The great leap to flotation

Five years since the dotcom bubble burst, the capital markets are in free-flow with money looking for a home and companies heading for the LSE in booming numbers that will allow it to grow faster than its suitors and cement its place as Europe’s flotation capital.

Most of the LSE’s growth in the first quarter just ended has been driven by the Alternative Investment Market (Aim). An estimated 130 companies have floated since January against 53 in the same period last year. March 2005 saw 69 companies float on Aim - the highest monthly total ever.

Aim’s phenomenal growth has been at the expense of the main market which saw 20 flotations in the first three months of this year, up from eight a year ago.

By the time Euronext or the Deutsche Brse can bid for the LSE, September at the earliest, there are likely to be more than 3,000 companies on the main London market and Aim, against 2,791 at the end of December.

Some of the momentum may be taken out of Aim’s growth rate by new rules on cash shell companies. But experienced market watchers believe the conditions are right for a flotation boom to continue at least until the end of the year, and London appears to be the favoured place to raise money. It is also attracting flotations from the United States on the back of New York’s new regulatory regime.

David Cunningham, an analyst at Bell Lawrie, the broker, says: "As long as the market has liquidity, the market will not disappear. We now deal with investors from the US and the rest of Europe. London has become the pre-eminent place for European trading."

Bell Lawrie is working on two US companies which want to float in the UK because of the tough new Sarbanes-Oxley listing rules in their home country. Cunningham says: "If we are working for a couple of US companies, then I’m sure a few of our rivals are as well."

New pan-European listing rules come into force in July, and could lead to another rush of market debuts before the end of June, he says. The introduction of new regulations is expected to make it difficult to open issues in the first half of the year and close them in the second half.

Companies testing the water for a float later this year include Infinite Data Storage, the Dunfermline CD technology company, and ProStrakan, the skin and bone drug developer based in Galashiels.

Much of the boom in market activity is down to greater enthusiasm for smaller firms. Investors’ attitudes to small companies have changed for the better over the past decade, according to Ben Thomson, the chief executive of finance house Noble Group. He says: "When people invested in technology companies in the late 1990s, they became interested in small companies. They were badly burnt, but in many cases they were inclined to try it again.

"There is more of a habit of looking at small companies now. The great thing about small companies is that, unlike FTSE 100 companies, it is often easy to understand what they do."

Thomson says continental European small company markets, for example the Neuer Markt in Frankfurt, were "pretty much deaded" by the technology slump, leaving Aim as the only serious trading place for promising young stocks.

The relatively stable market conditions of the last three months have encouraged both investors and companies looking for investment to have a go, according to Thomson. When share prices are rising rapidly, companies hold back because they believe they will achieve a better price later. When they fall rapidly, investors hold back because they think they will get more for their money later.

Thomson adds: "I think there will be two blips this year, one around the election when [the number of flotations] will come down a bit, and the other when the new European directive comes into force between June and July."

Seven Scottish companies have floated since October, when Thomson complained of a lack of appetite for joining the market north of the Border, and there has been only once since the turn of the year. The unwillingness of Scottish firms to join the flotation scramble is well documented, though there have been a few more expressions of interest. "The number of companies coming to market is still not as many, proportionately, as in England, but it is encouraging to see them come forward," says Thomson.

This evidence of greater corporate activity is backed by a generally buoyant and confident economy. Corporate earnings have been strong across the globe, with particularly encouraging signs emerging from the US. Official figures produced last week showed that America’s corporate earnings after tax leapt 12.5% in the fourth quarter of last year, driving the proportion of national income contributed by corporate profits to a record level. That trend has continued into the first three months of 2005 - and has been reflected across Europe and the UK.

Richard Batty, global investment strategist at Standard Life Investments, says: "In Europe - including the UK - 90% of companies have been meeting or beating their earnings targets, with only 10% falling short. That’s an impressive record. In the US it’s about 80% who are meeting or beating, which is also very strong."

Much of the increased corporate profitability has been re-invested into share buybacks and increased dividends, which has helped to prop up the market. The FTSE 100 spent much of February and March trading north of the 5,000-point barrier. The last month has seen a fairly rapid retreat - the sharpest monthly fall since last July - with the index closing the quarter a little below the 4,900 mark, due in part to high oil prices, fears of US corporate stability and pressure to raise interest on both sides of the Atlantic.

Nevertheless, the benchmark index is still up about 1.5% for the quarter, leaving it on track to match long-term annual growth rates of between 6% and 7%. Many fund managers believe the fall has been overdone.

According to Bell Lawrie’s Cunningham, the recent bout of selling will not continue for long. "A lot of it was to do with small investors consolidating their capital gains allowance for the tax year. I think you will see things start to pick up after April 6."

With increased earnings comes increased corporate spending power. Venture capitalists have money coming out their ears - and are fighting with each other to find the best places to invest it. After a successful year of exits, 3i has decided to hand back 300m to shareholders as it simply can’t find enough deals.

Penta Capital, the Glasgow private equity firm, has just raised 75m, most of which it hopes to plough into leisure and business services companies. The firm is looking over two investment prospects in Scotland and over a dozen south of the Border.

The retail sector is still hot - Apax is trying to buy Woolworths, and everyone seems to want to buy Somerfield. Other more obscure sectors, such as retirement homes, have been flush with deals.

Around the world, there was a small retrenchment in merger and acquisition (M&A) activity in the first quarter. The value of global M&A deals fell 23% in the first quarter compared to the last three months of 2004, according to Thomson, the financial data provider.

But Standard Life’s Batty says: "Even if the first quarter is a little behind the fourth quarter of last year, taken together, that’s still the strongest six-month period for deals in at least three years."

There are still a few worries, however. Goldman Sachs has not helped matters on this front by suggesting that crude oil prices could be set for a "super spike" period that will push prices as high as $105 a barrel. And Alan Greenspan’s suggestion that he doesn’t think he’s going to have "an inflation problem" has also set some traders thinking that we may be in for a prolonged bout of deflation.

Back in the UK, small and mid cap indices have continued to outperform the market, clocking up gains of about 3% and 2.5% respectively as a broad asset switch away from blue chips to livelier, smaller companies continues.

The last few days of the quarter saw no fewer than 13 new issues, the biggest of which was Proximagen, a drug-discovery firm spun out from King’s College, London, which raised 14.5m to fund research into Parkinson’s and Alzheimer’s diseases.

The sheer number of Aim flotations may eventually bring the boom to a halt. Bell Lawrie’s Cunningham points to the drop in activity which kicked in at the end of last year: "You need to have enough liquidity to digest everything. Last year the market did have a bout of indigestion."

Torquil Macnaughton, one of the directors of Penta Capital, says: "There have been a lot of Aim flotations recently, and there is a good chance that some of them will not meet their profit forecasts. You have to ask to what extent the flotation window will close if there are a lot of profit warnings. The market will have to sort the wheat from the chaff."