315 39510 viewpoint NUMBER NOTE 2007 Financing Innovation JaeHoon Yoo MARCH JaeHoon Yoo How to Build an Efficient Exchange for Small Firms (jyoo@worldbank.org) is a senior securities market More than 24 countries operate separate boards and exchanges aimed PRESIDENCY specialist with the Capital at small and medium-size enterprises (SMEs). Equity markets play a Market Advisory Group of VICE the World Bank. critical role in fostering economic productivity by financing innovation. But only a few SME exchanges function properly, providing coveted This Note is a summary of a new study by the fresh capital and liquidity. What steps are key to building an efficient author (Yoo forthcoming). exchange to provide risk capital for SMEs? Creating an SME-friendly DEVELOPMENT market architecture supported by effective institutions and forging links to policies that foster a new class of investable equities. SECTOR To increase access to equity finance for SMEs, a United Kingdom, KOSDAQ in the Republic of PRIVATE growing number of developing countries are Korea, and TSX-Venture Exchange (TSX-V) creating specialized equity markets, differenti- in Canada--clearly show the benefits of spe- AND ated from the main exchange. These new ini- cialized SME exchanges, creating a virtuous tiatives stem from the recognition that a cycle from private equity to public listing. specialized capital market segment--called new Collectively, these three new markets list FINANCIAL markets--can provide risk capital for promising more than 4,000 firms and attract more than entrepreneurs, promoting innovation crucial 450 new listings a year. AIM has helped firms for sustainable economic growth. raise US$80 billion since its inception in New markets that function well offer a 1995, and KOSDAQ US$26 billion since its range of benefits: greater access to growth cap- start in 1996. GROUP ital for innovative SMEs, new jobs through But few other new markets have been suc- entrepreneurship, more investment opportu- cessful. The experiences of the successful ones, BANK nities for domestic portfolio investors and along with the lagging performance of others, local venture capitalists, new sources of rev- raise several questions: enue for local stock exchanges, and an Why are so few new markets successful, and expanded mechanism for recycling public why do so many others fall short? WORLD funds to promote SMEs. NASDAQ in the How can new markets improve access to risk United States aside, three new markets--the capital for innovative SMEs in developing THE Alternative Investment Market (AIM) in the countries? F I N A N C I N G I N N O V A T I O N H O W T O B U I L D A N E F F I C I E N T E X C H A N G E F O R S M A L L F I R M S How can "light" regulations adapted to SMEs an exception: it sets higher standards for listed avoid compromising investor confidence in firms than the main market, emphasizing gain- new markets? ing investor trust over relaxing constraints. What new policy measures could be adopted Most new markets execute transactions other than those for developing main equity through order-driven systems. AlterNext (which exchanges? replaced Nouveau Marché in France) operates a quote-driven system. And AIM is largely a Main features of SME exchanges quote-driven market where liquidity is supple- New markets can be defined as regulated equity mented by market makers. Spain's Nuevo 2 markets that focus on SMEs with high growth Mercado adopted a hybrid format, retaining potential and set lower administration criteria specialists for certain shares and an open-outcry (Grant Thornton International 2006). They system. therefore exclude the least regulated or unreg- Finally, most new markets charge lower list- ulated over-the-counter (OTC) markets, which ing fees than the main market. embrace financial contracts and enterprises of all sizes and characteristics. New markets gener- Performance of SME exchanges ally cater to young, small, high-risk firms, aiming An assessment of the performance of the 22 new at the "sweet spot" size in their market. Firms markets shows that Korea's KOSDAQ outper- listed on AIM have a median market capitaliza- forms others in most dimensions measured, tion of US$35.4 million and those on KOSDAQ while the United Kingdom's AIM and Canada's a median of US$31.5 million--while the median TSX-V generally do better than average. Two for TSX-V is significantly smaller at US$7.1 mil- new markets in Japan, Hercules and Mothers, lion. In contrast, for NASDAQ the median is and GEM in Hong Kong, China, do notably well US$215 million. in attracting innovative firms. A survey of new markets in 11 developing and 11 developed economies identified other Size common features.1 While AIM, KOSDAQ, and All the new markets are significantly smaller in TSX-V take the form of a separate market, oth- size than the main market. Indeed, for most, ers are a separate board within the exchange total market capitalization and turnover value and operate in parallel with the main board. are less than 3 percent of the main market's. An KOSDAQ operates like a separate market even exception is KOSDAQ, with 36 percent of the after its merger with the main market: it is run trading