Country risk and valuation.pdf

Country risk and valuation.pdf - Managerial Finance...

  • No School
  • AA 1
  • 20

This preview shows page 1 out of 20 pages.

Unformatted text preview: Managerial Finance Downloaded by Universitas Islam Negeri Maulana Malik Ibrahim, UIN Maliki At 04:06 21 September 2018 (PT) Country risk and valuation of US-listed foreign IPOs Congsheng Wu, Article information: To cite this document: Congsheng Wu, (2012) "Country risk and valuation of US‐listed foreign IPOs", Managerial Finance, Vol. 38 Issue: 10, pp.939-957, Permanent link to this document: Downloaded on: 21 September 2018, At: 04:06 (PT) References: this document contains references to 29 other documents. To copy this document: [email protected] The fulltext of this document has been downloaded 870 times since 2012* Users who downloaded this article also downloaded: (2013),"IPO valuation and insider manipulation of R&D", Managerial Finance, Vol. 39 Iss 10 pp. 888-914 <a href=" ; (2007),"Do risk factors matter in the IPO valuation?", Journal of Financial Regulation and Compliance, Vol. 15 Iss 1 pp. 63-89 <a href=" doi.org/10.1108/13581980710726796</a> Access to this document was granted through an Emerald subscription provided by emerald-srm:609409 For Authors If you would like to write for this, or any other Emerald publication, then please use our Emerald for Authors service information about how to choose which publication to write for and submission guidelines are available for all. Please visit for more information. About Emerald Emerald is a global publisher linking research and practice to the benefit of society. The company manages a portfolio of more than 290 journals and over 2,350 books and book series volumes, as well as providing an extensive range of online products and additional customer resources and services. Emerald is both COUNTER 4 and TRANSFER compliant. The organization is a partner of the Committee on Publication Ethics (COPE) and also works with Portico and the LOCKSS initiative for digital archive preservation. *Related content and download information correct at time of download. The current issue and full text archive of this journal is available at 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 Abstract 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 aftermarket. 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 pp. 939-957 q Emerald Group Publishing Limited 0307-4358 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 Weisbach, 2002). 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...
View Full Document

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern