Ownership Structure and IPO Valuation Yin-Hua Yeh Corresponding author Graduate Institute of Finance Fu-Jen Catholic University, 510, Chung Cheng Rd, Hsin-Chuang, Taipei, 242 Taiwan. Tel: +886-2-2903-1111 ext.2725 Fax: +886-2-2901-9779 Email: trad1003@mails.fju.edu.tw Pei-Gi Shu Department of Business Administration, Fu-Jen Catholic University 2004 NTU International Conference on Finance
Ownership Structure and IPO Valuation Abstract We deem a firm s IPO as a negotiating process through which the controlling shareholders of issuing firms, the associated underwriters, and outside investors are sequentially invited to participate. The wealth effect of the controlling shareholders is implied in the ownership structure, which in turns affects the negotiating processes and therefore the IPO price settings. The results from 218 Taiwanese IPO firms in the 1992-2001 sampling period support the interest-alignment argument that the controlling shareholder s cash flow rights are positively associated with the comparable price multiples, while a deviating voting-cash structure associated with the controlling shareholder is negatively corrected with the comparable price multiples. The relationship between corporate governance and the initial return is less significant partly because of the contradictory predictions from the interest-alignment hypothesis and the reduced-monitoring hypothesis, especially when the controlling shareholders have high cash flow rights in the first place. Keywords: Ownership Structure, IPO, Corporate Governance, Interest-Alignment Hypothesis, Reduced Monitoring Hypothesis, 1
1. Introduction How does the ownership structure of an IPO firm affect the price setting and the initial returns? Existing studies extensively discuss why the IPO firms should underprice their issued shares and how could recoup their sacrifice 1. Among a thread of studies discussing the link between underpricing and ownership structure, managerial monitoring consideration is the most widely cited motive. For example, Brennan and Franks (1997) propose the reduced monitoring hypothesis, indicating that insiders generate excess demand for issued shares through underpricing to reduce the likelihood of being monitored or removed by institutional shareholders 2. Smart and Zutter (2003) use the special case of dual-class firms to support the monitoring consideration hypothesis 3. Other than monitoring considerations, the controlling shareholder s wealth effect is implied in the ownership structure, which in turns affects the IPO price setting. This is especially true for an ownership-concentrated economy. In fact, the IPO price setting monitoring consideration is relatively important for managers in diverse-ownership economies such as the U.S. and U.K. markets. The wealth effect is relatively important for controlling shareholders in the ownership-concentrated economies outside the U.S. and U.K. markets. Having a tie-in utility to the IPO price setting, the controlling shareholders in an ownership-concentrated economy demand a higher offer price to hopefully create a following buying cascade. In this study we deem a firm s IPO as a continuous negotiation process through 1 For a review of this literature, see Ritter (1998). 2 In contrast, Stoughton and Zechner (1998) argue that managers want large block shareholders in order to provide assurances to the market that managers are maximizing firm value. With different purposes in mind, the two papers propose a link between IPO underpricing and the resulting ownership structure. However, Field and Sheehan (2004) disapprove this linkage and find that in terms of acquiring new blockholders, there is no difference between firms that underprice and those that do not. 3 They find that with voting control secured in the first place, dual-class IPOs experienced less 2
which the controlling shareholders of issuing firms, associated underwriters, and outside investors are sequentially invited to participate. The ownership structure manifests the controlling shareholders motives and stakes in the negotiations and provides convincing signals to the underwriter and outside investors. Why is the ownership structure important and how could it affect the price setting? First of all, ownership outlines the company s superstructure that dictates the resources allocation in a firm. Moreover, it could convince the underwriters and outside investors to accept a higher IPO price. Finally, it contains manifest variables that reveal the controlling shareholder s motivation for having the firm run properly or his/her ambition to exploit wealth from the minority shareholders. In the first run of price setting, the offered price multiple is mutually negotiated between the controlling shareholder of the issuing firm and the associated underwriter. When the shares are traded on the market, outside investors are invited to participate. According to the interest-alignment hypothesis proposed by La Porta et al. (2002) and Claessens et al. (2002), controlling shareholders with high cash flow rights are desperate to anchor a high offering price to minimize their sacrifice in the IPO progression. A high offering price is also acceptable to underwriters that believe that the controlling shareholders will have the firm run properly for their own sake (Gomes, 2000) and deem their accounting data to be informative (Fan and Wong, 2002). In contrast, when entrenched controlling shareholders have voting rights far exceeding their cash-flow rights 4, the underwriters, on behalf of outside investors, worry about the possibility of wealth exploitation by the controlling shareholders and are reluctant to promote a higher offering price. Because the controlling shareholders underpricing while trading at lower prices relative to earnings and sales than single-class IPOs. 4 The general case that controlling shareholders leverage their control is through a pyramidal structure and cross shareholdings (La Porta et al.,1999 ; and Claessens et al., 2000) 3