value, but only 6 percent of the market by a different department and has its own rule- capitalization, of the main market. Generally, setting procedures. the market capitalizations of new and main mar- Most new markets adopt, implicitly or explic- kets are positively correlated. itly, a "junior market" strategy in which listed firms graduate to the main market. KOSDAQ Access (like NASDAQ), however, started as a compet- Access to new markets can be measured by the ing market and still holds a competitive position amount of equity offerings and number of listed by retaining large venture-backed firms. firms. KOSDAQ and AIM show vibrant new Nearly all new markets adopt looser listing equity financing activity. But for most new mar- and maintenance requirements than the main kets the capital raised (through primary and sec- market, typically allowing more relaxed criteria ondary equity offerings) is less than 1 percent of on operating history, minimum number of gross fixed capital formation; in contrast, the shareholders, past financial performance, and average for main markets is more than 6 percent. number of free-float shares. Recently AIM even Financing on new markets should be measured relinquished its regulated market status in the not only quantitatively but also qualitatively, European Union so that its listed firms no however, since funds raised through equity offer- longer need to adhere to strict EU standards for ings are closely linked to higher innovation and listing and disclosure. Brazil's Novo Mercado is productivity in the economy and depend on characteristics of listed firms (Carlin and Mayer Best practices in developing SME exchanges 2000). Analysis of the leading new markets--AIM, Size of financing and number of listings KOSDAQ, and TSX-V--identified several com- clearly differ as a sign of market success. TSX-V mon factors in their strong performance. ranks low on the size measure but attracts many firms. Lower costs for listed firms Firms are invariably wary of the costs of going Liquidity (and remaining) public. These costs, both New markets, because they deal with small- direct and indirect, range from listing fees to 3 capitalization firms, naturally do not have the insurance for independent directors. Since same market liquidity and depth as main mar- most are fixed, the costs are more burdensome kets. Still, the turnover ratio (trading value to for small firms. Successful new markets lower market capitalization) of the most liquid new costs for firms by establishing flexible entry markets exceeds 100 percent. KOSDAQ, where requirements, instituting light corporate gover- retail investors account for more than 90 percent nance rules, and reducing financial fees for list- of trades and 50 percent of ownership, has the ing and maintenance. highest turnover ratio at 690 percent. AIM tends to have lower liquidity because of its institutional Assurance of market integrity investors' market and use of specialized market To avoid lax regulations dampening investor makers. New markets commonly concentrate on interest, successful new markets adopt several selected liquid shares while providing a liquidity- operational practices: adding institutional enhancing mechanism such as a market maker arrangements for mentoring (such as AIM's use for illiquid shares. of nominated advisers, Nomads, to ensure ongoing support to firms), requiring lockup Market dynamics periods for major shareholders around equity One main characteristic of successful new markets offerings, and imposing strict delisting rules. is a high entry and exit rate, reflecting their focus Timely delisting of unqualified firms helps pre- on high-growth SMEs. For NASDAQ the listing serve investor confidence by maintaining the ratio(newlistingstototallistings)averages2.0per- market's profile as a high-risk, high-return mar- cent, and the delisting ratio 10.8 percent. Similarly ket, upholding high market integrity, and high listing and delisting ratios characterize AIM (9.3 percent, 4.0 percent), KOSDAQ (6.0 percent, Share of listed firms in highly innovative industries, selected new Table markets, 2005 (percent) 2.4 percent), and TSX-V (2.8 percent, 6.4 per- 1 cent). In contrast, the new markets in Japan, Italy, Industries with Industries with Industries with and Greece are anemic. And China's SME board, high capital high R&D high operating which applies the same listing requirements as the New market intensity intensity risk main board in the Shenzhen Stock Exchange, has Hercules (Osaka, Japan) 86 97 95 delisted no firms since inception. Mothers (Tokyo, Japan) 82 96 95 KOSDAQ (Republic of Korea) 17 78 80 Innovation GEM (Hong Kong, China) 35 69 69 How well new markets do in supporting AIM (United Kingdom) 51 56 55 TSX-V (Canada) 24 52 50 innovation--or their "innovativeness"--can be MESDAQ (Malaysia) 18 36 36 measured by industrial characteristics of their Medium & Small Capitalization listed firms. Japan's two new markets, Hercules Category (Greece) 17 28 31 and Mothers, rank highest on three innovation Irish Enterprise Exchange (Ireland) 58 25 25 criteria, followed by KOSDAQ and Hong Kong, New Zealand Alternative Market 22 22 22 China's GEM (table 