Saving Canada’s Venture Exchange

By By Ian C.W. Russell

Recent years have been particularly challenging for Canada’s Venture Exchange, an important source of funding for small-cap, early stage companies as well as mid-sized Canadian businesses that have outgrown access to angel networks or private equity and are turning to public markets to raise much needed funds to meet their strategic objectives.

Between 2002 and 2007, the S&P/TSX Venture Composite Index greatly outperformed virtually all major indices in the world. After a big dip during the global financial crisis, the Index trended higher until March 2011 as confidence returned, and then fell sharply as economic growth slowed and commodity prices receded. The Index is now hovering around financial crisis lows.

Can Canada’s Venture Exchange be saved? The Investment Industry Association of Canada (IIAC) believes so.

The numbers say it all

The S&P/TSX Venture Composite Index is down 72% from its most recent peak in March 2011 and down 80% from its all-time high in May 2007.

Issuers listed on the TSX Venture Exchange (TSXV) raised just over $5 billion in 2014, compared to $11.6 billion in 2007.

Total financings raised on the TSXV were only one-tenth as much as total financings raised on the Toronto Stock Exchange (TSE) in 2014, compared to one-quarter as much in 2007.

The total market value of the TSXV’s 2,347 companies was $26.9 billion at the end of 2014. By comparison, the market value of companies on the Canadian Venture Exchange was more than $100 billion in 2001.

Trading volume fell 27% over the 2007 to 2014 period (40% over the 2011 to 2014 period).

The home of a diverse range of companies

Roughly 60% of issuers listed on the TSXV are junior mining and exploration companies, and roughly two-thirds of equity capital raised on the TSXV in 2014 was resource related (i.e. mining and oil and gas). The TSXV is also home to many companies in the biotechnology, application software, medical (devices, instruments, diagnostics and research), industrial products, real estate services and asset management sectors.

Companies that grow and mature may eventually list on the TSE. In fact, about 20% of the companies on the S&P/TSX Composite Index graduated from the TSXV.

The TSXV is an intrinsic element of Canada’s capital markets and, as such, it must be nurtured and preserved. The challenges the TSXV faces are not insurmountable, but they do require our immediate attention and decisive action.

What ails the TSXV?

The challenges the TSXV faces are multi-faceted.

Weak resource prices

The drop in the price of crude oil and other commodities led to capitulation in resource stocks listed on the TSXV. Because many of the issuers on the TSXV are junior resource-based companies, they do not have the size, nor are they sufficiently diversified to weather a plunge in commodity prices.

Increased market volatility

Large swings in stock markets have been triggered partly by anxiety about Greece’s future within the Eurozone and growing anticipation the U.S. Federal Reserve will raise interest rates by the end of 2015. During times of uncertainty and intense market volatility, small-cap stocks tend to get hit the hardest as investors flee smaller speculative stocks in a flight to quality.

Unfavourable demographics

Canada’s population is aging. Older investors are generally more risk averse and, hence, tend to avoid speculative equities (like junior resource plays) in favour of more balanced portfolios that emphasize dividend and income streams.

High listing fees and associated costs

Listing fees for the TSXV are in the $7,500 to $40,000 range (depending on the total value of the shares listed). The addition of accounting and auditing fees ($25,000 to $100,000), legal fees ($75,000 +), underwriters’ commission (up to 12%) other related fees (e.g. securities commission fees and costs related to preparing valuation reports) and ongoing expenses to meet continuous disclosure and corporate governance requirements of the exchanges and securities regulators can be bring the costs of going public on the TSXV to more than $300,000. This represents a significant cost for many junior companies.

Consolidation among small investment dealers

Increased regulatory compliance costs, high costs associated with keeping up with technology, and stiff competition have led a number of boutique dealer firms who focus on the small-cap market to either exit the industry, or merge with large players. Others have registered as exempt market dealers.

The rise of the exempt market

Increasingly, small companies are bypassing the public markets because it is more economical to raise funds in the less regulated exempt market. Ordinarily, they would have turned to public markets to distribute new share offerings because of the liquidity advantage they offer, but with activity on the TSXV slowing considerably, the liquidity advantage has evaporated. There is less reason for small firms to utilize public markets. Retail investors still interested in riskier, more speculative companies are forced into the exempt market.

