Bcu msc cg week 11 leadership 260812

ASPECTS OF FINANCIAL RISK :
CORPORATE
GOVERNANCE, LEADERSHIP &
CONTROL
MSC ACCOUNTANCY & FINANCE :
CORPORATE GOVERNANCE
& OPERATIONS RISK ANALYSIS AND CONTROL
Stephen Ong
BSc(Hons) Econs (LSE),
MBA International
Business(Bradford)
Visiting Fellow, Birmingham City University
Visiting Professor, Shenzhen University

• Discussion : Forex exposure1
• Corporate
Control, M&A, IPO & CEOs
2
• Case Presentation: IBM3
Today’s Overview

1. Open Discussion
• Bartram, S (2008) What lies beneath: foreign
exchange rate exposure, hedging and cash
flows. Journal of Banking and Finance, 32 (8).
pp. 1508-1521

2. CORPORATE CONTROL &
POWER OF CEOS

Corporate Governance in Emerging
Markets
• What are the challenges that emerging markets
face in terms of stepping up their economic
development and enhancing the governance of
their corporations.
• Such challenges include the institutional
design, in particular the role accorded to the
stock market, the privatisation of state-owned
enterprises (SOEs) as well as social and political
barriers to economic development such as crony
capitalism.

Learning Outcomes
• By the end of this lecture, you should be able to:
1. Critically review whether large equity markets
combined with strong investor rights are a necessary
and sufficient condition for economic development
2. Comprehend the challenges that emerging markets
face in their attempt to improve corporate
governance
3. Evaluate corporate governance issues that may arise
in privatised or part-privatised SOEs
4. Assess the potential benefits and costs of political
connections.

Introduction
• We have seen that there may be a link between a
country’s institutional setting, including its legal and
financial systems, and the access of its corporations to
external capital via well developed stock markets.
• In turn, it is argued that a well developed stock
market is a necessary and sufficient driver of
economic growth.
• This view is held by a substantial body of the
academic literature as well as the World Bank and
IMF.

Introduction (Continued)
• However, there are some dissenting voices that
argue that some emerging and developed
economies have done well despite weak legal
institutions and that there substitutes to strong
investor protection.
• This lecture will start with a discussion of these
two opposing views.
• It will also look at two manifestations of crony
capitalism that tend to prevail in developing
countries.

• Finally, this lecture will also make some
recommendations about how to design
corporate governance in formerly state-
owned enterprises.

Large Equity Markets and Strong Property
Rights: The Only Way to Achieve Economic
Growth?
• The law and finance literature argues that legal
and political institutions shape corporate
governance and ultimately drive economic
growth.
• According to La Porta et al., capital markets will
only develop in countries with strong investor
rights.
• The absence of liquid capital markets impedes
the growth of firms as outside capital is sparse
and investment opportunities cannot be taken
up.

• Similarly, Mark Roe and Marco Pagano and
Paolo Volpin argue that capital markets will
only develop and dispersed ownership will
only emerge under strong property rights.
• Franklin Allen argues that at the core of the
law and finance literature is a narrow view of
what the corporation is all about.
• According to this view, the objective of the
corporation is to maximise shareholder value.
Growth? (Continued)

• However, this view is based on the
assumptions that markets are perfect and
complete.
• These assumptions are unlikely to hold, even
for the case of highly developed economies.
• For example, markets are not perfect given
the existence of negative externalities.
• A negative externality is a cost imposed on
others by one’s economic activity.
Rights:
The Only Way to Achieve Economic Growth?
(Continued)

• For example, in its pursuit of creating
shareholder value a firm may end up badly
polluting the environment.
• The benefits from polluting the
environment, via the cost savings from failing
to install pollution-reducing
equipment, accrue to the shareholders.
• However, the pollution affects the local
community and may result in a substantial
reduction in their quality of life.
Growth? (Continued)

• Allen argues that the assumptions behind the
law and finance literature are likely to be
violated for the case of developed economies
and even more likely for emerging economies.
• Allen proposes a much broader view of
corporate governance along the lines of how it is
typically defined in countries such as Germany
and Japan.
• Here, the objective of the firm is to look after all
its stakeholders, and not the shareholders.
Growth? (Continued)

• This view is likely to overcome one of the
shortcomings of the shareholder-centric
view, i.e. the omission of the issue of equitable
income distribution.
• This issue is likely a major concern in developing
countries where the distributions of wealth and
income are highly skewed.
• Given that the assumptions behind the law and
finance literature do not hold, the quality of law
is neither a necessary nor sufficient condition for
economic growth.
Growth? (Continued)

• Allen cites two examples of countries to
illustrate the irrelevance of the quality of law in
terms of economic growth
1. China has experienced remarkable economic
growth since it started opening its economy in
1979, despite weak law and accounting standards
2. The UK experienced a separation of ownership and
control before it had strong investor protection.
• The question then arises as to how economic
growth could be sustained in each country in the
absence of strong law.
Growth? (Continued)

• Allen proposes the four following alternatives
to good laws
– competition,
– trust and reputation,
– family ownership, and
– foreign ownership.
• There is fierce competition in China from
domestic firms and foreign firms.
Growth? (Continued)

• China has also managed to overcome the
weaknesses of its law by developing linkages
between social and economic
institutions, market and non-market institutions.
• In the UK, trust and information problems were
mitigated by floating companies on local stock
exchanges with close proximity to their
investors.
• Family ownership has also been important
across Asia and many successful Chinese firms
have ownership by their founders and
executives.
Growth? (Continued)

• Joint ventures between domestic and foreign
investors are another way of overcoming
institutional weaknesses and ensuring access to
outside capital.
• Conglomerates may be an additional way of
bridging bad laws as they operate internal
capital markets whereby affiliated firms with
excess funds finance those affiliated firms in
need of funding.
• There is support from India that firms affiliated
to highly diversified business groups have better
accounting and stock performance.
Growth? (Continued)

• Ajit Singh and colleagues also question the role
of stock markets as drivers of economic growth.
• Their view of the stock market is much more
damning.
• Singh disputes the view that the spectacular
economic growth of the USA is mainly due to its
large and well developed stock markets.
• He claims the assertion that stock markets are
better at allocating economic resources than e.g.
banks and the state is wrong for at least two
reasons.
Growth? (Continued)

1. Stock markets may suffer from mispricing and
investor over-optimism
– The overvaluation of the New Economy stocks and
the undervaluation of the Old Economy stocks
during the late 1990s is an example of misallocation
of resources to firms that were unlikely ever to
generate profits
– The work of Robert Shiller supports Singh’s
argument
– Singh also argues that the widespread use of stock
options in New Economy firms favoured over-
reporting of earnings and fuelled the
stock market bubble
Growth? (Continued)

– He also considers the growing use of stock
options to have contributed to increasing
income inequality in the USA.
Growth? (Continued)

Figure 1 – Real S&P stock price index and real S&P composite
earnings index
0
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1870 1890 1910 1930 1950 1970 1990 2010
RealS&PCompositeEarnings
RealS&P500StockPriceIndex
Year
Price
Earnings
Source: Robert J. Shiller’s online data website, http://www.econ.yale.edu/~shiller/data.htm,
accessed on 8 February 2011.
Slide 12.23
Goergen, International Corporate Governance, 1st Edition © Pearson Education Limited 2012

2. One of the key mechanisms whereby stock
markets reallocate resources is takeovers
– However, Singh claims that this mechanism is
not efficient as it does not necessarily favour
the survival of the fittest
– Large, but relatively less profitable firms are
much more likely to survive than
small, profitable firms given that the latter are
frequently targeted by the former via mergers
and acquisitions.
Growth? (Continued)

• Singh concludes that if stock markets are
prone to bubbles in highly developed
economies then stock markets in emerging
economies are likely to fare even worse.
• The main consequence of policy makers in
emerging economies focusing on developing
stock markets would then be to increase
the volatility of their economy rather
than steady economic growth.
Growth? (Continued)

• Singh cites the example of Indonesia
– Indonesia experienced a drop of 80% in its stock
market capitalisation during the height of the
Asian crisis
– This was followed by an equivalent drop in the
value of its currency.
• In contrast, Dennis Mueller argues that the
existence of a well developed stock market
can only constitute an advantage as it offers
firms the option to finance their investments
via equity.
Growth? (Continued)

Inherited Wealth
• Randall Morck, David Stangeland and
Bernard Yeung study the impact of inherited
billionaire wealth on economic growth for 42
countries.
• They find that countries, where inherited
billionaire wealth is large relative to
GDP, have both slower economic growth and
technological change.
• In contrast, entrepreneur billionaire wealth is
positively correlated with economic growth.

