vibrant new issues markets also restricted the ability of growing enterprises to acquire new share capital to sustain their growth. A secondary effect was that European new issues were redirected to the NASDAQ market, established in 1971. A large number of European high growth companies crossed the Atlantic to list on the large and liquid NASDAQ exchange, despite its more stringent disclosure requirements and higher degree of control imposed by the U.S. securities laws. By August 31st 1998, 135 European companies were present on the NASDAQ “International” list. (See Table 1).
This led to further restrictions on growth-oriented entrepreneurship in Europe, at a time when many traditional industries were experiencing decline, and unemployment was rising. An economic revitalisation was called for, underpinned by the opening of new issues markets and the expansion of these markets to a “world class” scale. As a first response, a group of entrepreneurs, in collaboration with governments and the financial community, launched new secondary markets, such as the Alternative Investment Market (AIM), the Société du Nouveau Marché (SNM), the EuroNM, the NMAX, the Neuer market, the Euro.NM Belgium and the European Association of Securities Dealers Automated Quotation System (EASDAQ). (See Table 2).
The European new issues markets have been in operation for several years now, and have contributed significantly to the evolution of growth-oriented entrepreneurial activity in Europe. The objective of this report is to achieve a better understanding of market trends and to evaluate the structure, process and performance of these markets, particularly in times of renewed volatility, as in the Summer of 1998. It represents the first real test of whether these markets are robust and operating on solid ground.
This report draws on several data sources including market officials, Exchange representatives and market-makers. Research into secondary sources included a search of the press, a review of various reports and the collection of stock market information from commercial sources. Due to the infancy of the markets, obtaining information proved difficult (such as incompatibilities in formats, inconsistencies in data reporting). This suggests the need for better data recording and collection, especially at this early stage, as otherwise valuable information could be lost forever. Although current analysis is limited due to the unavailability of some data, the statistics gathered have enabled us to provide some useful insights into trends.
The report focuses on the primary, growth business-oriented new issues markets and excludes some of the “off exchange” markets for smaller firms, as well as other markets where IPOs may occur (e.g., the Second Marché), but which are not positioned as the primary place for younger entrepreneurial businesses to be listed. Furthermore, given their different character, we have chosen to ignore the IPOs of newly privatised state-owned enterprises.
The report is split into four sections starting with the discussion of the evolution of the markets, followed by information pertaining to the evolving listing requirements for market entry. The nature of the current portfolio of companies in the market is described followed by a discussion about the extent and nature of market performance since inception. An overall evaluation of the markets’ performance and the challenges for the future conclude this report.
EVOLUTION OF THE NEW EUROPEAN STOCK MARKETS
A multiplicity of “new” markets developed in Europe since the creation of the Alternative Investment Market (AIM) in the United Kingdom in June 1995 (See Figure 2). EASDAQ, an international market located in Brussels, was founded with the intention of becoming the market for aggressive entrepreneurial growth companies and was to be the European equivalent of NASDAQ, which served as its model. Simultaneously, a number of European national markets saw the need to create some critical mass that would lead to a common platform for listing requirements. As a result, EuroNM was launched in March 1996. It was to be the framework for new secondary markets across Europe, and, over the last three years, has been joined by the SNM in France, NMAX in the Netherlands, the Neuer Markt in Germany and Euro.NM Belgium. EuroNM (and its widely reported index, the EuroNM All Share) represents an association that permits the collective communication of stock offerings, but the actual mechanics of trading remain with the individual member markets. However, this network of national markets is still evolving in terms of its role and function.
All of the exchanges are automated, but utilize different types of systems for undertaking transactions, fixing prices, and the roles of advisers and market-makers can vary from country to country. Each market is national in character, but includes companies with headquarters outside the domestic market, thus providing heightened visibility through listing, commentary from analysts, investor discussion and action on the part of market-makers that is further discussed by the financial Press.
EASDAQ is a Pan-European association with a global focus. Companies from Israel, Canada, and the U.S. have sought listing on EASDAQ. However, 25% of all companies listed there are Belgian, illustrating again the importance of location when choosing the most appropriate market on which to list.
The notion of “creating credibility through the choice of listing marketplace” is unfolding in some interesting ways. For example, some European biotechnology companies have reported listing on NASDAQ in the belief that it gives them greater market credibility and maximizes their value (Leleux and Muzyka 1998). However, in the long term, those valuations have fallen victim to the fact that these companies are sometimes perceived as “too exotic.” This appears to relate to the fact that when markets devalue, they treat companies operating outside the U.S. more aggressively. One reason ventured was that U.S. analysts do not fully understand the European markets served by those companies nor the companies’ respective competitive positions. U.S. analysts’ aggressive review of quarterly information could be damaging to some high technology firms operating predominantly in Europe, for whom a European listing may be more appropriate.
Figure 1 chronicles the growth of the new European markets in terms of the number of companies listed. Clearly, AIM, the oldest of the markets, has the largest number of companies with over 300, although the rate of its IPOs slowed down during 1998. EASDAQ, whose strategy is to attract somewhat larger companies, has been growing gradually since its launch, with a sharp increase in May–June 1998. The EuroNM exchanges have also shown a persistent increase since March 1997, with a strong upward trend during the early summer of 1998. A comparative chart noting the relative scale of each of the markets in terms of number of companies listed shows some rather large differences in scale.
Comparing the evolution of the markets in terms of the number of listings since the opening of each market (See Figure 2), it becomes clear that there are some differences in growth rates which reflects differences in strategies. AIM developed more rapidly in terms of the numbers of companies listed compared with Euro NM and EASDAQ.
It is interesting to note from these charts the relative impact the global market turmoil of the summer has had on the rate of new IPOs. A virtual cessation of IPO activity in all the markets is observed.
EuroNM’0s and EASDAQ’s relatively slower development in terms of the number of companies listed belies their actual market capitalisation’s (See Figure 3). The companies on EuroNM’s national markets as a whole represent the largest market in terms of value, followed by EASDAQ showing less than half that value. The market capitalisation of the EuroNM is largely based on the contributions from the Neuer Markt and the Nouveau Marché, collectively representing 94% of the total value. Value, or market capitalisation, particularly with reference to the EuroNM, has grown dramatically during 1998, and was clearly affected by the global stock market turmoil starting in the late summer of 1998.
On the whole, listed companies appear to be broadly happy with the markets and their ability to provide valuation, value and visibility. A survey of the AIM companies’ view of the market, conducted in July 1998 by Pannell, Kerr, Forster (Chartered Accountants),1noted that 85% of listed companies thought that AIM had met or exceeded their expectations. This evaluation related to both the initial flotation and the subsequent share-price performance (Pannell, Kerr, Forster note that this is an unusually high satisfaction level with such a new market). On the other hand, 49% ofthose interviewed felt that the image of AIM had declined in the last 12 months, primarily due to some well-publicised problem companies. This has resulted in increased investor caution and lower market liquidity.
LISTING AND REPORTING REQUIREMENTS
In terms of listing and reporting requirements, each new market has different strategies and procedures. None of them place any restrictions on the nationalities of businesses, and all express an interest in listing young, innovative and fast-growing companies. There are, however, some fundamental differences. For example, the Nouveau Marché requires a lower equity than the EuroNM Belgium. In terms of professional help (e.g. how many advisers / sponsors / market-makers are needed, or whether they have to be supplemented by additional investment brokers, lawyers, etc.) the stipulations vary. For example, companies to be listed on EuroNM must have separate sponsors and market-makers whereas the two roles can be fulfilled by one company for those listing on AIM.
The actual admission process is broadly similar for all markets. It requires records of companies, annual reports, business plans, a prospectus, etc. Beyond this general level, however, there are many individual, specific requirements. While most market institutions request significant amounts of data, a number of companies who have been through the listing process have reported that only a cursory review is subsequently conducted by the regulatory authorities.
The costs of obtaining a listing are generally not quoted and are dependent upon a number of factors, including the cost of advisors (e.g., legal work, due diligence), the time required to fill the “book” or find buyers for a substantial part of the new issue, etc. The figures quoted equal approximately 7–10% of the IPO funds raised for the direct costs of obtaining a listing. In Europe, factors such as the need to produce documents in several languages (for purposes of communication with the Exchanges, regulatory authorities and potential investors who may be outside the country of listing) contribute to the total cost. By comparison, the cost of listing in the US, with its comparatively more stringent reporting requirements, is reported at around 10% of the IPO value (Ritter 1987; Ritter and Weiss 1991; Ritter 1991; Loughran and Ritter 1993; Loughran and Ritter 1994; Loughran, Ritter et al. 1994; Ritter 1998).
