Ipo Case

Journal of International Business Studies (2010) 41, 206-222; doi:10.1057/jibs.2009.38

IPO underpricing and international corporate governance

Thomas J Boulton1, Scott B Smart2 and Chad J Zutter3

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

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

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

Correspondence: TJ Boulton, 3013 Farmer School of Business, Miami University, Oxford, OH 45056, USA. Tel: +1 513 529 1563; Fax: +1 513 529 8598; E-mail: boultotj@muohio.edu

Received 9 July 2007; Revised 13 February 2009; Accepted 8 March 2009; Published online 20 August 2009.

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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.

Keywords:

initial public offerings (IPOs), political economy, legal origin, event study, multiple regression analysis

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INTRODUCTION

The literature focused on the underpricing of initial public offerings (IPOs) establishes that in a typical IPO the stock price rises above the initial offer price after one trading day. Hence investors who purchase "underpriced" shares directly from issuing firms earn significant short-term returns. IPOs earn positive first-day returns on average in virtually every country, but underpricing varies dramatically across countries. In their summary of international IPO underpricing studies Loughran, Ritter, and Rydqvist (1994) report average country-level initial returns ranging from 4.2 to 80.3%. Why underpricing varies internationally is not well understood, in part because empirical work in this area is heavily skewed toward the US market. Because selling shares to investors at less than market value constitutes a substantial cost of going public (e.g., Ritter, 1987), cross-country underpricing variations translate into differences in the costs that entrepreneurs bear when issuing shares.

This paper examines whether differences in corporate governance across countries help to explain firm-level differences in the international IPO underpricing cross-section. References to corporate governance generally denote internal mechanisms (e.g., board effectiveness and performance-based executive compensation) or external mechanisms (e.g., the takeover market and shareholder activism) that are intended to align managers' and shareholders' interests. However, the effectiveness of corporate governance also depends on the quality of legal institutions, which herein we refer to as country-level governance.

Our motivation for exploring the relation between country-level governance and underpricing comes in part from the studies of La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1997, 1998, 2000a, 2000b, 2002) and La Porta, Lopez-de-Silanes, and Shleifer (1999, 2006), which establish that legal protections afforded to outside investors affect the size, value, and liquidity of a nation's capital markets. Investors pay higher prices for financial assets in countries in which legal systems limit the ability of managers and large shareholders to expropriate minority investors' wealth. Consistent with this idea, Bhattacharya and Daouk (2002) find that the cost of equity falls when a country prosecutes its first insider trading case, and Weitzel and Berns (2006) report that host-country corruption lowers takeover premiums in cross-border acquisitions. The evidence is overwhelming that protections afforded investors by a nation's governance environment have wide-ranging and generally positive consequences in financial markets.

Examining a sample of 4462 IPOs across 29 countries from 2000 to 2004, we find that IPOs in all countries are underpriced, with a mean first-day return near 28%. Underpricing varies dramatically across countries. The standard deviation of mean underpricing across countries is approximately 13.6%. Some variation results from differences in firm and deal characteristics, such as the offer size, current market conditions, the issuer's industry, and whether the firm is backed by a high-reputation underwriter. Most importantly, however, we find that underpricing is higher for firms going public in countries with corporate governance systems that strengthen the position of investors relative to insiders. These findings point to a possible control motivation for underpricing, namely that when going public in a country with strong corporate governance threatens insiders' control, IPO firms underprice more to generate excess demand for the offer. Excess demand leads to greater dispersion of post-IPO outside ownership and reduced incentives for outsiders to monitor management. In this view, underpricing is a cost that insiders pay if they want to maintain control of their firms in environments that promote outsiders' legal rights. Consistent with this hypothesis, we find that underpricing has a negative (positive) association with post-IPO outside blockholdings (private benefits of control). We also find that when a firm's ownership structure provides sufficient entrenchment for insiders, either

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