Inherited Wealth (Continued)
• They justify the negative effect of inherited
wealth on economic growth by four reasons
1. Inherited wealth may keep bad and incompetent
family managers in place
2. The highly unequal wealth distribution may create
market power in capital markets, thereby reducing
the efficiency of the latter in pricing securities and
allocating economic resources
3. Inherited wealth tends to be conservative and
opposed to technological change
4. It often has strong ties to politicians further
entrenching its position.

The Role of the Government
• Government ownership of large corporations
can be substantial in some emerging markets.
• The most extreme example of the
importance of government ownership is
China.
• In 67% of the firms the government is the
largest shareholder.
• Overall, the empirical evidence suggests that
the performance of privatised firms improves
after the privatisation.

(Continued)
• However, there are significant differences in
the post-privatisation improvements across
geographical regions.
• Companies from Africa and the Middle East
experience the smallest changes in
profitability, efficiency and output.

• Post-privatisation improvements seem to
increase with
– the degree of trade liberalisation,
– stock market liberalisation
– and the development and quality of law in
developing countries.
• However, the evidence is inconclusive as to
the impact of government ownership after
the privatisation.
The Role of the Government (Continued)

• However, the higher the percentage of
government ownership post-privatisation the
higher is the likelihood that politicians and ex-
politicians sit on the firm’s board of directors.
• In contrast, this likelihood decreases with
foreign ownership.
• Emerging economies where politically
connected firms represent more than 10% of the
market capitalisation include
Indonesia, Malaysia, the Philippines, Russia
and Thailand.

• Developed economies include
Belgium, Ireland, Italy, Taiwan and the UK.
• The question arise whether political
connections are good or bad for firm
performance.
• There are two views
1. The first view is the “grabbing hand” of
government
• Politicians on boards pursue their own objectives, in
particular winning votes from their electors
• One way to achieve this is to force the firm to
employ more people than is efficient

• Hence, politicians seeks rents and these are at the
expense of the shareholders
• Even if there are benefits from political
connections, these will be appropriated by the
politicians via bribes and other favours.
2. The second view is the “helping hand” of
government
• Political connections bring about favours such as
government subsidies and procurement orders.

• Evidence from Indonesia and Malaysia suggests
that political connections are highly valuable.
• In contrast, Mara Faccio finds that political
connections are more prevalent in countries
believed to be highly corrupt and the market
reaction to the appointment of politicians to the
board is nil.
• Faccio’s evidence suggests that politicians
manage to appropriate all the gains they create.
• However, her results suggest that there is a
positive market reaction when a business person
becomes a politician.

• Further evidence by Mara Faccio and David
Parsley from geographic ties with politicians
suggests that firms that
–are family-controlled,
–have high growth,
–are small,
–operate in the industry under the
influence of the politician, and
–are from countries with high corruption.
benefit the most from political ties.
(Continued)

The Design of Corporate Governance
in Formerly SOEs
• Ravi Dharwadkar, Gerard George and Pamela
Brandes make a series of recommendations
on the design of corporate governance in
SOEs from emerging markets based on their
review of the literature.
• The first set of recommendations consists of
three recommendations on the optimal
ownership and control of the former SOEs.

The Design of Corporate Governance
in Formerly SOEs (Continued)
1. Given that managers and employees with
experience of competitive markets are
sparse in emerging markets, managerial and
employee ownership is not effective.
2. Since investor protection is low, control by a
large shareholder rather than dispersed
ownership and control will be more
effective.
3. Foreign investors are likely to be most
effective type of large shareholder.

• The second set of recommendations consists of
four recommendations on the types of
management, organisational form and
managerial contracts as well as capital structure.
1.There needs to be a change of management as
– the incumbent management lacks the experience
needed to restructure the firm, and
– the government is likely to carry on exercising a
strong influence on the firm if the incumbent
management stays in place.
The Design of Corporate Governance in
Formerly SOEs (Continued)

2. The optimal organisational structure is a multi-
divisional structure as
– they increase the efficiency of the monitoring of the
management, and
– also creates internal capital markets substituting for
underdeveloped external capital markets.
3. Behaviour-based managerial contracts will be
more efficient as outcome-based contracts are
more difficult to enforce given the high
uncertainty of outcomes due to the weak
institutional setup in emerging economies.