bear only a small portion of the underwriting costs, they would not be as insistent as when they have high cash-flow rights. Therefore, we predict an insignificant or mildly negative relation between offer price and the control-cash deviation. Our empirical findings verify the aforementioned predictions. The reduced monitoring hypothesis indicates that insiders, valuing independence, ward off external monitoring through underpricing the new issued shares to generate excess demand, permitting discriminatory rationing against large bidders. However, this is less an issue in the ownership-concentrated economies because the controlling shareholders having intact control before IPOs are less likely to be threatened by outside blockholders and therefore will entertain a lower offering price. Consequently, the relationship between the comparable price multiples and cash flow rights is both positive for the interest-alignment hypothesis and for the reduced-monitoring hypothesis. As the offered price results from repetitive negotiations between issuing firms and underwriters, the initial returns are further intervened by outside investors. Even though the ownership structure is still the most important discerning variable that predicts a positive relation between the cash-flow rights and initial returns and a negative relation between a deviating voting-cash structure and initial returns, outside investors cannot access the relevant information, which blurs the predicted relations. The empirical results illustrate a less significant relation between corporate governance and initial returns. Because of the difficulty in obtaining the necessary data, we focus our analysis on one country, Taiwan. Taiwan represents an ideal setting to examine these issues because it features relatively high ownership concentration, a predominance of family control, and an abundance of pyramidal groups and cross-holdings characteristics 4
common to many countries (La Porta et al., 1999; Claessens, Djankov, and Lang, 2000; and Faccio and Lang, 2002). In this study we collect 218 Taiwanese non-financial IPOs in the 1992-2001 sampling period (98% of Taiwanese non-financial IPOs). The empirical results support that corporate governance plays the crucial role in affecting the IPO price settings. We find that the controlling shareholder s cash flow rights are positively associated with the comparable price multiples. A deviated voting-cash structure is associating with the controlling shareholder and negatively correlated with the comparable price multiples. However, the relationship between corporate governance and the initial return is less significant partly because of the contradictory predictions from the interest-alignment hypothesis and the monitoring considerations hypothesis. The remainder of this paper is organized as follows. Section 1 is the introduction. Section 2 develops the hypotheses. Section 3 describes the data and methodology. Section 4 reports the empirical findings. Section 5 presents our conclusions. 2. Hypothesis Development In this section we develop the hypotheses that connects the governance structure of an IPO firm to the offered price and therefore to the following initial return. There are two hypotheses to support our arguments: the interest-alignment hypothesis proposed by La Porta et al. (1999) and Claessens et al. (2002) and the reduced monitoring hypothesis proposed by Brennan and Franks (1997). 2.1. Cash Flow Rights and the Offered Price La Porta et al. (1999), Claessens et al. (2000) and Faccio and Lang (2002) portray that most firms around the world are predominantly controlled by a single 5
large shareholder. La Porta et al. (2002) indicate that higher cash flow rights could serve as a firm commitment for the controlling shareholder not expropriating minority wealth in countries with inferior shareholder protection. Claessens et al. (2002) find that firm value increases with the cash flow ownership of the largest shareholder. This is consistent with a positive incentive effect. However, the firm value falls when the voting rights of the largest shareholder exceed the owner s cash flow ownership, consistent with the entrenchment effect. Controlling shareholders with higher cash flow rights are strongly motivated to negotiate a higher offering price with underwriters in that they must bear much of the underwriting costs for the IPO. Moreover, concentrated ownership could serve as a credible commitment to not expropriate minority shareholder wealth (Gomes, 2000) Therefore, on the behalf of the minority shareholders, the corresponding underwriters are also willing to compromise on setting the share price. This commitment is credible because minority shareholders can discipline the controlling shareholder by discounting the stock price, at least to an extent equivalent to the portion extracted by the controlling shareholder. The incentive alignment effect predicts that an increase in controlling shareholder ownership beyond the minimum level needed for effective control improves the alignment of interests between the controlling and minority shareholders. Brennan and Franks (1997) develop the reduced monitoring hypothesis, illustrating that insiders valuing independence are willing to underprice new issues to generate excess demand, permitting discriminatory rationing against large bidders. However, this argument is less an issue for controlling shareholders with higher cash flow rights. With intact control in the first place, the controlling shareholders are reluctant to devalue the newly issued shares simply to prevent large new shareholding 6
block sizes. Moreover, Field and Sheehan (2004) report that a large fraction of going-public firms has large block-holders in place prior to the IPO. Therefore, if managers attempt to use share under-pricing to prevent blocks from forming, they would have already lost the battle in the first place. The outcome of a price-haggling forum composed of strong willed controlling shareholders and compromising underwriters would obliquely lead to higher comparable firm multiples. Hypothesis 1: The comparable price multiples of IPO firms are positively correlated with the controlling shareholder s cash flow rights. 2.2. Cash Flow Rights and Initial Return Initial return is referred to the price difference between the first days trading price and the offered price. Up to this open market trading stage, outside investors are invited into the negotiations. These outside investors would prefer to purchase the IPO firm shares where the controlling shareholders have higher cash flow rights and pay due diligence to have the company run properly for their own sake. High cash flow rights also serve as a credible commitment because the outside investors could discipline ill-intentioned controlling shareholders through discounting the stock price. A purchasing cascade would further increase the price and lead higher initial returns. Hypothesis 2a: The controlling shareholder s cash flow rights are positively correlated to IPO initial returns. In contrast, the reduced monitoring hypothesis proposed by Brennan and Franks (1997) implies that controlling shareholders with high cash flow rights are reluctant to initiate a lower price, leaving limited space for the first-day price to soar, and 7