Accounting and regulatory standards differ from country to country as a result of long-standing historical differences in the nature of institutions and the philosophy of information and control. Strong differences in accounting systems can also increase significantly transaction costs. The documents outlining listing procedures generally do not discuss these costs. This decreases transparency for investors and increases their business cost. Reports from, amongst others, KPMG and International Accounting Standards Committee2 (IASC), suggest that discussions concerning harmonisation of standards are continuing. However, this objective is a challenging one and will take some time to resolve. The most widely accepted standard which is considered to be the most transparent, especially amongst investors in high technology companies, is the U.S. Generally Accepted Accounting Principles (U.S. GAAP).
Rules, regulations and reporting are in a state of fluctuation given the evolving requirements of stakeholders, and particularly those of investors, but there are clear moves towards a further harmonisation amongst markets, especially by those within the confines of the EuroNM. EuroNM, playing the role of an umbrella organisation for four different markets, is continuing to provide a forum for the harmonisation of policies and procedures. Some argue that further harmonisation will lead to a further expansion of the markets in EuroNM, especially with the introduction of full electronic linkage, a common currency, and a further convergence of listing and reporting requirements. Several of those interviewed suggested that such improvements in the functionality of the national new markets will lead to questions about the role of EASDAQ.
Some listing procedures and practices, common in the more mature American market, are also becoming more prevalent in Europe. For instance, expertise is rapidly developing in planning and conducting “road shows” and building the initial book of buyers. This enables institutional investors to obtain a better insight into the company proposing to float.
The emergence of different characteristics for each of the new markets can be reviewed on a three-dimensional level: the relative concentration of market value in the top firms; the nature of the industries represented by the listed firms; the average size of the firms listed on the markets.
With regard to the relative concentration of market value in a few firms, the market which stands out is AIM where the top ten firms represent 19% of the value but only 3% of the listings. On the Nouveau Marché, the same top 10 firms represent 33% of the value (vs. 14% of listings) and on the Neuer Markt some 38% of the value (vs. 20% of the listings). The most concentrated market appears to be EASDAQ where 10 firms constitute 44% of the value (vs. 27% of the listings).
The analysis of listing distributions by industry highlights EASDAQ’s high technology focus and strategy, reflected in its distribution of companies, with 41% representing computers, telecommunications and biotechnology (See Figure 4). AIM, on the other hand, has a heavy concentration of smaller service firms. EuroNM emphasizes firms in computer-related fields (hardware and software), but otherwise shows a great deal of diversity.
The relative differences in company size are interesting. Whether by strategy (as reflected in the listing requirements), in collaboration with other stakeholders, or by choice (of the firms listed), each market represents a different set of companies in terms of size (See Figure 5). This can be associated with a number of factors, including the earlier differences noted concerning the sectorial make-up of the companies listed on the various Exchanges. Both the average and median sized firms are larger on the Neuer Markt and EASDAQ. AIM, with its greater collection of service firms, lists many smaller enterprises. NMAX is an intermediate case. Both the statistics and interviews with the Nouveau Marché indicate differences between the type of firms it attracts, and its strategy, and that of its closest alliance partner on Euro NM, the Neuer Markt. The Neuer Markt attracts larger companies. The Nouveau Marché lists somewhat smaller, more diverse companies and loses some of its potential, larger candidates to its sister market, the Second Marché (an interim step to the main market).
In summary, the markets are evolving to represent different companies by size and sector and, in the process, are acquiring their own unique character. It is a result of a deliberate strategy and positioning, influenced by the national location, the market makers and investment bankers. The strategies, as embodied in listing requirements, are evolving however towards more common practices, so that further changes in the portfolio compositions are expected.
In line with the overall positive performance of the main stock markets, the price performance of the new markets has generally been positive (See Figure 6). The EuroNM All Share index has shown good growth since inception, as has EASDAQ. The only exception to these overall price trends is the AIM market, where the overall price index has struggled. However, there was a reasonable upward trend until its performance growth was truncated by the global market turmoil. Price indices have risen impressively in 1998 in all markets, with the single exception of AIM, which finished September 1998 below its January level.