4. There should be as little debt as possible in
the capital structure as
– the disciplinary role of debt is unlikely to work
given the weak law enforcement, and
– more debt is likely to increase the agency
problem of debt.

Conclusions
• Are large stock markets necessary and
sufficient condition for economic
development?
• Inherited wealth and economic growth.
• Political connections.
• The design of corporate governance in
former SOEs.

Contractual Corporate Governance
• Firms that are highly dependent on equity
financing and are based in economies with
underdeveloped capital markets may face
financial constraints and a high cost of capital.
• We discuss the ways that enable firms to
overcome the absence of highly liquid local
capital markets and to tap into more developed
foreign capital markets. These ways include
foreign cross-listings, reincorporations and
cross-border mergers.
• We also discuss whether competition among
regulatory systems is good or bad for investors.

Learning Outcomes
1. Demonstrate how different contractual devices may
enable firms from countries with weak corporate
governance to improve the level of shareholder
protection they offer
2. Assess how firms can reduce their cost of capital by
tapping into more developed foreign capital markets
3. Critically review the arguments on both sides of the
debate on whether regulatory competition causes a
race to the top or a race to the bottom.

Introduction
• The lecture on the taxonomies of corporate
governance systems suggests that there is a link
between a country’s political and legal setting
and the size and development of its capital
market.
• In the lecture on corporate governance, types of
financial systems and economic growth, we saw
that some industries are highly dependent on
equity and will only thrive in the presence of a
highly developed capital market.

• Concerning the link between the institutional setting
and the size and development of the capital market, a
firm’s access to capital may be determined by
– the quality of law, in particular investor protection, as
well as the enforcement of law in its home country;
– the way social peace is maintained, including the political
orientation of the country’s government; and
– the type of electoral system.
• So how can firms in countries with underdeveloped
stock markets get better access to capital?

• More generally, how can firms based in
countries with weak corporate governance
standards exceed those standards credibly?
• Firms can do so by using particular types of
contractual devices such as:
– cross-border mergers and acquisitions,
– (re)incorporations, and
– cross-listings.
which enable them to choose their preferred
level of investor protection and regulation.

• Henry Hansmann and Reinier Kraakman
argue that firms that do not adopt a
shareholder-oriented approach will be
punished via a higher cost of capital.

Cross-Border Mergers and Acquisitions
• Firms may improve their corporate
governance and access to capital via cross-
border mergers and acquisitions.
• The questions that then arise are as follows
– Does the target benefit from the stronger
corporate governance of the bidder or does the
bidder benefit from the stronger corporate
governance of the target?
– Do bidders with weak corporate governance
harm targets with better corporate governance?

Cross-Border Mergers and
Acquisitions (Continued)
• Marina Martynova and Luc Renneboog
distinguish between three possible effects.
– The first two assume that the target adopts the
corporate governance of the bidder
• There is a positive spillover effect if a bidder with better
corporate governance improves the corporate governance of
the target
• There is a negative spillover effect if a bidder with
weaker corporate governance reduces that of the target.
– The third assumes the reverse
• The bootstrapping effect consists of a bidder with weaker
corporate governance adopting the stronger corporate
governance of the target.

• Bootstrapping is voluntary in the case of a full
acquisition, but in the case of a partial acquisition
the bidder has to honour the corporate
governance regulation that the target is subject
to (extraterritoriality principle).
• Stefano Rossi and Paolo Volpin find
that, compared to bidders, targets are from
countries with weaker shareholder protection.
• They find evidence of a positive spillover effect
as bidders with stronger corporate governance
have a positive effect on takeover volume and bid
premiums.
(Continued)

• Laura Starks and Kelsey Wei assume that the
target adopts the corporate governance of the
bidder.
• They argue that the bid premium should be
higher for bidders with lower corporate
governance as the target shareholders will be
more concerned about the increased risk.
• They find evidence for their hypothesis as US
targets of bidders from countries with weaker
standards earn higher announcement returns.
(Continued)

