Lower The Wall, Lift The Market

Editor’s note: Sandy Miller is a general partner at Institutional Venture Partners. He co-founded investment bank Thomas Weisel Partners and served as a senior partner at Montgomery Securities.  

The tech IPO market is booming, but only when you compare it to the lean years of the past decade. If we look back a little further, to the healthy days that preceded the dot-com bubble, the 51 tech startups that went public last year appear paltry in comparison.

A key difference is that Wall Street is fixated today on the biggest names (Facebook, Alibaba, GoPro) to the detriment of hundreds of smaller startups that don’t get the attention they deserve. The universe of venture-backed tech startups was much smaller when I ran technology investment banking at Montgomery Securities in the 1990s.

And yet, more than 150 tech startups went public in 1996, precisely because the market appreciated quality, regardless of the size of the company. As such, small- and mid-cap companies were the bread and butter of the IPO market back then, and there is no reason they can’t be once again.

The solution is controversial and I will propose it — because someone has to. It’s time to lower the Chinese Wall that has completely and utterly separated investment bankers from equity research analysts. Once we do that – through a series of well-calibrated amendments to the Global Analyst Research Settlements of 2003 – investment banks will once again find it in their interest to recommit resources to equity research, which will in turn generate awareness of and interest in the logjam of startups that ought to be going public but currently can’t quite get there.

Exceptional Stories Only, Please

A startup today needs an exceptional story to go public. Tech firms that grab all the headlines and the attention of Wall Street are the high-fliers that have vast addressable markets and grow at an extravagant 40 to 50 percent or more, annually.

But for every GoPro or Alibaba, there are dozens of successful small- to mic-cap startups that few on Wall Street have even heard about. These are well-run companies with good products serving niche markets and are valued at between $200 million to $1 billion. They pull in $25 million to $100 million in revenue, grow at a solid 20 percent to 40 percent clip and are often more profitable than the high-flying tech giants of which investors can’t seem to get enough. Mid-cap startups routinely used to go public in the heyday, but today’s smaller tech firms – many of which are solid IPO material – tend to be completely overlooked by the market.

Why? Partially because the world of mid-cap tech research is like a big black hole. Where there was once ample coverage of up-and-coming tech startups, the scope of research on technology companies is now extremely limited. And without equity research analysts doing the legwork they used to do, investment bankers and the rest of Wall Street are far less familiar with the hundreds of young companies that should be on the IPO track.

We can trace this problem back to the research settlement, a well-intentioned agreement designed to address the abuses of the dot-com bubble era, when investment banks chasing huge fees put pressure on equity analysts to promote IPO names.

The settlement erected a stout Chinese Wall between research and banking. It also put in place measures that would divorce analysts’ compensation from their firms’ investment banking and trading profits. Equity analysts suffered as a result — their status was diminished, their integrity questioned and compensation clipped. Many top analysts moved to hedge funds, mutual funds and venture capital groups, leaving a void on Wall Street that exists to this day.

Outgrowing the Fix

There is no doubt the research settlement righted some of the wrongs of that era; new ground rules have taken root over the past decade. But we’ve outgrown the fix and it is now time to lower some of the barriers that keep bankers and analysts apart. This would be constructive for everyone in the system.

Under current rules, a legal chaperone must be present anytime an investment banker meets with an equity analyst. This is an impractical requirement that inhibits the day-to-day exchanges in which analysts used to share their industry knowledge or insights about firms. Letting the two sides coexist once again would help bankers to make better judgments about which companies should go public and create a better overall investment product. This would help open the middle market.

To be clear, I am not calling for the reversal of long-standing securities laws that prohibit parties from sharing confidential information. Nor am I suggesting that we completely overturn current compensation policies that ensure equity analysts do not have outsized monetary incentives to tout specific stocks. These provisions have stood the test of time and should remain in effect.

But a few carefully considered changes to Global Analyst Research Settlements of 2003 would help to create a flywheel effect that breathes new life into the entire mid-market. Enabling investment bankers and analysts to cooperate more closely will generate more IPOs, which in turn will boost the flow of stock trades and consequently spur new investment in tech research.

And by putting additional resources back into equity research, investment banks will be priming the pump for a much stronger IPO market in the future, increasing liquidity for companies and revenue for the banks. Mid-market and boutique investment banks will inevitably respond to the opportunity, for this is their natural business.

Striking the right balance between banking and research is fundamental. We lived it for many decades before excessive greed and the research settlement brought us our current unwieldy reality. The Chinese Wall was built too high. By lowering it and allowing research and banking to rediscover their natural equilibrium, we can start the flywheel turning once again.