Based on the overall index charts, the recent monthly return figures have been quite impressive, despite the global stock market slump. From January to May 1998, the EuroNM All share index gained in excess of 125%. When incorporating the effect of the summer slump in the stock market performance, the EuroNM All share index is still up 50% on the year to October 1998. The answer to the question of whether the markets have been significantly disrupted by the shock waves moving through the world markets is a cautious “no.”
Analysis of the performance data suggests that in some cases the new markets have definitely outperformed the broader market indices. This is certainly apparent in France and in Germany. This may be the result of rational differences in the value creation potential of the growth-oriented firms in the markets, or the somewhat less than rational exuberance or speculation based on a comparative lack of corporate information. Not all of the indices have exceeded those of the broader, more established markets. An exception that stands out is AIM. It has, almost without exception, underperformed the FTSE 100 and has shown markedly more sensitivity to the “flight to quality” which reportedly has accompanied the recent global stock market turmoil. This may be due to any number of factors, from the nature of the underlying business portfolio, to the relatively smaller scale of the businesses which, could lead to it being a more speculative market. It may even be due to the larger number of analysts in the London city institutions or, as some sources point out, to certain examples of bad performance in listed companies.
Table 3 shows the correlation between the returns on the various market indices. The correlation matrix suggests that the new market index return correlation is relatively low, definitely lower than the levels observed among most major market indices which suggests that investors see different portfolios of companies and expect different outcomes. Furthermore, the correlation between the new market index returns and those of the major markets also appear to be comparatively weak. Potentially, this has a strong implication for portfolio managers. It may make investment sense for portfolio managers to become involved in these new markets in order to obtain diversification benefits that they cannot otherwise obtain.
Analysis of the volatility of market prices and the monthly average standard deviation of daily stock returns (based on the market indices) demonstrates that when the market value surged in early summer, volatility was at a relatively low point. Recent comment in both the Press and in our interviews indicated a higher level of volatility in September and October, while our analysis suggests that current volatility levels are not dramatically higher than those previously experienced on most markets and on the EuroNM overall (Figure 7). The comments relating to volatility may have been the result of some investors perceiving greater “volatility” during a downward movement in overall prices than “volatility” when prices were moving up.3This provides further evidence that, especially European investors, are less mindful of risk on the upside, but complain of “risk” on the downside.
The analysis of the correlation between return volatilities among markets in 1998 indicates a much higher contagion of “the jitters.” Increased volatility seems to spill over from market to market more effectively than do the returns (see Table 4).
An interesting hypothesis in support of integration is that markets with more “depth” (more analysts, a broader pool of more sophisticated investors) and “breadth” (more firms listed, with larger market capitalisation) are actually better able to weather market shocks. Given that, market information is still being assembled, simple tests on market breadth were used to evaluate the relationship with market volatility in 1998. Simple regressions of the volatility of monthly returns over the summer of 1998 (June to September) on the number of firms listed and market capitalisation4for the seven major new market indices in Europe show a significant negative correlation with the number of firms listed, and an insignificant effect of market capitalisation (R2 = 0.22). In other words, a preliminary investigation, not including controls for other factors which may have caused increased volatility, highlights the role played by a very simple proxy for market breadth, namely the number of firms listed: markets with more firms listed : markets with more firms listed suffered from relatively lower levels of volatility than their smaller siblings. This may be attributed to a number of factors: the greater diversification of such indices, the larger pool of analysts active in them, the nature of share ownership (institutional vs. individual), etc.
Given the recent turmoil, the research included a test to see if the markets have maintained reasonable trading volumes after the stock market shocks began. The analysis shows that the markets, in general, experienced reduced but clearly visible trading volumes after the summer shocks. We found significant proof of this in the case of both the Nouveau Marché and EASDAQ. Some of this fall-off would be associated with the reduced levels of new IPO activity during the late summer and early Autumn. The Neuer Markt, however, is maintaining reasonably high trading volumes. While the late summer shock is visible, it is much less than that on the Nouveau Marché and EASDAQ. In the final analysis, however, the markets are alive and trading.