• Martynova and Renneboog also find that bidders tend
to have better corporate governance.
• They find evidence for the positive spillover
effect, but no evidence for the negative spillover
effect.
• They report that, for bidders with weaker corporate
governance, the returns to both the bidder and target
are higher.
• This suggests that there is a bootstrapping effect.
• The latter is mainly observed for partial acquisitions.
(Continued)

• To conclude, the empirical evidence suggests
that:
– Targets in cross-border acquisitions tend to be
from countries with weak corporate governance
– Targets with better shareholder protection
require a higher premium when taken over by
bidders with weaker governance
– There is evidence of a positive spillover
effect, including evidence suggesting an
industry-wide positive spillover effect
(Continued)

– There is evidence of a bootstrapping effect
whereby bidders with weaker corporate
governance adopt the corporate governance of
their targets. However in line with the
extraterritoritality principle, this effect is mainly
found for partial acquisitions
– While targets tend to benefit from being taken
over by a bidder with better governance, there is
some evidence that bidders lose value when
taking over weaker targets.
(Continued)

(Re)incorporations
• A reincorporation consists of a firm which is
already incorporated in one country moving its
legal seat to another country.
• The main motives behind reincorporations are
– putting in place takeover defences,
– reducing directors’ liability,
– the move to a jurisdiction with more flexible corporate
law,
– savings on tax or franchise fees,
– the reconciliation of the legal and operating domicile of
the firm, and
– the facilitation of cross-border mergers and acquisitions.

(Re)incorporations (Continued)
• The adoption of takeover defences and
reducing directors’ liability are the most
popular motives.
• There are two principles in law applying to
incorporations
1. The real seat principle
2. The incorporation principle.
• According to the real seat principle, the law
applying to the firm is that of the location of
its headquarters or main activities
– Firms are subject to the law of their real seat.

• According to the incorporation principle, the law that
applies is that of the country of incorporation.
• Most Continental European countries have adopted
the real seat principle whereas Ireland, the UK and USA
have adopted the incorporation principle.
• Until recently, only US firms were able to change the
state of their incorporation whereas corporate mobility
was significantly restricted in Europe.
• However, recent rulings by the European Court of
Justice (ECJ) have increased corporate mobility for
incorporations, but not for reincorporations.

• The question that arises is whether managers
choose locations for their (re)incorporations that
satisfy shareholder interests rather than their
own interests or whether the converse is the
case.
• There are two schools of thought on this:
1. The first school argues that competition between
jurisdictions leads to better quality corporate law
Firms will choose jurisdictions that provide legal
services at the lowest cost and that suit their needs
the best
This is the cost avoidance hypothesis
This school argues that there will be a race to the top

2. The second school argues that, in order to maximise
the revenues from incorporations, jurisdictions will
compete to provide laws that cater for managerial
rather than shareholder interests
This is the shareholder-exploitation hypothesis
This school predicts that there will be a race to the
bottom which will harm economic efficiency.
• Empirical evidence by Stephen Ferris et al.
supports the shareholder-exploitation
hypothesis
– US managers choose the federal state for the
location of their firm based on the discretion they
will have in each location.

• In turn, the argument about the race to the
bottom has been challenged
– Jurisdiction shopping is indispensable to
guarantee competition between jurisdictions and
is therefore not necessarily against shareholder
interests
– Several studies find that firms incorporated in
Delaware have higher share prices.
• However, other studies report that the higher
share prices cannot be observed after 1996
and that the main reason firms move to
Delaware is to set up anti-takeover devices.

• The large body of empirical studies
documenting a negative market reaction to
the adoption of takeover defences supports
the shareholder-exploitation hypothesis.
• Hence, it is as yet not clear whether
regulatory competition is good or bad.

• In recent years, a series of rulings by the ECJ
have reaffirmed the principle of freedom of
establishment within the EU.
• Some scholars predict lots of incorporations
of foreign companies in the UK.
• The recent trends observed by Marco Becht
et al. suggest that this prediction is likely to
become reality
– During 2002-5, the number of new private
limited companies from other EU member states
established in the UK was over 55,000.

Cross-listings
• A cross-listing consists of a firm listing on a
foreign stock exchange at the time of its
domestic IPO or thereafter.
• According to the so called bonding hypothesis
proposed by John Coffee, firms from weaker
corporate governance regimes cross-list on the
US market in order to commit not to
expropriate their minority shareholders.
• If the bonding hypothesis holds, cross-listed
firms trade at a premium.

