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Congsheng Wu, (2012) "Country risk and valuation of US‐listed foreign IPOs", Managerial Finance, Vol. 38
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Country risk and valuation
of US-listed foreign IPOs US-listed
foreign IPOs Congsheng Wu
Downloaded by Universitas Islam Negeri Maulana Malik Ibrahim, UIN Maliki At 04:06 21 September 2018 (PT) School of Business, University of Bridgeport, Bridgeport, Connecticut, USA
Purpose – Many foreign firms have made their initial public offering (IPO) debuts in the USA,
without first being listed in their home market. The purpose of this paper is to investigate the
association of a wide range of country risk measures with the valuation of foreign IPOs.
Design/methodology/approach – Based on the law and finance literature, it is hypothesized that
IPO firms domiciled in countries with higher country risk are worth less, other things equal. This
hypothesis is tested with a sample of international companies making their IPO debuts in the USA
between 1986 and 2002.
Findings – It is found that several commonly used country-level variables explain the observed
IPO valuation differences across countries. In particular, the index of economic freedom,
developed by the Heritage Foundation, and the Transparency International’s corruption index have
a significant impact on post-offer IPO valuations. Specifically, IPO firms hailing from countries
with more economic freedom and less corruption are associated with higher valuation in the
Originality/value – The paper investigates whether some commonly-used country risk measures
affect the valuation of newly US-listed foreign firms. 939
Received September 2011
Revised January 2012
Accepted March 2012 Keywords United States of America, Stock markets, Flotation of companies, Initial public offerings,
Valuation, Foreign IPOs, Country risk, Economic freedom, Corruption
Paper type Research paper I. Introduction
Over the past few decades, many foreign companies have made their initial public
offering (IPO) debuts in the USA, without first being listed in their home market. The
primary driver of this practice is the increasing demand for foreign shares by
American investors. While such a US listing provides a more convenient channel for
investors to achieve global diversification, its economic effect has been examined
extensively by researchers.
Most studies of foreign IPOs focus on the first-day return (also known as
underpricing). Bruner et al. (2004), for instance, show that foreign firms making IPOs in
the US experience approximately the same underpricing on average as US domestic
IPOs. They argue that the risk of foreign IPOs arising from asymmetric information and
high country risk are offset by characteristics that reduce their risk relative to
US domestic IPOs. Bruner et al. (2006) further show that there is no significant difference
in underpricing between emerging and developed market IPOs made in the USA. On the
other hand, Bell et al. (2008) demonstrate that firms from countries with governmental
policies and institutional practices that protect the economic freedom of its citizens are
significantly less underpriced than IPOs of firms originating from countries
experiencing lower levels of economic freedom.
JEL classification – G15 Managerial Finance
Vol. 38 No. 10, 2012
q Emerald Group Publishing Limited
DOI 10.1108/03074351211255155 Downloaded by Universitas Islam Negeri Maulana Malik Ibrahim, UIN Maliki At 04:06 21 September 2018 (PT) MF
38,10 940 While studying the IPO short-run performance is important, a relatively unexplored
area is how the valuation of US-listed foreign IPOs is determined in the aftermarket.
Examination of post-offer valuation of newly listed firms is relevant because only a
fraction of the total shares are sold in an IPO, and the vast majority of the shares are
held by long-term shareholders. The IPO literature documents evidence that some
offer- and firm-specific characteristics such as industry and size affect valuation
(Aggarwal et al., 2009). But since these foreign IPOs come from countries with
substantial differences in levels of economic development, economic freedom, and laws
and institutions, it is both interesting and important to see if the valuation of foreign
IPOs is influenced by these country-level characteristics.
The purpose of this paper, therefore, is to investigate whether some commonly used
country-level variables affect the cross-section of IPO valuations. A closely related
study to this paper is Doidge et al. (2004), who find that companies from around the
world that cross list in USA are associated with valuation premiums relative to other
firms from their home country that do not cross list. They suggest that their results are
consistent with the bonding and monitoring hypothesis (Coffee, 1999, 2002; Reese and
Unlike the cross-listed firms examined by Doidge, Karolyi and Stulz, however, the
foreign IPOs in this study are not already listed in their domestic market prior to their
US capital market debuts. These foreign IPOs allow us to test for the existence of
country risk premium in their valuations. While a US listing provides an opportunity
for firms domiciled in a segmented market to achieve a higher valuation, US bound
foreign firms are faced with a couple of obstacles that may prohibit them from reaching
the full valuation level. The first obstacle is the information asymmetry that lies
between investors and foreign companies seeking a cross-listing. Whereas information
barrier, to a certain extent, can be mitigated due to the uniform accounting standards
for exchange-listed IPOs in the USA, it is far from being eliminated.
The second, perhaps more severe, barrier that may keep a foreign IPO from reaching
its full valuation through a US listing is the risk associated with the country where the
listing company is domiciled. Previous studies have shown that country risk indeed
affects equity valuations. Erb et al. (1996), for instance, find that several country-risk
measures are correlated with future equity returns. Recent empirical work in the law and
finance literature (La Porta et al., 1997, 1998) indicates that legal variables such as the
respect for the rule of law, protection of property rights, enforceability of contracts, and
legal heritage have a causal relationship with levels of economic growth.
A related line of research focuses on the link of economic freedom to economic
growth. Economic freedom, after all, is the fundamental right of every human to
control his or her own labor and property. Economic theories from as early as
Adam Smith in 1776 indicate that economic freedom affects not only incentives, but
also productive effort and the effectiveness of resource use. Empirical studies alone this
line generally document a positive link between economic freedom and growth
(De Haan and Sturm, 2000; Wu, 2011).
In general, countries with weak legal institutions or less economic freedom are
associated with weak investor protection and shaky corporate governance. Hence, our
main hypothesis is that the valuation of foreign IPOs is inversely related to country
risk. In other words, firms domiciled in countries with higher country risk are worth
less, other things equal, at their IPO debuts in the USA. Downloaded by Universitas Islam Negeri Maulana Malik Ibrahim, UIN Maliki At 04:06 21 September 2018 (PT) We test this hypothesis with a sample of foreign IPOs listed in the USA between 1986
and 2002. We investigate whether some commonly used country-level measures explain
the observed variances in IPO valuation. To our knowledge, this study is the first among
the growing body of foreign IPO literature to examine a wide range of country-risk
measures in the same study. The first country-risk measure used is an indicator variable
that shows a country’s legal heritage. La Porta et al. (1998) assign each country to one of
four legal traditions: English common law, French civil law, German civil law and
Scandinavian civil law. They show that laws vary a lot across countries, partly due to
differences in legal origin. The drawback of the legal heritage indicators is that they fail
to capture the distinctive contemporary characteristics and nuances of each nation’s
legal system and institutions within the same heritage. In other words, countries with
the same legal heritage are taken as the same. To overcome this drawback, we use
several other gauges of country risk, which include the index of economic freedom,
developed by the Heritage Foundation, and Transparency International’s corruption
index. We also adopt two relatively new measures of investor protection: the
anti-self-dealing index and the revised anti-director rights index, both taken from
Djankov et al. (2008).
Overall, this paper finds that the valuation of US-listed foreign IPOs is significantly
affected by a number of country-risk measures, the most pronounced of which are
economic freedom and corruption. This result is comparable to Bell et al. (2008), who
examine the degree of underpricing for a sample of foreign IPOs made in the USA
between 1997 and 2004, whereas our sample time frame extends back to 1986.
Nevertheless, they show that firms from countries with less economic freedom are
significantly more underpriced.
The rest of the paper proceeds as follows. The next section reviews the literature
and postulates the hypothesis. Section III explains the sample and data. Section IV
provides the descriptions of the variables used in the paper and the summary statistics.
Section V presents the regression results. Section VI summarizes.
II. Literature review and hypothesis
Foreign firms pursuing a US listing are of two types. The first type includes those
firms that are already listed in their domestic market prior to their US capital market
debut. This practice is commonly referred to as cross-listing. The second group
includes firms that pursue a US IPO without first being listed in their domestic market.
This section reviews the literature that covers both types, with a focus on the second.
Previous studies have examined the economic benefit and motivation of a US listing
from multiple angles. The market segmentation hypothesis is the most often cited
motive for cross-listing. This hypothesis posits that cross-listing allows international
investors to avoid cross-border barriers to investment. These barriers may arise from
regulatory restrictions which prevent investors from investing in these markets,
asymmetric information, or simply from lack of knowledge about a security or market
(Merton, 1987). Removing barriers and integrating markets allows for more efficient
diversification and thus lowers the risk of a security. Based on this hypothesis, a firm’s
stock price will rise and the cost of capital will decline in response to the cross-listing.
Miller (1999) tests this market segmentation hypothesis directly and finds that a
cross-listing on a US stock exchange by a non-US firm is associated with a
significantly positive price reaction in the home market. This finding suggests that US-listed
foreign IPOs 941 Downloaded by Universitas Islam Negeri Maulana Malik Ibrahim, UIN Maliki At 04:06 21 September 2018 (PT) MF
38,10 942 the market expects the cross-listing to have a positive impact on the firm’s value. Later
studies have attempted to identify the sources of the positive impact. These sources
may arise from:
risk premium reduction (Foerster and Karolyi, 1999);
access to more developed capital markets (Lins et al., 2005); and
information disclosure. See Karolyi (2006) for a survey.
In recent years, the bonding hypothesis, which is built on the notion that listing in a
developed market improves corporate governance, has gained more attention in the
empirical literature. Coffee (1999, 2002) and Stultz (1999) are the first to point out that
corporate governance matters in cross-listing. They propose that firms with poor home
country corporate governance often cross-list their securities on stock markets located
in countries with more rigorous governance standards. By bonding themselves to
higher accounting, disclosure and governance standards in the USA, foreign firms
enhance access to capital, which, in turn, lowers the cost of capital and increases the
value of the firm.
Firms outside the USA are generally controlled by large shareholders and, from the
controlling shareholder’s perspective, there are costs as well as benefits from
cross-listing. Cross-listing limits the ability of controlling shareholders to take private
benefits from their firms, but it also provides external finance and funds firms’
investment opportunities. Controlling shareholders are willing to “bond” themselves
not to take private benefits when the value of having access to external capital is large
relative to the size of private benefits. In such circumstances, firms often have
investment opportunities that require external financing.
A number of studies have tested the bonding hypothesis. Reese and Weisbach
(2002), for example, examine the relation between the number of US cross-listings and
the level of investor protection in the cross-listed firms’ home countries. They show
that equity issues increase following all cross-listings, regardless of shareholder
protection. Moreover, the increase is larger for cross-listings from countries with weak
protection. These results are deemed as consistent with the bonding hypothesis.
Doidge et al. (2004) examine the firms’ valuation premium with and without
cross-listing, using Tobin’q as the measure of valuation. Using data from 40 countries on
the valuation samples of 714 cross-listed and 4,078 non cross-listed firms in 1997, they
find a substantial positive valuation premium for firms cross-listed in the USA. The
valuation difference is statistically significant and largest for exchange-listed firms. The
premium persists even after controlling for a number of firm and country characteristics.
Many studies have examined the direct and indirect issue costs of foreign firms
making their IPO debuts in the USA. Bruner et al. (2004), for instance, document that
foreign IPOs in the US experience approximately the same underpricing on average as
US domestic IPOs. They find that while foreign IPOs start out being less familiar to
US investors in terms of analyst coverage and riskier in terms of country risk, they also
have certain characteristics such as greater size, asset tangibility, and geographic
proximity. They argue that the risk of foreign IPOs arising from asymmetric
information and high country risk are offset by these characteristics that reduce their
risk relative to US domestic IPOs.
Bruner et al. (2006) further show that IPOs from emerging markets experience the
same costs on average as IPOs from developed market countries. Although there Downloaded by Universitas Islam Negeri Maulana Malik Ibrahim, UIN Maliki At 04:06 21 September 2018 (PT) is a large gap between the country risk ratings of the emerging and developed market
countries, IPO issuers from emerging markets appear to bridge that gap by being large
issuers in their respective home countries, listing more frequently on the New York
Stock Exchange (NYSE), and having a greater proportion of activity in manufacture
and infrastructure segments, and a lower proportion in high-tech segments. These
issues occur following periods of strong USA and home market equity performance
which helps to alleviate country risk. In comparison to their developed market peers,
emerging market issuers are a select group of higher-quality firms.
Blass and Yafeh (2001) examine a sample of Israeli IPOs in the USA and Israel to
understand how firms choose a specific listing location. They find that companies that
choose to list in the USA are young and overwhelmingly high-tech oriented. They
argue that high-quality innovative firms are willing to incur additional costs associated
with listing in the USA in order to real their value and distinguish themselves from
firms that issue stock back home, a result consistent with the signaling arguments.
Francis et al. (2010) also examine foreign IPOs from the perspective of the signaling
arguments. They find that signaling does matter in determining IPO underpricing,
especially for firms domiciled in countries with segmented markets. They report a
significant positive and robust relationship between the degree of IPO underpricing
and segmented-market firms’ seasoned equity offering activities. The evidence
supports the notion that some firms are willing to leave money on the table voluntarily
to get a more favorable price at seasoned offerings when they are substantially wealth
constrained, a prediction embedded in the signaling theory.
Ding et al. (2010) take a different approach by analyzing a stock listing as an
entrepreneurial decision and interpret the choice of IPO location as entrepreneurial
signaling. Building on institutional economic theory, they show that a foreign listing in a
developed market with better institutional infrastructure enables firms from an
emerging economy to enjoy a more efficient institutional environment, which is
beneficial to their pursuit of long-term benefits. From this strategic perspective, they
find evidence that the IPO location decision is driven not only by short-term financial
considerations, but also by the entrepreneur’s pursuit of long-term benefits.
Despite extensive research, however, a relatively unexplored area is how
country-level characteristics affect the valuation of foreign IPOs in the USA. A US
listing provides an opportunity for firms domiciled in segmented markets to achieve a
higher valuation. However, these US bound foreign firms are faced with a couple of
obstacles that may prohibit them from reaching the full valuation level.
First of all, a significant degree of asymmetric information exists between investors
and foreign companies seeking a US listing. The uniform accounting standard...
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