Oxford Handbook of IPOs (Oxford Handbooks) 0190614579, 9780190614577

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THE

OXFORD HANDBOOK OF

IPOs

THE OXFORD HANDBOOK OF

IPOs Edited by DOUGLAS CUMMING and

SOFIA A. JOHAN

OXPORD UNIVERSITY PRESS

OXTORD UNIVBRSITY PRS»

Oxford University Press is a department of the University of Oxford. It furthers the University's objective of excellence in research, scholarship, and education by publishing worldwide. Oxtord is a registered trade mark of Oxford University Press in the UK and certain other countries.

Published in the United States of America by Oxford University Press 198 Madison Avenue, New York. NY 10016, United States of America.

O Oxford University Press 2018

AU rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press, or as express!)' permitted by law. by license, or under terms agreed with the appropriate reproduction rights organization. Inquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press, at the address above.

You must not circulate this work in any other form and you must impose this same condition on any acquirer.

Library of Congress Cataloging-in-Publication Data Names: dimming. Douglas, editor. | fohan. Sofia A., editor. Title: The Oxford handbook of IPOs / edited by Douglas). dimming and Sofia A.fohan.

Description: New York, NY: Oxford University Press, [2018] | Includes bibliographical references. Identifiers: LCCN 2018006470 | ISBN 978-0-19-061457-7 (hardcover: alk. paper) | ISBN 978-0-19-061458-4 (udpf) I ISBN 978-0-19-061459-1 (cpub) Subjects: LCSH: Going public (Securities)—Handbooks, manuals, etc. | Investments—Handbooks, manuals, etc. | LCGHT: Handbooks and manuals. Classification: LCC HG4028.S7 O94 2018 | DDC 658.15/224—dci.t I,C record available at https://lccn.loc.gov/2018006470 135798642

Printed by Sheridan Books, Inc., United States of America

Contents

List of Contributors

ix

1. Introduction

1

Douglas Cumming and Sofia A. Johan PARTI.

THE ECONOMICS AND

REGULATION OF IPO MARKETS

2. The Law and Economics of the Going-Public Decision

27

Jay Kesten

3. IPO Regulators Gone Wild

52

Kevin K. Boeh and Craig G. Dunbar

4. Determinants of Variation in IPO Underpricing

81

Thomas J. Boulton, Scott B. Smart, and Chad J. Zutter

5. IPO Valuation: The International Evidence Sanjai Bhagat, Jun Lu, and Srinivasan Rangan

6. Survey and Synthesis of the IPO Underpricing Literature: The Fixed-Offer Price Constraint as a Unifying Core Explanation

108

146

Steven L. Jones and John C. Yeoman

7. IPO Market Conditions and Timing over the Long Run

175

Wei Wang and Chris Yung

PART II.

MERGERS VERSUS IPOs

8. The Interplay of IPO and M&A Markets: The Many Ways That One Affects the Other

Nihat Aktas, Christian Andres, and Ali Ozdakak

201

VI

CONTENTS

9. Lower Visibility Platforms Serving as Stepping Stones to National Stock Exchanges: The Case of Shell Reverse Mergers

233

Joseph J. Cecala, Jr., and Ioannis V. Floros

10. Going Public in China: Reverse Mergers versus IPOs on Chinese Markets Zijian Cheng, Grant Fleming, and Zhangxin (Frank) Liu

11. Specified Purpose Acquisition Company IPOs

283

301

Yochanan Shachmurove and Milos Vulanovic

PART III.

INSTITUTIONAL TIES TO

IPOs: ANALYSTS, INVESTMENT BANKS, AUDITORS, AND VENTURE CAPITALISTS

12. The Impact of IPOs' Analyst Coverage on the Choice and Timing of SEOs: A Survival Analysis

331

Nesrine Bouzouita and Carole Gresse

13. Auditor Selection and IPO Underpricing

359

Miriam Koning, Gerard Mertens and Peter Roosenboom

14. The Structure and Role of the Underwriting Syndicate

390

Sebastien Dereeper and Armin Schwienbacher

15. Venture Capital and Financial Reporting in Newly Public Firms

412

Lars Helge Hass and Monika Tarsalewska

16. The Dark Side of Venture Capital Syndication and IPO Firm Performance: The Impact of Different Institutional Environments

430

Salim Chahine, Igor Filatotchev, Robert E. Hoskisson,

and Jonathan D. Arthurs

17. All Ties Are Not Created Equal: Institutional Equity Ties, IPO Performance, and Market Growth of New Ventures Yong Li and Beiqing (Emery) Yao

460

CONTENTS

PART IV.

VII

INTERNATIONAL

PERSPECTIVES ON IPOs

18. Is Exchange Regulation Effective for Junior Public Equity Markets?

487

J. Ari Pandes and Michael J. Robinson

19. Corporate Governance in European IPOs

506

Fabio Bertoni, Michele Meoli, and Silvio Vismara

20. Survival of Initial Public Offerings on Europe's New Stock Markets

534

Tao Jiao, Peter Roosenboom, and Giancarlo Giudici

21. Initial Public Offerings in Germany between 1997 and 2015

559

Andreas Oehler, Tim A. Herberger, and Matthias Horn

22. The Underpricing of Initial Public Offerings and Private Placements of Equity in China

573

Gang Nathan Dong and Ming Gu

23. IPOs in New Zealand: An Analysis of Benchmark-Adjusted Performance

592

Huong Dang and Michael Jolly

24. Initial Public Offerings in Hong Kong

62I

Queenie Lai

25. The Admission and Regulation of Overseas Issuers: A Survey of the Top Four Financial Centers

652

Horace Yeung

26. IPOs in a Major Emerging Market Economy—India Rajesh Chakrabarti

676

viii

contents

PART V.

ALTERNATIVES TO IPOs: PRIVATE

MARKETPLACES AND CROWDFUNDING

27. Private Capital Marketplaces and IPOs

697

Saman Adhami, Gianfranco Gianfrate, and Giuseppe Soda

28. Crowdfunding: Business and Regulatory Perspective

720

Alexandra Andhov (Horvathova)

29. Regulatory Arbitrage in Cross-Border Crowdfunding

746

Arjya B. Majumdar Index

773

Contributors

Saman Adhami is Teaching Assistant at Bocconi University. Nihat Aktas is Chair of Mergers and Acquisitions at WHU—Otto Beisheim School of Management.

Christian Andres is Chair of Empirical Corporate Finance at WHU—Otto Beisheim School of Management.

Jonathan D. Arthurs is Associate Dean for Faculty and Research in the College of Business at Oregon State University.

Fabio Bertoni is Associate Dean for Research and Professor of Corporate Finance at EMLYON Business School.

Sanjai Bhagat is Provost Professor of Finance at the University ofColorado at Boulder. Kevin K. Boeh is Visiting Associate Professor at the Warrington College of Business, University of Florida. Thomas J. Boulton is Lindmor Professor and Associate Professor of Finance at the

Farmer School of Business, Miami University. Nesrine Bouzouita is Associate Professor at the Paris School of Business.

Joseph J. Cecala, Jr., is the Founder and CEO of the Dream Exchange, LLC. Salim Chahine is Professor of Finance and Abdul Aziz Al Sagar Endowed Chair in Finance at the American University of Beirut.

Rajesh Chakrabarti is Executive Director of the Bharti Institute of Public Policy and Clinical Associate Professor at the Jindal Global Business School, Jindal Global University.

Zijian Cheng is a Lecturer in Accounting at the Business School of Shandong University, Weihai. Douglas Cumming is the DeSantis Distinguished Professor of Finance and Entrepreneurship at the Florida Atlantic University College ofBusiness. Huong Dang is Senior Lecturer at University ofCanterbury Business School. Sebastien Dereeper is Affiliated Professor ofFinance at Skema Business School.

X

CONTRIBUTORS

G. Nathan Dong is Assistant Professor in the Department of Health Policy and Management at Columbia University. Craig G. Dunbar is Paul Desmarais/London Life Faculty Fellow in Finance at Ivey Business School, Western University.

Igor Filatotchev is Professor of Corporate Governance and Strategy at Cass Business School, City University of London. Grant Fleming is Partner at Continuity Capital Partners, Canberra, Australia. Ioannis V. Floros is Assistant Professor of Finance at the University of WisconsinMilwaukee, Lubar school of Business.

Gianfranco Gianfrate is Giorgio Ruffolo Fellow at Harvard Kennedy School, John F. Kennedy School of Government. Giancarlo Giudici is Associate Professor of Corporate Finance at the Polytechnic University of Milan. Carole Gresse is Professor of Finance at University Paris-Dauphine.

Ming Gu is Assistant Professor of Finance at Renmin University of China. Lars Helge Hass is Associate Professor in Finance and Accounting at Lancaster University Management School. Tim A. Herberger is a Research and Teaching Assistant in the Department of Finance at the University ofBamberg. Matthias Horn is a Research and Teaching Assistant in the Department of Finance at the University of Bamberg. Alexandra Andhov (Horvdthovd) is Assistant Professor of Corporate Law at CEVIA— Centre for Enterprise Liability, University of Copenhagen.

Robert E. Hoskisson is George R. Brown Emeritus Professor of Management at Rice University

Tao Jiao is Lecturer in Accounting at the Paul Merage School of Business, University of California, Irvine.

Sofia A. Johan is an Assistant Professor of Finance at the Florida Atlantic University College ofBusiness. Michael Jolly is Analyst in Investment Banking at Forsyth Barr.

Steven L. Jones is Professor of Finance at University-Indianapolis Campus.

Kelley School of Business, Indiana

Jay Kesten is Associate Professor at Florida State University, College of Law.

CONTRIBUTORS

XI

Miriam Koning is Assistant Professor at Rotterdam School of Management, Erasmus University.

Queenie Lai is Deputy Programme Director of the Postgraduate Certificate in Laws Programme at the Chinese University of Hong Kong.

Yong Li is Lee Professor of Entrepreneurship and Research Director of the Troesh Center for Entrepreneurship and Innovation at the University ofNevada, Las Vegas. Zhangxin (Frank) Liu is Assistant Professor of Accounting and Finance at University of Western Australia Business School.

Jun Lu is Assistant Professor in Finance at Chinese Academy of Finance and Development, Central University of Finance & Economics.

Arjya B. Majumdar is Associate Professor and Director, Office of Academic Planning, Co-ordination and Interdisciplinarity at Jindal Global Law School. Michele Meoli is Assistant Professor in the Department of Economics and Technology Management at University of Bergamo. Gerard Mertens is Dean at Faculty of Management, Science & Technology, Open Universiteit of the Netherlands.

Andreas Oehler is Full Professor and Chair of Finance at the University of Bamberg. Ali Ozdakak is Associate at EY Innovalue Management Advisors.

J. Ari Pandes is Associate Professor of Finance at the Haskayne School of Business, University of Calgary.

Srinivasan Rangan is Associate Professor of Finance and Accounting at Indian Institute of Management, Bangalore. Michael J. Robinson is Associate Professor of Finance at the Haskayne School of Business, University ofCalgary. Peter Roosenboom is Professor of Entrepreneurial Finance and Private Equity at the Rotterdam School ofManagement, Erasmus University. Armin Schwienbacher is Professor of Finance at Skema Business School.

Yochanan Shachmurove is Professor of Economics and Business at the City College and the Graduate Center of the City University ofNew York. Scott B. Smart is Clinical Associate Professor of Finance and Whirlpool Finance Faculty Fellow at Kelley School of Business, Indiana University. Giuseppe Soda is Full Professor of Organization Theory and Design and Network Analysis at the Department of Management and Technology, Bocconi University.

Xll

CONTRIBUTORS

Monika Tarsalewska is Senior Lecturer in Finance at University ofExeter. Silvio Vismara is Associate Professor in the Department ofEconomics and Technology Management at the University of Bergamo. Milos Vulanovic is Professor of Corporate Finance at EDHEC Business School, Lille, France.

Wei Wang is Assistant Professor of Finance at Monte Ahuja College of Business, Cleveland State University.

Beiqing (Emery) Yao is Professor at the Gatton College of Business & Economics, University of Kentucky. John C. Yeoman is Professor of Finance at the University ofNorth Georgia. Horace Yeung is Lecturer in Commercial Law at the University of Leicester.

Chris Yung is Associate Professor of Commerce at the University of Virginia. Chad J. Zutter is Associate Professor of Business Administration and Dean's Excellence

Faculty Fellow at the University of Pittsburgh.

THE

OXFORD HANDBOOK OF

IPOs

Introduction

Oxford Handbooks Online Introduction   Douglas Cumming and Sofia Johan The Oxford Handbook of IPOs Edited by Douglas Cumming Print Publication Date: Jan 2019 Subject: Economics and Finance, Business Economics, Financial Economics Online Publication Date: Dec 2018 DOI: 10.1093/oxfordhb/9780190614577.013.37

Abstract and Keywords The worldwide landscape for raising firm capital from Initial Public Offerings (IPOs) has significantly evolved over the last few decades. This introductory chapter reviews more recent research on initial public offerings. The Oxford Handbook of IPOs comprises twenty-nine chapters from authors around the world. The chapters describe the economics of going public, short- and long-term performance of IPOs, regulation of IPOs, IPOs versus acquisitions, reverse mergers, special purpose acquisition companies, service providers including investment banks and auditors, venture capital funds, international differences in IPOs, and crowdfunding. The Introduction summarizes the chapters that appear in the Handbook and highlight research trends on topic. Keywords: initial public offerings, IPOs, short-run performance, long-run performance, regulation, reverse mergers, service providers, crowdfunding

FIRMS begin as privately owned entities. When they grow large enough, the decision to go public and its consequences are among the most crucial times in a firm’s life cycle. The first time a firm becomes a public reporting issuer gives rise to tremendous responsibilities about disclosing public information and accountability to a wide array of retail shareholders and institutional investors. Initial public offerings (IPOs) offer tremendous opportunities to raise capital. Over 1980–2014, firms in the United States raised $805.77 billion in capital from IPOs, and in 2001–2014 firms raised $396.15 billion. Some IPOs in recent years have been quite successful, such as Alibaba,1 while others, such as Facebook, have been associated with less success and even lawsuits.2 The worldwide landscape for IPOs has significantly evolved over the last few decades. In 2015, Hong Kong was the largest IPO market in the world (see Chapter 24 of this Handbook). Doidge et al. (2017) show that the number of listed firms in the United States fell from 8,025 in 1996 to 4,101 in 2012, while non-US listings increased from 30,734 to Page 1 of 122

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Introduction 29,427 over the same period. And unusual differences exist even among neighbor countries. For example, in 2012, despite having roughly 10% of the population of the United States,3 Canada had 3,673 listed companies,4 or 90% the number of listed companies in the United States. Clearly, there has been a global shift in where companies list, and part of that explanation comes from regulation of the IPO market, as documented in this Handbook. The economic and legal landscape for IPOs has been rapidly evolving across countries. There have been scant IPOs in the United States in the aftermath of the 2007–2009 financial crisis and associated regulatory reforms that began in 2002. In 1980–2000, an average of 310 firms went public every year, while in 2001–2014 an average of 110 firms went public every year (Gao, Ritter, and Zhu, 2013; Ritter, 2015). At the same, there are so many firms that seek an IPO in China that there has been a massive waiting list of hundreds of firms in recent years.5 (p. 2) Some countries are promoting small junior stock exchanges to go public early, and even crowdfunding to avoid any prospectus disclosure. Financial regulation over analysts and investment banks has been evolving in ways that drastically impact the economics of going public, with some countries, such as the United States, drastically increasing the minimum size of a company before it is expected to go public. This Handbook systematically and comprehensively consolidates a large body of literature on IPOs, and provides a foundation for future debates and inquiry. This Handbook studies the international landscape of IPOs in the aftermath of the financial crisis. Moreover, it provides studies of special types of IPOs, such as special purpose acquisition companies (SPACs) and reverse mergers. It further shows alternatives to IPOs, including mergers and acquisitions, private marketplaces, and crowdfunding. There is a body of quality work on IPOs, but the literature is fragmented, including work in economics, finance, management, international business, and law. This Handbook combines work from different scholars in these areas from around the world. IPOs and related topics of securities regulation, including investment banks, auditors, reverse mergers, venture capital, and crowdfunding, have been of significant interest in the recent literature. Evidence on the importance and growth of these topics is seen in Figure 1.1. The data indicate that crowdfunding is one of the fastest growing topics of academic interest. There is strong evidence of continued research on these topics in coming years.

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Introduction

Figure 1.1. Google Scholar hits on various search terms for IPOs and related issues. “Base” refers to the number of hits on the base year 2014. The base for IPO is 21,900; for “reverse merger” is 177; for “crowdfunding” is 4,980; for “venture capital” is 22,400; for “auditor” is 28,500; for “investment bank” is 7,100; for “securities regulation” is 1,950; for “securities regulation” IPO is 358.

1.1. Chapters in The Oxford Handbook of IPOs (p. 3)

The chapters in the Oxford Handbook of IPOs are summarized in Table 1.1. The chapters are organized into five main parts. Part I deals with the economics of IPOs, and offers statistics and regulatory insights from the United States and other countries around the world. Part II covers mergers versus IPOs, as well as reverse mergers and special purpose acquisition companies. Part III analyzes institutional ties in IPOs, including analysts, investment banks, auditors, and venture capitalists. Part IV provides international perspectives on IPOs from Canada, Europe, Hong Kong, China, India, and New Zealand. Part V discusses alternatives to IPOs, including private marketplaces, and crowdfunding. More specifically, Part I of this Handbook begins in Chapter 2 with Kesten’s analysis of why companies seek to raise capital in an IPO. Chapter 3 by Boeh and Dunbar examines the regulatory burdens associated with listing in the United States, and the economic consequences for the number of listings over time.6 Chapter 4 by Boulton, Smart, and Zutter (2017) examines the international IPO market in 38 countries and factors correlated with the extent to which IPOs are underpriced in different countries. Chapter 5 by Bhagat, Lu, and Rangan provides an analysis of the factors that affect IPO valuation in Australia, Canada, China, Germany, India, Japan, the United Kingdom, and United States. In Chapter 6, Jones and Yeoman provide an explanation as to why IPOs are underpriced in both hot and cold markets. Part I concludes with Wang and Yung’s Chapter 7 on IPO longrun returns, volume, and delisting.

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Introduction Part II of this Handbook begins with an analysis of mergers versus acquisitions in Chapter 8 by Aktas, Andres, and Ozdakak. Thereafter, reverse mergers are studied in the United States by Cecala and Floros in Chapter 9, and in China by Cheng, Fleming, and Liu in Chapter 10. Shachmurove and Vulanovic study special purpose acquisition companies in Chapter 11. These alternative listing forms provide interesting insights into complements and substitutes to the IPO market, and are growing in importance over time. Part III of this Handbook examines the role of different institutional ties in IPOs, including the role of analysts in Chapter 12 by Bouzouita and Gresse, auditors in Chapter 13 by Koning, Mertens and Roosenboom,7 underwriters in Chapter 14 by Dereeper and Schwienbacher,8 and venture capitalists by Hass and Tarsalewska (Chapter 15) and Chahine, Filatotchev, Hoskisson, and Arthurs (Chapter 16). The final chapter in Part III, by Li, Yao (Chapter 17), measures the differential benefits of alternative types of institutional ties in IPOs. Part IV of this Handbook provides international perspectives on IPOs. Chapter 18 by Pandes and Robinson studies the Canadian IPO marketplace and special programs of capital pools.9 Chapter 19 by Bertoni, Meoli, and Vismara examines the importance of corporate governance in European IPOs. Jiao, Roosenboom, and Giudici study the survival of European IPOs in connection with low listing standards on these markets in Chapter 20. IPOs are empirically examined in Chapters 21, 22, and 23 by Oehler, Herberger, and Horn (Germany); Dong and Gu (China); and Dang and Jolly (New Zealand), respectively. Regulatory and institutional perspectives on IPOs are discussed (p. 4) (p. 5) (p. 6) (p. 7) (p. 8)

(p. 9)

(p. 10)

(p. 11)

(p. 12)

(p. 13)

(p. 14)

(p. 15)

(p. 16)

(p. 17)

(p. 18)

(p. 19)

in Chapter 24 by Lai for Hong Kong; in Chapter 25 by Yeung for New York, London, Hong Kong, and Singapore; and in Chapter 26 by Chakrabarti for India. (p. 20)

(p. 21)

(p. 22)

(p. 23)

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Introduction Table 1.1 Overview of Studies in The Oxford Handbook of IPOs

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Introduction Chapter #

Author(s)

Data Source(s)

Country Samples

Time Period

Dependen t

Main Explanato

Main Findings

Variables

ry Variables

Not

Not

This

applicable

applicable

chapter evaluates

Part I. The Economics and Regulation of IPO Markets 2.