Cross-listings (Continued)
• Virtually all of the finance literature focuses on
firms cross-listing in the USA.
• Firms seeking a US cross-listing can do so in two
different ways
1. They can cross-list via American Depository Receipts
(ADRs)
2. They can cross-list via Global Registered Shares
(GRS).
• William Reese and Michael Weisbach find that
firms from French civil law countries have more
US cross-listings (10.5%) than firms from common
law countries (6.7%).

• They also find that cross-listed firms from
civil law countries are more likely to issue
their equity outside the USA.
• Craig Doidge examines whether the cross-
listing has an impact on the voting premium
– The ratio of the price of the voting right to the
price of the cash flow right.
• He finds that firms with a US cross-listing
have lower voting premiums than those
without.

• In another study, Doidge and others examine the
valuation effect caused by a US cross-listing.
• They expect a US cross-listing to result in a
reduction in the firm’s cost of capital for at least
four reasons:
– The cross-listing increases the shareholder base and
risk is therefore shared among more shareholders
– The cross-listing increases the liquidity of the firm’s
shares
– The higher disclosure standards reduce the
information asymmetry between insiders and
outsiders
– A US cross-listing leads to higher scrutiny and
monitoring by the financial press.

• They argue that the large shareholder faces a
trade-off when cross-listing her firm
– The reduction in the cost of capital, which increases
the ability to finance growth opportunities, leading to
higher future cash flows
– The reduction in her private benefits of control due to
improved minority shareholder protection.
• As a result, only firms with significant growth
opportunities will cross-list.
• They measure growth opportunities by the
Tobin’s q (the ratio of market value to book
value).

• As expected, they find that the Tobin’s q of
cross-listed firms is higher (by 16.5%) than
that of firms from the same country without a
cross-listing.
• Wissam Abdallah and Marc Goergen examine
the decision about the choice of the host
market for a sample of 175 firms cross-listing
on 19 different stock exchanges.

• They argue that there are at least three reasons
why ownership and control may influence this
decision
1. The large shareholder faces a trade-off between the
benefits from dispersed ownership (liquidity and risk
diversification) and the private benefits from
retaining control
The large shareholder will only be willing to give up
control if the benefits from doing so outweigh her
private benefits of control
If this is the case, it makes sense to cross-list on a
market with higher shareholder protection bringing
about a higher valuation

2. Owners of high-risk firms will prefer to cross-list
on a market with higher diversification potential
which in turn has been shown to be linked to
investor protection
3. While the ownership and control structure itself
is likely to have an impact on the decision, the
link is not straightforward.
• They find that a firm’s ownership and
control structure does indeed have an
impact on this decision.

• However, contrary to their expectations, they
find that firms with substantial private
benefits cross-list on markets with better
investor protection.
• This relationship is particularly pronounced
for firms where control is concentrated in the
hands of a single shareholder.

• Further, firms with significant minority
shareholders are more likely to cross-list on a
better market whereas those with several
large shareholders are more likely to cross-list
on a market with similar or worse investor
protection.
• To sum up, Abdallah and Goergen find
support for the bonding hypothesis.

• To conclude, there is strong empirical support
for the bonding hypothesis.
• Firms based in countries with weak investor
protection tend to cross-list on better markets
to commit themselves not to expropriate their
minority shareholders.
• However, the US Sarbanes-Oxley Act of 2002
seems to have changed investors’ and
academics’ views on the benefits from cross-
listings.

• While the Act may have benefitted some
firms, it also seems to have generated
significant costs, outweighing in many cases
the benefits from a US cross-listing.

Conclusions
• Contractual corporate governance.
• Cross-borders mergers.
• (Re)incorporations.
• Cross-listings.

Corporate Governance in
Initial Public Offerings
• When a firm goes public, typically there is a substantial
reduction in the entrepreneur’s incentives to maximise
shareholder value as he/she no longer owns all of the
equity, but still has significant control over the firm.
Hence, the initial public offering (IPO) calls for a redesign
of the firm’s corporate governance arrangements.
• In addition, IPO firms also frequently suffer from higher
asymmetry of information between the insiders and
outsiders than more mature firms.
• They also often have financing provided by venture
capitalists which comes with its own benefits but may
also cause conflicts of interests.