therefore resulting in a lower initial return. In ownership-concentrated economies the controlling shareholders with intact control in the first place are also less likely to underprice shares to create a posterior buying cascade. Therefore, the initial returns are expected to be lower. Hypothesis 2b: The controlling shareholder s cash flow rights are negatively correlated to IPO initial returns. The two contradictory hypotheses balance between the favorable response from investors credence in a sound governance structure and the insider s reluctance to undervalue the issued shares. The exact relation between these two hypotheses is left for further empirical verification. 2.3. Control-Cash Deviation and Offer Price The agency problem stemming from concentrated ownership focuses on the conflicts between the controlling owner and minority shareholders. Grossman and Hart (1988) and Harris and Raviv (1988) show that separating ownership and control lowers shareholders value and may not be socially optimal. Shleifer and Vishny (1997) illustrate that as ownership gets beyond a certain point, large owners gain nearly full control, generating private control benefits that are not shared by the minority shareholders. Claessens et al (2002) show that for the largest shareholders, the difference between control rights and cash flow rights is associated with a value discount and that this discount generally increases with the size of the wedge between control rights and cash flow rights. With a deviating control-cash structure, the 8
controlling owners are strongly motivated to opportunistically deprive minority shareholders of their rights through opaque transactions in which profits are transferred to other companies that the controlling share holders control. The pursuit of non profit-maximizing objectives is limited in return for personal gain. With increasing managerial ownership, the entrenched owner is less subject to board governance and market discipline. Under a divergent control-cash ownership structure, the controlling shareholders would not be as insistent, as when they invest a high degree of cash flow rights, in asking for a high issuing price in that they would have only to bear a small portion of the underpricing costs. Meanwhile, the corresponding underwriter bears the risk of unfavorable market response if the issuing shares dominate the price setting and would be reluctant to allow a high offering price. Moreover, the informativeness of the firm s report would be less credible because it reflects the controlling owner s self interest rather than the firm s true economic condition. Needless to say, when the controlling owner manipulates the firm s earnings for outright expropriation, the unsound governance structure from the divergent control-cash relationship would propel lower comparable price multiples for the issued shares (Fan and Wong, 2002). From the reduced monitoring hypothesis perspective, the controlling shareholder with entrenched power prior to the IPO would be relatively passive to the price setting even though they do not have to make concessions. Under a deviating control-cash structure, hard-line underwriters vis-à-vis the passive controlling shareholders would negotiate lower price multiples. Therefore, we hypothesize a negative relationship between the deviating ownership structure and comparable firm multiples. 9
Hypothesis 3: The comparable price multiples of IPO firms are negatively correlated with the divergence between the controlling shareholder s degree of cash flow and voting rights. 2.4. Control-Cash Deviation and Initial Return Rational investors are less likely to demand shares from issuing firms with a deviated control-cash structure. From the corporate governance perspective, the initial returns for these newly issued shares are negatively correlated with the control-cash deviation. From the reduced monitoring perspective, the controlling shareholders are confronted with a challenge from outside block share-holders that would like to generate excess demand through share underpricing. However, the controlling shareholders entrench control through dual capitalization, as illustrated in Smart and Zutter (2003), or through a pyramidal ownership arrangement and through cross shareholding. The typical case for most ownership-concentrated economies is less willingness to underprice issuing shares to create a buying cascade. Essentially, we expect a negative relationship between control-cash divergence and the initial stock offering return. Hypothesis 4: The initial IPO firm returns are negatively correlated with the divergence between the controlling shareholder s degree of cash flow rights and voting rights. 10
3. Data and Methodology 3.1 The Data In this study we collect 218 out of 223 Taiwanese non-financial IPOs in the 1992-2001 sampling period. We exclude financial firms in that they are different in characteristics and subject to different regulatory requirements. The 5 deleted IPOs are firms without a traceable ownership structure for calculating cash flow and voting rights. Therefore, our sample covers 98% of Taiwanese non-financial IPOs, mitigating the potential problem of selection bias. According to the ultimate control concept proposed by La Porta et al. (1999), we trace the ultimate controlling shareholder and calculate his/her voting rights and cash flow rights. Those controlling owners that have dominant voting rights are recognized as the ultimate controlling shareholders. Most controlling shareholders are a family whose family members 5 possess the dominant controlling power over the company. The ultimate voting rights equal the sum of direct and indirect voting rights that belong to the same controlling body. Direct voting rights refer to the shares registered under the names of the controlling shareholder and his affiliated individuals. Indirect voting rights refer to the shares registered under other companies or institutions controlled by the same controlling shareholder. According to Claessens (2000), when multiple control chains exist, the voting rights are the voting rights summed along each chain with the weakest link among all holding layers. The affiliations of the ultimate controlling shareholder are identified from the book The Research on Taiwanese Groupings published by China Credit Corporation. Other sources for identifying these relationships come from company 11
