The Kay Review: Throwing Light on Market Distortion, Contributed by Donald Stewart, Faegre & Benson LLP

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As the outlook for the UK economy appears to be getting worse, it feels like things are getting quite fraught around at the Department for Business, Innovation and Skills (BIS). Following the 2010 election, the Rt Hon Dr Vince Cable MP, the new Secretary of State for Business, lost no time in establishing his agenda to "create the conditions for the private sector to grow and remove unnecessary barriers that can stifle growth."1 In November 2010, BIS, together with HM Treasury, published the Growth Review.2 While George Osborne, Chancellor of the Exchequer, clearly endorsed the initiative, the more dominant hand of Dr Cable is obvious in the Government's ambitious agenda "to return the UK economy to balanced, sustainable growth."3 Since then there has been a plethora of initiatives ranging far and wide from employment law to patent registration to health and safety and pensions. But, despite the volume and variety of ingredients, the pudding has not arrived yet to prove the recipe and, amid reportedly increasing Cabinet tensions, Dr Cable now is alleged to believe that some of his colleagues have "failed to grasp the gravity of the situation facing British companies."4

Kay Review

In its efforts to leave no stone unturned, the equity markets buy-side is the latest focus of BIS’ enquiries. In June 2011, Dr Cable invited economist and columnist, Professor John Kay, to conduct an independent review of "UK Equity Markets and Long-Term Decision Making." His own views on the subject being self-confessedly contradictory,5 Professor Kay has become increasingly sceptical about market efficiency. His view can probably be summed up in his statement that "in securities markets the efficient market hypothesis is largely true but attractive investment opportunities are found only when the efficient market hypothesis is not true."6

Call for Evidence

On 15 September 2011, Professor Kay announced a call for evidence7 to help his team in their work. Although Professor Kay set out 10 broad areas, the focus of the enquiry clearly is on the relationship between the investing community and how its requirements, priorities, and behaviours affect what goes on in Britain’s boardrooms. While the ground covered by the review certainly will overlap the stewardship side of the corporate governance equation, Professor Kay claims this work is not anticipated to lead to any new code or tick box list. It is intended to be about practical outcomes, actions, and effects. So, how do the "mechanisms of control and accountability provided by UK equity markets, and the behaviour of the agents in that process, affect the performance of the UK business?"8

Functions of Equity Markets

Equity markets clearly have two separate functions. The first is to provide a mechanism for businesses to access investors and raise capital. This is usually referred to as the primary market function. Second, equity markets provide a mechanism under which investors’ objectives, needs, and timescales can be decoupled effectively from the capital needs of those same businesses. This is the so-called secondary market function. However, the two functions are like conjoined twins—they really cannot be separated and, like chicken and egg, it is virtually impossible to say which is the more important. In an efficient market, the correlation between the economic performance of a business and its share price would be clear and directly proportionate. However, that is not what happens in reality.

Regulatory Distortions

There are distortions caused by law and regulation. For instance the 2005 implementation of the EU Prospectus Directive9 has had a fundamental impact on the primary market function. Certain types of fundraising activity which existed before 2005 have declined or disappeared completely. Chief among these are public equity offerings. Largely due to the expense of complying with the Prospectus Directive, many companies choose to access primary markets by seeking funding only from institutional investors rather than looking to spread their equity more widely across the market. This has created regulatory obstacles for retail investors to participate in primary market activity which, in turn, has had a clear consequence for secondary market activity. The investment parameters and ultimate goals of pension funds and insurance companies are quite different from those of individual private investors. For an issuer to get the most out of an equity market, it needs a diverse investor base so that there can be sufficient liquidity to avoid significant market inefficiency balanced by an appropriate degree of stability. Another example of market inefficiency caused by identifiable and unfortunate regulation is the impact of balanced portfolio requirements, introduced to prevent investment managers favouring some clients over others. The need to spread new investments across a range of portfolios has lead some investment managers to cease supporting primary market activity at the smaller end because the diffused investment parcels become too small to justify the administration costs. The impact of economic performance has been affected for some businesses by the move from historic cost accounting to mark-to-market accounting through the adoption of international financial reporting standards (IFRS). For instance, the results of trading businesses with significant freehold property interests can be affected fundamentally by movements in property prices which have little bearing on the health of the underlying trade.

Other Distortions

Yet, as boards struggle to maintain or improve their share price they are also faced with a slew of non-regulatory factors unrelated to the economic performance of their business. "Market sentiment" is a well-documented phenomenon which works on the way up as well as the way down. The herd mentality of the fund management community can be seen repeatedly across rising and falling markets. In bull markets the initial public offering of one type of business can often be seen to herald a raft of imitators. Likewise in bear markets, a single set of poor results can lead to a whole sector being marked down. Paradoxically, the increasing reliance on computerised algorithmic trading based on market movement and the decreasing level of human investment interface also must be contributing to market inefficiency as it increases the distance between share prices and underlying economic performance.


There is a huge amount to examine in this area. The dislocation between economic performance and share price performance is not getting any smaller. Moreover, it has important economic ramifications for all users of equity markets. The financial crisis has highlighted the role in which business in general, and smaller growing businesses in particular, are the key to sustainable economic growth, wealth creation, and jobs. At this time of reduced bank lending to the corporate sector it is more important than ever that companies can access healthy capital markets. As Luke Johnson, entrepreneur and columnist pointed out, "a vigorous pipeline of IPOs is a sure sign of a healthy and expanding economy, and successful flotations create a positive feedback loop that stimulates entrepreneurship, jobs and invention."10 On the flip side, with all time low interest rates, savers also are looking for somewhere to invest with markedly better returns. Hopefully Professor Kay’s work will produce some tangible results which can bring improvements to both primary and secondary market activity and help realise Dr Cable’s vision for growth in the UK economy. 

Donald Stewart is a partner in the corporate department of Faegre & Benson LLP in London. Donald's practice is focused mainly on corporate finance, takeovers, mergers and acquisitions, and UK publicly listed companies. Donald is a past chairman of the Quoted Companies Alliance, a UK non-for-profit organisation dedicated to promoting the cause of smaller quoted companies, is currently a member of the International Regulatory Strategy Group, an advisory body to the City of London Corporation and TheCityUK on the international regulatory regime, and is the UK’s representative on the legal committee of European Issuers, the pan European organisation promoting the common interests of listed companies in the EU. Telephone: +44 (0) 20 7450 4586; E-mail:

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