Kesten

Jay Ritter’s

United

website: https://

States

1980–2016

site.warrin gton.ufl.ed

several competing

u/ritter/ipodata/

and complemen tary hypotheses that attempt to explain why firms go public. The author analyzes the macroecon omic determinan ts of IPO

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Introduction market cyclicality alongside the strategic and corporate governance considerati ons faced by private firms arising from the costs and benefits of going public.

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Introduction 3.

Boeh and Dunbar

Thomson Financial

United States

1998–2014

Not applicable

Not applicable

This chapter

Securities Data New

explains key US

Issues Database;

securities regulations

Securities and

over the last two

Exchange Commissio

decades that have

n

affected the IPO process. While motivated by good intentions, many of these regulations have led to burdens on issuing firms and have had deleterious effects on the US

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Introduction capital markets. The authors posit that these effects are driven by the burdens placed on firms, the incentives of firms to pursue alternative s to an IPO, the disincentiv es for banks to conduct IPOs, and the attractiven ess of more profitable (and less Page 9 of 122

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Introduction regulated) alternative activities available to banks. This opens a set of questions to IPO researcher s concerning the effects of such regulations .

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Introduction 4.

Boulton, Smart, and Zutter

Thomson Financial

15,076 IPOs in 38

January 1, 1998 to

SDC Platinum

countries

December 31, 2014

New Issues Database

Underprici ng

Offer size, Recent

This chapter

market, Recent

focuses on internation

return, IPO activity,

al differences

Stock market

in IPO underprici

turnover, Top tier

ng, with emphasis

underwrite r, VC

on research

backed, Integer

that explores

offer price, Book built,

the effects of cross-

Firm commitme nt, Equity carve-out, High-tech firm

country differences in disclosure or governance . The authors first summarize global IPO patterns

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Introduction since 1998 and explore the robustness across national borders of firm-level and deallevel factors that US-based research identifies as having a significant impact on IPO underprici ng. Second, they summarize the results of several studies that examine Page 12 of 122

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Introduction how differences in disclosure requireme nts and practices contribute to internation al underprici ng differences . They examine research that highlights how corporate governance practices and legal institutions around the world affect IPO Page 13 of 122

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Introduction underprici ng. Finally, the authors offer some thoughts on future directions for scholars who wish to conduct research in this area. Chapter #

Author(s)

Data

Country

Time

Dependent

Main

Main

Source(s)

Samples

Period

Variables

Explanator y Variables

Findings

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Introduction 5.

Bhagat, Lu, and Rangan

Thomson Reuters

6,199 IPOs in

SDC Platinum

Country characteris

This chapter

Australia, Canada,

tics, Market

explains internation

New Issues Database

China, Germany,

conditions, Firm-

al differences

(SDC)

India, Japan,

specific characteris

in IPO valuation.

United Kingdom,

tics

Net income is

and United States

1998–2015

Valuation

positively related to IPO valuation in each of the eight countries. The economic impact of net income is largest for Chinese IPOs and smallest for Australian IPOs. Book

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Introduction value is positively and significantl y related to IPO valuation in only Canada, Germany, India, and the United States. Capital expenditur e is significantl y and positively related to IPO valuation in only Canada, Germany, India, the United Kingdom, Page 16 of 122

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Introduction and the United States. There is a positive and statistically significant relation between insider retention and IPO valuation only in China, Germany, the United Kingdom, and the United States; positive but marginally significant relationshi p for India Page 17 of 122

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Introduction and Japan. Underwrite r reputation has a positive and statistically significant relationshi p for IPOs only in China, Germany, India, the United Kingdom, and the United States. Net income is positively and statistically significantl y related to IPO valuation Page 18 of 122

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Introduction during the years 1998–2015, and this relationshi p has strengthen ed over time. Capital expenditur e is positively and significantl y related to IPO value during 1998–2015, and this relation appears to be stable over time.

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Introduction 6.

Jones and Yeoman

Not applicable

Not applicable

Not applicable

Not applicable

Not applicable

This chapter examines the phenomeno n of IPO underprici ng over both hot and cold markets. The first part of this chapter surveys much of the associated literature, including the major theories, along with selected empirical work. The second part to the

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Introduction chapter summarize s the fixedoffer price constraint theory of Ibbotson (1975). The third and final part of this chapter explains how the fixed-offer price constraint can be viewed as a unifying core explanation , bringing together important component s of other work, while Page 21 of 122

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Introduction also showing how underprici ng can serve in the mutual interest of investors, underwrite rs, and issuers, even in best-efforts IPOs.

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Introduction 7.

Wang and Yung

Thomson SDC

United States

1965–2015

IPO volume,

Market conditions

This chapter

Long-run returns,

(Returns, Volatility),

examines the

Delisting

Firmspecific

determinan ts of IPO

variables

volume in four broad categories: (1) demand side, i.e., contempor aneous investment opportuniti es; (2) supply side, reflecting timevarying entreprene urial diversificat ion incentives; (3) timevarying

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Introduction overall mispricing; and (4) strategic pooling of low quality issuers with highquality issuers. The evidence is inconsisten t with the second and third channels. Timevarying risk does not appear to drive the entreprene urial decision to go public. While IPOs offer low Page 24 of 122

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Introduction average returns, there is little evidence that they are mispriced relative to similar public firms, either in the full sample or in hot markets. Instead, IPOs tend to cluster when actors in the economy more broadly are behaving as if Page 25 of 122

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Introduction investment opportuniti es are robust. Part II. Mergers versus IPOs

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Introduction 8.

Aktas, Andres, and Ozdakak

Not applicable

Not applicable

Not applicable

Not applicable

Not applicable

This chapter analyzes the interaction s of initial public offerings (IPOs) and mergers and acquisition s (M&As), in contrast with the common approach of studying them in isolation. Of the many motivations to conduct an IPO (e.g., fundraising , access to

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Introduction capital, increased liquidity, publicity), several of them clearly relate to takeover activities. A few theoretical and empirical studies consider, for example, trade-offs between IPOs and M&As as exit options, dual-track strategies, or the role of IPO Page 28 of 122

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Introduction firms in M&As. However, a complete, integrated perspective on their mutual relations does not exist. To close this gap, this chapter paints a complete picture of the many ways that one market affects the other, according to three key forms of interaction.

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Introduction 9.

Cecala and Floros

Two main data

United States

2005–2014

Not applicable

Not applicable

This chapter

sources: the

analyzes the

PrivateRais e SRM

financial profiling,

database and the

financing event

extended hand-

specifics, disclosure

collection of shell

levels, and governance

companies

schemes of the private companies that are quoted on lower visibility platforms. The authors examine SRMs forward in time and identify a unique

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Introduction sample of SRMs that is successful getting upgraded to main US stock exchanges. The authors report their financial characteris tics and how they differ from the SRMs that do not manage to get upgraded. Further, they delve into the pricing, source of Page 31 of 122

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Introduction financing, and contractual terms of PIPE transaction s that constitute their main capitalraising events. They note any differences in the financing and governance characteris tics surroundin g SRM firm listing changes.

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Introduction 10.

Cheng, Fleming, and Liu

China Stock

Choice between

Firmspecific

This chapter

Market and Accounting

reverse merger

variables, Market

provides analysis of

Research (CSMAR)

and IPO

conditions

companies undertakin

database

China

2002–2015

g a reverse merger (RM), as opposed to an initial public offering (IPO), on Chinese stock markets. The authors find that Chinese RM firms have lower liquidity, higher leverage, and lower asset

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Introduction turnover than firms which go public through an IPO. Promoters of Chinese RM firms also hold more shares as compared with IPOs. Finally, Chinese RM firms have higher return on assets and lower underprici ng at listing. The results identify several Page 34 of 122

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Introduction characteris tics of Chinese RM firms which differentiat e them from firms that go public via a RM in Western markets, suggesting that Chinese institutions and stage of stock market developme nt may impact the decision to go public.

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Introduction 11.

Shachmurove and Vulanovic

Securities and

United States

2003–2016

Not applicable

Not applicable

Specified purpose

Exchange Commissio

acquisition companies

n

(SPACs) are a special type of public company currently available to investors in financial markets. As an investment vehicle, modern SPACs are traced back to eighteenthcentury England, where blank checks

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Introduction were first mentioned as blind pools during the infamous South Sea Bubble. In the United States, the Security and Exchange Commissio n classifies SPAC as a blankcheck company. This chapter reviews the academic and financial literatures about SPACs, Page 37 of 122

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Introduction describes their institutiona l characteris tics, and analyzes their market performanc e since initial public offering (IPO). The sole purpose of SPACs is to use the proceeds to finance future acquisition. Part III. Institutional Ties to IPOs: Analysts, Investment Banks, Auditors, and Venture Capitalists

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Introduction 12.

Bouzouita and Gresse

Euronext Paris

France

1995–2012

SEOs, survival

Analysts, Underwrite

Based on a survival

rs, Firmcommitme

analysis on a sample of

nt versus best

initial public

efforts, Firm-

offerings (IPOs)

specific variables

undertaken on Euronext and their subsequent seasoned equity offerings (SEOs) over the period 1995–2012, the authors show that analyst coverage in the months following an IPO facilitates

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Introduction subsequent SEOs and favors the longevity of the firm’s relationshi p with its initial underwrite r. SEOs are facilitated in several dimensions : post-IPO analyst coverage increases the likelihood of the IPO firm to conduct an SEO with a firm commitme nt underwriti Page 40 of 122

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Introduction ng; it increases the occurrence speed of that SEO; and it increases the probability of that SEO to be intermedia ted by the same underwrite r as the IPO.

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Introduction 13.

Koning, Mertens and Roosenboom

Thompson Financial and London Stock Exchange

U.K.

1995–2003

Underprici ng, Auditor

Firm characteris

This chapter

choice

tics, Ownership

focuses on the

characteris tics, Deal

selection of an audit

characteris tics

firm by UK IPO firms. It documents that many IPO firms switch to an audit firm in a different segment (big, midsize, or small), which suggests that IPO firms carefully select an audit firm of a

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Introduction particular quality level before they go public. The chapter examines whether the selection of an auditor by IPO firms is driven by the demand for certificatio n or insurance. The authors find that IPO firms are more likely to choose a highPage 43 of 122

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Introduction quality auditor when the uncertainty of the firm’s future prospects is higher and they want to signal quality (certificatio n driven by signaling). In addition, we find that firms with more risky IPO offerings select higher quality auditors, in line with the Page 44 of 122

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Introduction insurance hypothesis. They find mixed results for the certificatio n hypotheses when testing for the effect of auditor reputation on initial returns. On the one hand, underprici ng is lower when IPO firms switch to a more reputable auditor, which is consistent Page 45 of 122

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Introduction with the certificatio n hypothesis. On the other hand, the finding that IPO firms with a big or midsize audit firm have higher underprici ng is in contrast to the certificatio n hypothesis. The findings suggest that although IPO firms purposely Page 46 of 122

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Introduction select an appropriat e auditor, the selection does not improve the performanc e of the IPO as reflected in underprici ng.

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Introduction 14.

Dereeper and Schwienbacher

Thomson SDC

Europe and United States

2000–2015

Not applicable; correlations between

This chapter

syndicate structure and IPO characteristics

presents more recent strands of literature on the IPO bank syndicate structure. The authors argue that while underwrite rs are and will remain important, they are not alone; other bankers play a role, and this banking syndicate is not

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Introduction neutral on the success of IPOs. Many important questions arise before the IPO that shape the IPO process later on. For example, how many banks should be included in the syndicate? What responsibili ties can be shared? This chapter provides an Page 49 of 122

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Introduction overview of the different research questions and discusses avenues for future research on IPO syndicate structure.

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Introduction 15.

Hass and Tarsalewska

Thomson SDC

United States

1980–2015

Accrual earnings

Venture capital,

Financial intermedia

manageme nt, Real

Firmspecific

ries such as venture

earnings manageme

characteris tics, and

capitalists (VCs) not

nt

Financial statement

only provide

variables

financing, they also play an active role in firm governance and in financial practices before the firm goes public. VCs are actively engaged in monitoring and advising their portfolio firms.

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Introduction Thus, the authors also expect them to exert significant influence over the developme nt of financial reporting practices. This chapter reviews recent literature and empirical evidence on VCs and financial reporting quality in newly public firms. It Page 52 of 122

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Introduction surveys the role of VCs in such activities as earnings manageme nt. In particular, the authors discuss how their monitoring activities and reputation can impact how their portfolio firms establish financial reporting practices. Also, the authors review the consequen ces of Page 53 of 122

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Introduction misreporti ng, and whether they affect VC behavior ex ante. Finally, the authors use recent data to provide empirical evidence on the effect of VCs on accrual and real earnings manageme nt.

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Introduction 16.

Chahine, Filatotchev, Hoskisson, and Arthurs

London Stock

United Kingdom

Exchange New Issues

and United States

1996–2006

IPO Underprici

Country characteris

The authors

ng

tics, Firmspecific

integrate agency

files in the UK and

characteris tics,

research with an

Thomson Financial

Market conditions

institutiona l

Security Data

perspective and

Corporatio n (SDC)

investigate multiple

New Issues database

agency conflicts in venture capital (VC) syndicates and their effect on stockmarket performanc e of IPOs in the United States and United Kingdom.

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Introduction Using a matched sample of 402 IPOs, they show that size and diversity of a VC syndicate have a negative impact on performanc e, but this impact is higher in the United States. Ownership concentrati on within a syndicate improves performanc e, but this effect is stronger in Page 56 of 122

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Introduction the United Kingdom. Results indicate that the extent of multiple agency conflicts and their potential remedies are not universal and depend on formal and informal institutions .

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Introduction 17.

Li and Yao

Shanghai and

Time to IPO,

Firmspecific

This chapter

Shenzhen Stock

Returns at IPO, Sales

characteris tics,

examines whether

Exchanges, SINOFIN

and asset growth

Institutiona l ties

and how different

database (http://

post-IPO

www.sinofi n.net/)

China

1994–2001

types of institutiona l ties affect new venture performanc e at different organizatio nal stages. The authors propose that institutiona l equity ties to governmen tal agencies will enhance

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Introduction the speed and returns of IPO but hinder post-IPO market growth. By contrast, the authors posit that institutiona l equity ties to research institutes will contribute positively to both IPO performanc e and postIPO market growth. The authors build their arguments Page 59 of 122

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Introduction on how the two types of institutiona l ties meet new ventures’ need to be legitimate and competitiv e pre- and post-IPO. They test their hypotheses with new ventures in the pharmaceu tical and chemical industries that went public in China and find supportive Page 60 of 122

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Introduction evidence for their arguments. Part IV. International Perspectives on IPOs

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Introduction 18.

Pandes and Robinson

Financial Post (FP)

Not applicable; Analysis of graduations from Junior

This chapter

Advisor database

TSX-V to Senior TSX and returns in relation to firm-

focuses on the CPC

and Toronto

specific characteristics

program on the TSX-

Stock Exchange

Canada

2000–2014

V in Canada, which is an exchangeregulated program. The results suggest that the CPC program has helped increase the number of junior public firms within Canada, and that a reasonable percentage

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Introduction of these firms (in excess of 10%) have been able to grow and graduate to a more senior exchange within a relatively short period of time (on average under three years). The results also indicate that these graduating CPC firms have experience d strong Page 63 of 122

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Introduction secondary market performanc e while listed on the TSX-V, both before and after their QT transaction s. However, they further show that the postgraduation performanc e of these firms is much worse than the market index in the threeand fiveyear periods after the Page 64 of 122

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Introduction graduation. This underperfo rmance holds across various types of graduating firms, such as concurrent graduates, prerevenue graduates, and all other graduates. Overall, the results regarding the effectivene ss of a demandside segmentati Page 65 of 122

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Introduction on market in Canada are mixed. Although such a market can help junior public firms access capital and grow, it appears that the firms try to time their graduation based on the performanc e of the overall equity markets, and this could indicate that the Page 66 of 122

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Introduction firms are graduating too soon and thus experience relatively poor performanc e subsequent to their graduation. This result is interesting in light of other recent research that finds regularly listed TSXV IPOs that graduate to the TSX perform relatively well after Page 67 of 122

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Introduction their graduation. The contrasting results provide some evidence that a demandside segmentati on market is not as effective as a sequential segmentati on market.

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Introduction 19.

Bertoni, Meoli, and Vismara

EurIPO database

France, Germany, Italy

1995–2011

Not applicable; correlations between IPO

Establishin g effective

valuation and corporate governance practices

corporate governance is most important at the time of an initial public offering (IPO), because the IPO represents a significant step by a company toward moving to the public arena. This chapter focuses on three characteris tics that help

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Introduction describe the board structure at the time of IPO: board size (i.e., the number of members on a board), board independe nce (i.e., the proportion of nonexecutive members on the board), and board leadership (i.e., the choice to overlap the roles of CEO and Page 70 of 122

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Introduction chairman of the board). The authors present empirical evidence from a sample of 969 companies that went public between 1995 and 2011 in France, Germany, and Italy that shows the importance of corporate governance , and how these companies Page 71 of 122

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Introduction differ from their US and UK counterpar ts.

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Introduction 20.

Jiao, Roosenboo

Internet URLs of

France, Germany,

m, and Giudici

stock exchanges

1996–2000

Survival

Country characteris

Nearly 20 competing

the Netherland

tics, Firmspecific

new stock markets

s, Belgium, Italy, and

characteris tics;

opened their doors

the United Kingdom

Market conditions

in 12 Western European countries between 1995 and 2005. These stock markets copied the model of NASDAQ, with its low barriers to entry and tight disclosure rules, and had one common aim—to

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Introduction attract untested, early stage, innovative, and highgrowth SMEs. The authors predict that by setting the entry barriers too low, these new markets risked attracting too many low-quality firms, which created a “lemons problem” that negatively Page 74 of 122

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Introduction impacted the survival prospects of all firms listed on that market. Their key finding is that the IPO firm failure on the six of these new stock markets is almost double the IPO firm failure on longestablished official stock markets with more stringent Page 75 of 122

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Introduction listing requireme nts. The exception is the unregulate d Alternative Investment s Market, where firms have similar survival prospects compared to companies listing on the London’s Official List.

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Introduction 21.

Oehler, Herberger,

Deutsche Boerse

and Horn

Group

Germany

1997–2015

Number of IPOs

Market conditions

This chapter (1) provides a descriptive overview of the IPO activities in Germany in the last two decades, and (2) analyzes the IPO market’s dependenc e on the yearly return and turnover of the German stock market. The authors show that most IPOs

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Introduction and highest volumes were observed during the dot-com bubble phase (1997– 2000) and that the German IPO market’s liquidity shows a stable developme nt in the last years after the subprime crises. Regression analyses show that the IPO Page 78 of 122

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Introduction market activity strongly depends on the overall stock market turnover. But the stock market returns play a subordinat ed role for the IPO market liquidity in Germany.

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Introduction 22.

Dong and Gu

China Securities Regulatory Commissio n (CSRC)

China

2006–2014

Underprici ng; Private

PEP discount;

The costs borne by

placements

IPO underprici

Chinese firms in

ng; Firm and market

raising external

characteris tics

capital through initial public offerings (IPOs) and private placements of equity (PEPs), a special but important type of post-IPO equity offering in China, are well documente d. Although PEPissuing

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Introduction firms can minimize the costs of issuing securities by setting the offer prices close to the secondarymarket prices, more often than not they choose not to do so. The question naturally arises of whether there is a meaningful effect of IPO underprici ng on the Page 81 of 122

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Introduction level of discount and amount of issues in subsequent equity placements . The pricing of IPOs and PEPs can be related for many reasons: persistent imbalance in supply and demand, signaling the quality of the issuing firm, and mispricing

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Introduction attributabl e to irrational behavior of investors. This chapter empirically studies the determinan ts of IPO underprici ng and PEP discount and examines the statistical association between the two measures of capitalraising costs. The authors find that while the Page 83 of 122

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Introduction pricing behavior of a firm’s IPO is a strong predictor of the issue size of subsequent PEPs, it is irrelevant to the level of discount in future PEPs.

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Introduction 23.