1). Though AIM has fewer firms in highly innovative sectors, it still scores Note: Methodology adapted from Binh, Park, and Shin (2006). The innovative industries (all in manufacturing) are identified using data solidly. TSX-V shows strength largely in intensity on NASDAQ firms and on the basis of three criteria: capital intensity (ratio of total assets to sales), R&D intensity (ratio of average R&D expense to average sales revenue), and operating risk (standard deviation of the operating cash flow [EBITDA] margin). of research and development (R&D). Source: Exchange Web sites; author's calculations. F I N A N C I N G I N N O V A T I O N H O W T O B U I L D A N E F F I C I E N T E X C H A N G E F O R S M A L L F I R M S establishing management discipline in listed Running the new market as a business by firms. operating it as an independent entity either inside or outside the current exchange-- Support services for issuers while also providing an incentive structure to In several countries the new market and the gov- promote the new market and ensure its com- viewpoint ernment provide services aimed at nurturing mercial viability. young enterprises that are or will be listed on the Supporting competition in the local venture market--such as promoting institutional invest- capital industry and introducing foreign ven- is an open forum to ment, boosting the visibility of listed firms, and ture capitalists to alleviate the typical short- encourage dissemination of raising public awareness of alternative invest- age of local skilled experts. public policy innovations for ments. TSX-V helps SMEs go public through a Enhancing transparency and coordination in private sector­led and "capital pool company." This alternative pro- supportive public programs, such as pro- market-based solutions for gram for early-stage equity financing fills a cap- grams to match private venture capital with development. The views ital gap--an investment amount too large for public funding. published are those of the angel investors but too small for institutional Merely creating a new board within the authors and should not be investors. The initiative has led to more than exchange does not ensure a vibrant exchange attributed to the World 1,350 listings on TSX-V in its 20-year history. for SMEs. The government, the exchange, and Bank or any other affiliated other players (such as investment banks and organizations. Nor do any of Policies linked to market development venture capitalists) need to make a concerted the conclusions represent To ensure a stable flow of new equities into a effort to build a new market architecture sup- official policy of the World new market, governments can link policies for ported by effective institutions and industrial Bank or of its Executive promoting innovation and entrepreneurship policies. Directors or the countries with the market's development. Ways to do this they represent. include introducing a flexible stock option and mezzanine finance system, promoting the ven- To order additional copies ture capital industry and skills, developing tax Note contact Suzanne Smith, incentives for listing on and investing in the new 1. New markets for the study were selected from those managing editor, market, and promoting networking among Room F 4K-206, listed in the Small and Medium Enterprises Markets sec- angel investors. The World Bank, tion of the World Federation of Exchanges Web site 1818 H Street, NW, Korea's venture promotion policy has pro- (http://www.world-exchanges.org/WFE/home.asp? Washington, DC 20433. duced notable results: In 2005 venture capital menu=382). investments topped 0.25 percent of GDP, Telephone: higher than the OECD average, and the number References 001 202 458 7281 of venture-backed companies surpassed 10,000. Binh, Ki-Beom, Sang-Yong Park, and Bo-Sung Shin. Fax: The firms accounted for 5 percent of the coun- 2006. "Financial Structure Does Matter for Industrial 001 202 522 3480 try's exports and 3 percent of its employment. Growth: Direct Evidence from OECD Countries." Paper Email: presented at the Asian Finance Association Meeting, ssmith7@worldbank.org Conclusion Auckland, July 10­12. A successful new market can form the core of a Carlin, Wendy, and Colin Mayer. 2000. "Finance, Produced by Grammarians, system enabling varied small companies to grow Investment, and Growth." CEPR Discussion Paper 2233. Inc. and varied investors to stake their capital. Such Centre for Economic Policy Research, London. a market can not only benefit selected SMEs by Grant Thornton International. 2006. Global New Printed on recycled paper allowing them access to public equity but also Markets Guide. http://www.gti.org/documents/GNMG% help nurture a larger population of new entre- 202006%2014th%20July.pdf. preneurs by creating a more vibrant environ- Yoo, JaeHoon. Forthcoming. Developing SME ment for equity financing. To overcome the Exchanges. Washington, D.C.: World Bank. challenges inherent in creating a new market in a developing country requires attention to three policy areas: T h i s N o t e i s a v a i l a b l e o n l i n e : h t t p : / / r r u . w o r l d b a n k . o r g / P u b l i c P o l i c y J o u r n a l