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IPO underpricing and international corporate governance

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Abstract

It is well established that a link exists between a country's legal system and the size, liquidity, and value of its capital markets. We study how differences in country-level governance affect the underpricing of initial public offerings (IPOs). Examining 4462 IPOs across 29 countries from 2000 to 2004, we find the surprising result that underpricing is higher in countries with corporate governance that strengthens the position of investors relative to insiders. We conjecture that when countries give outsiders more influence, IPO issuers underprice more to generate excess demand for the offer, which in turn leads to greater ownership dispersion and reduces outsiders’ incentives to monitor the behavior of corporate insiders. In other words, underpricing is a cost that insiders pay to maintain control in countries with legal systems designed to empower outsiders. Consistent with this control motivation for underpricing, we find that underpricing has a negative association with post-IPO outside blockholdings and a positive association with private control benefits. In addition, firms whose insiders are entrenched either by majority ownership or by dual-class structures do not underprice more in countries with better governance. In these firms the ownership structure protects managers from outside influence, eliminating the incentive to increase outside ownership dispersion through underpricing.

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Notes

  1. Of course, firms might also take actions to strengthen the rights of outsiders relative to insiders. Firms operating in countries with relatively weak investor protections could choose to list their shares in a market with stronger protections. Miller (1999) finds a large positive stock price reaction to US listings by foreign firms.

  2. Consider the following example: two identical firms that would both be worth $10 in the secondary market if both were from the same country, but suppose one firm is in a country with excellent governance and the other is in a country with very poor governance. Suppose that the valuation effect of this difference is that one firm will be worth $11 in the open market and the other firm will be worth $9. Next, suppose that all factors that affect underpricing for these two firms are identical, except the country-level governance. In the absence of this difference both firms would underprice by 10%, so one firm would have an offer price of $10 and the other would be offered at $8.18. According to the Brennan and Franks theory, the firm facing stricter investor protections will want to underprice even more. As long as the additional underpricing required to protect private control benefits is less than $1.82, the firm with the higher value will have both more underpricing and a higher offer price.

  3. The bank ownership requirement eliminates Hong Kong, Norway, and Pakistan from the sample of countries. All results are robust to excluding the bank ownership control variable and including these three countries in the analysis. Schenone (2005) finds lower underpricing when an IPO firm has a banking relationship with its ultimate underwriter prior to the IPO.

  4. Most IPOs originate and list in the same country, but some choose to list outside their country of origin, usually in the UK or the US. Numerous studies confirm that listing abroad is beneficial for the listing firm's shareholders (e.g., Doidge, 2004). The positive effect of listing abroad is informative about the benefits that accrue when a firm bonds itself to a foreign market's standards, but it is also suggestive about the relative importance of firm-level and country-level governance structures. If it were costless for firms to commit to good governance practices, and if these practices served as substitutes for country-level investor protections, then firms could capture the benefits of listing abroad simply by adopting their own strong governance provisions.

  5. Examples include Rock (1986) and Welch (1989).

  6. See Carter and Manaster (1990).

  7. Recent underpricing studies, including Loughran and Ritter (2004), report that the relation between underwriter reputation and underpricing flipped in the 1990s, with greater underpricing associated with deals underwritten by more reputable banks.

  8. Although our main regressions control for several firm- and country-level factors that are known to influence underpricing, they do not control for the structure of executive compensation. The exclusion of such a control may bias our results, particularly if one believes that managers have an incentive to manipulate underpricing as a function of the degree to which their compensation is tied to their firm's equity. For example, managers may desire to set the offer price lower when at the time of the IPO they are awarded stock options with strike prices set equal to the IPO offer price. To alleviate this concern we rerun our main regressions and include a measure of the structure of executive compensation. The measure is the average of the ratio of total equity-based compensation (stock option compensation plus stock compensation) to total compensation for firms within a given country – this measure is taken from Bryan, Nash, and Patel (2006). Relative to our Table 4 results, including the control for the structure of CEO compensation affects two of our governance measures. “Anti-self dealing public enforcement” becomes negative and significant, and “Rule of law” becomes positive and significant. Interestingly, the coefficient on the compensation variable is negative and significant – suggesting that managers underprice less, the more their compensation is tied to their firm's equity.

  9. La Porta et al. (1998) provide evidence that French civil law countries offer the weakest investor protection, followed by German and Scandinavian civil law countries, with English common law countries providing the strongest protection. La Porta et al. also show that the enforcement of laws is strongest in Scandinavian and German civil law countries, with French civil law countries exhibiting the weakest law enforcement. Therefore the governance quality hypothesis predicts the highest degree of underpricing in English common law nations and the lowest underpricing in French civil law nations. Unreported regressions use legal origin as a proxy for country-level governance. The results demonstrate that IPOs from English common law and German civil law countries, which offer stronger investor protections and law enforcement than French civil law countries, generally experience larger first-day returns than IPOs in French civil law countries. Scandinavian civil law countries are associated with smaller initial returns when compared with new issues in French civil law countries. These results are at least partially consistent with the governance quality hypothesis.

  10. To alleviate concerns that our results may be driven by the large capital markets in the UK and US, we exclude those countries and rerun our regressions. The coefficients on the investor protection measures are similar in sign, significance, and magnitude to those reported in Table 4. Excluding the US and UK markets does not alter our finding that underpricing tends to be higher in markets with stronger investor protections. In contrast to the large IPO markets of the US and UK, some countries in our sample have very few IPOs. In unreported regressions we drop countries with fewer than 10 or fewer than 50 IPOs from our sample. The signs and significances of the coefficients for our governance variables are not different from those reported in Table 4. Rather than calculating the initial return as the percentage difference between the first-day closing price and the IPO offer price, we examine a model that uses the closing price 22 trading days (roughly one calendar month) after the IPO date. This model is designed to address the possibility that price stabilization activities may distort IPO returns in the short run and bias our earlier results. The effects of price stabilization should fade over time as underwriters withdraw their support from the market, so measuring the initial return over the first 22 trading days should limit any bias introduced by stabilization activities. We find that the country-level governance quality measures display correlations with underpricing consistent with those reported in Table 4.

  11. Employee and family holdings is the total amount of holdings over 5% by employees and holders with a substantial position in the company, that in the event of a vote the voting power would be significant.

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Acknowledgements

For valuable comments, the authors express their appreciation to the editor, Lemma Senbet, two anonymous referees, Oya Altinkiliç, Utpal Bhattacharya, Robin Grieves, Robert Jennings, Kenneth Lehn, Gershon Mandelker, Jay Ritter, Shawn Thomas, Greg Udell, Xiaoyun Yu, and seminar participants at Central Michigan University, Duquesne University, Eastern Finance Association Meetings (St. Petersburg), Financial Management Association Meetings (Orlando), Marquette University, Louisiana Tech University, Miami University, Oklahoma State University, Seton Hall University, University of Nebraska, University of Otago, University of Pittsburgh, West Virginia University, and Wright State University. Any remaining errors or omissions remain the responsibility of the authors.

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Authors and Affiliations

  1. Farmer School of Business, Miami University, Oxford, USA

    Thomas J Boulton

  2. Kelley School of Business, Indiana University, Bloomington, USA

    Scott B Smart

  3. Katz Graduate School of Business, University of Pittsburgh, Pittsburgh, USA

    Chad J Zutter

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  1. Thomas J Boulton
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Correspondence to Thomas J Boulton.

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Accepted by Lemma Senbet, Area Editor, 8 March 2009. This paper has been with the authors for three revisions.

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Boulton, T., Smart, S. & Zutter, C. IPO underpricing and international corporate governance. J Int Bus Stud 41, 206–222 (2010). https://doi.org/10.1057/jibs.2009.38

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