Dang and Jolly

New Zealand

IPO Performanc

Firmspecific

The NZX Gross All

Stock Exchange

e over 1 year, 3–5

characteris tics;

Index and two

(NZX) Company

years

Market conditions

portfolios of matched

Research database

New Zealand

1991–2015

peers based on sector/ industry and either sales forecast or book-tomarket ratio are constructe d as benchmark s. Compared with three benchmark portfolios, IPO firms outperform in the short term (1

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Introduction year) but underperfo rm in the medium and longterm investment horizons (3–5 years). Depending on the benchmark to which the IPO returns are compared, investors investing in the IPO portfolio and holding it for five years earn a cumulative average Page 86 of 122

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Introduction abnormal return (CAR) of between –5 percent and –20.4 percent and an average holding period return differential of between –2.7 percent and –20.07 percent. The authors conduct three subsample analyses to examine the association between Page 87 of 122

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Introduction differences in valuation multiples (E/P, EBITDA/ EV, and P/ S) and long-term returns. The findings are consistent with the general consensus of superior returns from value investment s: IPOs with above median earnings ratio (E/P and EBITDA/ Page 88 of 122

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Introduction EV) and below median P/S exhibit higher CAR than IPOs with below median earnings ratio and above median P/ S. Investors investing in IPOs with high E/P achieve a CAR of 9.92% over a five-year period, whereas those investing in IPOs with low E/P experience Page 89 of 122

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Introduction a five-year CAR of – 33.16%.

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Introduction 24

Lai

Hong Kong Securities

Hong Kong

Not applicable

Not applicable

Not applicable

This chapter

and Futures

explains the

Commissio n

regulatory and governance structure rules of listings in Hong Kong. As well, rules for listing from China are explained. Changes over time are described. Statistics on market size are provided for select years. In 2015,

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Introduction Hong Kong was the world’s largest market for IPOs.

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Introduction 25.

Yeung

Sources: Various

New York, London,

Not applicable

Not applicable

Not applicable

This chapter

stock exchanges

Hong Kong and

examines the

Singapore

potential discrepanci es in the regulation applied to overseas issuers, as opposed to domestic issuers, of four leading financial centers: New York, London, Hong Kong, and Singapore. It consists of three substantive parts. The first part

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Introduction reviews existing literature and empirical evidence concerning the motivations and current state of crosslisting. The second part, the major part of the chapter, examines the listing route for an overseas issuer and inquires how it might be Page 94 of 122

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Introduction different from a domestic listing in the host country. This chapter particularly concerns the potential discrepanci es of rules between a foreign listing and a domestic listing and asks if those discrepanci es would lead to better or inferior

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Introduction investor protection.

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Introduction The third part inquires the continuing regulation of foreignlisted companies. This part reviews some regulatory concerns involving cross-listed companies and discusses what can be done to curb the problems, for instance, through regulatory cooperatio Page 97 of 122

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Introduction n between home and host regulators.

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Introduction 26.

Chakrabart i

Ministry of Corporate

India

2007–2016

Not applicable

Not applicable

Given India’s

Affairs, Governmen

growing importance

t of India Website,

as a major emerging

http:// iepf.gov.in/

market, understand

IEPF/ Types_of_Is

ing the IPO market in

sues.html

India is important in itself for the global investor. In addition, by providing an institutiona l context that is largely similar to the US setting but different in a few small

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Introduction but critical ways, as well as by changing the rules related to IPO offerings, the Indian IPO market provides a testing ground for broader finance questions. Over the last couple of decades a growing body of empirical research has focused on the Indian IPO market with Page 100 of 122

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Introduction occasionall y interesting findings. This chapter provides a survey of this literature, stringing together a set of diverse inquiries relating to IPOs in India. Part V. Alternatives to IPOs: Private Marketplaces and Crowdfunding

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Introduction 27.

Adhami, Gianfrate, and Soda

Securities and

United States

Not applicable

Not applicable

Not applicable

The possibility

Exchange Commissio

of issuance and resale

n; Various webpages

of private securities

of different private

was originally

capital marketplac

introduced in the

es

United States by the Securities Act of 1933, but the nature of such securities made their trades costly and extremely rare. Over last few years, a series of regulatory

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Introduction changes has progressiv ely made the trade of private securities issued by young companies easier and more efficient. In this framework and especially in response to the sharp decline in IPOs during the financial crisis, two ventures (namely Second Page 103 of 122

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Introduction Market and SharesPost ) were pioneers in launching online exchanges for secondary, private securities. While not all startups are able to use such platforms to enhance their liquidity, the more mature ones— those that would have probably gone public otherwise Page 104 of 122

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Introduction —have generated enough trades to partly solve their financing needs. As a consequen ce, many of such preIPO companies seem to have found it convenient to stay private longer, thus affecting the decisions on whether and when to go public. Page 105 of 122

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Introduction Private capital marketplac es are currently flourishing both in the United States and abroad, thus becoming a recognized tool in the entreprene urial finance ecosystem. The emerge of such marketplac es poses several theoretical and empirical issues Page 106 of 122

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Introduction regarding the following: whether they function more like complemen ts or substitutes of IPOs; the nature and magnitude of the associated costs and benefits for both investors and corporate stakeholde rs; and the extent to which those marketplac Page 107 of 122

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Introduction es are efficient, transparen t, and exposed to conflicts of interest.

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Introduction 28.

Horváthová

Countryspecific

United States;

regulatory codes

European Union

Not applicable

Not applicable

Not applicable

Crowdfund ing is a way of raising money through small contributio ns from a large number of investors (i.e., “crowd”). Crowdfund ing constitutes a common denominat or for numbers of financing methods, from donations through lending up to venture

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Introduction capital, while all taking place online. Therefore, there are numerous legal challenges, namely use of copyright, distributio n of loans and credits, or possible sale of securities. The scope of this chapter is predomina ntly focusing on the developme Page 110 of 122

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Introduction nt of equity crowdfundi ng, which shows many similarities with classical IPO as a financing tool, yet in smaller scale. This chapter analyzes the existing regulatory framework of equity crowdfundi ng in the United States and in the European Union.

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Introduction 29.

Majumdar

Countryspecific

Australia, Hong

Not applicable

Not applicable

Not applicable

In the aftermath

regulatory codes

Kong, Italy, Japan,

of the 2008 financial

Malaysia, New

crisis, small

Zealand, Singapore,

businesses found it

United Kingdom,

increasingl y difficult

United States

to raise funds. As a response, equity crowdfundi ng has emerged as a viable alternative for sourcing capital to support innovative, entreprene urial ideas and ventures.

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Introduction Equity crowdfundi ng merges the complexity of public funding with the systemic risks of venture capital funding. A key responsibili ty of any securities regulator is that of investor protection. Securities laws, involving stringent eligibility criteria for fundraising Page 113 of 122

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Introduction companies and detailed disclosure requireme nts, have been most instrument al in mitigating risks for public retail investors to some extent. A number of securities regulators across the world have dealt with, or are in the process of dealing with, equity crowdfundi Page 114 of 122

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Introduction ng as a disruptive innovation to established processes of corporate fundraising . However, most equity crowdfundi ng regulations do not take into account one critical aspect of crowdfundi ng—that of crossborder crowdfundi ng.

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Introduction Using a comparativ e analysis of a number of jurisdiction s around the world in their treatment of equity crowdfundi ng, the chapter argues that in jurisdiction s where crowdfundi ng activities are unregulate d or have a low threshold of regulations Page 116 of 122

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Introduction , the opportuniti es arising from the resultant regulatory arbitrage could then be used by fundseeking companies based in jurisdiction s where crowdfundi ng is prohibited or highly regulated. As a result, securities regulators must work together to derive minimum standards Page 117 of 122

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Introduction of acceptable behavior in crossborder crowdfundi ng markets. Notes: This table summarizes the chapters in this Handbook, including the authors, data sources, countries, time periods, and variables. The main findings are paraphrased and/or copied from of the papers to best and succinctly represent the authors’ contributions, but are not meant to exhaustively represent all of the findings from the chapters.

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Introduction Part V of this Handbook concludes with alternatives to IPOs. Specifically, Chapter 27 by Adhami, Gianfrate, and Soda discusses private marketplaces, and provides interesting examples of such marketplaces in the United States. It is surprising that these marketplaces have not received as much academic attention.10 Chapters 28 and 29 by Horváthová and Majumdar, respectively, discuss crowdfunding, and international differences in regulation in the United States and Europe (Chapter 28), and regulatory arbitrage across countries (Chapter 29). There is a growing concern about the appropriate level and design of crowdfunding regulation, despite the fact that fraud rates are not as high as that in IPO markets in many countries around the world.11

1.2. Conclusion Overall, the evidence in this Handbook points to the growing importance of research on IPOs, new forms of IPOs including reverse mergers and special purpose acquisition companies, and alternatives to IPOs including private marketplaces and crowdfunding. These developments in new forms of IPOs, and the developments in the new international landscape of IPOs around the world, show the massive importance of securities regulation. Regulation has significant potential to improve surveillance and corporate governance, and to mitigate the frequency and severity of fraud. New developments including but not limited to crowdfunding offer new research contexts and insights into the economics of new listings around the world. We hope that the chapters in this handbook inspire many more papers on the topic over the coming years.

References Aitken, M., D. J. Cumming, and F. Zhan. 2015. “Exchange Trading Rules, Surveillance, and Suspected Insider Trading.” Journal of Corporate Finance 34: 311–330. Chircop, J., S. A. Johan, and M. Tarsalewska. 2018. “Common Auditors and Cross-Country M&A Transactions.” Journal of International Financial Markets, Institutions and Money 58: 43–58. Cumming, D. J., B. Dannhauser, and S. A. Johan. 2015. “Financial Market Misconduct and Agency Conflicts: A Synthesis and Future Directions.” Journal of Corporate Finance 34: 150–168. Cumming, D. J., and L. Hornuf. 2016. “Marketplace Lending of SMEs.” Available at SSRN: https://ssrn.com/abstract=2894574. Cumming, D. J., L. Hornuf, M. Karami, and D. Schweizer. 2016. “Disentangling Crowdfunding from Fraudfunding.” Available at SSRN: https://ssrn.com/ abstract=2828919.

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Introduction Cumming, D. J., and S. A. Johan. 2008. “Global Market Surveillance.” American Law and Economics Review 10: 454–506. Cumming, D. J., S. A. Johan, and D. Li. 2011. “Exchange Trading Rules and Stock Market Liquidity.” Journal of Financial Economics 99: 651–671. Doidge, C., A. Karolyi, and R. Stulz. 2017. “The U.S. Listing Gap.” Journal of Financial Economics 123 (3): 464–487. Gao, X., J. R. Ritter, and Z. Zhu. 2013. “Where Have All the IPOs Gone?” Journal of Financial and Quantitative Analysis 48 (6): 1663–1692. Ibbotson, R.G. 1975. Price performance of common stock new issues. Journal of Financial Economics 2 (3), 235–272. Jackson, H., and M. Roe. 2009. “Public and Private Enforcement of Securities Laws: Resource-Based Evidence.” Journal of Financial Economics 93: 207–238. Johan, S. A. 2010. “Listing Standards as a Signal of IPO Preparedness and Quality.” International Review of Law and Economics 30(2): 128–144. La Porta, R., F. Lopez-de-Silanes, and A. Shleifer. 2006. “What Works in Securities Laws”. Journal of Finance LXI: 1–31. La Porta, R., F. Lopez-de-Silanes, A. Shleifer, and R. Vishny. 1998. “Law and Finance.” Journal of Political Economy 106: 1115–1155. La Porta, R., F. Lopez-de-Silanes, A. Shleifer, and R. Vishny. 2000. “Investor Protection and Corporate Governance.” Journal of Financial Economics 58(1–2): 3–27. Ritter, J. R. 2015. “Growth Capital‐Backed IPOs.” Financial Review 50 (4): 481–515. Tao, Q., Y. Dong, and Z. Lin. 2017. “Who Can Get Money? Evidence from the Chinese Peer-to-Peer Lending Platform.” Information Systems Frontiers 19 (3): 425–441. Vismara, S., A. Signori, and S. Palearia. 2015. “Changes in Underwriters’ Selection of Comparable Firms Pre- and Post-IPO: Same Bank, Same Company, Different Peers.” Journal of Corporate Finance 34: 235–250.

Notes: (1.) https://www.seeitmarket.com/alibaba-baba-shares-look-poised-to-hit-new-all-timehigh-16763/ (2.) http://money.cnn.com/2012/05/23/technology/facebook-ipo-what-went-wrong/ (3.) https://www.lib.sfu.ca/system/files/27258/WorldPopulation.PDF

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Introduction (4.) http://apps.tmx.com/en/pdf/china/TSXOverview-en.pdf (5.) Hung, Shen. “Chinese Regulator Plans to Prune Waiting List for IPO. Wall Street Journal (Asia Edition), 5 July 2016. (6.) The U.S. evidence of the impact of regulatory changes over time in Chapter 3 presents an interesting comparison to cross-country work that shows different evidence on the impact of regulations (La Porta et al., 2006), and enforcement (Cumming and Johan, 2008; Jackson and Roe, 2009) on IPOs. For related cross-country work, see also La Porta et al. (1998, 2000), Aitken e al. (2015), Cumming, Dannhauser, and Johan (2015), and Cumming, Johan, and Li (2011). (7.) Of course, auditors play a significant role in M&A transactions as studied in Part II of this handbook; see also, for example, Chircop, Johan, Tarsalewska (2018). (8.) See also the related work of Vismara, Signori, Palearia (2015). (9.) See also Johan (2010) for an examination of the senior versus junior Toronto Stock Exchange IPOs. (10.) There has been some attention to marketplace lending, such as Cumming and Hornuf (2016) and Tao, Dong, and Lin (2017), but the context in Chapter 27 is rather distinct. (11.) Cumming, Hornuf, Karami, and Schweizer (2016) show that there have been only slightly over 300 fraud cases among over a hundred thousand crowdfunding campaigns, while in the U.S. detected fraud comprises 2-4% of listed companies each year on NASDAQ and NYSE (Cumming, Dannhauser, and Johan, 2015).

Douglas Cumming

Douglas Cumming is the DeSantis Distinguished Professor of Finance and Entrepreneurship at the Florida Atlantic University College of Business. Sofia Johan

Sofia A. Johan is an Assistant Professor of Finance at the Florida Atlantic University College of Business.

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Introduction

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PART

I

THE ECONOMICS AND REGULATION OF IPO MARKETS

The Law and Economics of the Going-Public Decision

Oxford Handbooks Online The Law and Economics of the Going-Public Decision   Jay B. Kesten The Oxford Handbook of IPOs Edited by Douglas Cumming Print Publication Date: Jan 2019 Subject: Economics and Finance, Business Economics, Financial Economics Online Publication Date: Dec 2018 DOI: 10.1093/oxfordhb/9780190614577.013.12

Abstract and Keywords An initial public offering (IPO) is one of the most important events in the life cycle of a developing firm. The decision to “go public,” however, is complicated by the persistently cyclical market for public offerings. This chapter analyzes the macroeconomic determinants of IPO market cyclicality alongside the strategic and corporate governance considerations faced by private firms, arising from the costs and benefits of going public. The law and economics of the going-public decision also are relevant to the secular decline in IPOs since the turn of the millennium. This chapter evaluates several competing and complementary hypotheses that attempt to explain this phenomenon, each of which relies at least in part on the various features of the going-public decision-making process. Keywords: initial public offering, IPO, firm, cyclicality, law, economics

AN initial public offering (IPO) is one of the most important events in the life cycle of a developing firm. The decision to “go public,” however, is complicated by the persistently cyclical market for public offerings. This chapter analyzes the macroeconomic determinants of IPO market cyclicality alongside the strategic and corporate governance considerations faced by private firms, arising from the costs and benefits of going public. The law and economics of the going-public decision also are relevant to the secular decline in IPOs since the turn of the millennium. This chapter evaluates several competing and complementary hypotheses that attempt to explain this phenomenon, each of which relies at least in part on the various features of the going-public decision-making process.

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The Law and Economics of the Going-Public Decision

2.1. Introduction Going public is one of the most important decisions in the life cycle of a successful developing company, and the market for IPOs in turn affects various aspects of the domestic economy.1 Because IPOs involve both costs and benefits, firms must make a threshold determination concerning whether to go public or stay private. All else being equal, the aim is relatively straightforward: maximize an objective function composed of the IPO proceeds, the expected value of future proceeds, plus any private benefits inuring to the firm’s insiders. But that calculus is complicated by the fact that IPO pricing— typically the most significant variable in that objective function—is not exclusively determined by firm quality. Rather, the market for IPOs is persistently cyclical; “hot” phases with a high volume of IPO activity and relatively high valuations alternate with “cold” phases, (p. 28) in which both the frequency of IPOs and their relative valuations plummet. There are, therefore, significant strategic considerations related to timing the going-public decision alongside the threshold cost–benefit inquiry. Moreover, some firms do not have an indefinite real option to stay private. There may be additional factors, such as the presence of venture capitalists (VCs) with constrained investment time horizons or acute intra-firm capital needs, that modify firms’ strategic decision-making. The dynamics of the IPO market are also thought to impact various macroeconomic conditions. For example, the vibrancy of IPO activity is closely related to the availability of VC funding (Black and Gilson, 1998; Kaplan and Lerner, 2010; Chaplinsky and GuptaMukherjee, 2013). VC funding in turn impacts the pace of innovation and entrepreneurship, employment growth, and potentially gross domestic product (GDP) (see, e.g., Gompers and Lerner, 1999; Kortum and Lerner, 2000; Weild and Kim, 2009; Samila and Sorenson, 2011; Schwartz, 2012; Cumming and Li, 2013).2 It is therefore with some alarm that observers have documented a secular decline in IPOs in the United States since the turn of the millennium (Gao et al., 2013; Doidge et al., 2017). The causes of this sustained trend are not yet fully understood, but an emerging literature posits several hypotheses that bear on firms’ going-public decision-making process. This chapter analyzes the law and economics of the going-public decision both through the lens of strategic choices in a persistently cyclical market and as a function of the secular decrease in IPO exits. The chapter is organized as follows. Section 2.2 briefly surveys the main benefits and costs of an IPO to frame the subsequent discussion. Section 2.3 analyzes the key determinants of IPO cycling—business conditions, investor sentiment, adverse select costs arising from asymmetric information, and political uncertainty—and their impact on both inter- and intra-cyclical going-public strategy. Section 2.3 then considers financial and corporate governance variables that can alter allelse-equal optimal market timing. Section 2.4 evaluates the going-public decision in the context of competing theories explaining the secular decline in IPOs: regulatory overreach, the increasing value of economies of scope, and institutional investors’ reduced demand for small-cap IPO shares. Section 2.4 also proposes another potential Page 2 of 29

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The Law and Economics of the Going-Public Decision explanation, the rise of shareholder activism, which has been largely overlooked in the academic literature to date. Section 2.5 concludes by highlighting policy implications and possible paths of future research.

