Capital Markets: Where to next for the capital markets?

Lloyd Kavanagh, Partner Minter Ellison Rudd Watts.

According to the Reserve Bank, New Zealand's equity and bond markets have grown in size and depth in recent years. Despite this, New Zealand's capital markets remain small and under-developed by international standards. The banking system continues to dominate funding for New Zealand firms, and with the exception of the largest of companies equity remains hard to raise.

For many businesses they still fall back on the founder's own resources and contributions from friends and family. The reason that matters to all New Zealand business owners is that having weaker capital markets has a pervasive effect on our economy influencing the cost of capital to NZ businesses of all types, making investment by them more expensive, and putting them at a disadvantage when competing with overseas firms to buy New Zealand assets.

It also tempts owners to sell out to international corporate buyers rather than to grow the business from New Zealand so that the profits (and top level jobs) are retained here.

Progress so far

There has been progress in recent years, following various government initiatives:

• The growth of KiwiSaver accounts has contributed to an uptick in domestic institutional holdings in limited companies, but the vast majority of that capital continues to be exported.

• The partial privatization of Government owned power companies, may have encouraged retail investors to consider other direct equity investments, and has reconnected some retail investors with the capital markets.

• The Financial Markets Conduct Act 2013 (FMCA) came in to force on 1 December 2014 creating a new regulatory framework which may encourage more businesses to access capital markets in various ways, including:

• The new offers requirements under the FMCA with shorter product disclosure statements (PDS) in place of prospectuses and investment statements should encourage new issuers to raise capital - though so far there have been only two niche offerings under PDS so it is early days.

• The new equity crowd-funding and peer-to-peer lending platforms recently licensed under the FMCA potentially provide lower cost ways for smaller business - though we have yet to see them widely used.

• The FMCA also makes it easier for small businesses to raise funds, for example, from employees and close business associates, as well as for other categories of eligible investors, with investing experience.

• The FMCA framework for 'alternative' public exchanges has been used by NZX to create its NXT market - which it intend to provide a trading platform for those smaller companies for whom a full listing is not yet appropriate. But despite those initiatives, banks are still overwhelmingly the main source of debt capital for New Zealand businesses, and a few large companies continue to dominate the NZX50 index with 2 companies accounting for a third by capitalization and the top 10 make up 54 per cent of that index.

The liquidity of stocks falls off steeply after that group. That suggests for many smaller companies, access to the public capital markets remains a challenge, and private capital is also scarce.

Though the past two years have seen initial public offers (IPOs) at the rate of more than 10 a year, twice the rate of the 2006/7 period, many have failed to achieve the Projected Financial Information (PFI), risking investors becoming disillusioned.

IPOs may be seen as more of a way for existing owners to cash out, than as a way of raising fresh capital to grow the business, and reach higher levels. And the original government proposal to strengthen available financial expertise and capability in New Zealand by promoting it as a funds administration hub has fallen by the wayside due to the pessimism of Treasury that New Zealand could be attractive to foreign financial sector businesses.

That matters because to the extent New Zealand loses that capability to regional financial centres such as Singapore or Sydney, which have relatively less interest in supporting the smaller offerings which typify New Zealand, businesses here find it harder to find the expertise they need for capital raising.

What should be on NZ's capital markets agenda?

• So much remains to be done to achieve a developed capital market of proportionate size to other developed countries.

• Participants in the capital markets, independent directors, investment bankers, lawyers and accountants need to ensure the new offers they bring forward, whether by fully fledged IPOs or crowd-funded, are priced and sold to deliver on their promise, especially PFI forecasts. That supports continuing investor confidence and appetite for future offers.

• The Financial Markets Authority needs to continue its positive engagement helping the willing compliers cope with the new FMCA regime and achieve its potential. They can do that by guiding new practices for both the issuers, and for investors such as licensed fund managers and discretionary investment management services. This is important as, otherwise, the complex FMCA may be interpreted overly conservatively, so the full benefit of the new act is not achieved because of a fear of getting it wrong. Guidance is a much more effective tool than the threat of enforcement, for the responsible players, because it has an impact now, not years in the future.

• The Government needs to consider how to support the private sector in promoting New Zealand internationally as an innovative, open financial centre, to retain and grow expertise here. It must also continue to expand the excellent work of the Retirement Commissioner in promoting financial literacy, and the need to save for one's future through appropriate investment - to build the investor base, and encourage diversification.

• At the same time, the Government should resist the temptation to tinker with the new legislation until it has time to bed down. The changes over the past seven years have been profound, and many financial services businesses have been stretched keeping up with the pace of change. Typically it takes 10 years for the impact of new rules to become embedded, yet officials like to review legislation five years after it is enacted.

• Lloyd Kavanagh is a Partner in Minter Ellison Rudd Watts, Lawyers, Banking and Financial Services Team. Disclosure: Lloyd has been closely involved in the law reforms that led to the FMC Act and acts for a wide range of banks, fund managers, and other financial service providers.