Eric Watson: Plenty of cash for new firms

With Xero, Rod Drury has developed a company worth billions. Photo / Mark Mitchell

According to the NZX, there is a gap in our capital markets infrastructure that hampers small and mid-sized companies' abilities to raise capital.

I find it hard to believe that such a gap exists, but if it does, I don't think the New Market proposed by NZX is what we need.

A back-of-the-envelope calculation suggests there is capital on the order of $750 million sitting in private equity funds in New Zealand that is looking for a home.

These funds - operated by firms such as Direct Capital, Waterman, Pencarrow and Pioneer - are specifically targeted at SMEs that seek capital to fund expansion or to facilitate a transition from family ownership.

These firms have substantial teams that look at hundreds of opportunities each year. They're very selective, choosing to invest in only those firms that offer an appropriately high level of return for the risk involved.

So it seems that the gap in the market is not because of a lack of infrastructure but through a shortfall in the risk-adjusted returns that SMEs offer private equity investors.

In response, the NZX proposes to establish the New Market as a mechanism for SMEs to raise capital more easily from the public. Compared with the main board, the New Market would have simplified listing rules, template-based procedures and periodic (rather than continuous) disclosure.

Is the New Market a good idea? Will it meet the requirements of the law to be a fair, orderly and transparent market that promotes the confident and informed participation of investors?

Let's look at Xero, a start-up that listed on the main board in 2007 and would have been a good candidate for the New Market, had that avenue been available.

Over the 18 months to mid-March, its share price experienced a nine-fold increase.

This appears to have had little to do with the true worth of the firm, and lots to do with what we saw during the (dare I say it) dotcom bubble of 1997-2000.

First, we have the sexy marketing. Xero has clearly invested heavily in the design of its websites and user interfaces, along with clever messaging that seeks to portray its software as "beautiful". This has caught the attention of investors.

Then there is the lack of serious financial journalism. For example, when Xero's share price hit $37 in November last year, numerous commentators observed that "Xero is now worth more than Telecom".

That would be true if one could calculate the value of a business by simply multiplying the total number of shares by the price at which a few thousand have recently traded.

On that basis, Xero's apparent "worth" was nearly $6 billion just one month ago, but is now around $3.6b. While its negative profitability is appropriate in this phase of its growth, the fact is that its revenue is running at just over $90 million.

Clearly Xero has not experienced such variations in its true worth. What the media and the NZX should have been highlighting - but did not - was that gyrations of this scale are not unexpected for companies like Xero, whose free float (the proportion of shares freely available for trading) is small.

According to Xero's disclosures, big chunks of the firm's equity are held by strategic investors who are not really interested in selling - yet.

Tellingly, of Xero's 4715 shareholders in May last year, slightly more than 3700 held fewer than 5000 shares each.

Of course, in this so-called transparent world of ours, public investors can't suss out what's going on behind the scenes without a Bloomberg screen or Xero's share register, neither of which are readily accessible.

So in my view, if there truly is a shortage of capital for SMEs, we shouldn't be looking for ways to make it easier for the public to fill the gap.

Our focus should be on increasing the depth and breadth of the private equity market. Hopefully the Financial Markets Authority, in considering the NZX's proposal, will agree.

• Disclosure of Interests: Eric Watson currently holds a position in Xero shares.

Kerre McIvor is on holiday and will return next week.