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The Law and Economics of the Going-Public Decision

2.2. The Benefits and Costs of an IPO A voluminous literature details the potential benefits of going public. These benefits fall primarily within three categories: the proceeds of the offering, the expected value of future benefits to the firm, and the private benefits of the offering to insiders. Perhaps most important, access to public equity markets allows firms to raise substantial capital at a cost that better approximates fair market value (Sanger and McConnell, 1986; Koeplin et al., 2000). Contemporaneously, the IPO provides a valuable exit event for earlystage (p. 29) equity investors, such as VCs (Tirole, 2006). Indeed, IPOs are typically viewed as the best possible outcome for VCs (Schwienbacher, 2008) and, at least historically, they generate substantially higher returns on average than other forms of exit. For example, from 1985 to 2008 the mean and median company-level returns from IPO exits were 209.5% and 108.8%, compared with 99.5% and –32.1% for mergers and acquisitions (M&A) exits (Chaplinsky and Gupta-Mukherjee, 2013). While the most valuable M&A exits compare favorably to the most valuable IPOs, M&A exits are much more likely to fall within the lowest quintile of returns, and account for a disproportionate share of cases where the VC fails to recover the full amount of capital invested in the portfolio firm (Chaplinsky and Gupta-Mukherjee, 2013). IPOs also generate several second-order benefits for the firm. The creation of a liquid market in the firm’s securities allows the firm to more easily use its shares as incentive compensation and consideration for acquisitions (Bainbridge, 2002; Tirole, 2006). Going public may also enhance the firm’s reputation and visibility in the product market (Maksimovic and Pichler, 2001), and can improve the firm’s bargaining power with bankers or other creditors and thereby lower the future cost of capital (Rajan, 1992; Pagano et al., 1998). Finally, insiders (such as the firm’s founders) obtain private benefits from going public. The creation of a liquid market for the firm’s shares allows founders to diversify their own personal holdings (Colaco et al., 2009; Bancel and Mittoo, 2013). Also, many IPOs allow founders to regain control over their firms. In VC-backed startups, founders typically relinquish a variety of control rights contractually in exchange for venture funding (Cumming, 2008; Cumming and Johan, 2008; Schwienbacher, 2009). Going public generally extinguishes these contractual terms, and returns control to founders after the VCs’ exit (Black and Gilson, 1998). Founders can take full control of the newly public firm by retaining a majority voting stake or by employing a dual-class high-vote/low-vote share structure. And even in widely held firms, they can exert de facto control given the combination of their significant, albeit minority, stockholding, directorships and top managerial positions. In either case, founders obtain the private benefits of controlling a publicly traded firm, which are generally considered quite significant (Black and Gilson, 1998; Dyck and Zingales, 2004).3 Thus, entrepreneurs largely prefer IPOs over M&A

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The Law and Economics of the Going-Public Decision exits, in which they are more likely to lose their control rights and managerial influence (Schwienbacher, 2008). Surveys of corporate executives, conducted both before and after the Internet bubble, shed light on the relative importance of these theorized benefits.4 In the United States, these executives report that funding for growth and the ability to use the firm’s stock for M&A activity are the most important factors in the going-public decision.5 Boosted firm reputation, the availability of an exit event, lowered cost of capital, and stock liquidity each enjoy moderate support in the aggregate, but may be more important for certain types of firms. For example, younger, venture-backed, and high-technology firms are more likely to view reputation enhancement as an important strategy component of the going-public decision. Finally, corporate executives claim that the prospect of increased bargaining power vis-à-vis potential lenders and heightened external monitoring are relatively unimportant to many firms.6 But going public entails meaningful costs as well. There are nontrivial transaction costs associated with the IPO itself, for example, legal, underwriting, and other advisory fees (Tirole, 2006). Then, once public, the firm takes on mandatory reporting obligations to regulators and investors. There are direct costs associated with preparing these disclosures, as well as indirect costs of revealing proprietary information to competitors (Bainbridge, 2002; Tirole, 2006). Public firms also become potential takeover targets in the market for corporate control,7 and expose themselves to increased litigation risk in the form of securities class actions and breach of fiduciary duty claims (Soderquist and Gabaldon, 2006). Corporate executives report that exposing their firm to the scrutiny of public markets is one of the most significant costs of going public (Bancel and Mittoo, 2013). (p. 30)

Thus, private firms face a threshold cost–benefit analysis in advance of an IPO, in which the firm attempts to maximize an objective function that can be approximated as: {IPO proceeds + present value of future proceeds and benefits to the firm + private benefits to insiders}.8 Assuming that expected benefits exceed anticipated costs, the company must decide when to conduct its IPO. All else being equal, the objective is straightforward: maximize the benefits of the IPO by raising the greatest amount of capital relative to the percentage of the firm’s equity sold (Klausner, 2003). But this decision is complicated by the fact that pricing is not exclusively a function of firm quality; the going-public decision must be made strategically due to the cyclicality of the IPO market. Indeed, corporate executives view market conditions as a key determinant of whether and when to go public (Bancel and Mittoo, 2013).

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The Law and Economics of the Going-Public Decision

2.3. IPO Cycles and the Going-Public Decision The market for IPOs is persistently and dramatically cyclical. “Hot” markets, characterized by increased IPO volume, heightened valuations, and severe underpricing (the difference between the offering price and the closing price on the first day of trading in the secondary market), are followed by “cold” periods in which the number of IPOs plummets, valuations are less attractive, and underpricing is less pronounced (see, e.g., Ibbotson and Jaffe, 1975; Hoffman-Burchardi, 2001; Alti, 2005; Păstor and Veronesi, 2005; Colaco et al., 2009; Colak and Gunay, 2011). Figure 2.1 illustrates the cyclicality of IPO volume and underpricing.9 Four major determinants of IPO cycles emerge from the current literature: changing economic/business conditions, investor sentiment, adverse selection caused by asymmetry of information between insiders and public investors, and the impact of political uncertainty. These hypotheses are by no means mutually exclusive; many of the same forces that drive demand for equity capital also motivate investors to supply such funds. (p. 31) As such, multiple determinants might be mutually reinforcing, and can thereby prolong either “hot” or “cold” market cycles. This section evaluates each of these hypotheses standing alone, and considers the resultant inter- and intra-cyclical strategic behavior relative to the going-public Figure 2.1. IPOs: volume and underpricing (1980– 2016). Source: https://site.warrington.ufl.edu/ritter/ipo-data/

decision. The section then turns to financial, contractual, and corporate governance considerations that can alter this

decision-making process.

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The Law and Economics of the Going-Public Decision

2.3.1. Determinants of IPO Cycles The business-conditions hypothesis is the most intuitive and well-established determinant of IPO cycles (Ivanov and Lewis, 2008). Put simply, the business-conditions hypothesis asserts that the frequency of IPOs depends on current conditions in the economy, and thus will be positively correlated with various measures of business activity, such as the prevailing cost of capital, expected profitability, and changes in uncertainty about the profitability of IPO firms. Early models of the business-conditions hypothesis pertain to firms’ financing choices more generally. For example, Lowry (2003) posits that IPO volume is driven by private firms’ aggregate demand for capital. When economic conditions are favorable, companies tend to seek more financing with which to capture their portion of that expected growth. In her model, IPOs are one method among many of obtaining such financing. More recently, Păstor and Veronesi (2005) develop a model specific to the going-public decision, in which IPO volume fluctuates based on three economic conditions: expected market return, expected aggregate profitability, and prior uncertainty about post-IPO average profitability in excess of market profitability. In their model, private firms face trade-offs between current positive net present value projects that require a capital influx and the time value associated with a real option to go public in the future. If market conditions remained constant, it would be optimal to go public as soon as possible to begin production. If conditions vary over time, however, rational firms might delay an IPO in anticipation of more favorable conditions. In the (p. 32) Păstor and Veronesi (2005) model, going public is particularly attractive when expected market return is low, expected aggregate profitability is high, and prior uncertainty is high. Thus, private firms making optimal strategic decisions will wait for improvements along those axes. These improvements push firms toward conducting an IPO for two reasons: the value of the option to wait decreases because market conditions are typically meanreverting; and the opportunity cost of delaying the IPO, insofar as the firm is forgoing current profits, increases. Once conditions improve sufficiently, many firms are likely to exercise their option to go public, thus creating a cluster of IPOs. As these economic conditions worsen, firms are more likely to wait, thus creating a “cold” period. Empirical evidence is largely consistent with the business-conditions hypothesis. Lowry (2003) examines data on IPOs from 1960 to 1996, and finds a strong connection between IPO volume and economic conditions, such as market-to-book ratios, and proxies for private firms’ aggregate demand for capital, such as future sales growth and the number of new corporations. Păstor and Veronesi (2005) extend the sample out to 2002, and find that IPO volume is more closely related to changes in stock prices rather than the absolute level of stock prices, which they interpret as supporting their claim that firms strategically wait for improvements to fundamentals. They also find that IPO volume is sensitive to proxies for discount rates, expected cash flows, and prior uncertainty. Using an autoregressive conditional count model on a similar sample, Ivanov and Lewis (2008) also find empirical support for each of the three channels identified by Păstor and

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The Law and Economics of the Going-Public Decision Veronesi. Notably, unlike several of the hypotheses described in the following, the business-conditions explanation for IPO cycles and the data from which it draws its support do not require any systematic mispricing or asymmetrical information in the market for IPOs. By contrast, the investor-sentiment hypothesis suggests that markets regularly misprice new issues (Loughran and Ritter, 1995; Pagano et al., 1998; Ivanov and Lewis, 2008). Specifically, this explanation posits that during certain periods, public investors are irrationally optimistic about investment opportunities. This enthusiasm leads to greater demand for new security issues, which in turn lowers the cost of equity capital. Reducing the cost of equity capital makes a wider range of projects attractive at the margin, and thus entices a wider range of private firms to conduct an IPO. At the extreme, firms with negative net present values may go public opportunistically (Yung et al., 2008). Anecdotally, proponents of this theory point to events such as the Internet bubble as being illustrative of this irrational exuberance. At other times, investors may undervalue firms, thus raising the cost of capital and unduly deterring firms from going public (Lowry, 2003). Investor sentiment also seems to be an important determinant of IPO cycles, though the data are mixed. Păstor and Veronesi (2005) acknowledge that their rational-behavior model does not conclusively disprove a mispricing explanation for IPO clustering, but argue that it constitutes a plausible alternative that better explains several empirical findings. For example, in their sample, they find little significant relationship between the level of aggregate market-to-book ratio, which they assert would manifest if IPO cycles were caused primarily by share price overvaluation. Nevertheless, several (p. 33) commentators conclude that investor sentiment plays a meaningful role in the market for IPOs. Fink et al. (2010) document a large spike in idiosyncratic risk during the late 1990s, which they attribute, in part, to the decline in firm age at the time of its IPO. On the other hand, Helwege and Liang (2004) find that firms going public in “hot” rather than “cold” markets do not differ significantly along several observable metrics such as industry, age, and growth potential. Proponents of the investor sentiment theory also point to the fact that IPO firms persistently underperform both the market and similarly situated nonissuing firms. For example, Coffee and Sale (2012) report that IPO firms underperform the market during both one- and three-year periods after the initial offering. Ritter calculates three-year buy-and-hold returns for issuers between 1980 and 2014, and reports that, while there is year-to-year variance, on average IPO firms materially underperform both market benchmarks (–17.8%) and style-matched firms (–6.3%). Figure 2.2 presents the time series of these returns.

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The Law and Economics of the Going-Public Decision

Figure 2.2. Average three-year IPO returns (1980– 2014).

In addition to temporal variance, several other firm-specific features seem correlated with stock returns. Larger IPO firms (measured by pre-issuance sales) perform better than do smaller firms. Indeed, the largest IPOs (>$1b) generate positive marketand style-adjusted returns. VC-backed firms, too, outperform firms without VC funding.10

Note: Mkt = market.

Several analysts also attempt to measure investor sentiment more directly. Lowry (2003) employs the discount on closed-end funds and the post-IPO market returns as a proxy for investor sentiment. Based on those specifications, she finds that investor sentiment is both statistically and economically significant. Ivanov and Lewis (2008) also (p. 34) find a meaningful association between IPO volume and both investor and consumer sentiment, using proxies for each. They conclude, though, that the impact of investor sentiment on the IPO market is less than that of business conditions; one standard deviation shock to the proxy variables of the former results in a change of 19.2%, whereas a similar shift in the latter results in a change of 28%. Source: https://site.warrington.ufl.edu/ritter/ipo-data/

The third determinant—time-varying adverse selection—holds considerable intuitive appeal, but, at least to date, rests upon shakier empirical ground. This hypothesis claims that the IPO market suffers from adverse-selection problems due to informational asymmetries between firm insiders and public investors. There are several flavors of adverse-selection explanations that lead to differing conclusions about the impact of that asymmetrical information. Choe et al. (1993) and Korajczyck et al. (1992) argue that informational advantages held by insiders cause investors to demand large discounts when purchasing equity. Thus, periods of heightened informational asymmetry may lead to “cold” cycles in the IPO market. Building on this insight, several analysts suggest that “hot” IPO clusters arise from information spillovers and the concomitant reduction of asymmetrical information. Hoffman-Burchardi (2001) models a system in which informed investors might have valuable private information relating to particular industries. This information is made public via the price-setting process in early-cycle IPOs. If investors are asymmetrically informed about valuation metrics that apply across several firms, then the outcome of an IPO generates useful public information that reduces the asymmetry, which in turn increases the likelihood of subsequent firms going public.

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The Law and Economics of the Going-Public Decision While the information spillovers in Hoffman-Burchardi’s (2001) model are exogenous, Alti (2005) derives an equilibrium for a system with endogenous spillover effects. In his model, a high offer price reveals positive news to other firms regarding these valuation fundamentals, which heats up the market as other firms incorporate this information in their going-public calculus. A low offer price realization, however, does not necessarily decrease uncertainty. While it might portend bad news about fundamentals, it might also result if investors with favorable valuation information do not participate in an early-cycle offering. Alti suggests that such investors might rationally refrain from participating in early-cycle IPOs to preserve their informational advantage for future IPOs, or due to exogenous factors such as liquidity constraints. Yung et al. (2008) reach an entirely different conclusion, arguing that informational asymmetries are in fact more pronounced during “hot” markets. In their model, waves of IPOs are caused by exogenous positive information or technological shocks that increase the expected value of private firms’ potential projects. During these “hot” periods, a greater number of seemingly—but not actually—identical firms go public. Thus, the variance of unobservable qualities during these periods is higher than during “cold” periods. To date, the empirical evidence suggests that adverse selection has a rather modest effect on IPO cycles. Lowry (2003) concludes that the costs of asymmetrical information are not an economically significant determinant of IPO volume. Ivanov and Lewis (2008) proxy for asymmetric information using volatility of returns on the Standard & Poor’s (S&P) 500, along with market analyst dispersion and diffusion. They conclude (p. 35) that a one standard deviation shock to those proxies results in only a 1.3% change in IPO volume across their sample, which is more than an order of magnitude less than the analogous impact of business conditions and investor sentiment. These results might suggest that the asymmetrical information hypotheses overstate the absolute magnitude of adverse selection costs. Alternatively, adverse selection costs might manifest only minor impact because market intermediaries can and do mitigate these costs themselves by modulating issuing firms’ ability to free-ride. For example, the information spillover literature argues that information revealed via the IPO creates positive externalities for non-issuing firms. Because early-cycle firms bear the cost of producing this information disproportionately, we might expect some of them to delay their IPOs or refrain from entering the market altogether. Benveniste et al. (2002) present a model in which underwriters overcome this free-rider problem by bundling IPOs of firms whose valuations depend on a common factor (often firms within the same industry), and presenting these IPO opportunities to a common pool of investors. This bundling allows underwriters to spread the costs of information production across multiple firms, rather than placing that burden primarily on first-movers. Finally, recent studies present both theory and evidence that political uncertainty affects the market for IPOs independently of the three traditional determinants of IPO cycles. Kesten and Mungan (2015) develop a surplus-sharing model of the going-public decision under conditions of political uncertainty (i.e., potential changes in governmental policy or the legislative and regulatory landscape that might impact the economic environment). In their model, IPO volume and pricing are inversely correlated with political uncertainty. Page 10 of 29

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The Law and Economics of the Going-Public Decision Heightened political uncertainty simultaneously impacts not only private firms’ propensity to launch an IPO, due to the higher variability of future cash flows, but also investors’ valuation of new issues, due to an increased discount rate. Moreover, investors and firm insiders might have materially different views on the impact of political uncertainty. Based on the dynamics of the underwriting process, Kesten and Mungan also predict that IPO underpricing decreases as political uncertainty increases. The Kesten and Mungan model is largely consistent with the limited available empirical evidence. Colak et al. (2017) employ gubernatorial elections as a proxy for political uncertainty. As regularly scheduled events, these elections are exogenous shocks that create predictable cycles of increasing and decreasing political uncertainty, which peak during the election year and decline in the post-election period as governmental policies take shape. These elections also allow for cross-sectional (i.e., state-to-state) variation, which facilitates isolating the effects of political uncertainty from baseline macroeconomic and business conditions. Using a sample of 317 events from 1988 to 2011, Colak et al. (2017) report a robust relationship between these electoral cycles and IPO activity. First, IPO activity is lowest during election years, peaks in the second year post-election, and then begins to decline again in the year prior to the following election. Cross-sectional analysis illustrates that these fluctuations are most pronounced in the ten states with the highest number of IPOs during the sample period. These variations in IPO activity are robust to controlling for state and nationwide economic conditions. (p. 36) Thus, political uncertainty appears to dampen otherwise “hot” IPO markets. Moreover, Colak et al. present data that support the Kesten and Mungan model of underpricing under political uncertainty. In their sample, first-day returns are, on average, 11% for election-year IPOs as compared with 23% for off-election IPOs. These findings bolster the conclusion that political uncertainty has an effect independent of the standard business conditions hypothesis. Indeed, as Colak et al. (2017: 2526) note, “elections seem to induce their own IPO cycles.” In sum, each of the four theorized determinants described above seem to play some role in creating a persistently cyclical IPO market, though the magnitude of their respective impact remains in dispute.

2.3.2. Intra-Cyclical Strategic Behavior The hypotheses described in the preceding attempt to explain what causes “hot” and “cold” cycles in the IPO market. While some analysts assume that exogenous factors alone drive the order in which firms go public (e.g., Hoffman-Burchardi, 2001; Benveniste et al., 2002), several aspects of these hypotheses suggest that firms behave strategically within those cycles as well. Modeling this strategic behavior allows for predictions about the order in which firms go public and the characteristics of firms that issue at various stages of an IPO cycle. In the Alti (2005) model, IPO waves are initiated by “pioneer” firms that have the highest project discovery probabilities. Subsequent “follower” firms go public in descending order of project discovery probability as information spillovers Page 11 of 29

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The Law and Economics of the Going-Public Decision from the preceding IPOs diminish informational asymmetries. If the outcome of prior IPOs decreases informational asymmetries sufficiently, even firms with very small chances of discovering valuable opportunities might go public. By implication, Alti’s model suggests that firms go public in roughly descending order of quality within a given IPO cycle. Colak and Gunay (2011) also consider the endogenous effects of information spillovers, but their game-theoretic analysis predicts the opposite sequencing. In their model, all firms have an incentive to engage in strategic waiting until prior IPOs confirm that favorable conditions exist in the market. However, solving their model yields two Perfect Bayesian Nash equilibria. The first is a pure strategic separating equilibrium in which low-quality firms always issue first and high-quality firms always wait until uncertainty about economic conditions has been cleared. The second is a mixed-strategy equilibrium in which lower-quality firms have a greater probability of issuing first. Colak and Gunay (2011) suggest that the latter is more likely across a wide range of parameters, and is consistent with several empirical observations. Employing a sample of IPOs from 1973 to 2007, they report that, on average, firm quality is lower in the early stages of a burgeoning IPO cycle. Specifically, lower-quality firms go public, on median, between 28 and 88 days earlier in the cycle than do high-quality firms, depending on the specification employed.11 IPOs of future S&P 500 companies, arguably among the highest-quality firms, are most likely to issue in the mid-stages of any particular cycle. (p. 37) And these firms are rarely (less than 25%) the first issuers in their industry as delineated by threedigit Standard Industrial Classification (SIC) code. For example, Genentech was fifth, Starbucks was fifteenth, and Apple and Microsoft were both eighteenth to issue in their corresponding industries and cycles.

2.3.3. Other Considerations Based on the foregoing, private firms attempting to make optimal going-public decisions must carefully consider various measures of business conditions, investor sentiment, and political uncertainty. To a lesser degree, at least based on current evidence, these firms must also consider possible adverse selection costs arising from asymmetrical information between buyers and sellers in the market. Then, within a given cycle, firms must decide whether to act as a pioneer or strategically wait for information from other firms’ issuances. Some firms have a real option to stay private indefinitely, and can make their going-public decision based purely along these strategic dimensions. However, two other considerations might cause an issuer to diverge from an all-else-equal optimal market timing strategy: VC involvement and the issuer’s capital needs. Collectively, these other considerations might explain, at least in part, why some firms go public during “cold” periods. First, the presence of VC investors is likely to alter a firm’s IPO timing decision. Issuers with no VC backing and flexible capital requirements often have a real option to stay private indefinitely (Schwienbacher, 2010). But VCs, when present, have strong Page 12 of 29

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The Law and Economics of the Going-Public Decision incentives to exit their portfolio companies on a schedule set by the contractual terms of the limited partnership agreements with their own investors. Generally, VCs aim to exit within four to seven years of their initial investment (Cumming and MacIntosh, 2003; Schwienbacher, 2008). Because VCs typically bargain for sufficient control rights to direct a firm’s exit strategy (Black and Gilson, 1998; Schwienbacher, 2010), VC-backed companies might conduct an “early” IPO to secure a timely return for the VC’s investors. Given that VC-backed firms account for a majority of IPOs (Kaplan et al., 2009; Kaplan and Lerner, 2010), VCs’ exit preferences are likely to have a significant aggregate effect on issuing firms’ market-timing decisions. VC behavior is not, however, entirely exogenous. VCs vary their exit and investment preferences in response to business conditions and the vibrancy of the IPO market. Facing market illiquidity, VCs reduce their investments (Cumming et al., 2005; Kaplan and Lerner, 2010), and, conditional on making investments, tend to invest in earlier-stage firms as a means of postponing exit decisions (Cumming et al., 2005). Second, issuers have variably pressing needs for capital depending on the anticipated availability of positive net present value projects such as capital expenditures, research and development (R&D), marketing, and expansion opportunities (Alti, 2005; Kim and Weisbach, 2008). For some firms, delaying an IPO can result in substantial opportunity costs, and thus undermines net firm valuations (Colaco et al., 2009).12 Certain commentators theorize that valuation, rather than financing needs, is the primary (p. 38) driver of the going-public decision (Pagano et al., 1998; Alti, 2005). However, the weight of evidence suggests that capital requirements are a meaningful factor in many firms’ decision-making process. Kim and Weisbach (2008) employ a large, cross-country sample to demonstrate that IPOs are significantly correlated with increases in capital expenditures and R&D expenditures for up to four years post-offering. Leone et al. (2007) report that firms’ IPO prospectuses illustrate that proceeds are used to fund a wide variety of operating endeavors. Schwienbacher (2010) argues that IPOs are vital for the survival of high-growth startups, which generally do not have sufficient capital resources to survive absent a significant capital influx. He thus concludes that these firms’ ability to time the market is significantly constrained. Finally, Bancel and Mittoo (2013) present survey evidence that corporate executives consider funding growth a primary driver of the going-public decision, though there appears to be time variation in their data. For example, funding growth was the most important factor listed by executives from a sample that included both pre- and post-Internet bubble IPO firms. By contrast, the ability to use stock for acquisitions was the most important factor listed by executives from a sample of exclusively post-bubble IPO firms.