prospectuses and annual reports in which the relative associations between top managers, directors and supervisors are noted. Moreover, the ownership registered under other companies or institutions that are in turn controlled by the controlling shareholder are hand-collected from the invested business, major shareholders, and trades with affiliated persons items in the company prospectuses or annual reports. We also use data provided by the Central News Agency to check the interwoven relationships among the controlling shareholders. 3.2 Definition of Ownership and Board Composition 1. Voting Rights and Cash Flow Rights The voting rights of the controlling family are summed from their collective direct and indirect voting rights over the firm. Direct voting rights refer to the shares registered under the names of the controlling shareholder and affiliated individuals. Indirect voting rights refer to the shares registered under the companies or institutions that are in turn controlled by the same controlling shareholder. According to La Porta et al. (1999), controlling shareholders obtain indirect voting via a pyramidal structure and cross shareholding. When the controlling shareholder invests in a listed company A that in turn invests another listed company B, we define that the controlling shareholder obtains indirect control over company B through a pyramidal structure. There could be multiple layers of chains through the line of control. Cross shareholding is defined as when the affiliated group companies associated with or controlled by the ultimate controlling shareholder hold equity shares in one another. There are cases of cross shareholding in Taiwan in which the controlling shareholder 5 The immediate family of a person refers to his spouse, parents, children, siblings, mother-in-law, father-in-law, sons and daughters-in-law, brothers and sisters-in-law. 12
of a listed firm uses the company s funds to found a subsidiary company, which in turn buys shares in the listed company. The cash flow rights along each chain are the products of all ownership rights in the intermediate companies along that chain. The total cash flow rights, according to Claessens et al. (2000), are equal to the sum of all cash flow rights from all ownership chains. For example, suppose family A owns 30% of company B, which in turn owns 20% of company C. In addition family A owns 20% of company D directly, which in turn owns 10% of company C (This constitutes the second control chain of family A over company C). Family A s control rights over company C are Min (30%, 20%) + Min (20%, 10%) = 30%, while the cash flow rights generated from company C are 30%*20% + 20%*10% = 8%. Voting rights in this study are deemed the controlling shareholder s ability to affect the company s decisions, including the election of directors to the board and supervisors. Cash flow rights are deemed as the controlling shareholder s share in the profits, dividends and the losses due to agency misconduct. Gomes (2000) show that a higher ownership concentration can serve as a credible commitment that the controlling owner is willing to build a reputation for not expropriating minority shareholders. Therefore, cash flow rights are associated with the controlling shareholder s incentive effect in that his/her interests are well aligned with the company s profits. In contrast, a divergence between the controlling shareholder s voting and cash flow rights serves as a proxy that the controlling owner has high motive to extract wealth from the firm, since in so doing he/she receives the entire benefit but only bears a fraction of the cost. Note that there are cases in which a private investment company is included on the list of major shareholders for a listed company. The controlling shareholder s 13
family members represent this private investment company on the board of this listed company. We check the status of this private investment company from numerous sources, including The Study of Taiwanese Groupings, company prospectuses, annual reports, and newspaper clippings, to determine if the voting rights of this private investment company belong to the controlling shareholder. In calculating the cash flow rights, we need the detailed structure along each layer of ownership. However, when the detailed ownership structure of the private investment company is unavailable, we assume that the private investment company is equally invested by the controlling shareholder and his other affiliated companies. 2. Second Largest Shareholder The second largest shareholder is the one not associated with the largest shareholder or his affiliated persons or institutions. The existence of a second large blockholder facilitates corporate governance as it allows him/her to exert greater influence on the management and to ward off non-profit-maximizing behavior by the controlling shareholders. We assign a dummy variable with a value of 1 for the second largest shareholder when the second largest shareholder holds 5% or more 6 of the shares and 0 otherwise. In Taiwan, the second largest shareholder tends to be the second largest family, an insurance company, the government, or other institutional investor. 3. Board Composition We focus mainly on the proportion of directors and supervisors represented by 6 In our sampling period, Article 241 of Taiwanese Company Law stipulates that shareholders that have continuously held 5% or more of the total number of outstanding shares in a company over one year may request in writing to the company supervisors to institute, in the company interest, an action against a company director. In case the supervisors fail to institute an action within 30 days after having received the request, the shareholders filing such request may then institute an action for the company. Therefore, the existence of a second largest shareholder holding 5% or more of the shares provides a counterbalancing power to deter the controlling shareholder from misconduct. 14
the controlling shareholder. The greater the proportion of board membership controlled by the largest shareholder, the easier an entrenched controlling owner could pursue non-profit-maximizing objectives in return for personal utilities The proportion of board membership controlled by the controlling shareholder serves as a proxy that the controlling shareholder will expropriate wealth from the minority shareholders. If the controlling shareholder pertains to a family, the affiliated members, including family members and representatives of controlled institutions, that serve as directors or supervisors are counted. If the controlling shareholder is the government or a widely held company, its designated representatives serving as directors or supervisors are counted. 3.3 IPO Price Multiples and Initial Return According to Kim and Ritter (1999) and Purnanandam and Swaminathan (2002) we use the comparable firm multiples to evaluate the IPO firms. We examine whether the IPO valuation is related to corporate governance. The value of IPO is determined by price multiples, such as price-to-book, price-to-sales, and price-to-ebitda 7. These multiples are then compared to or divided by the corresponding multiples of the one-on-one matching sample, fitting for the following conditions: the same industry code, equivalent in assets value, similar product line, publicly listed for more than one year, and no issuance of new shares within two months around the IPO event. These IPO multiples are deflated by peer multiples to serve as the dependent variables of the regressions that examine the influence of corporate governance on IPOs pricing. Note that we calculate the matching firms 7 EBITDA stands for Earnings before Interest, Taxes, and Depreciation and Amortization. It is also referred to as Operating income before depreciation and amortization. 15
price multiples for both one-year and three-year averages prior to the IPOs. The empirical results are similar. For briefness we only report the results for the latter. The IPO underpricing is defined as the difference between the price on the first trading day and the offered price divided by the offered price. However, the enacted price limit in the Taiwan stock market deters information transmissions. We redefine IPO underpricing (or initial return) as the difference between the price on the first day that is not closed at the limit and the offered price divided by the offered price. For example, if the offered price is set at NT$20 and the first-day price is NT$21.4 (NT$20*1.07), closed at a 7 % price limit. No initial return is calculated. If the following-day price is closed at NT$22.5, within the 7% price limit, the initial return is then calculated at 12.5% ((NT$22.5-NT$20)/NT$20). To circumvent the market condition impact, we also calculated the adjusted initial return that subtracts the corresponding market return from the IPO initial return. 3.4 IPO Firms Characteristics 1. Underwriting Variables Our control variables for the under-writing process include the issuing proceeds, the accountancy reputation, the under-writer s reputation, and the average odds rate for the fixed price offered. Proceeds is defined as the natural logarithm of the multiplicity of the offered price and the issued shares (Ritter, 1991). Michaely and Shaw (1995) indicate that an IPO firm signed by a renowned accounting firm tends to have a higher initial return. The dummy variable for reputed accounting firm is assigned 1 when the associated IPO accounting firm is in the top six accounting firms, namely Arthur Anderson (AA), Klynveld, Peat, Marwick, and Goerdeler (KPMG), 16
PriceWaterhouseCoopers (PwC), Deloitte Touche Tohmatsu (DTT), Ernst & young, Coopers & Lybrand 8, and 0 otherwise. Carter, Dark, and Singh (1998) find that IPO stock under-performance relative to the market is less severe for IPOs handled by more prestigious underwriters 9. We also use a dummy variable to signify the reputation effect of the lead underwriter, assigned a value of 1 when the lead underwriter is one of the following underwriters: Grand Cathay Securities Corp. (GCSC), Taiwan International Securities Corp. (TISC), Yuanta Group, National Investment Trust Co., Ltd. (NITC), Chinatrust Securities, and Chiao Tung Bank, and 0 otherwise. The lottery odds are defined as the new issued shares divided by the qualified shares subscribed to by investors. More optimistic investors subscribing shares will lead to a lower lottery odds rate. Therefore, a low lottery odds rate signifies investor optimism regarding the issuing firm and a strong demand for the new issued shares. 2. Company Characteristics We also control the characteristic issuing firm variables. The electronic industry dummy is assigned a value of 1 when the issuing firm is in the electronics industry with the first two industry code digits of 23 or 24, and 0 otherwise. The firm age is controlled in the model and calculated as the time from its founding to the time it goes public. Loughran and Ritter (2001) report that the median age of firms going public has been remarkably stable at about 7 years old since 1980 with the exception of the Internet bubble period. The third control variable is the natural logarithm for the asset 8 In 1999 KPMG merged Cooper & Lybrand, and in 2003 AA and DTT merged into Deloitto & Touche. 9 For other related work within the common stock IPO literature that examine the underwriter reputation effect on IPO initial performance, see Logue (1973), Beatty and Ritter (1986), Titman and Trueman (1986), and Maksimovic and Unal (1993). 17
size of the issuing firm at the yearend prior to the IPO. The debt ratio is defined as the total debt divided by total assets at the yearend prior to the IPO. We also use the five-year average return on asset (ROA) prior to the IPO to measure the profitability of the issuing firm. The five-year average for the R&D expenditure and advertising expenses sum divided by sales served as the proxy variable for the issuing firm s growth potential. The five-year standard deviation in EBIT prior to the IPO is used to measure the volatility of the issuing firm. The greater this measure, the greater the investor tendency to discount the firm s value. 4. Empirical Results 4.1. Basic Statistics Table 1 summarizes the basic statistics of 218 qualified IPOs in the 1992-2001 sampling period. The ownership structure statistics summarized in Panel A show that the mean (median) voting rights held by the controlling shareholders are 38.48% (36.07%). The mean (median) cash flow rights invested by the controlling shareholders are 31.40% (27.91%). The deviation in voting rights from cash flow rights is 7.09%. The proportion of cash flow to voting rights is 81.39%. These results illustrate that IPO firm ownership is concentrated mainly in the hands of controlling shareholders. It is quite common for the controlling shareholders to leverage control over these IPO firms through pyramidal shareholding (31.19%) and cross shareholding (13.30%). Around half of the IPO firms (46.79%) has a second largest shareholder that might provide a governance counter balance to ward off wealth exploitation from the minority shareholders. One of the manifest ways for the controlling shareholders to affect IPO firm operations is through board membership 18
representation, including the board of directors and board of supervisors. In total the controlling shareholders control 39.45% of the board membership. Panel B shows that the price multiples deflated by the matching firms multiples are greater than 1. The price multiple with respect to the book value per share (2.41) is higher than the multiple to sales per share (1.98) and the multiple to EBITDA per share (1.65). The results in panel C show that these IPO firms on average has an initial return of 29.02%, and a market adjusted initial return of 28.97%, which is even higher than the first-day return in the U.S., 18.1%, in the sampling period from 1980 through 2001. The gross proceeds distribution is skewed to the right with a mean of NT$1.56 billion (equivalent to U.S. $50 million) and a median of NT$0.47 billion. The average amount is somewhat smaller than that for the U.S ($78 million). The evidences also shows that about 75% of the IPO firms (or 124 IPO firms) are countersigned by the top six accounting firms. Fifty-five percent of the IPO firms (or 119 IPO firms) are issued by the top six reputed underwriters. The average lottery odds are 12.84%, indicating that investors had a high inclination to buy the IPO shares. Among these IPOs, 81 are electronic firms. The median age of 10 years is older than that of 7 years reported by Loughran and Ritter (2001). Note that the standard EBIT deviation five years prior to the IPOs is 162.35%, indicating that these IPO firms are highly volatile. 19
Table 1 Basic Statistics This table reports the basic statistics for 218 qualified IPOs. The voting rights are the summed voting rights along each chain with the weakest link among all holding layers. The cash flow rights along each chain are the products of all ownership in the intermediate companies along that chain. The total cash flow rights are equal to the sum of all cash flow rights from all ownership chains. The second-largest-shareholder dummy is assigned the value of 1 when a second largest shareholder with 5% or more shares exists, and 0 otherwise. The pyramidal dummy is assigned the value of 1 when the controlling shareholder has indirect voting via a pyramidal structure, and 0 otherwise. The cross-shareholding dummy is assigned the value of 1 when the controlling shareholder has indirect voting via cross shareholding, and 0 otherwise. The price multiples are the offering price divided by book value per share, sales per share, and EBITDA per share prior to IPO. These multiples are then deflated by corresponding multiples of matching firms. Initial return is defined the difference between the first trading day that is not closed at the price limit and offered price divided by the offered price. The adjusted initial return subtracts the corresponding market return from the initial return. Proceeds is defined as a multiplication of the issued shares and the offered price. The accountancy dummy is assigned the value 1 when the associating IPO accounting firm is one of the top six accounting firms, and 0 otherwise. The underwriter dummy is assigned the value 1 when the lead underwriter is one of the following underwriters: Grand Cathay Securities Corp. (GCSC), Taiwan International Securities Corp. (TISC), Yuanta Group, National Investment Trust Co., Ltd. (NITC), Chinatrust Securities, and Chiao Tung Bank, and 0 otherwise. Variable Mean S. D. Q1 Median Q3 Panel A: Ownership Structure Voting Rights (%) 38.481 21.831 22.179 36.070 54.001 Cash Flow Rights (%) 31.395 20.475 15.935 27.910 43.338 Voting Rights Cash Flow Rights (%) 7.085 10.354 0.000 2.320 11.030 Cash Flow Rights/Voting Rights (%) 81.390 23.153 64.803 93.374 100.00 Dummy (Second Largest Shareholder) 0.468 0.500 0.000 0.000 1.000 Dummy (Pyramidal) 0.312 0.464 0.000 0.000 1.000 Dummy (Cross Shareholding) 0.133 0.340 0.000 0.000 0.000 Proportion of Directorates and Supervisors (%) 39.445 20.253 25.000 37.500 50.000 Panel B: Price Multiples of IPOs (deflated by the Multiples of Matching Sample) 3-year averaged (Price/Book Value per share) Prior to IPO 2.410 1.595 1.378 2.000 3.039 3-year averaged (Price/Sales per share) Prior to IPO 1.981 2.315 0.664 1.230 2.815 3-year averaged (Price/EBITDA per share) Prior to IPO 1.653 1.664 0.753 1.240 2.094 Panel C: Initial Returns Initial Returns (%) 29.024 33.753 4.051 18.533 48.669 Adjusted Initial Returns (%) 28.967 33.612 5.072 18.996 46.729 20