This early assessment of performance, especially in light of the current disruption of world-wide stock markets, is positive. The markets, despite the fragility associated with their youth, have performed well: they are still showing reasonable returns for their investors. Price volatility has increased since the summer but has not dramatically exceeded levels seen previously on most markets. As discussed earlier, trading volumes, which peaked in the spring and during the early summer IPO surge, have decreased, but trading has been maintained .
This research suggests that there is reluctance on the part of investment bankers to advise companies to go public at this time. This is coupled with some disappointment on the part of companies who are keen to proceed with an IPO. However, the markets still look to be a reasonable home for new entrants. Investment bankers we interviewed saw any decline in IPO activity as a temporary phenomenon. Their advice was to let the shock waves settle and to let price levels move back up to “where they should be” before companies move to the markets.
This initial review of the performance of the new secondary stock markets in Europe suggests some room for optimism. The stock markets, with some exception, have been performing well and weathered the summer storms relatively unscathed. IPOs have been moving onto the markets with vigour in the first half of. Our analysis shows a higher level of both performance and market durability (in light of the global stock market shocks) than we expected. There are a number of reasons to be positive about current trends:
There are also a number of cautionary notes:
At the present time, there is potential competition between EASDAQ and members of the EuroNM for new listings. Each of these markets has relative strengths and weaknesses. EASDAQ, with its pan-European focus, may have lacked somewhat in local contact and visibility. This has been addressed by the opening of three additional offices in Europe (Paris, Frankfurt and London). EuroNM is taking steps to harmonise the markets further and to present a networked platform for trading. With these steps, the de facto competition may intensify. Based on these developments, some of those involved are predicting the demise of one or the other market, while others see no real problem, as one respondent commented. No matter what the evolution of the new issues markets, it is important to realise that competition is not necessarily bad as long as it does not serve to confuse investors. There are obvious differences between the characters of the markets today, as highlighted in this analysis. It is important that these are understood, especially as the markets evolve, by investors and IPO candidates.
While performance to date has been positive, there is still scope for many opportunities to be captured. The new European markets collectively show a capitalisation that is strong and that would not exist without the significant efforts made over the past five years. The challenging news is that there is a long way to go if one compares the results to NASDAQ (on a logarithmic scale, with NASDAQ several orders of magnitude larger).
In line with the 3i entureLab commitment to the development of entrepreneurship, we will proceed with the development of an “IPO Observatory” which aims to document every development of these new markets in Europe. We believe that continuous information gathering to chronicle the evolution of the markets is important, as it helps us to understand their dynamics and the ways in which overall performance can be enhanced. The health of these markets is critical to the future evolution of growth-oriented entrepreneurship in Europe. We hope to provide the data to those active in the market-place as well as to academics searching for a better understanding of how the markets function.
A database containing individual stock and overall market performance information, and all listing documentation for companies that have proceeded with an IPO (cataloguing the “initial conditions”) is currently under construction as are the continuous analytical structures and database mechanisms required to conduct trend analyses.
1. This survey achieved a response rate of 40% of the 307 companies listed on AIM at the time it was conducted.
2. These observations are taken from a speech given by Gilbert Gélard, Directeur Associé KPMG France and Membre de l’Exécutif of IASC entitled L’Ouverture des Sociétés Cotées aux Normes Internationales. The speech was made on 1 October 1998 at the Journée des Entreprises EuroNM.
3. Human decision process research strongly suggests that such perceptual differences would indeed exist. Human reactions to upside and downside movements have been shown to be asymmetric: not fully capitalizing on the upside but taking actions on the downside that ensure larger losses.
4. Actually, the natural logarithm of the end of month, Euro-based market capitalizations.
5. Interestingly, iXOS’s IPO provides a good example of some of the “cultural” differences between the exchanges. The initial public offering was made on the Neuer Markt at a rate of DM 170. This was deemed to be too high a price for the “normal” NASDAQ stock, so it is offered at $20.75 per share in the form of an American Depository Share (ADS) representing one-fifth of a share. This is a phenomenon which has been suggested by several investment bankers we have interviewed: shares must be cheaper on NASDAQ than on the European new markets.
CONTACT: Benoit Leleux, Arthur Blank Center for Entrepreneurship 111, Babson College, Babson Park, MA 02457; (T) 781-239-5577; (F) 781-239-4178; leleux@babson.edu
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1999 by Babson College. All rights reserved. Last updated March 2000.