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The Law and Economics of the Going-Public Decision

2.4. The Going-Public Decision and the Secular Decline in IPOs Independent from the cyclicality of IPO waves, the market for new issues has declined drastically since the turn of the millennium. From 1980 to 2000, an average of 310 firms conducted IPOs annually. From 2001 to 2012, however, on average fewer than a hundred companies went public per year (Gao et al., 2013). While there was a slight uptick in IPOs during 2013 and 2014 (169 and 197, respectively), IPO volume remains far below historic averages (Bartlett et al., 2016). This decline in IPO activity has been most pronounced among small companies. For example, Bartlett et al. (2016) report that there were 464 nonfinancial IPOs in 1997, and approximately half involved firms raising less than the inflation-adjusted mean for IPOs in 1990. In 1998, small firms comprised only 30% of all IPOs, and that fraction would decline to 10% by 1999. With some year-to-year variation, small IPOs have remained a tiny fraction of the market for new issues ever since. Relatedly, the smallest listed firms today are substantially larger than the smallest listed firms during the peak of domestic listings in the 1990s (Doidge et al., 2017). This secular decline in IPO activity does not seem to be explained by domestic business conditions, such as a prolonged economic downturn.13 Rather, Doidge et al. (2017) demonstrate that the United States is currently experiencing a “listing gap.” Analyzing a series of macroeconomic, legal, and institutional variables that predict worldwide listings per capita (log of GDP, GDP growth, a rule of law index, an index of investor protection, and an anti-director rights index), they conclude that the domestic public markets have several thousand fewer firms than expected. They further demonstrate that this listing gap is (p. 39) caused in significant part by lower than expected new listings. Controlling for industry, the number of firms eligible for listing has increased since the 1990s, but the propensity of such firms to conduct an IPO has declined. This section evaluates several explanations proposed to explain this decline in propensity to go public, each of which turns on various aspects of the costs and benefits of going public outlined earlier.

2.4.1. Regulatory Overreach One group of explanations for the secular decline in IPOs posit that increased regulation stifles firms’ desire to go public either by increasing the cost of doing so or by decreasing its benefits. Criticizing the Sarbanes-Oxley Act of 2002 (SOX), and particularly the internal controls reporting and auditing required by Section 404, has become a cottage industry. Critics claim that the compliance and reporting obligations mandated by SOX have unduly increased the costs of being public, and thereby dissuade firms from conducting an IPO and encourage public firms to delist.

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The Law and Economics of the Going-Public Decision Several studies document nontrivial compliance costs associated with SOX (Ahmed et al., 2010; Iliev, 2010; Rose and Davidoff Solomon, 2016). Moreover, these costs disproportionately affect smaller firms (Kamar et al., 2009). However, several factors suggest that SOX compliance is not a primary driver of the secular decline in IPOs. First, Doidge et al. (2017) demonstrate that at least half of the listing gap existed before the passage and implementation of SOX. Thus, they conclude that the benefits of being public had already begun to decline in the absence of regulatory intervention. Gao et al. (2013) present similar evidence that a decline in small firm profitability began years prior to SOX. Collectively, these data points suggest that changes in systemic market conditions, rather than regulatory compliance costs, initiated the decline in IPO volume, especially among small firms. Second, compliance costs have decreased since peaking in the middle of the first decade of the 2000s. Median annual audit costs for small firms declined from a peak of over $400,000 in 2008 to just over $200,000 in 2012. Large-cap firms experienced a similar decline from approximately $1.75 million in 2008 to $1.2 million in 2012 (Rose and Davidoff Solomon, 2016). Yet, the listings gap continues to widen. Third, Gao et al. (2013) argue that while SOX compliance might reduce the market value of firms at the margins, those costs are generally insufficient to render an otherwise profitable firm unprofitable. They demonstrate that SOX compliance costs have virtually no impact on the likelihood that a mid- or large-cap firm is profitable. Among small firms, they estimate that SOX costs push only 4%–5% of the cohort into negative EPS. Finally, Doidge et al. (2013) and Gao et al. (2013) find no evidence that firms are fleeing the US public markets in favor of foreign listings, which one would expect if SOX compliance costs were the main deterrent to going public. Ultimately, while SOX compliance might affect a small fraction of going-public decisions, those costs do not explain much of the secular decline in IPOs. Other proponents of the regulatory overreach hypothesis point to a constellation of regulatory and administrative activity—including Regulation Fair Disclosure, (p. 40) promulgated by the Securities and Exchange Commission in 2000, and the 2003 Global Settlement—that they claim has diminished the incentive for analysts to cover firms. The intuition is that analyst coverage, especially for small firms, is likely to increase valuation ratios and lower the cost of capital. Consistent with this theory, Jegadeesh and Kim (2010) report that both the number of sell-side analysts and the number of firms covered peaked in 2002, and have subsequently declined. But this hypothesis, too, seems unlikely to explain much of the observed decline in IPO volume. As noted earlier, IPOs started disappearing years before the pertinent governmental activities. Also, Gao et al. (2013) report near universal coverage for IPO firms both before and after that peak—more than 95% of IPO firms receive coverage from at least one analyst. Thus, while the absolute number of analysts and covered firms has declined since 2002, IPO firms as a cohort have not faced a significant decline in analyst coverage.

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The Law and Economics of the Going-Public Decision

2.4.2. Reduced Institutional Investor Demand Bartlett et al. (2016) propose a demand-side explanation for the secular decline in IPOs. They argue that several events in the late 1990s fundamentally shifted large institutional investors’ investment preferences away from IPO risk generally, and particularly the liquidity risk associated with small-firm IPOs. First, during the 1990s, assets under management for the largest mutual funds grew sharply. Based on both investment theory and regulatory factors, Bartlett et al. (2016) posit that, in the face of growing assets under management, it is more efficient for fund managers to avoid investments in smaller firms. For example, Pollet and Wilson (2008) demonstrate that fund managers respond to asset growth by increasing the size of their positions, rather than increasing the number of investments. In this regard, the Investment Company Act of 1940—which restricts “diversified” funds from holding more than 10% of the voting securities of any given portfolio company—biases large funds toward fewer positions in larger firms. Moreover, as assets under management rise, it becomes increasingly costly to trade efficiently, especially in smaller, less liquid securities (Pollet and Wilson, 2008; Yan, 2008). Small-firm IPOs are among the least liquid exchange-traded securities. And yet, despite these increased transactions costs, investing in even a successful small-firm IPO would yield only a tiny absolute contribution to the fund’s return. Second, the Panic of 1998, which triggered a massive flight to liquidity, further amplified large funds’ attentiveness to liquidity risk. This, too, caused large mutual funds’ demand for small IPOs to fall precipitously. As these funds exited the marketplace, the real and perceived liquidity of these small IPOs declined even further, which Bartlett et al. (2016) argue created a vicious cycle of illiquidity-begets-illiquidity. While small cap market returns and volatility eventually normalized, they argue that the exogenous shock of the Panic of 1998, coupled with the efficiency concerns described earlier, led to a persistent decline in large-fund demand for small-firm IPOs. In support of their theory, Bartlett et al. (2016) demonstrate that median illiquidity for small-firm IPOs increased post-1998, moving from the third to the fourth quartile. (p. 41) Consistent with their predictions, they report that the largest mutual funds’ participation in small-firm IPOs declined sharply during the 1990s, and has been virtually nonexistent ever since. For example, in 1990, over 10% of all mutual funds invested in small-firm IPOs; in 2010, less than 1% entered that market. Similarly, in 1990, nearly half of all small-firm IPOs had at least one fund investor. Since 1999, however, no more than 10% of small-firm IPOs attracted a single fund investor in any given year, with most years ranging from 0% to 3%. Using a difference-in-difference approach, they also find that since 1998 the largest mutual funds invest in significant fewer small-firm IPOs—and especially those with greater illiquidity—than did smaller funds during the same period. Similarly, they report that conditional on investing in an IPO, the largest funds shifted their investment strategy toward larger, more liquid IPOs than did smaller funds.

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The Law and Economics of the Going-Public Decision Based on the foregoing, the investment preferences of large mutual funds—which now control nearly 90% of all fund assets under management—have substantially decreased the demand for small-firm IPOs. Assuming this demand has not been replaced by other investors, the likely outcome is an increased cost of capital for such firms and a concomitant reduction in the benefits of going public.

2.4.3. Systemic Changes in the Economy Several scholars assert that the secular decline in IPOs is due to fundamental shifts in the domestic economy. Gao et al. (2013) argue that systemic market changes have increased the value of economies of scope. In their view, the pace of technological innovation has increased the importance of getting big quickly because profitable growth opportunities have narrower windows of action. This market dynamic suggests a reduction in small-firm profitability whether public or private; earnings will be higher as part of a large firm that can take advantage of economies of scope and faster time to market. Thus, they theorize that many small firms can achieve greater operational profits, and thus presumably higher valuations, via M&A exit, rather than through organic growth fueled by an IPO. Gao et al. (2013) present a range of evidence consistent with the economies of scope theory. The percentage of small firms that are unprofitable within three years of their IPO has increased substantially since 1997. By contrast, aside from a temporary deviation in the aftermath of the Internet bubble, the percentage of unprofitable large firms has remained largely unchanged. In parallel, the percentage of M&A exits compared to IPOs has increased dramatically since the late 1990s. Indeed, M&A exits have accounted for more than 80% of all VC exits in every year from 2001 to 2012. If—as is typical—VCs control the exit decision in the majority of these firms, these data strongly suggest that M&A exits are expected to generate greater proceeds than IPOs for this cohort.14 Of the small firms that do go public, the percentage that are either acquired or make acquisitions soon after their IPO has increased over time, which suggests that small firms now rely less on organic growth. This finding is consistent with the survey evidence that corporate executives consider the ability to make stock acquisitions one of the most important reasons to go public (Bancel and Mittoo, 2013). Of the firms that are (p. 42) acquired soon after their IPO, most are bought by other publicly traded companies. Gao et al. (2013) report no increase in going-private transactions, either as a stand-alone entity or by private firms and buyout groups. Davis (2016) identifies a different sea change in the domestic economy: the emergence of what he terms the “virtual corporation.” These businesses have recently proliferated in many sectors, and are fundamentally different from the prototypical large firms of the past. In order to scale up or down quickly and easily, they occupy virtual spaces and rent capacity, rather than investing in capital assets or purchasing real estate. They often outsource production and distribution entirely, and focus instead on developing intellectual property, design, branding, and/or marketing. As a result, they employ a tiny Page 17 of 29

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The Law and Economics of the Going-Public Decision number of employees as compared to firms with in-house production. For example, in 2007, Vizio (200 employees) sold as many televisions as Sony (150,000 employees). Similarly, Blockbuster had 83,000 employees and 9,000 physical stores at its peak; Netflix provides a broader range of products and services with only 2,200 employees and server capacity rented from Amazon. And some of these firms have rather short time horizons; they do not aspire to become long-term social institutions characterized by organic growth, but instead seek primarily to fill a narrow market need that may disappear as a result of technological innovation or rapidly changing consumer tastes. Davis (2016) reports that the median IPO firm since 2001 grew employment by only 51 jobs, and many shrank after going public. Of the firms that expanded employment substantially, much of this growth was a result of acquisitions rather than organic growth, and many of the jobs created were part-time, seasonal, or relatively low wages. The combination of these features creates lightweight and flexible, sometimes ephemeral, firms that do not require a large capital base, and thus have fewer reasons to bear the costs and risks of going public (Davis 2010, 2016). The different “changing economy” explanations proffered by Gao et al. (2013) and Davis (2016) are not mutually exclusive. Rather, they may illustrate the two clusters of an increasingly bimodal distribution of firms in the economy. At one end of the distribution are the firms that must get big, fast, in order to survive. These “economies of scope” firms are generally acquired by other, larger firms or go public with a view to rapid growth via acquisitions. At the other end, “virtual companies” with comparatively small capital requirements need not access the public equity markets at all. Increasingly absent is the middle of the spectrum: firms that go public to raise funds for substantial capital investment to facilitate organic growth.

2.4.4. Shareholder Activism and Time Variation in the Private Benefits of Control Another possible explanation for the downturn in IPO volume is that shareholder activism has reduced the value of the private benefits of control. This dynamic has been undertheorized in the academic literature to date,15 though corporate executives report that exposure to the scrutiny of the public markets is the most significant downside (p. 43) of going public (Bancel and Mittoo, 2013). This section briefly sets forth the theoretical motivation for hypothesizing a reduction in the private benefits of control, which in turn might lead to more frequent M&A exits rather than IPOs. Recall that an IPO is typically seen as the best-case exit option for entrepreneurs. In addition to historically greater proceeds from the offering, entrepreneurs can regain (in VC-backed firms) or maintain (in firms with no VC backing) control of the company by conducting an IPO. By contrast, entrepreneurs generally lose control in an M&A exit. Entrepreneurs generally prefer IPOs due to the value of private benefits of control (Schwienbacher, 2008), which are generally theorized as substantial (Black and Gilson, 1998; Dyck and Zingales, 2004). Doidge et al. (2009), for example, present evidence that Page 18 of 29

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The Law and Economics of the Going-Public Decision the ability to extract private benefits of control (or lack thereof) is an important factor in whether foreign firms cross-list their securities in the US. Shareholder activism, especially hedge fund activism, could plausibly reduce the expected value of those control rights. Going public exposes a firm to the possibility of an activist campaign. Hedge fund activists generally seek to force targeted companies to engage in a limited range of corporate actions aimed at generating shareholder value in the short term. Typical interventions include replacing the current chief executive officer (CEO), forcing spin-offs or other divestitures, and urging full-scale M&A transactions (Coffee and Palia, 2015; Cremers et al., 2015). Each of the foregoing threatens the power of incumbent management and, in many cases, ultimately deprives them of control over the firm. If entrepreneurs perceive hedge fund activism as a threat to their control rights when their firm goes public, they may discount the value of the private benefits of control. While no study has tested this explanation empirically, several data points provide suggestive support. The rise of hedge fund activism largely coincides with the gradual decline of IPOs beginning in the late 1990s (Bebchuk et al., 2015; Partnoy, 2015), and has steadily increased to the present (Coffee and Palia, 2015; Griffith and Reisel, 2016). Hedge fund activists on average target smaller firms (Coffee and Palia, 2015), which are the primary focus of the other explanations for the secular decline in IPO activity. And, since the turn of the millennium, IPO firms have increasingly adopted corporate governance regimes that shield managers from the market for corporate control (Davis, 2016). For example, there has been a drastic rise in the number of IPO firms that employ dual-class voting structures, which generally vest control in the founders or other pre-IPO shareholders. During 1980–1999, approximately 6% of firms, on average, went public with dual-class voting structures as compared with over 20% during 2000–2016. Figure 2.3 presents the time-series frequency of dual-class IPOs.16 And some prominent firms have recently gone public with even more extreme governance structures. For example, in 2017 Snap, Inc. raised nearly $3.4 billion issuing a class of public shares with no voting rights whatsoever. When IPO valuations dominate those achieved through M&A exits, the level of private benefits of control is not likely to affect the going-public decision. However, when M&A valuations increase compared to IPOs—as documented by Gao et al. (2013)— entrepreneurs face a trade-off between greater offering proceeds and the value of the private benefits of control. In firms without VC backing, we should expect that as the (p. 44) private benefits of control decrease, more entrepreneurs will voluntarily select an M&A exit. Heightened M&A valuations as compared to IPOs amplifies the magnitude of this effect. In VC-backed firms, the dynamic is more complex, though the outcome is similar. When the value of private benefits of control are high, exit preferences can diverge between VCs and entrepreneurs. We might thus expect entrepreneurs to adjust their behavior ex ante to channel their firms toward an IPO. Entrepreneurs might bargain to retain some contractual rights relative to the choice of exit. Or, as Schwienbacher (2008) theorizes, this potential divergence of interest between entrepreneurs’ and VCs’ exit preferences could distort the innovation process itself insofar as entrepreneurs might make ex ante product market and R&D decisions with a view to maximizing the likelihood Page 19 of 29

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The Law and Economics of the Going-Public Decision of an IPO. As the value of private benefits of control decrease, however, these agency conflicts subside. Entrepreneurs are more likely to acquiesce to VCs’ preference to maximize the proceeds of the sale regardless of the type of exit. As M&A valuations increase relative to IPOs, we should expect fewer IPOs at the margins. In this regard, the private benefits explanation is complementary to both the reduced demand and changing economy hypotheses.

Figure 2.3 Percentage of dual-class IPOs (1980– 2016). Source: https://site.warrington.ufl.edu/ritter/ipo-data/

2.5. Conclusion The parameters of the going-public decision must be understood as a function of a persistently cyclical market for IPOs. This chapter has evaluated four determinants of IPO cyclicality: business conditions, investor sentiment, adverse selection costs, and political uncertainty. While their precise magnitude has not yet been clearly defined, each except adverse selection seems to have a meaningful impact on IPO volume. The true impact of adverse selection costs resulting from asymmetrical information could be minimal, or might simply be obscured due to the activity of market intermediaries intentionally (p. 45) dampening its effects. Either way, theorizing asymmetries of information in the market for IPOs is important due to their effect on firms’ strategic intra-cyclical behavior. Several avenues for future research arise from this analysis. Many of the empirical studies testing the impact of IPO cycle determinants employ samples that end in the first decade of the 2000s; so too the qualitative surveys of corporate executives. Given what appears to be a systemic change in market conditions since 2000, it is worth extending these studies to determine whether the previously identified effects persist throughout the period of secular decline, and whether the views of corporate insiders have changed concerning the benefits and drivers of going public. Additionally, the political uncertainty hypothesis has only recently emerged in the literature. Subsequent work will hopefully refine the theoretical model and expand the empirical evidence concerning its impact on the market for IPOs.