Table 1 Basic Statistics (continued) Variable Mean S. D. Q1 Median Q3 Panel D: Underwriting Proceeds (in million NT dollars) 1,564.0 10,862. 4 279.3 446.0 921.8 Dummy (Reputation of Accountancy) 0.752 0.433 1.000 1.000 1.000 Dummy (Reputation of Lead Underwriter) 0.548 0.499 0.000 1.000 1.000 Odds Rate (%) 12.838 27.461 0.683 1.690 6.051 Panel E: Company Characteristics Years from Foundation 17.454 9.113 10.000 16.000 23.000 Assets (in million NT dollars) 6,708.1 33,080. 8 1,520.3 2,406.6 4,615.4 Debt Ratio (%) 44.650 14.869 34.380 44.530 55.770 Returns on Assets (%) 14.353 7.592 9.492 12.706 17.876 (R&D Expenditure + Advertisement) / Sales (%) 3.010 8.046 0.312 1.238 2.851 Standard Deviation of EBIT (%) 162.347 270.589 40.762 75.941 161.849 4.2. Corporate Governance and IPO Price Multiples Following the notion of Purnanandam and Swaminathan (2002), we calculate the price multiples with respect to the book value, sales, and earnings before interest and taxes after depreciation and amortization (EBITDA) at a per-share basis three years prior to the IPOs. These multiples were then divided by the corresponding multiples from the matching sample in the same industry and close in characteristics. These comparable price multiples are then regressed on corporate governance variables and other controlled variables. Note that we also include listing year dummies in each regression, while not report in Table in order to save space. The regression results are summarized in Tables 2, 3, and 4, respectively. The results show that both the controlling shareholder s cash flow rights and the proportion of his/her cash flow rights to voting rights are positively correlated with 21
the comparable price-to-book IPO firm multiples at the 5% significance level. The positive interest-alignment argument is still sustainable when the dependent variable is replaced by the comparable price-to-sale multiple in Table 3 or by the comparable price-to-ebida multiples in Table 4, though the results are less significant. The results support Hypothesis 1 that a controlling shareholder with high cash flow invested is strongly motivated to ask for a high price multiple. The accompanying underwriter would also compromise the price setting in the sense that the interest-alignment argument is creditworthy. This results also corroborates the reduced-monitoring hypothesis prediction that a controlling shareholder with high cash flow rights is well entrenched before the IPO and is less willing to make a concession on the offer price setting. The results indicate that the cash flow rights surely dictate the comparable price multiple negotiations between the controlling shareholder of the issuing firm and the associated underwriter. According to Hypothesis 3 we argue that a divergent voting-cash ownership structure is negatively correlated with the comparable price multiples in that the controlling shareholder bears only a small portion of underpricing cost will not be as insistent as when he/she invests high cash flow rights and underwriter assumes the unfavorable market response risk on the issued shares. The controlling shareholder would then haggle over the offering price. Though the reduced-monitoring hypothesis states that the controlling shareholder with entrenched control through a cross shareholding or pyramidal ownership structure does not need to concede the price setting, we believe that he/she will be relatively passive in responding to questions from the underwriter. We find that using the voting-cash deviation alone in the regression is less significant. However, it is negatively correlated with the comparable price-to-book 22
multiple at the 5% significance level when the interaction between the voting-cash deviation and the cash-flow dummy is included. The cash-flow dummy is assigned a value of 1 when the controlling shareholder s cash flow rights exceed the sample median and 0 otherwise. This result indicates that the controlling shareholder s entrenchment from the cash-voting divergence is somewhat suppressed by the interest-alignment effect when his/her cash flow rights exceed the sample median. This leads to an insignificant impact by the cash-voting divergence on the price multiple. The voting-cash deviation is negatively correlated with the comparable price-to-sale multiple at the 5% significance level. The relation between the voting-cash deviation and comparable price-to-ebida is negative while less significant. The overall results generally support Hypothesis 3. Were the manifest variables, such as the proportion of board membership represented by the controlling shareholders, more informative or easier to access than the implicit variables, such as the controlling shareholder s cash flow rights and control-cash deviation, we would expect the former to have more explaining power on the comparable price multiples than the latter. However, the empirical results do not support this argument. The results of other control variables in Tables 2 to 4 indicate that the size and electronic industry dummy are positively correlated with comparable price multiples. We argue that issuing firms with larger proceeds are able to negotiate a higher price multiple with the underwriters. In our sampling period, firms in the electronic industry were promising and favored by investors. With that the underwriters could easily induce a buying cascade, even at high price multiple levels. The other variables are significant in some tables but not all. For example, the debt ratio is only marginally significant related to the price-to-book multiple in Table 23
2. The free cash flow hypothesis proposed by Jensen (1986) indicates that a high level of debt reduces the agency costs because the fixed corporate debt payments force managers to disgorge any free cash flow that may have been misused. High debt levels can act as a corporate governance mechanism. Moreover, the time from company founding to IPO is negatively associated with the comparable price-to-sales multiple in Table 3, indicating that younger firms possessing growth potential are welcomed by the market and have higher price multiples. Also in Table 3, we find that the R&D expenditure plus advertisement expenses divided by sales are positively related to the adjusted price-to-sales multiple. This echoes the finding with Mishra et al. (2001) that firms with relatively more tangible assets in their asset structure have lower value. 24
