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For bankers, small-cap gravy train about to be derailed

Forget correction. Canada's small-capitalization companies are enduring a full-on bear market.

The big-cap Standard & Poor's/TSX Composite index made news last week by dipping into official correction territory, dropping 10 per cent from its most recent high. But that decline is positively picayune compared to what's happening at the lower end of the equity market.

The S&P/TSX Venture index, a measure of companies listed on Canada's primary exchange for junior companies, is down a touch more than 22 per cent from its peak in early March. June has been particularly ugly, with only three positive days so far in the month. The dismal performance, including another loss on Monday, has taken the Venture index back to where it was in October.

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Volumes are also plunging, signalling a general lack of interest even in bargain hunting. In June, the average day on the Venture market has seen fewer than 200 million shares change hands. In the months prior to the sell-off, days of 400 million and 500 million shares were relatively regular occurrences.

Over on the TSX, smaller companies are also getting it bad. The S&P/TSX Small Cap index is down 15 per cent since its peak in March, with the number of stocks hitting new 52-week lows each day vastly outnumbering those reaching new highs. (On Monday, there were seven of the former and none of the latter.)

Some of the sell-off stems from concern about economic growth and slowing in China, which has whacked commodity prices. That has knocked down the valuations of many of the smaller mining and oil companies, which make up a lot of the small-cap universe in Canada. Some of the plunge is simply the risk-off trade: When things get dicey, smaller cap companies feel it the most.

Until now, investors have taken the brunt of the pain, but the bankers who specialize in small-cap deals are inevitably going to be next.

Across Canada, there are dozens of smaller investment dealers, known as boutiques, that focus on up-and-coming companies. The fees from financing those companies account for many of the Porsches and Ferraris in Toronto, Calgary and Vancouver that belong to bankers.

Unlike the big-cap companies that make the headlines, venture companies don't raise billions or even hundreds of millions of dollars at a time. It's a game of a few million here, a few more there. Yet the profits for the underwriters still add up nicely.

Deals for smaller-capitalization companies tend to be full of gravy for bankers, with relatively higher fees plus goodies like broker warrants that investment dealers take as payment. If the stock goes up, those warrants add big-time to the upside. Small companies don't have the leverage to push back too hard on fees.

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And how the fees have poured in. Equity financings have been very hot on the TSX Venture exchange, tracking so far in 2011 at levels about 90 per cent above 2010, according to market owner TMX Group Inc. Companies on the Venture Exchange have raised about $6-billion selling stock in the first five months of this year, after bringing in $3.2-billion in the same period last year.

Based on an average fee of 6 per cent, that's at least $360-million of investment banking fees that has flowed into the accounts of Canadian securities firms so far this year from financing Venture companies alone. A disproportionate amount of that flows to boutiques.

That's not going to continue as the market slides. Companies that have financed have cash in the bank. Those that haven't won't want to go ahead on an equity issue with their stocks well off recent highs, unless they are desperate,.

Even all those broker warrants, now underwater thanks to the market plunge, aren't going to help.

Short of a turnaround in small-cap markets, the back half of 2011 is setting up to be a tough one.

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