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The Law and Economics of the Going-Public Decision The going-public decision must also be understood in the context of a secular decline in IPO volume that has characterized public markets from 2001 to the present. This chapter has considered several explanations for the secular decline in IPOs. While some of these hypotheses are complementary, each counsels a different policy response. The regulatory overreach hypothesis argues that a variety of governmental interventions during the first decade of the 2000s negatively affected the IPO market by simultaneously increasing the cost of going public and reducing its benefits in a way that disproportionately affects small firms. If these interventions “broke” the market, then deregulatory efforts might undo these ill effects. On the other hand, if—as many commentators argue—the regulatory overreach hypothesis has little explanatory power, deregulation would not meaningfully increase the volume of domestic IPOs, but could instead damage public markets by needlessly weakening investor protection or further contributing to small firm illiquidity (Bartlett et al. 2016; Rose and Davidoff Solomon, 2016). The reduced demand hypothesis posits that large mutual funds have exited the market for small-firm IPOs almost entirely. This flight to liquidity has substantially reduced the demand for those issues and thereby has reduced small firm valuations. If this explanation is accurate, potential remedies should focus on enhancing IPO liquidity to encourage institutional investors to re-enter that market. The economies of scope hypothesis claims that systemic market changes and technological advances have devalued small firms, whether public or private. Small firms are more valuable as part of a larger entity than they are on a stand-alone basis, and thus M&A valuations have in many cases overtaken the proceeds available from IPOs. Rational small firms have thus increasingly conducted M&A exits, and those that do go public are more frequently acquired soon after their IPOs. While this explanation is complementary to the reduced demand hypothesis, it counsels a rather different policy response. Specifically, Gao et al. (2013) argue that if the economies of scope hypothesis is correct, encouraging small companies to remain independent rather than engage in M&A transactions is likely to harm the economy. Given the tension between the reduced demand and economies of scope hypotheses, future studies should explore in more detail whether the decline in IPOs has adversely affected small firms’ access to (p. 46) capital, and whether alternative capital-raising methods such as crowdfunding or angel investors can effectively replace traditional channels. The virtual corporation hypothesis also highlights profound changes in the economy, but focuses on the emergence of firms that need relatively little fixed capital and do not aspire to significant organic growth. These firms need not access the public equity markets, and do so primarily to create a liquid market for the firm’s shares to facilitate acquisitions and/or exit by early investors and employees compensated in stock (Davis, 2016). The implications of this hypothesis are wide-ranging, and call into question the traditional relationship between IPOs and innovation (Bernstein, 2015), employment (Davis, 2016), and foundational matters of corporate governance such as the role of the

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The Law and Economics of the Going-Public Decision market for corporate control and the corporation as a social institution (Davis, 2010, 2016). Finally, the shareholder activism hypothesis asserts that the private benefits of control have become less valuable over time as shareholder activists, and specifically hedge fund activists, intervene more frequently in public companies. As the value of private benefits decrease, entrepreneurs’ preference for IPOs over M&A exits should be expected to weaken, leading to fewer IPOs. Future studies should refine this theory and test its predictions empirically.

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The Law and Economics of the Going-Public Decision Choe, H., R. W. Masulis, and V. Nanda. 1993. “Common Stock Offering across the Business Cycle: Theory and Evidence.” Journal of Empirical Finance 1: 3–31. Coffee, J. C., and D. Palia. 2015. “The Wolf at the Door: The Impact of Hedge Fund Activism on Corporate Governance”. Journal of Corporation Law 41: 545–607. Coffee, J. C., and H. A. Sale. 2012. Securities Regulation, 12th ed. New York: Foundation Press. Colaco, H. M. J., C. Ghosh, J. D. Knopf, and J. L. Teall. 2009. “IPOs, Clustering, Indirect Learning and Filing Independently.” Journal of Banking and Finance 33: 2070–2079. Colak, G., and H. Gunay. 2011. “Strategic Waiting in the IPO Markets.” Journal of Corporate Finance 17: 555–583. Colak, G., A. Durnev, and Y. Qian. 2017. “Political Uncertainty and IPO Activity: Evidence from U.S. Gubernatorial Elections.” Journal of Financial and Quantitative Analysis 52: 2523–2564. Cremers, M. K. J., E. Giambona, S. M. Sepe, and Y. Wang. 2015. “Hedge Fund Activism and Long-Term Value,” accessed at https://papers.ssrn.com/sol3/papers.cfm? abstract_id=2693231. Cumming, D. 2008. “Contracts and Exits in Venture Capital Finance.” Review of Financial Studies 21: 1947–1982. Cumming, D. and J. MacIntosh. 2003. “Venture Capital Exits in Canada and the United States.” University of Toronto Law Journal 53: 101–200. Cumming, D., G. Fleming, and A. Schwienbacher. 2005. “Liquidity Risk and Venture Capital Finance.” Financial Management 34: 77–105. Cumming, D., and S. A. Johan. 2008. “Preplanned Exit Strategies in Venture Capital.” European Economic Review 52: 1209–1241. Cumming, D., and D. Li. 2013. “Public Policy and Business Creation in the United States.” Journal of Corporate Finance 23: 345–376. Davis, G. F. 2010. “The Twilight of the Berle and Means Corporations.” Seattle University Law Review 34: 1121–1138. Davis, G. F. 2016. The Vanishing American Corporation. Oakland, CA: Berrett-Koehler. De Fontenay, E. 2017. “The Deregulation of Private Capital and the Decline of the Public Company.” Hastings Law Journal 68:445–502.

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The Law and Economics of the Going-Public Decision Doidge, C., G. A. Karolyi, and R. M. Stulz. 2013. “The U.S. Left Behind? Financial Globalization and the Rise of IPOs Outside the U.S..” Journal of Financial Economics 110: 546–573. Doidge, C., G. A. Karolyi, and R. M. Stulz. 2017. “The U.S. Listing Gap.” Journal of Financial Economics 123: 464–487. Doidge, C., G. A. Karolyi, K. V. Lins, D. P. Miller, and R. M. Stulz. 2009. “Private Benefits of Control, Ownership, and the Cross-Listing Decision.” Journal of Finance 64: 425–466. (p. 49)

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The Law and Economics of the Going-Public Decision Johan, S. A. 2010. “Listing Standard as a Signal of IPO Preparedness and Quality.” International Review of Law and Economics 30: 128–144. Kamar, E., P. Karaca-Mandic, and E. Talley. 2009. “Going-Private Decisions and the Sarbanes-Oxley Act of 2002: A Cross-Country Analysis.” Journal of Law Economics & Organization 25: 107–133. Kaplan, S. N., and J. Lerner. 2010. “It Ain”t Broke: The Past, Present, and Future of Venture Capital.” Journal of Applied Corporate Finance 22: 36–47. Kaplan, S. N., B. A. Sensov, and P. Stromber. 2009. “Should Investors Bet on the Jockey or the Horse? Evidence from the Evolution of Firms from Early Business Plans to Public Companies.” Journal of Finance 64: 75–115. Kesten, J. B. 2010. “Managerial Entrenchment and Shareholder Wealth Revisited: Theory and Evidence from a Recessionary Financial Market.” Brigham Young University Law Review (2010): 1609–1660. Kesten, J. B., and M. C. Mungan. 2015. “Political Uncertainty and the Market for IPOs.” Journal of Corporation Law 42: 431–458. Kim, W., and M. S. Weisbach. 2008. “Motivations for Public Equity Offerings: An International Perspective.” Journal of Financial Economics 87: 281–307. Klausner, M. 2003. “Institutional Shareholders, Private Equity, and Antitakeover Protection at the IPO Stage.” University of Pennsylvania Law Review 152: 755–784. Koeplin, J., S. Atulya, and A. C. Shapiro. 2000. “The Private Company Discount.” Journal of Applied Corporate Finance 12: 94–101. Korajczyck, R. A., D. J. Lucas, and R. L. McDonald. 1992. “Equity Issues with TimeVarying Asymmetric Information.” Journal of Financial and Quantitative Analysis 27: 397– 417. (p. 50)

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Notes: (1.) This chapter focuses primarily on the US IPO market, but at several points includes comparative data from other jurisdictions. (2.) Some commentators, however, question whether recent structural shifts in the economy have fundamentally altered the relationship between public equity markets, venture capital, and innovation (e.g., Bernstein, 2015; Davis, 2016). Section 2.4 considers this issue in more detail. (3.) Section 2.4 questions whether the value of these private benefits of control has decreased in recent years as a result of increased shareholder activism. (4.) Bancel and Mittoo (2013) collect and analyze these surveys. (5.) Davis (2016), however, suggests that firms increasingly go public without a pressing need for capital to fund organic growth. (6.) By contrast, both of these factors enjoy strong support among European executives. (7.) This exposure may also have a positive effect on firm value by mitigating managerial agency costs (Kesten, 2010). (8.) Loughran and Ritter (2004) propose a similar objective function. Their definition of private benefits, however, focuses primarily on direct side payments to insiders, such as the “spinning” phenomenon prevalent during the dot-com bubble, which has been drastically curtailed by regulation and the Global Settlement between top investment banking firms and the NASD, NYSE, and SEC. (9.) IPO volume and underpricing data were obtained from Jay Ritter’s website (https:// site.warrington.ufl.edu/ritter/ipo-data/). The sample consists of IPOs with an offer price of at least $5.00, and excludes certain types of offerings (ADRs, unit offers, closed-end funds, REITs, natural resource limited partnerships, small best efforts offerings, banks and S&Ls, and stocks not listed on the NYSE, NASDAQ, or Amex). Of course, the level of Page 27 of 29

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The Law and Economics of the Going-Public Decision underpricing does not depend exclusively on the “heat” of the IPO market. For example, Johan (2010) analyzes data from the Canadian equity markets and demonstrates that less stringent listing standards cause a significant increase in underpricing, though not necessarily medium-run (1-year) share price performance. (10.) IPO return data were obtained from Jay Ritter’s website (https:// site.warrington.ufl.edu/ritter/ipo-data/). The sample consists of IPOs with an offer price of at least $5.00, and excludes certain types of offerings (ADRs, unit offers, closed-end funds, REITs, natural resource limited partnerships, small best efforts offerings, banks and S&Ls, and stocks not listed on the NYSE, NASDAQ, or Amex). (11.) Firm “quality” is inherently difficult to observe directly. Colak and Gunay (2011) employ several proxies, such as 3- and 5-year post-IPO market cumulative abnormal returns, buy-and-hold abnormal returns, and average cash flows. (12.) Colaco et al. (2009) also suggest that firms might go public off-cycle to satisfy insiders’ desire to diversify their investment portfolios. While the evidence on this point is thin, their theory accords with aspects of the corporate executive surveys reported by Bancel and Mittoo (2013). (13.) Domestic capital markets have however, fundamentally changed in at least one way relevant to this discussion. Private equity capital has become substantially more plentiful and liquid in the past decades (De Fontenay, 2017). Even mutual funds, which were once as a class significant IPO investors, have begun investing directly in private startups (Schwartz, 2017). This increased availability of private funding sources creates a real option for some firms to stay private by dampening some of the benefits of going public. An emerging literature considers a range of economic and legal causes and consequences of this shift in the capital markets (Pollman, 2012; Guttentag, 2013; Rodrigues, 2015; De Fontenay, 2017; Schwartz, 2017). (14.) Entrepreneurs might nevertheless prefer an IPO if the private benefits of control are greater than the difference between the proceeds obtainable from an M&A exit versus an IPO. (15.) Indeed, Gao et al. (2013) posit that there is no reason to think that private benefits of control have changed materially over time. (16.) Dual-class IPO data were obtained from Jay Ritter’s website (https:// site.warrington.ufl.edu/ritter/ipo-data/).

Jay B. Kesten

Jay Kesten is Associate Professor at Florida State University, College of Law.

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The Law and Economics of the Going-Public Decision

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IPO Regulators Gone Wild

Oxford Handbooks Online IPO Regulators Gone Wild   Kevin K. Boeh and Craig Dunbar The Oxford Handbook of IPOs Edited by Douglas Cumming Print Publication Date: Jan 2019 Subject: Economics and Finance, Business Economics, Financial Economics Online Publication Date: Dec 2018 DOI: 10.1093/oxfordhb/9780190614577.013.29

Abstract and Keywords A complex set of regulations is intended to guide and control the capital markets and the equity initial public offering (IPO) process, with the goal of creating efficient markets for equity capital and investor protection. Often in response to market innovations, regulators impose new, and reinterpret existing, regulations. This chapter documents key US securities regulations over the past two decades that have affected the IPO process. While motivated by good intentions, many of these regulations have led to burdens on issuing firms and have had deleterious effects on US capital markets. The authors posit that these effects are driven by the burdens placed on firms, the incentives of firms to pursue alternatives to an IPO, the disincentives for banks to conduct IPOs, and the attractiveness of more profitable (and less regulated) alternative activities available to banks. This suggests questions for IPO researchers concerning the effects of such regulations. Keywords: initial public offering, IPO, securities regulation, capital, bank, investor

A complex set of regulations is intended to guide and control the capital markets and the equity initial public offering (IPO) process, with the goal of creating efficient markets for equity capital and investor protection. Often in response to market innovations, regulators impose new, and reinterpret existing, regulations. We document key US securities regulations over the last two decades that have affected the IPO process. While motivated by good intentions, many of these regulations have led to burdens on issuing firms and have had deleterious effects on the US capital markets. We posit that these effects are driven by the burdens placed on firms, the incentives of firms to pursue alternatives to an IPO, the disincentives for banks to conduct IPOs, and the attractiveness of more profitable (and less regulated) alternative activities available to banks. This opens a set of questions for IPO researchers concerning the effects of such regulations.

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IPO Regulators Gone Wild

3.1. Introduction Given the essential economic benefits that a well-functioning capital market provides to an economy, securities regulations (broadly speaking) promote stock market development and protect the welfare of investors (see La Porta et al., 2006, for a cross-country review). An issuer considering accessing the public capital markets must consider the regulatory costs and benefits, both of the listing process and the requirements to stay listed. The motivations driving capital markets regulation, especially those involved in the issuance process, which involves substantive information asymmetry and agency costs (Mahoney, 1995), should, therefore, align with the creation of efficient markets for raising capital, including raising capital in IPOs. Our first goal here is to provide a timeline and discussion of regulatory changes that have affected the IPO process, with a focus on the last two decades. The stated intentions behind the regulatory changes are broad, but include easing the process of raising capital, providing greater market liquidity, ensuring greater investor protections, and (p. 53) increasing transparency, among other reasons, some of which are not specific to the IPO process. Nevertheless, we discuss regulatory changes that we theorize have had an effect on either (potential) issuers or the investment banks that facilitate the IPO process. While the underlying goals of capital market efficiency and investor protection should be primary, we discuss whether the imposition of regulatory changes has had unintended consequences and deleterious effects on the functioning of the markets for growth-oriented firms seeking to access public market capital. In large part, we bring a detailed chronology of regulatory burdens driving much of what Gao, Ritter, and Zhu (2013) call the “regulatory overreach hypothesis.” In each case, we provide the motivations driving the regulatory change and, where possible, review research that has included the (potential) effects on the market for IPOs. Where little (or no) literature exists, we provide an agenda for future researchers wishing to consider open questions regarding the impact of regulations on the IPO market. To the extent that enacted regulations have the desired effects on issuers and the IPO market (as opposed to the null of no impact), open questions remain about whether there are also unintended consequences. Beyond research specifically focused on the impacts of regulations, we posit that most IPO research with sample frames that include implementation of these regulations should include controls from our chronology. Many research studies include time period control variables, but mostly these are based on calendar years. We believe a more thoughtful approach would be to define time period variables corresponding to periods having common regulations. Finally, we believe our chronology of regulatory changes can be of use to researchers beyond those solely examining the market for IPOs. Most corporate finance research faces challenges due to endogeneity, so researchers often attempt to find “natural experiments” in which exogenous variation is created by a rule change that can be exploited to test alternative theories. We believe many of the regulatory changes documented here could be useful for Page 2 of 40

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IPO Regulators Gone Wild such research design (e.g., Hayes, Lemmon, and Qiu, 2010, use adoption of FAS 123R in 2005 as an exogenous shock to test whether option-based compensation is primarily driven by the desire to create economic incentives for managers). Through our chronology and discussion, we find several common themes concerning the impacts, whether intentional or not, of regulatory changes. Most impacts support the notion that the increasingly burdensome regulatory environment has made the US IPO market less competitive and less attractive. The first (of three) themes concerns changes that have made either the IPO process or the burden of being public thereafter relatively unattractive to a potential issuer. In some cases, alternatives to the IPO have become more attractive while not directly affecting the IPO process itself. A second theme relates to changes that have affected investment banks, making it less attractive (profitable) to conduct IPOs or the accompanying services typical of the IPO process, such as producing research coverage or market-making in the newly issued securities. Critically, the fall of the Glass-Steagall Act allows banks to shift from investment to commercial banking activities if the latter activities are more lucrative or less burdensome. A final theme relates to consequences, mostly unintended, that have had the impact of lowering transparency for investors. While some changes had other intentions, (p. 54) we argue that the amount or quality of disclosure, research coverage, or information available to investors may have increased information asymmetry for investors, surely counter to the goal of investor protection. We further expect that decreases to transparency and increased information asymmetry, all else being equal, would have the effect of crowding out some issuers in the IPO market. While this chapter presents no original empirical research, we complement some of our discussion of regulatory changes with descriptive statistics on US IPOs between 1998 and 2014. We obtain data on all US firm-commitment IPOs from the Thomson Financial Securities Data (TFSD) New Issues database. Consistent with many prior studies, we exclude issues by banks, unit offerings (combinations of equity and warrants), and other non-equity securities, real estate investment trusts (REITs), special purpose acquisition companies (SPACs), American depositary receipts, American depositary shares, global depositary receipts (or global depositary shares), and closed-end funds. Issuers must list on major US exchanges (NASDAQ, American [NYSE MKT], and New York Stock Exchanges) with trading data (price and volume) available on CRSP. The full sample consists of 2,548 issues. We offer several contributions. First, the chronology of regulatory changes that have affected IPO issuers and bankers should be of interest to (potential) issuers, bankers, and investors. While those in the regulatory bodies are surely aware of the history, we provide an outside discussion of intended and (potentially) unintended outcomes from the perspective of efficient markets for equity capital. In some cases, this suggests considering a more careful ex ante examination of the (potential) long-run consequences of legislative changes that may have been enacted in response to near-term stimuli. Finally, while we discuss some literature that has focused on regulatory impacts, it

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IPO Regulators Gone Wild becomes clear that future empirical studies with data frames crossing the dates on which such changes were implemented need to account for the relevant changes.

3.2. IPO Regulation 3.2.1. Background—The 1933 and 1934 Acts: Origins The primary body of regulation that guides the IPO process comes from the Securities Act of 1933 (the “Securities Act”) and the Securities Exchange Act of 1934 (the “Exchange Act”).1 Have the Acts been successful? A study of the level of dispersion of abnormal market returns before and after the implementation of the 1933 Act shows that the greater information disclosure by firms led to less return dispersion for new issues (Simon, 1989). However, other research on already listed issues (mostly regulated by the 1934 Act) showed no discernible change in information asymmetry after the Acts (Mahoney and Mei, 2006). It should be noted that the Acts were enacted to reduce fraud, rather than information asymmetry. While research can often show some support for conflicting positions, our concern is whether the imposition of regulation has unintended (and often negative) consequences. The original Acts originally applied only to New York Stock Exchange (NYSE) and American Stock Exchange (AMEX) listed securities. In 1964, the Acts were broadened to include firms trading on over-the-counter (OTC) markets. Research on that extension of the Acts shows that firms (and investors) encountered no gains from the additional regulatory requirements, but instead that numerous firms decided to move to the NYSE instead of staying on the OTC, given that such disclosures were required anyway (Battalio et al., 2011). The primary beneficiary was the NYSE, and not investors. In 1999 the 1934 Act was extended to OTC Bulletin Board (OTCBB) stocks. In a study of the effects, Bushee and Leuz (2005) find that over three-quarters of the sample firms on the OTCBB delisted, presumably because of the additional costly compliance burdens. Investors in the delisted firms suffered dramatic reductions in liquidity and loss of value. The firms that remained listed (the largest ones), however, experienced increases in liquidity, consistent with reduced information asymmetry, but also consistent with there being fewer stocks to trade, forcing investors to choose from among the surviving firms. (p. 55)

The Acts have been frequently amended and interpreted through the years, requiring an ongoing regulatory compliance effort for firms. Following the spread of the Acts to OTC and OTCBB markets, numerous regulatory changes were enacted that have had a more direct impact on the IPO markets. We detail some of these in the paragraphs that follow.