Table 2: Regression of Price-to-Book Multiple on Corporate Governance This table reports the regression of IPO price-to-book multiple on the corporate governance variables prior to the IPO. The dependent variable, price-to-book multiple, is deflated by the equivalent matching sample multiple. The matching sample is selected to fit the following conditions: the same industry code, equivalent assets value, similar product line, publicly listed for more than one year, and no new shares issued within two months. The cash flow rights and voting rights refer to La Porta et al. (1999) and Claessens et al. (2000). The cash-flow-rights dummy is assigned the value of 1 when the controlling shareholder s cash flow rights exceed the sample median, and 0 otherwise. The accountancy dummy is assigned the value of 1 when the signing accountant belongs to the top six accounting houses, and 0 otherwise. The underwriter dummy is assigned the value of 1 when the lead underwriter belongs to the top six renowned investment banks, and 0 otherwise. The electronic-industry dummy is assigned the value of 1 when the IPO firm is classified with industry codes 23 and 24, and 0 otherwise. The listing year dummies are also included in each regression while not reported in order to save space. In each cell the regression coefficient is reported in the upper case and t-statistics in parentheses is reported in the lower case. ***, **, and * represent significance level of 1%,5%, and 10%, respectively. Independent Variable Intercept Cash flow Rights Voting Rights Cash Flow Rights Cash Flow Rights / Voting Rights Proportion of Directorates and Supervisors Dummy (Cash Flow Rights) * (Voting Rights Cash Flow Rights) Dependent Variable: IPO Price-to-Book Multiple deflated by Matching Sample -0.440-0.265-1.120-0.244-0.307 (-0.583) (-0.353) (-1.336) (-0.322) (-0.410) 0.009 (1.985)** -0.012 (-1.372) 0.009 (2.324)** 0.001 (0.289) -0.023 (-2.024)** 0.022 (1.701)* -0.298 (-0.399) -0.011 (-1.688)* Dummy (Cash Flow Rights) * Proportion of Directorates and Supervisors Ln (Proceeds) Dummy (Reputation of Accountancy) Dummy (Reputation of Underwriter) Dummy (Electronic Industry) Time from Foundation Debt Ratio (R&D + Advertisement)/ Sales 0.013 (2.631)*** 0.303 0.343 0.353 0.311 0.362 0.373 (2.769)*** (3.077)*** (3.214)*** (2.788)*** (3.241)*** (3.322)*** 0.034-0.027-0.020-0.001-0.025-0.032 (0.161) (-0.129) (-0.094) (-0.004) (-0.119) (-0.153) 0.051 (0.293) 0.056 (0.319) 0.045 (0.258) -0.045 (0.254) 0.035 (0.198) 0.005 (0.031) 0.725 0.613 0.663 0.660 0.605 0.664 (3.354)*** (2.846)*** (3.133)*** (3.041)*** (2.817)*** (3.108)*** -0.011-0.011-0.013-0.010-0.011-0.010 (-1.031) (-1.027) (-1.160) (-0.940) (-1.041) (0.946) 0.011 0.011 0.010 0.011 0.010 0.008 (1.862)* (1.898)* (1.841)* (1.884)* (1.638) (1.473) -0.005-0.005-0.006-0.006-0.004-0.003 (-0.408) (-0.488) (-0.554) (-0.504) (0.377) (-0.350) R 2 (%) 16.69 15.95 17.40 15.19 16.90 18.07 25
Table 3: Regression of Price-to-Sales Multiple on Corporate Governance This table reports the regression of IPO price-to-sales multiple on corporate governance variables prior to the IPO. The dependent variable, price-to-sales multiple, is deflated by the equivalent matching sample multiple. The other variables are defined in Table 2. In each cell the regression coefficient is reported in the upper case and t-statistics in parentheses is reported in the lower case. ***, **, and * represent significance level of 1%,5%, and 10%, respectively. Independent Variable Intercept Cash flow Rights Voting Rights Cash Flow Rights Cash Flow Rights / Voting Rights Proportion of Directorates and Supervisors Dummy (Cash Flow Rights) * (Voting Rights Cash Flow Rights) Dependent Variable: IPO Price-to-Sale Multiple deflated by Matching Sample 1.398 1.410 0.445 1.586 1.367 1.513 (1.343) (1.378) (0.386) (1.523) (1.346) (1.456) 0.008 (1.837)* -0.027 (-2.336)** 0.011 (2.138)** -0.0004 (-0.064) -0.037 (-2.544)** 0.022 (1.138) 0.010 (-1.072) Dummy (Cash Flow Rights) * Proportion of Directorates and Supervisors Ln (Proceeds) Dummy (Reputation of Accountancy) Dummy (Reputation of Underwriter) Dummy (Electronic Industry) Time from Foundation Debt Ratio 0.093 (0.618) -0.178 (-0.622) -0.280 (-0.116) 0.627 (2.110)** -0.031 (-1.971)* -0.003 (-0.397) 0.170 (1.130) -0.276 (-0.972) 0.009 (0.038) 0.486 (1.664)* -0.031 (-2.000)** -0.002 (-0.293) 0.153 (1.016) -0.238 (-0.840) -0.027 (-0.115) 0.578 (1.987)** -0.032 (-2.076)** -0.003 (-0.374) 0.107 (0.701) -0.218 (0.750) -0.039 (-0.161) 0.561 (1.888)* -0.029 (-1.870)* -0.003 (-0.331) 0.187 (1.239) -0.277 (-0.978) -0.013 (-0.055) 0.475 (1.627) -0.031 (-1.997)** -0.004 (-0.459) 0.010 (1.516) 0.154 (0.998) -0.249 (-0.856) -0.066 (-0.273) 0.568 (1.915) -0.028 (-1.824)* -0.004 (-0.549) 0.099 0.100 0.099 0.010 0.101 0.100 (R&D + Advertisement)/ Sales (6.485)*** (6.584)*** (6.490)*** (6.406)*** (6.659)*** (6.516)*** R 2 (%) 29.00 30.40 30.09 28.44 30.87 29.28 26
Table 4: Regression of Price-to-EBITDA Multiple on Corporate Governance This table reports on the regression of IPO price-to-ebitda multiple on corporate governance variables prior to the IPO. EBITDA is defined as the earnings before interest, taxes, depreciation and amortization at per share basis. The dependent variable, price-to-ebitda multiple, is deflated by the equivalent matching sample multiple. The other variables are defined in Table 2. In each cell the regression coefficient is reported in the upper case and the t-statistics are reported in parentheses in the lower case. ***, **, and * represent 1%,5%, and 10% significance levels, respectively. Independent Variable Intercept Cash flow Rights Voting Rights Cash Flow Rights Cash Flow Rights / Voting Rights Proportion of Directorates and Supervisors Dependent Variable: IPO Price-to-EBIDA Multiple deflated by Matching Sample -0.033 0.138-0.184 0.059 0.151 0.047 (-0.055) (0.229) (-0.263) (0.098) (0.248) (0.078) 0.007 (1.856)* -0.004 (-0.595) 0.003 (0.955) 0.007 (1.119) -0.002 (0.236) 0.005 (0.898) Dummy (Cash Flow Rights) * (Voting Rights Cash Flow Rights) -0.004 (-0.321) Dummy (Cash Flow Rights) * Proportion of Directorates and Supervisors Ln (Proceeds) 0.205 (2.296)** 0.225 (2.484)** 0.229 (2.533)** 0.191 (2.117)** 0.223 (2.441)** 0.002 (0.541) 0.200 (2.175) Dummy (Reputation of Accountancy) -0.122 (-0.695) -0.177 (-1.009) -0.171 (-0.981) -0.110 (0.621) -0.178 (-1.012) -0.115 (-0.650) Dummy (Reputation of Underwriter) -0.019 (-0.128) -0.032 (-0.209) -0.029 (-0.194) -0.025 (-0.170) -0.032 (-0.214) -0.026 (-0.175) Dummy (Electronic Industry) 0.474 0.413 0.426 0.460 0.417 0.458 (2.586)** (2.233)** (2.328)** (2.515)** (2.245)** (2.496)** Time from Foundation -0.011-0.010-0.010-0.012-0.010-0.012 (-1.196) (-1.070) (-1.113) (-1.349) (-1.075) (1.337) Debt Ratio 0.003 0.003 0.003 0.003 0.003 0.002 (0.590) (0.595) (0.606) (0.513) (0.617) (0.453) (R&D + Advertisement)/ Sales 0.003 0.003 0.003 0.002 0.002 0.003 (0.201) (0.250) (0.196) (0.127) (0.149) (0.166) R 2 (%) 13.60 12.03 12.32 13.36 12.08 13.51 27