Reversing the UK Small & Mid-Cap Market Decline
The UK's financial ecosystem is currently in a “Doom Loop,” according to a recent article by the UK investment bank, Peel Hunt. Facing what it describes as a relentless decline, companies are suffering from low valuations, diminishing liquidity, investor withdrawals, and a lack of enthusiasm for IPOs. Without swift and effective action Peel Hunt stated, the UK could lose a crucial part of its financial infrastructure, especially in the small-cap sector. While there is little disagreement that regulatory reforms are overdue, the demand side of the equation also needs a serious intervention.
The bleeding across the pond echoes problems in the US market, which while different, have been affecting investor sentiment. The US this year has grappled with massive volatility, a lackluster IPO market and the domination of the “Magnetic 7” tech stocks. The less-than robust IPO market did have its share of exciting moments with three IPOs in Q3 raising over $500 million, including the ninth largest IPO in the last 20 years. Though lackluster aftermarket performance coupled with an uncertain macroeconomic and political environment requires prospective companies to demonstrate strong growth potential and profitability or at the very least, a well-articulated and defined route to profitability. (This last point, has become non-negotiable for earning the trust and confidence of investors.)
This has made it especially challenging for small caps in the US, especially those on trading on the OTC. Investors have become more selective, leading to reduced interest and funding for high-potential, young companies. As a result, small caps face increased hurdles in raising awareness and therefore, capital through IPOs which can significantly impede growth and expansion plans.
Every exchange has its share of winners and losers, yet one that is expanding will attract increased investments driving up valuations and enticing new companies to list. The US markets used to thrive in this regard, but exits since 2022 have been stalled. The UK's IPO market for the small-cap sector has been shrinking year-over-year too. This means investment is flowing elsewhere, most notably to private equity. What’s even more disturbing is that a substantial number of companies exiting the public market in the UK are in the tech sector, a sector the UK government has been keen to support.
Most of the small tech companies who go public tend to be unprofitable. According to data by Ritter, of the tech companies that went public in 2017, only 17% were profitable, while over 43% of non-tech companies were profitable. However, the tech sector experienced a sobering year in 2022, as numerous leading stocks tumbled dramatically due to rising inflation and increasing risks of recession.
In the UK, the FTSE SmallCap index has been most affected, with a 30% reduction in equities and a 50% decrease in market cap over the past five years. This sharp decline weakens the support structure for smaller companies and reduces available funds for growth. To reverse the trend, regulatory changes which could make listed companies more agile have been on the table for some time. However, higher proposed listing fees, increased regulation, and more stringent reporting requirements could be counterproductive if companies are hesitant to go public due to these factors.
Conversely, many UK companies overlook the fact that it's not an "either-or" choice between going public in the UK or the US. UK issuers can get the best of both worlds on the OTC, the largest US stock market for international securities, providing trading access to over 12,000 listed stocks worldwide, including major British brand owners such as Marks & Spencer, easyJet and J. Sainsbury.
News of the UK’s imminent decline as a preeminent small and mid-cap market though are not overhyped. Increasing demand across the global markets is key to setting in motion a positive cycle of higher investment, improved valuations, and increased liquidity, which would also attract more foreign investment.
Breaking free of the Doom Loop won’t be easy. Small caps in the UK seeking growth can transform their prospects by taking advantage of opportunities presented by the OTC, which offers vast reach and access to US investors. It's like striking a diabolically clever bargain.