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IPO Regulators Gone Wild

3.2.2. Order Handling Rules (1997) and Regulation ATS (1998; Effective April 21, 1999) The Order Handling Rules (“OHRs”) for NASDAQ were enacted by the Securities and Exchange Commission (SEC) in 1997.2 In short, the SEC enacted major changes to the way that traders and the NASDAQ handle trades. The rule changes included several major provisions. Limit orders had to be displayed in the NASDAQ best bid and offer screens, thereby allowing more investors to compete with market makers. It also required market makers to publicly display their best quotes from across trading systems, meaning that even bids on an electronic communication network (ECN) had to be included, thereby allowing market participants access to the “best” bids. The OHR also allowed market makers to adjust their spreads from 125% of the average narrowest spreads to 150% of the average of the three narrowest spreads during that month. This allowed market makers some flexibility in setting their spreads. Finally, the OHRs allowed market makers to reduce their minimum quote size (depth) from 1,000 to 100 shares, with the intention of allowing market makers to reduce risk and thereby be willing to make more competitive trades. The implementation of the OHRs had the effect of reducing spreads by 30% (Barclay et al., 1999). The new rules reduced overall trading costs, spreads, and tick sizes (Chung and Van Ness, 2001). (p. 56)

The SEC adopted Regulation Alternative Trading Systems (ATSs, aka “Dark

Pools)3

to help promote the adoption and use of innovative trading systems that would increase market liquidity by giving investors access to alternative markets (see Domowitz and Lee, 2001). The regulation exempted ATSs from exchange registration requirements, although it did impose other regulatory requirements if trade sizes exceeded a threshold or exceeded 5% of the trading volume in a particular security. As such, these dark pools generally do not disseminate public bids or offers on shares. Similar to the effect of OHRs, the result has been to create competing systems to market maker-driven trading exchanges. The increased competition for trading has had the effect of lowering spreads and volumes, thereby decreasing the profitability of market making—these profits were traditionally a key source of (potential) income for underwriters after underwriting an IPO. As of 2013, such ATS and dark pool trading represented about 36% of all US stock trading volume (Rosenblatt Securities, 2013). The OHRs and ATS regulations reduced trading costs and provided a near-term win for many investors. The net effect, however, was to reduce the spread available to market makers—the mechanism by which they make money, resulting in less incentive to do so. The reduction in depth likely hurt larger investors with a demand for immediacy. When market makers do not make markets, there is less liquidity—by definition, a critical problem for a new issue. A key component of the IPO issuance process is the market making that underwriters provide in order to ensure sufficient liquidity of the newly issued stock. The mean quoted spread on NASDAQ traded stocks fell almost 70% from a mean of $0.03904 in 1999 to $0.0128 in 2006 (Chung and Chuwonganant, 2014), evidence of the magnitude of the declining economics of market making. These small Page 5 of 40

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IPO Regulators Gone Wild spreads create little incentive for market makers, and reduce the opportunity for a market maker to place an aggressive order inside the spread to induce liquidity. A market maker’s volume is driven by how aggressively it quotes stock prices (bids and asks), and this effect is greater in a more competitive market (Klock and McCormick, 2003). However, competition has fallen dramatically—Chung and Chuwonganant (2014) also report a 56% reduction in the number of dealers on NASDAQ, from 516 in 1999 to 221 in 2006, likely because there were fewer rents to be shared. The result is that there are fewer dealers competing to conduct IPOs. It should be noted, however, that trading volumes have not declined; high-frequency traders have replaced both market makers and specialists. In Table 3.1 we provide mean post-IPO trading volume by year to complement our discussion of the effect of regulatory changes on market-making incentives. We examine both the early aftermarket (the first two days of trading), as well as a longer period postIPO (from the 3rd to 90th trading day). We consider large- (based on pre-IPO revenues) and small-firm IPOs separately given changes in the mix of IPOs over time documented by Gao, Ritter, and Zhu (2013).5 As seen in Table 3.1, initial aftermarket trading has declined significantly for small firms over time, while trading over the first three months declined substantially after 2004 but has recovered in recent years. The trading data are consistent with our conjecture that regulatory changes have altered IPO economics for investment banks. (p. 57)

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IPO Regulators Gone Wild Table 3.1 IPO Trading Volume (1998–2014) Year

Number

Average

Average

Number

Average

Average

Number

Average

Average

of IPOs

Daily Trading

Daily Trading

of SmallFirm

Daily Trading

Daily Trading

of LargeFirm

Daily Trading

Daily Trading

Volume, First 2

Volume, Days 3–

IPOs

Volume, First 2

Volume, Days 3–

IPOs

Volume, First 2

Volume, Days 3–

Days as % of

90 as % of Float

Days as % of

90 as % of Float

Days as % of

90 as % of Float

Float for Small

for Small

Float for Large

for Large

Firms

Firms

Firms

Firms

Float

1998

270

28.0

2.0

191

29.0

2.3

79

25.7

1.3

1999

455

50.4

3.6

379

53.2

3.9

76

36.4

2.0

2000

353

40.3

2.3

283

41.4

2.3

70

36.1

2.2

2001

76

36.0

2.0

27

30.3

2.1

49

39.1

1.9

2002

64

30.9

1.6

18

22.8

1.0

46

34.1

1.8

2003

63

30.2

1.7

21

27.8

2.2

42

31.3

1.4

2004

171

26.9

2.0

77

23.4

2.2

94

29.8

1.8

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IPO Regulators Gone Wild 2005

156

35.3

2.0

52

27.1

2.0

104

39.4

2.1

2006

158

36.6

2.4

67

32.8

2.5

91

39.3

2.2

2007

155

36.0

2.1

65

31.4

1.6

90

39.3

2.5

2008

20

34.3

1.9

4

27.9

1.3

16

35.9

2.1

2009

39

42.1

2.3

5

45.4

3.4

34

41.6

2.1

2010

92

33.0

2.0

26

23.7

1.6

66

36.7

2.1

2011

80

42.3

2.7

27

27.5

1.8

53

49.8

3.1

2012

92

45.9

2.7

17

13.9

1.2

75

53.2

3.0

2013

149

43.2

2.7

45

31.0

2.5

104

48.5

2.8

2014

155

47.6

3.5

70

35.8

2.6

85

57.3

4.3

1998– 2003

1281

40.1

2.6

919

42.7

2.9

362

33.5

1.8

2004– 2008

660

33.6

2.1

265

28.5

2.1

395

36.9

2.1

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IPO Regulators Gone Wild 2009– 2014

607

43.0

2.8

190

30.1

2.9

417

48.9

1.8

Notes: This table reports means of trading volume variables for various subsamples of IPOs between April 2012 and December 2014. The full sample includes all US firm-commitment IPOs from the Thomson Financial Securities Data new issues database that list on major exchanges (NASDAQ, AMEX, and NYSE), and excludes issues by banks, unit offerings (combinations of equity and warrants) and other non-equity securities, real estate investment trusts (REITs), American depositary receipts, American depositary shares, global depositary receipts, or global depositary shares, limited partnerships, and offerings with issue price below $5. Subsamples are defined based on firm size. Small (large) IPOs are defined as those coming from firms with pre-IPO revenues (in constant 2010 dollars) of less than (greater than or equal to) $50 million. Average daily trading volume first two days as a % of float is the sum of the trading volume on the first two days of public trading divided by two times the number of shares offered in the IPO. Average daily trading volume days 3–90 as a % of float is the mean trading volume on trading days 3–90 (or until trading ceases, whichever comes first) divided by the number of shares offered in the IPO.

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IPO Regulators Gone Wild (p. 58)

(p. 59)

3.2.3. Plain English (1998; Adopted January 22, 1998; Effective October 1, 1998) Under the leadership of (former) SEC Chairman Arthur Levitt, the Commission decided that investors would benefit from being able to more clearly understand what they were buying by having IPO filings (and other SEC documents) written in plain English rather than complex jargon and legalese. The SEC adopted Rule 421(d), requiring that the prospectus cover, back pages, summary, and risk factors be written in plain English, while Rule 421(b) required the entire prospectus to be written in this manner (SEC, 1998).6 While the implementation of the rule has substantively changed firm reporting behaviors (Loughran and McDonald, 2014), textual analyses of prospectuses before and after the change often do not account for the dramatic difference (e.g., Loughran and McDonald, 2013). While the intention was to make documents accessible to the average investor, there have been some unintended consequences. As reported in Loughran and McDonald (2013), the typical prospectus in 1997 had 40,000 words, while the typical 2010 IPO document had about 80,000. They also find that firms “improve” their prose in anticipation of seasoned equity offerings. The latter practice brings into question whether marketing spin is used in financial filings to persuade naïve investors. Using IPOs from 2009–2012, PriceWaterhouseCoopers (2012) finds that prospectus printing costs represent perhaps 3%–6% of typical IPO expenses, at $0.2M for offerings below $50M, to an average of $0.5M for offerings above $300M (ranging as high as $9.8M). While small in magnitude, a 28% increase in page count equates to a commensurate increase in printing costs.

3.2.4. Glass-Steagall Repealed by Gramm-Leach-Bliley Act (1999) Glass-Steagall refers to provisions of the Banking Act of 1933 that created a separation of commercial and investment banks. Over the years leading up to its overturn, federal regulators slowly chipped away at its provisions until it was officially overturned by the Gramm-Leach-Bliley Act (GLBA) of 1999 (enacted November 12).7 In the late 1997–1999 period, some banking firms were offering both commercial and investment banking services, the latter through their “section 20” subsidiaries, often referred to as a “banc” rather than a “bank” so as to reduce investor confusion. When a pre-IPO firm has an existing relation with a bank that then manages its IPO, there is a reduction in asymmetric information that results in significantly lower IPO underpricing (Schenone, 2004). This relation only became possible with the fall of GlassSteagall. This should bode well for private firms with existing (e.g.) lending relationships with commercial banks that then decide to go public.

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IPO Regulators Gone Wild

(p. 60)

3.2.5. Regulation FD (2000)

In October 2000, the SEC ratified Regulation Fair Disclosure (“Reg FD”)8 to promote equal access to information by all investors, from large funds to the individual investor. The intent was a more transparent market in which all investors received access to information at the same time. A common practice among public firms is to use investor conference calls to discuss financial results. Firms commonly restricted access to these calls to sell-side research analysts, who would then interpret and analyze the information before disseminating it to investors. Before Reg FD, individual investors did not have equal access to information. After Reg FD, conference calls were open to the public. An interesting outcome is that stock volatility and the amount of individual investor volume increased significantly during the actual call window (Bushee et al., 2004). This suggests that individual investors used the newfound access to information to speculate on outcomes. The net effect of Reg FD surely lowered the value of sell-side stock research, however. Institutional investors (managing mutual funds, hedge funds, pension funds, etc.) invest on behalf of their investors. Institutions historically “paid” sell-side research analysts for their ideas and analyses, delivered by way of research reports and phone calls from institutional (sell-side) sales professionals who called with ideas from their analysts. Payment came in the form of informal reciprocity agreements whereby a fund manager would trade through the brokerage house that had delivered the idea (research), paying commission rates above the cost of execution, with this incremental revenue known as “soft dollar” payments. Commission dollars generated were payment for access to unique, timely, and valuable research ideas, as well as access to allocations of underpriced IPOs. Reg FD reduced the ability to deliver such information without widespread dissemination. The net effect was that institutions no longer paid as much for research, without which underwriters have little incentive to provide research. We posit that this led to a lower quantity and quality of research, given that many sell-side analysts left for the hedge fund world.9 A basic premise behind financial regulation is to encourage market efficiency by way of transparency. There is high information asymmetry about new issues, and the typical mechanism by which investors are informed about new issues is by way of sell-side research coverage. The initiation of sell-side coverage on uncovered publicly traded stocks results in a 4.86% abnormal return (Demiroglu and Ryngaert, 2010), and 4.1% for IPOs (versus 0.1% for those with no coverage) following initiation of coverage (Bradley, Jordan, and Ritter, 2003)—evidence that research coverage is impactful. Further, Bradley et al. find that the abnormal return is correlated with the number of analysts that initiate coverage. To the extent that regulatory conditions lessen the quantity or quality of research, we posit that the efficiency of markets is reduced and investors may be harmed.

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IPO Regulators Gone Wild In theory, this should reduce the attractiveness of pursing an IPO, but we will leave this to future research. To complement the discussion on the economics of analyst coverage, we present mean analyst following statistics in Table 3.2. We again consider large- (based on pre-IPO revenue) and small-firm IPOs separately. We consider the number of unique analysts following as of three months post-offering, as well as the number of analysts following, excluding book-runner(s) (several researchers have found that the number of bookrunners on IPOs have grown over time, so the latter measure provides some insight on the desirability of acting as analysts not considering the economics of the IPO itself). As seen in Table 3.2, while the number of analysts following has grown, the number excluding book-runners has declined for small firm IPOs. (p. 61)

3.2.6. Rule 477 Revision, and Rule 155 and the Integration Doctrine (Effective March 7, 2001) The integration doctrine, which had existed in federal securities law since 1933, provides a framework for determining whether multiple securities offerings should be treated as separate offerings or instead as a single transaction.10 The integration doctrine is meant to prevent an issuer from artificially dividing its securities transactions in a manner to evade different aspects of the securities regulatory system. For example, an issuer wishing to conduct an offering under Rule 506 that would include more than 35 nonaccredited investors (Rule 506 did not permit more than 35 non-accredited investors) may not artificially divide the offering into a series of smaller offerings (each with fewer than 35 such investors) in an attempt to avoid the limitation. An issuer seeking to avoid integration may look to either the SEC’s five-factor test, or to safe-harbor provisions that are specific to particular types of transactions. A commonly used safe harbor is one contained in Regulation D (a private offering of securities solely to non-retail investors), which provides that transactions that are completed six months before the commencement of a Regulation D offer, or that are not commenced until six months after the completion of a Regulation D offer, will not be integrated with the Regulation D offer. This six-month safe harbor applies beyond Regulation D transactions, with the SEC’s five-factor test serving primarily in those instances when a six-month cooling-off period cannot be accommodated. The 2001 changes to Rule 155 reduced this six-month period to 30 days. For the IPO firm, this meant that failed offerings—as many as one-third of IPO offerings (Boeh and Southam, 2011)—could more quickly retrench and instead find private capital. The rule changes had impact. Boeh and Dunbar (2016) find that less than 1% of withdrawers stated the intent to seek private capital before the rule changes, while over 17% stated the intent afterward. However, they also find that the stated plans in the Form RW (Request for Withdrawal) have little relation to the actual outcomes.

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IPO Regulators Gone Wild Rule 477 specified that Form RW filers had to state the reason for withdrawal, and that the reason must be consistent with the public interest and the protection of investors. If deemed so, the SEC would grant its consent to withdraw. The Rule 477 Revision changed (p. 62) (p. 63) (p. 64) this such that the withdrawal would be deemed granted immediately upon filing of the Form RW, unless, within 15 calendar days, the SEC notifies the issuer otherwise. The result is that issuers could be less informative in a Form RW (i.e., stating no reason for withdrawal), and if not objected to, could withdraw. Many firms simply abandon their filings (do not file a Form RW), in which cases, the SEC deems the filings withdrawn after 270 days. Boeh and Dunbar (2016) show that 19% of firms abandoned their offerings before the rule change, while only 6% did so afterward. Interestingly, 7% stated no reason for withdrawal before the rule, while 15% did so afterward. This suggests that issuers took advantage of the 15-day rule, while the investing public is left less informed.

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IPO Regulators Gone Wild Table 3.2 Analyst Following IPOs from 2002 to 2014 Year

Number

Number

Number

Number

Number

Number

Number

Number

Number

of IPOs

of Analysts

of Analysts

of SmallFirm

of Analysts

of Analysts

of LargeFirm

of Analysts

of Analysts

(from I/ B/E/S)

(from I/ B/E/S)

IPOs

(from I/ B/E/S)

(from I/ B/E/S)

IPOs

(from I/ B/E/S)

(from I/ B/E/S)

Making Estimate

Making Estimate

Making Estimate

Making Estimate

Making Estimate

Making Estimate

s within Three

s within Three

s within Three

s within Three

s within Three

s within Three

Months of the

Months of the

Months of the

months of the

Months of the

Months of the

IPO

IPO Excludin

SmallFirm IPO

SmallFirm IPO

LargeFirm IPO

Large Firm IPO

g BookRunner(

Excludin g Book-

Excludin g Book-

s)

Runner( s)

Runner( s)

2002

64

3.47

2.42

18

2.83

1.89

46

4.95

3.73

2003

63

3.30

2.03

21

2.67

1.69

42

3.90

2.66

2004

171

3.65

2.32

77

2.82

2.19

94

4.63

3.32

2005

156

3.51

1.96

52

2.95

2.23

104

4.09

2.81

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IPO Regulators Gone Wild 2006

158

4.09

2.46

67

3.63

2.65

91

4.73

3.06

2007

155

4.46

2.68

65

4.05

2.72

90

5.02

3.25

2008

20

4.00

2.05

4

4.00

2.33

16

4.25

3.09

2009

39

6.10

3.26

5

5.80

3.40

34

6.15

3.55

2010

92

4.96

2.52

26

3.79

2.61

66

5.62

3.25

2011

80

6.00

3.15

27

4.54

2.61

53

6.96

4.00

2012

92

6.14

3.14

17

4.00

2.08

75

6.68

3.80

2013

149

5.83

2.50

45

3.54

1.76

104

6.95

3.52

2014

155

5.57

2.36

70

3.79

1.90

85

7.22

3.66

2002– 2008

787

4.09

2.87

304

3.31

2.40

483

4.55

3.12

2009– 2014

607

5.85

3.20

190

3.92

2.14

417

6.68

3.62

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IPO Regulators Gone Wild Notes: This table reports means of analyst following variables for various subsamples of IPOs between April 2012 and December 2014. The full sample includes all U.S. firm commitment IPOs from the Thomson Financial Securities Data new issues database that list on major exchanges (NASDAQ, AMEX, and NYSE), and excludes issues by banks, unit offerings (combinations of equity and warrants) and other non-equity securities, real estate investment trusts (REITs), American depositary receipts, American depositary shares, global depositary receipts, or global depositary shares, limited partnerships, and offerings with issue price below $5. Subsamples are defined based on firm size. Small (large) IPOs are defined as those coming from firms with pre-IPO revenues (in constant 2010 dollars) of less than (greater than or equal to) $50 million. Number of analysts (from I/B/E/S) making estimates within three months of the IPO is the number of unique analysts as reported on I/B/E/S issuing reports on the IPO firm within three months of the offering. Number of analysts (from I/B/E/S) making estimates within three months of the IPO excluding book-runner(s) is the number of unique analysts as reported on I/B/E/S issuing reports on the IPO firm within three months of the offering, not counting analysts working for any of the book-runners on the IPO.

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IPO Regulators Gone Wild These rule changes intended to make it easier to withdraw an IPO filing and, when desired, seek private capital. A study of withdrawn offerings needs to consider this change. An interesting potential (unintended) consequence of these changes is that firms can more easily “test the waters” of the IPO markets. The ease of testing should allow poor-quality firms to test the waters on the off chance that the markets are willing to pay more than a firm was worth. In this sense, more bad firms should slip through the cracks (Type I errors) and become bad public firms, leading to investor losses.

3.2.7. Decimalization (Implemented April 2001) The United States had historically used 1/8 dollar increments to trade securities. Many trading firms avoided odd-eights prices (such as 3/8 or 5/8) and thus the effective increment was often 2/8, or 25 cents (see Christie and Schultz, 1994). In 1997 the AMEX, NASDAQ, and NYSE all moved to 1/16 increments. In January 2000 the SEC ordered the exchanges to adopt decimalization (.01 increments) and to implement the reforms during the September 2000 through April 2001 time frame.11 As discussed in the preceding sections concerning OHRs, ATS, and the reductions in incentives to make markets in stocks, the move to a $.01 increment further reduced the profits available to a market maker by reducing both the quote and effective spreads (e.g., Bessembinder, 2003).12 Existing research finds a decline in spreads for large-cap stocks from 7.01 cents to 1.62 cents, and for small-cap stocks from 12.70 to 7.98 cents per share. Market making for stocks, especially smaller (new IPOs) became less attractive and reduced the incentives of banks to conduct IPOs (see Table 3.1 for complementary statistics).

3.2.8. SRO Rules, Sarbanes-Oxley Act, Global Settlement (2002–2003) During the 2002–2003 period, there were four key regulatory milestones. The selfregulatory organizations (SROs) (the NASD and NYSE) proposed a first round of reforms in 2002.13 The US Congress enacted the Sarbanes-Oxley (SOX)14 legislation in 2002. The Global Analyst Research Settlement (“Global Settlement”)15 that occurred in (p. 65) 2003 was quickly followed by a second round of amendments by the SROs to comply with SOX and the Global Settlement. In February 2002, the SROs proposed a set of reforms that would separate banking from research. This included restrictions on research analysts soliciting underwriting business, compensation linked to underwriting, and personal trading, while also requiring quiet periods, disclosure of conflicts, and disclosure of the distribution of buy/hold/sell ratings. The SEC approved these proposals on May 10, 2002, and they went into effect on July 9, September 9, and November 6, 2002.

