As it’s a bit of a long (but very interesting) read, we decided to share AIM Chaos’ blog to the world about London’s Alternative Investment Market (AIM). It is a very informative read which we encourage every smallcap investor to take a look at.
“In April 2016, at the ripe old age of 29, I resigned from my position as equity analyst at a City-based corporate finance house in order to establish my own family office. Besides residential property, some high-grade debt and several business start-ups, the bulk of the office’s funds have been invested by me directly in equities – specifically, in companies that are listed on AIM, which is the London Stock Exchange’s junior market for small and growing companies. After all, my career in the City was predominantly focussed on offering services to AIM-listed businesses, whilst in a private capacity I have been investing in AIM companies for over ten years.
I have penned this brief note as a simple introduction to AIM for the sake of newcomers to the market. I comment on the basic landscape of the AIM market: the institutions, players, mechanics and mentalities; my own investing strategies, including examples; and, in short, how and why AIM offers the prospects of potentially huge returns.
So, the AIM Market… Where to begin!
AIM is often considered by many investors – especially by those who walk in the circles of high finance – as a casino of sorts. Originally known as the Alternative Investment Market and latterly renamed as its acronym, AIM, the market was launched in 1995 as a sub-market of the London Stock Exchange (‘LSE’). AIM was designed to be the LSE’s growth market, hosting smaller, younger businesses than the Main Market. It has a more flexible regulatory system than the Main Market, which enables its constituents to much more easily raise capital required via the issuance of new equity than otherwise would be the case on the Main Market. There is also less red tape with regard to deal making, and financial reporting is more flexible.
One of the most fascinating elements of AIM is what is known as the ‘Nomad’ system. A nominated adviser, or ‘Nomad’ for short, is a corporate finance house that is licensed by the LSE to essentially police the AIM market.
Very basically, the LSE simply doesn’t have the manpower to police both the Main Market and AIM: the Nomad system was developed to combat this problem.
Every company that lists on AIM must appoint a Nomad: it is the Nomad’s duty to ensure that its client is acting properly – reporting operational updates to the market promptly, putting out financial statements correctly, and generally not doing anything illegal. The market is, in effect, self-regulated. For its gatekeeping duties, the Nomad charges the client an annual fee – usually between £15k and £75k, dependent on the size of the company (and the quality and reputation of the Nomad!).
Now this is where it gets interesting. As we have discussed, AIM is primarily suited for growth companies. Growth companies regularly require fresh capital to fuel their expansion. AIM-listed companies appoint broking houses to assist them in raising new finance. As with Nomads, brokers charge an annual fee as well as commission from any finance they raise for their clients (the commission is usually around 3% to 5%, but has been known to come in at as high as 10%).
Whilst there are a number of entities that offer only Nomad services or only broking services to AIM companies, there are also those (and these constitute the majority) that offer both the Nomad and the broking role. Indeed, it is now commonplace for an AIM company to use the same corporate finance house for both of these roles.
Of course, there are Chinese walls in place within these dual service offerors. By law, the corporate finance team must be insulated from the research and sales teams. Were a corporate transaction (an equity fundraise, for example) to be underway by the client in question, with the corporate finance team working diligently on it, it would be completely unethical (not to mention illegal) for the research and sales teams to be promoting the company during this period, thereby inflating the share price so that the client in question could minimise the equity dilution to its existing shareholders.
Unfortunately, given the relatively small sizes of the majority of these corporate finance houses, coupled with the fact that the LSE doesn’t have the manpower to directly oversee activities on and around AIM, and moreover the FCA has much larger fish to fry – the integrity of these Chinese Walls could perhaps justifiably be called into question.
It is suffice to say that, from an investor’s perspective, one must tread extremely carefully when investing on AIM, and especially on its lower reaches (£1m to £50m market capitalisation, the ‘nano-cap’ space). On the one side, the dual Nomad-broker has corporate clients, i.e. the AIM-listed companies; and on the other, it has investor clients, i.e. institutional investors, family offices, high net worth individuals, and anyone else who might be willing to invest when one of the Nomad’s corporate clients is seeking to raise fresh capital.
It’s a fine line that is trodden daily as the Nomad-broker seeks to keep both groups happy. For the investor, it is crucial to remember that when speaking to sales persons at Nomad-brokers or reading research published by Nomad-brokers, irrespective of Chinese Walls any promotions of and notes on their corporate clients should be taken with a sizeable pinch of salt.
Why? Because although the Nomad-broker is being paid to police the client, it is simultaneously being paid to promote the company (and ultimately its share price) to the investment community.
Investors should, as far as is in their capabilities, always do their own due diligence and research. Even the company-specific research out there in the public domain that is not written by a company’s Nomad – of which there really is very little – should be treated with caution. The reason for this is that the authors of those pieces too are invariably incentivised by the company.