The increase in private equity

Recent years have seen an increase in support of viable early stage companies by private equity and venture capital firms in a number of sectors including natural resources, software and information technology. This has allowed issuers to defer listing until they are at a more mature stage.

Structural issues

The standards advisors use in assessing the suitability of investments for their clients have been raised. Key factors advisors are required to take into account include the client’s age and time horizon. These investor suitability requirements are a key element of the Client Relationship Model reform initiative, and may preclude investments in riskier, more speculative stocks listed on the TSXV.

These trends foreshadow the continued erosion of trading on the TSXV.

What can be done?

The only real hope of stimulating activity on the TSXV is going to have to come from policymakers in the form of tax and regulatory changes.

For example, the federal government could implement legislation to provide for the deferral of income taxation on taxable capital gains incurred in a taxation year when the proceeds are reinvested in small business shares within a six month period. This would, in effect, unlock significant amounts of capital tied-up in low-return investments and would encourage investors to take advantage of opportunities offered by small-cap companies with faster growth potential.

There have been calls to delist TSXV companies that fall outside the listing standards so investors have a small number of higher quality stocks to choose from, but most stakeholders believe the market should determine which companies succeed and which fail.

There have also been calls for regulators to make it easier for companies to raise capital and maintain their listings.

The Canadian Securities Administrators have responded by lightening the regulatory load on companies residing on the TSXV, while at the same time ensuring investor confidence is not compromised. One of the most important changes aims to streamline venture issuer disclosure by providing issuers the option to provide quarterly “highlights” disclosure rather than full interim Management’s Discussion and Analysis in respect of financial years beginning on or after July 1, 2015. The quarterly highlights would include a brief discussion of the issuer’s operations, liquidity and capital resources. Additionally, venture issuers may use a scaled down form of disclosure for executive and director compensation arrangements. Moreover, a venture issuer’s initial public offering (IPO) prospectus will only need to include two instead of three years of historical audited financial statements.

It is also important that we have a better understanding of the type of firm or investor operating in exempt markets. This can be done through better data collection. We know that small and medium-sized businesses facing high listing fees and associated costs as well as ongoing expenses to meet continuous disclosure requirements are staying private for longer. Others are turning to the exempt market for cheaper sources of financing. This raises important questions with respect to the roll and regulation of the exempt market and to levelling the playing field.

It is also worthwhile to look at what other jurisdictions are doing to boost demand, increase liquidity, reduce volatility and improve market quality for stock of some smaller companies. In the U.S., for example, the Securities and Exchange Commission (SEC) approved a two-year pilot program aimed at boosting liquidity of small-cap stocks. The program will reward brokers for making markets in less-liquid stocks by widening the amount they earn when buying and selling shares. Instead of trading in pennies, stocks will trade in 5-cent increments. This will apply to approximately 1,400 thinly-traded stocks issued by companies with market capitalization of $3 billion or less that trade at a volume-weighted average price of at least US$2.00 per share every trading day. The goal is to increase brokers’ interest in trading these less active stocks so they do not become neglected. The pilot program will begin on May 6, 2016.

It may also be useful to explore whether it makes sense to arrange auctions for thinly-traded small-cap stocks intermittently through the day rather than through continuous trading. In general, continuous trade increases stock liquidity, price accuracy and value for most stocks (see, for example, studies by Amihud, Mendelson and Lauterbach), but continuous trading may not suit well thinly-traded small-cap stocks (see, for example, Easley, Kiefer, O’Hara and Paperman). Spreading the thin volume over the day may generate volatile and inaccurate transaction prices that may deter potential traders. Therefore, it may be more optimal to concentrate all trade in one or a few auctions.

In summary

Creating a healthy environment for funding small, growing companies should be a top priority for policymakers and regulators. The search for solutions begins with a diagnosis of the problem. It is not enough to blame weak economic conditions and poor resource markets. Whistling past the graveyard is no answer. The issues affecting financing and trading on Canada’s Venture Exchange are multi-dimensional and require action on many fronts.

We need to put our best minds together to create a strong and sustainable venture capital marketplace that will enable small Canadian businesses to achieve their desired objectives and their full potential.

Ian C. W. Russell is the President and CEO of the Investment Industry Association of Canada (IIAC).