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IPO Regulators Gone Wild On July 30, 2002, the US Congress enacted the SOX Act, requiring the adoption (by July 30, 2003) of rules to address conflicts of interest involved in securities analyst recommendations. Many provisions had already been approved by the SEC in the May 2002 round. Several provisions directly affected IPO issuers, including extending from 25 to 40 calendar days the “quiet period” during which insiders and outsiders (research analysts of managing underwriters) could make or publish statements about the newly issued IPO. Dealers (but not managing underwriters) were required to wait 25 days, while all were required to remain quiet within 15 days of a lock-up expiration (or waiver). IPO issuers were affected by the SOX Section 402 ban on loans to directors and officers at the time of filing an initial S-1 to kick off the IPO process. SOX Section 404 has perhaps received the most attention. It requires the firm to have an external attestation of internal controls. As well, SOX Section 906 required officer certification of filed financial statements after becoming a public company, with heavy personal penalties for failure. SOX Section 301 imposed restrictions on audit committees, including that all members had to be independent, atypical of closely held private firms, where boards are often largely made up of investors (VCs) and founders. On April 28, 2003, an agreement between 10 of the largest US investment banking firms, the SEC, NASD, and NYSE, called the “Global Settlement,” was finalized. Fines and other payments totaling US$1.435 billion were handed out. Specific to IPO issuers, the 10 firms voluntarily agreed to restrict allocations of “hot” IPOs to executives and officers (a practice known as spinning; see Liu and Ritter, 2010). On July 29, 2003, a second set of amendments was approved by the SEC that further pushed to increase analyst objectivity and reduce conflicts of interest. This second round of amendments was also used to enact the changes mandated by SOX. Major provisions to help the former goal included analyst compensation, the prohibition of analyst involvement in soliciting investment banking business and of making statements/ appearances around lock-up expirations, among other provisions. While the first round of SEC amendments that preceded SOX already included much of the SOX regulation, the second round extended the quiet period rules to include all firms involved (underwriters and dealers), required investment banking fee disclosures, and modified the definition of a research report to include communications beyond just those containing a recommendation, among other provisions. The second-round provisions mostly went into effect on September 29, 2003, while others became effective October 17, 2003, or January 26, 2004. SOX was intended to reduce fraud. While we focus here on its burdens and costs, it should be noted that firms and investors may be willing to endure these costs commensurate with the reduction in the costs from any fraud avoided. While SOX (and the associated 2002–2003 amendments) made widespread changes, two specific effects are likely to have been most important to the IPO markets. First, the regulatory and explicit costs to an issuer of becoming and staying public grew with the added burdens. Second, the sweeping changes to the conduct of investment banking and analyst (p. 66)

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IPO Regulators Gone Wild activities made it more difficult and less attractive to conduct IPOs. We discuss these in turn in the following. Iliev (2010) estimates the cost of SOX compliance and finds that SOX reduced the market value of small firms commensurate with the costs of compliance. Iliev also found that certain firms became more conservative in their reporting in the face of SOX 404 requirements. The result of these costs, especially to smaller firms less able to absorb the compliance costs, is shown in research by Piotroski and Srinivasan (2008). Using a sample of 1995–2006 IPOs, while they find no change for large firms, they find that small firms were less likely to list in the United States, and instead many chose to list on the London Stock Exchange’s Alternative Investment Market (AIM). Another SOX rule limits loans to directors and officers. It had been common for insiders to be extended credit by underwriters (their brokers) to enable the cashless exercise of options in the firm and also to be extended credit to pay taxes due upon the exercise of in-the-money options on stock locked up and unavailable for sale until a lock-up (typically 180 days post-IPO). As expected, many executive officers and directors are also owners in such firms, and often have substantial equity stakes. SOX made the IPO route less attractive, while instead the M&A route (perhaps with immediate liquidity in the form of an acquirer’s stock or cash) more attractive. Gao, Ritter, and Zhu (2013) provide evidence that VC exits began tilting toward M&A exits in the early 1990s. SOX also affected the way banks chose to cover (or not cover) stocks, and the attractiveness of conducting IPOs and of conducting sell-side research. After the Global Settlement, analysts moved to a three-tier ratings system (instead of five), and the overall informativeness of recommendations declined (Kadan et al., 2009). Following SOX, there has been a severe reduction in the amount of information Wall Street has produced for consumption by investors. A 2005 Wall Street Journal article (Craig, 2005) laid out the facts nicely: there were 8,726 publicly traded firms in the United States in 2005. Since 2002, 691 of those had lost analyst coverage, of which 99% had market values less than $1 billion. Part of the Global Settlement required that the 10 firms spend $432.5 million to fund independent research for clients over the 2003–2008 period, ostensibly to serve as a second opinion to their own sell-side research. According to Lee and Metaxas (2004), in the year that followed the Global Settlement, research coverage fell by 20% on 1,100 small cap stocks, Morgan Stanley cut US stock coverage by 26%, and Merrill Lynch cut back 30%. They attribute the fall to a doubling of compliance costs (research needs its own compliance group in the wake of the Settlement) and because investment banking fees had formerly funded 35%–40% of research (now disallowed). As the Global Settlement was being hammered out and (p. 67) in the months that followed, Smith Barney lost 16 of its 60 analysts and (at least temporarily) discontinued coverage of 250 stocks (Thomas, 2003). The economics of research relied on trading commissions and monies shifted from investment banking fees for services provided to firms they covered. As a result of reduced investment banking

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IPO Regulators Gone Wild revenue, the inability to tie research compensation to investment banking fees, and dwindling trading revenue, covering smaller, less liquid stocks became economically unfeasible.

3.2.9. Regulation AC (2003) Regulation Analyst Certification (“Regulation AC”) took effect on April 14, 2003.16 AC requires that analysts of brokerage houses certify that the views expressed in their research reports accurately reflect their own personal views. It also requires that an analyst disclose whether she or he had received compensation in connection with the recommendations or views. The brokerage houses are required to obtain periodic certifications by those same analysts in connection with public appearances (where there is no written report). Regulation AC is a “gotcha” type regulation, similar to the certifications required of executive officers in connection with filing their financial statements. If it turns out that the views expressed in a written report were not those of the analyst, the analyst is on record as having certified the opposite, ensuring a strong legal case for misrepresentation. Informal discussions with several research analysts led us to conclude that these changes made it less attractive to be a sell-side research analyst, consistent with the exodus of such analysts to the buy-side. The net effect is a reduction in sell-side research and thus a less informed investor base. Further, initiation of research coverage on newly listed firms has been a critical (typical) step in the IPO process, without which capability an investment bank is very unlikely to win an IPO underwriting mandate.

3.2.10. Prohibition of Research Analysts from Road Shows (and Pitches) (Effective 2005) Based on proposals from the SROs (NASD and NYSE), the SEC approved proposed changes to the interactions allowed between investment banking and analyst personnel.17 Effective April 2005, analysts were not allowed on pitches to discuss investment banking services with potential clients. As well, analysts were not allowed on road shows (e.g., to issue securities). Essentially, most three-way interactions (bankers, analysts, and firms) were disallowed. Before this rule change, research analysts regularly participated in pitches for investment bank services, although they were not regular participants in road shows. Analysts are allowed to talk to (perspective) banking clients, although not with an investment banker also present.

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IPO Regulators Gone Wild

(p. 68)

3.2.11. SEC Eliminates Quiet Period (for Issuers) (2005)

On June 29, 2005, the SEC modified the quiet period rules (aka “waiting period”) that restricted the communications an issuing firm could make from the time it files an IPO registration statement with the SEC until the statement is effective.18 The modification allows issuing firms to distribute materials (in addition to a prospectus). The firm’s representatives may speak publicly as long as they file a copy of the remarks with the SEC. Roadshow presentations need not be filed with the SEC so long as they are made readily available to an unrestricted audience. The changes went into effect December 1, 2005. In practice, research recommendations from managing underwriters are delayed until 25 days after an IPO, even though the wait is no longer mandated.

3.2.12. Regulation NMS (2005) The SEC adopted Regulation National Market System (“NMS”)19 effective August 29, 2005, that intended to foster competition in markets and orders (bids and asks), with the goal of reducing the cost of trading. The rules required price priority (to the best price) across markets by having those quotations be automatically accessible. It required access to data across markets. It also established the $0.01 minimum price increment for securities above $1.00. This so-called Sub-Penny Rule prohibits traders from accepting, displaying, or ranking orders based on increments smaller than a penny. This reduced the ability to increase the chances of order execution by having an order appear first (e.g., by bidding $0.00000001 higher than other orders). Consistent with the other changes that affected market makers, this change makes it even less attractive to make a market in a client’s newly issued securities.

3.2.13. Regulation FD and Websites (Effective August 7, 2008) Although SEC rules concerning the use of websites were already in place, in 2008 it provided updated guidance.20 The underlying goal was to help firms clearly disseminate material information to the public. In short, the SEC guidance suggests that information on a website is “public” for purposes of Reg FD, that a company is liable for what is on its website, and that a disclaimer is insufficient to protect itself from antifraud liability for hyperlinked information. While the guidance is timely given the proliferation of information dissemination via the Internet, there is likely some overreach. Firms must consider whether hyperlinks implicitly suggest some sort of endorsement, and (p. 69) must also consider information posted in blogs and whether it complies with securities regulations. The release encourages blogs and other interactive communications with investors, but also warns firms that such communications are subject to antifraud provisions of federal security laws. These changes could present a major concern for firms considering the IPO process given the proliferation of online information sources

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IPO Regulators Gone Wild (on websites) including blogs that contain unmoderated information and content from customers, or anyone else.

3.2.14. Changes to Rule 144 (Effective February 15, 2008) For background, the 1933 Act Rule 144 concerns the distribution and resale of unregistered and control securities.21 Rule 144 (Sec 4(1)) exempts securities transactions other than by an issuer or an underwriter from 1933 Act registration. Rule 144 regulates restricted securities (securities acquired in a private placement from the issuer or an affiliate) and control securities (securities held by an affiliate of the issuer). Such restricted securities are common in pre-IPO firms and are often received in private placements, Regulation D offerings, and are given to pre-IPO investors and other firms that support pre-IPO firms. These restricted securities cannot be sold in the marketplace unless they are registered with the SEC (e.g., through an IPO process) or are exempt from registration requirements. In changes that became effective February 15, 2008, the SEC changed Rules 144 and 145 (restricted securities acquired via mergers, combinations, etc.). The Rule 144 changes involved halving the holding period restrictions for resale of restricted securities for both reporting and non-reporting companies (waiting periods for non-reporting firms are longer). Rather than encouraging IPOs for the benefits of liquidity, the changes allow investors to more easily sell their shares outside an IPO process. The Rule 145 changes allowed immediate resale of securities acquired in a business combination, making the merger of a private firm attractive when compared to an IPO. The 2008 changes made both being a private firm and the process of a backdoor (Form 10) IPO more attractive. One path to becoming a reporting company is by way of a Form 10 SEC registration statement, which is defined under the 1934 Exchange Act, not the 1933 Securities Act. It is used by private firms as a backdoor mechanism to go public, but also is required of firms with over $10 million in total assets and 750 or more shareholders. The filing of a Form 10 subjects the firm to public company reporting requirements (e.g., annual 10-K, quarterly 10-Q, and periodic 8-K filings). Filing of a Form 10 is used to register a class of securities with the SEC, and once filed, the firm becomes an SEC reporting company, with all its ongoing burdens and disclosure requirements. The Rule 144 and 145 changes brought new liquidity options outside the traditional IPO process, adding another explanation for the decline in traditional IPOs.

3.2.15. Dodd-Frank Wall Street Reform and Consumer Protection Act (July 15, 2010) (p. 70)

While Dodd-Frank22 brought sweeping changes to the regulation of financial markets in the United States, the reforms were aimed at the overall financial system. We highlight a

Page 22 of 40

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IPO Regulators Gone Wild handful of the provisions of interest to IPO issuers, mostly those intended to bring better governance to public firms. Dodd-Frank required compensation committee independence for all public company boards. Rules concerning broker discretionary voting require that brokers receive explicit instructions from shareholders in order to vote. Post-IPO firms may find it difficult to reelect their board members. Dodd-Frank allows shareholders with >3% stake to nominate board members. A firm wishing to continue board momentum (e.g., on ongoing, long-term projects) must take steps to ensure continuity of the existing board members. Dodd-Frank claw-back provisions require that post-IPO firms adopt specific claw-back policies. A claw-back is required whenever a public firm needs to prepare an accounting restatement resulting from noncompliance with financial reporting requirements. The company must claw-back incentive-based compensation paid to executives (that would not have been paid) over the three years preceding the affected year. IPO issuers are often young, growth-oriented firms that use such incentives widely, making this a daunting provision. “Say-on-pay” provisions required that firms allow shareholders to hold nonbinding votes approving (or not) executive compensation. While the vote is nonbinding, it will likely result in greater investor involvement in compensation matters. The related “say-ongolden parachutes” provision required firms to allow investors to cast nonbinding votes on compensation arrangements related to mergers and acquisitions, unless those arrangements had already been voted upon in a say-on-pay vote. Further, Dodd-Frank required the SEC to enact rules requiring firms to justify why it has a single person in the chair and chief executive officer (CEO) roles, or why it has separated these roles. SEC rules already required a broader discussion of the appropriateness of leadership structure. Finally, an interesting provision of Dodd-Frank is the compensation disclosures. A firm must report the total compensation paid to its named officers and the relation to the financial performance of the firm. Firms must report the relation of executive compensation as a multiple of the median compensation of all (except the CEO) employees. A final important provision, Section 989G, was an exemption for nonaccelerated filers (less than $75 million in market cap) from SOX 404(b), the requirement of an audit of internal control over financial reporting. The preceding provisions were part of the 2010 Act, but were phased in (or implemented) over time by the SEC. For example, the compensation committee independence requirements were proposed by the exchanges in September 2012, and approved by the SEC in 2013.23 In its final implementation, newly public firms were required to have at least one independent compensation committee member at IPO, a majority within three months, and a fully independent committee at the one year anniversary.

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IPO Regulators Gone Wild

3.2.16. SOX 404(c) Exemption from 404(b) for Non-Accelerated Filers (2010) (p. 71)

In September 2010, the SEC conformed its rules to Dodd-Frank’s amendment of Section 404(c) to SOX.24 Non-accelerated filers with under $75 million in market capitalization became exempt from having to obtain a registered independent auditor’s attestation regarding internal controls over financial reporting. An “accelerated filer” is a firm with a market value from $75–700 million, while a “large accelerated filer” is a firm with a market value of $700 million or greater.

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IPO Regulators Gone Wild

3.2.17. SEC Widens Permissible Price Range (March 2012) Previously, the price range at which IPO (and other) securities was a matter of SEC staff interpretation and not a specific statute. Section 5(b)(1) of the 1933 Act states that an issuer can only distribute a prospectus that meets the requirement of Section 10 of the 1933, specifically, that the preliminary prospectus be substantially complete and must contain a bona fide estimate of the range of the maximum offering price. A substantially complete prospectus with a price range (but before becoming effective) is called a “red herring” (without a price range, it is sometimes called a “pink herring”) because certain information must be printed on the cover, such as the statement “subject to completion.” Given the extreme information asymmetry and uncertainty about the market price of an IPO, the range is an important guide used by investors. Before March 2012, the SEC staff had taken the view that a price range should be no more than $2 or 10% of the high end of the price range. In comments25 made by the director of Corporation Finance of the SEC in March 2012, the SEC expressed an amended view that the range should be no more than $2 if the price is $10 or less, or 20% if the maximum price is greater than $10. The 20% figure is based on the high end of the range. The Facebook IPO was an example of this greater latitude, with a range of $28–$35 ($35 – 28 = $7 = $35 x .2). If the offering is a Dutch auction offering, the staff had already permitted a range of $4 or 20%, again based on high end of price range. An example of the latter was the Google’s Dutch auction IPO with a price range of $108– $135 ($135 – 108 = $27 = $135 x .2). A consequence is that investors now have less guidance about what issuers consider to be a bona fide range of values for their shares. This change induces uncertainty into the process of finding a market clearing price. On one hand, the pricing latitude may allow issuers to adapt their offering price to meet market demand at the last moment, while on the other hand an issuer can now signal less information. We suspect the result of the latter will be greater volatility in IPO pricing and early aftermarket returns. To complement this discussion, we present mean IPO pricing statistics in Table 3.3. We examine all IPOs after April 2012 and separate issuers into two groups: those for which pricing range conforms to the old rules and those for which the pricing range is (p. 72) (p. 73) wider, consistent with the new rules. We again consider large firm (based on preIPO revenues) and small firm IPOs separately. We also consider IPOs with a high filing price between $10 and $20, as these are the issues most affected by the rule change. IPO pricing variables include IPO Initial Return, defined as 100 times the difference between the closing price on the first day of trading and the IPO price, divided by the IPO price; Absolute Price Adjustment, defined as the absolute value of 100 times the difference between the offering price and the midpoint of initial filing range divided by the midpoint of initial filing range; and Priced outside the initial filing range, defined as a dummy variable equal to one if the offering price is greater (less) than the high (low) initial filing price, and zero otherwise. Our expectation is that fewer IPOs with wider filing ranges Page 25 of 40

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IPO Regulators Gone Wild should price outside the filing range and have lower absolute price adjustments, as less is learned through the book-building process. Initial returns should also be more positive, reflecting the greater resulting uncertainty regarding firm valuation. As seen in Table 3.3, the data are largely consistent with these predictions. Of interest are firms taking advantage of the wider pricing range rule. Smaller firms that do so exhibit more underpricing (initial returns) (25.5% compared to 13.1%), while large firms exhibit less underpricing (14.1% compared to 19.8%). Further, firms filing between $10 and $20 also have more underpricing (initial returns of 26% compared to 17.5%). While these exploratory statistics are consistent with our expectations, further exploration is warranted.

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IPO Regulators Gone Wild Table 3.3 IPO Initial Returns and Price Adjustments (April 2012–December 2014) Sample

Number of IPOs

Initial Return (%)

Absolute Price

Priced Outside the

Adjustment (%)

Initial Filing Range

All IPOs April 2012 to December 2014

360

17.1

16.1

0.58

IPOs with price range

301

17.3

16.5

0.58

59

16.2

14.0

0.58

126

14.2

18.8

0.56

Small IPOs with price range that conforms with pre-2012 rules

115

13.1

18.8

0.56

Small IPOs with price range larger than pre-2012 rules

11

25.5

18.8

0.55

that conforms with pre-2012 rules IPOs with price range larger than pre-2012 rules All small IPOs April 2012 to December 2014

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IPO Regulators Gone Wild All large IPOs April 2012 to December

234

18.7

14.6

0.59

186

19.8

15.1

0.59

48

14.1

12.9

0.58

282

18.0

17.4

0.59

IPOs with high filing price between $10 and $20 that conform to pre-2012 rules

266

17.5

17.4

0.59

IPOs with high filing price between $10 and $20 with range larger than pre-2012 rules

16

26.0

17.3

0.56

2014 Large IPOs with price range that conforms with pre-2012 rules Large IPOs with price range larger than pre-2012 rules All IPOs with high filing price between $10 and $20

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IPO Regulators Gone Wild Notes: This table reports means of IPO pricing variables (initial returns, absolute price adjustments, and priced outside the initial filing range) for various subsamples of IPOs between April 2012 and December 2014. The full sample includes all US firmcommitment IPOs from the Thomson Financial Securities Data new issues database that list on major exchanges (NASDAQ, AMEX, and NYSE), and excludes issues by banks, unit offerings (combinations of equity and warrants) and other non-equity securities, real estate investment trusts (REITs), American depositary receipts, American depositary shares, global depositary receipts, or global depositary shares, limited partnerships, and offerings with issue price below $5. Subsamples are defined based on whether the initial filing range (difference between high and low filing price) conforms with the rules in place prior to April 2012 (the maximum range is the maximum of $2 or 10% of the high filing price) or is larger than the pre-2012 rules (as of April 2012, the maximum range became the greater of $2 or 20% of the high filing price). Other subsamples are defined based on firm size. Small (large) IPOs are defined as those coming from firm with pre-IPO revenues (in constant 2010 dollars) of less than (greater than or equal to) $50 million. Finally, subsamples are defined based on the high filing price. The IPO Initial Return is defined as 100 times the difference between the closing price on the first day of trading and the IPO price, divided by the IPO price. The Absolute Price Adjustment is the absolute value of 100 times the difference between the offering price and the midpoint of initial filing range, divided by the midpoint of initial filing range. Finally, the Priced outside the initial filing range is a dummy variable equal to one if the offering price is greater (less) than the high (low) initial filing price, and zero otherwise.

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IPO Regulators Gone Wild

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IPO Regulators Gone Wild

3.2.18. Jumpstart Our Business Startups Act (April 5, 2012) (Effective 2013–2016) In response to the ongoing US recession, the US Congress saw the need to lessen the regulatory burdens on small businesses in accessing capital. Much of what was signed into law were directives to the SEC to study or enact rules to address regulatory burdens. Here we discuss key provisions of the Jumpstart Our Business Startups (JOBS) Act (it has several sections, Titles I–VII) that went into effect from 2013–2016.26 Title I intended to reopen US capital markets to emerging growth companies (EGCs). It defines EGCs as firms with total annual gross revenue