In other words, it is commissioned research: unless either the PLC in question is uninvestable on every metric fundamentally and technically, or else the analyst at the research house in question is atrocious at his job, then the research paper will inevitably be positive, and recommending that the company’s share price is a buy. Whilst it is paraded as independent research, in truth, it is paid for promotion.
Besides the issue of the dual Nomad-broker role, this dearth of authentic independent research on AIM companies (particularly at the smaller end) is, I believe, a result of a lack of a decent sized pool of institutional money interested in the space.
There are almost a thousand companies on AIM. Whilst the mean market capitalisation of AIM’s constituents is around £70m or so, the median market capitalisation is in fact around £20m.
Now imagine a fund manager who runs a £500m micro-cap fund. Realistically, the manager’s smallest unit size might be £2.5m – or 0.5% of assets under management. The manager’s issue with regard to AIM is that for half of the companies listed on AIM, he’d be taking at least 12% stakes in them were he simply to invest his smallest unit size. Most fund mandates prevent the manager from taking a 10%+ stake in an individual investee company. Regularly, the manager might want to put in say 2.5% of his fund into one particular company that he likes. This amounts to £12.5m.
It is evident that the AIM market is simply too small for the vast majority of funds to viably operate in. The population of feasible investee companies is just too narrow. I could name perhaps only two dozen or so funds that specialise either exclusively or primarily on the AIM market, and the majority of those rarely, or sometimes never, invest in companies with market capitalisations of sub £20m.
So, how does this lack of institutional investment in the lower reaches of AIM tie in with the similar dearth in authentic independent research? Well, in short, trading volumes from private investors are not meaningful enough to warrant the writing and publishing of independent research. Bear in mind that whilst banks and other large sell-side institutions have historically generated significant revenues from secondary trading commissions and related services, a much greater portion of revenues for AIM Nomad-brokers is generated by commissions from equity placings that they carry out on behalf of their corporate clients.
The limited number of institutional investors that do invest in AIM companies can simply request the model from the sell-side analyst, and then modify the model with their own (invariably much more realistic!) assumptions.
All of the above results in inexperienced retail investors often being left in the dark, when it comes to understanding business models and projecting financial forecasts and cash requirements of AIM-listed nano and micro-caps.
Another significant element of the AIM market to always consider is the relative illiquidity of trading in the majority of companies listed on it. Many of these use the manual SETSqx or the SEAQ services, as opposed to the ecteronic SETS services used by larger companies listed on the Main Market.
The SETSsq and SEAQ services employ market makers to set share prices of companies. Market makers are supposed to move share prices according to supply and demand of stock in the marketplace. They profit from the spread they create between the ‘bid’ price (how much they will pay for an investor’s shares, i.e. the sell price for the investor) and the ‘ask’ price (how much they want to get paid by an investor for the shares they hold, i.e. the buy price for the investor). Given the manual nature of a market maker’s job, manipulation of share prices is possible and indeed a common occurrence. A novel could be penned on the antics of AIM’s market makers, notorious as they are amongst the retail investment community. For the sake of this brief note, I will provide one (perhaps the most common) example of market makers manipulating a company’s share price.
Say a market maker that provides a quote for a particular company has perceived that demand for said company’s stock has been increasing over the past week, and has increased the share price accordingly (so that existing holders will sell shares to him) to meet said demand. Through discussions with other market participants (fellow market makers, brokers, etc.) he understands that the recent increase in demand for shares is due to an anticipated news release from the company that the investment community overall believes will be positive. He therefore appreciates that it would be sensible to hold a greater number of shares going into this period than he would be accustomed to, so that were the news to indeed be positive, he would not be required to push the bid up so aggressively and create a spike in the process. Accordingly, during trading when a number of sells hit his order book, the market maker – having spotted that a large block of shares is available at a lower price through the hitting of a ‘stop loss’ (an instrument used by an investor to automatically sell shares once the share price hits a certain price, thereby limiting the investor’s loss) – duly drops the bid (on occasions significantly) more than would be considered necessary to balance the book. The stop loss order is executed, the investor is knocked out of his position, and the market maker now has a large supply of cheap shares that he can sell at a tidy profit to investors when the anticipated good news does arrive.
A lack of institutional investors (who tend not to involve themselves in short term trading, thereby providing a steady level of support to share prices of companies that they invest in) and quality independent research, coupled with the manual market making element of AIM, essentially results in extreme volatility in AIM company’s share prices. It is not uncommon for a company’s share price increase 100%+ in a day on AIM. On that note, I should also state that it is not uncommon for a company’s share price to increase 100%+ in a single hour on AIM… And then for the same share price to close the day in the negative”.
AIM Chaos is the research branch of a private investment vehicle named Sons of Ulster. Investment ideas shared are neither solicitations to buy nor offers to sell securities to 3rd parties.
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