The Systemic Dilemma for Small-Cap Service Providers3 minute read

by Aug 19, 2019Capital Markets, Investor Relations, Public, Service Providers

A recent piece in The Wall Street Journal eluded to a fascinating insight: “Companies appear to avoid hiring auditors that have a history of critical audits at other companies…”  Every experienced investor knows that this phenomenon is not solely limited to auditing.

Put a mix of buy-side folks around a table and eventually the conversation will come around to the following: “how has no one ever told that CEO what a poor presenter they are?” Or “it’s amazing to me that a public company still has a website like that in 2019.” The reason is related to the phenomenon uncovered by the Journal’s research.

There are three common threads that contribute to underwhelming small-cap advice.

Incompetence. In order to have a candid conversation about small-cap service providers, there needs to be a realization that there are numerous firms that are run by people who are unsophisticated, disingenuous, or both.  It would be nice if that weren’t the case, but it is.  Accordingly, one of the reasons why many small-cap companies perform poorly is that they are getting poor advice – full stop.

Strategic omission. There are, of course, terrific small-cap service providers.  Many of them, however, have learned the lesson of the auditing firms referenced in the WSJ research.  That is, client retention is often inversely proportional to hard/critical conversations.

The “strategic omission” is, on the one hand, easily understood, but it unfortunately often has grave consequences.  For example, when the IR firm doesn’t want to tell the CEO – who thinks they are a master orator – that investors actually think the opposite, or when the investment banker doesn’t want to point out to the CEO that their compensation is out of step with better-performing peer companies, the results are always the same: investors, companies, and their employees all lose.

The Imperial CEO.  As it turns out, just like audit committees and CFOs might not like to have material control weaknesses pointed out to them by audit firms, many CEOs don’t want to employ service providers that point out personal or corporate weaknesses.  Every great service provider knows that telling small-cap CEOs the unvarnished truth… is risky business.

So, what are some constructive takeaways?

  • Before hiring service providers, companies need to do more thorough vetting, including asking some of their largest, longest tenured investors for their feedback. Investors have every desire to see their companies improve, and are a great source of referral.
  • Savvy, hiqh-quality service providers need to think longer term about what “strategic omissions” ultimately say about them, and their brands.
  • CEOs who don’t surround themselves with smarter people – and listen to them – are likely to make less money, and drive less value for shareholders. And the long-term implications are far more dour.

Experienced small-cap investors judge companies, in part, by the company they keep. Management should take note.