Learning Outcomes
1. Evaluate the conflicts of interests that may prevail in
IPO firms
2. Assess the ways whereby IPO firms can mitigate
conflicts of interests between their insiders and
outsiders as well as mitigate other problems arising
from asymmetric information
3. Explain the benefits from the presence of venture
capitalists as well as the conflicts of interests they
may cause.

Introduction
• Asymmetric information is about different
actors holding different levels of information.
• In corporate governance, asymmetric
information typically refers to the management
having better information about
– the firm, and
– their own effort
than outsiders such as shareholders and
debtholders.

• Asymmetric information implies that
complete contracts which specify
– what the managers have to do in each
contingency of the world, and
– the distribution of profits in each contingency
are not possible.
• Hence, conflicts of interests cannot be
entirely prevented and corporate governance
remains an important issue.

• Corporate governance is an issue for well-
established, stock-market trade companies.
• It is even more so for firms going through or
having recently gone through their initial public
offering (IPO) for at least four reasons
1. When it goes public, the firm experiences a
separation of ownership and control
2. IPO firms tend to suffer more substantially from
problems of asymmetric information
3. The power of the CEO in an IPO is relatively high
4. Venture capitalists, with their own benefits and
conflicts of interests, are often involved in IPO firms.

Asymmetric Information, Pricing Anomalies and
the Separation of Ownership and Control in IPOs
• As part of the process of going public, the firm
normally appoints an investment bank which
will help with the issuing and sale of the equity
shares as well as their pricing.
• Broadly speaking, there are two pricing
mechanisms
– In an offer at a fixed price, the price of the
shares, the so called offer price, is determined by the
investment bank
– In a book-building offer, the pricing is more complex
and consists of three stages.

Asymmetric Information, Pricing Anomalies
and the Separation of Ownership and Control
in IPOs (Continued)
• The three stages of the book-building are
1. The investment bank asks its major clients for non-
binding expressions of interest specifying a price for
the shares and a quantity and then determines the
price range for the shares
2. During the actual book-building stage, investors are
asked to apply for the shares by specifying the
quantity and the maximum price (within the price
range) they are willing to pay
3. The investment bank goes through the
book, determines a strike and all investors that
applied at a price equal or higher than the strike
price will get shares.

• Three pricing anomalies have been observed
for IPOs
– the initial underpricing of IPO shares,
– their subsequent bad performance over the long
term,
– and the cycles in the number of IPOs and their initial
returns, i.e. the hot-issue markets.
• All three phenomena are pricing anomalies
because they violate the efficient market
hypothesis (EMH).
• According to the EMH, there should be no
persistent and predictable patterns in securities
prices.
in IPOs (Continued)

• Hot-issue markets are driven by more general
cycles in markets.
• However, both IPO underpricing and the bad
long-term performance of IPOs have been
directly linked to corporate governance.
• Hence, we shall focus on the latter two.
• IPO underpricing consists of an IPO being
oversubscribed and its offer price being lower
than the closing price on the first day (week)
of trading.
(Continued)

• IPO underpricing has been observed for a large
number of countries, including developed as
well as emerging economies.
• Average underpricing ranges from 4.2% in Russia
to 156.1% in China.
• Although there are many theories on IPO
underpricing, there is as yet no single theory
that explains all of the IPO underpricing and has
empirical support across both different types of
firms and markets.
(Continued)

Average initial IPO returns for 48 countries
Notes: see source for details of country studies.
Source: Professor Jay Ritter’s IPO data website,
http://bear.warrington.ufl.edu/ritter/ipodata.htm, accessed on 6 January 2011

• Michael Brennan and Julian Franks link
underpricing to corporate governance, i.e. the
allocation of power between insiders and
outsiders after the IPO.
• They argue that the incumbent owners of IPO
firms deliberately underprice the share to keep
control over the firm.
• By underpricing the shares, the IPO will be
oversubscribed.
• This then enables the incumbents to
discriminate in favour of small investors in the
allocation of shares.
(Continued)

• This will reduce the concentration of outside
ownership.
• While IPOs are initially underpriced, they
under-perform over the long term relative to
other firms that have been on the stock
exchange for a while and are of a similar size.
(Continued)

Percentage returns of US IPOs from 1970-2008
over the first five years after the issue compared
to firms of a similar size
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
First year Second
year
Third
year
Fourth
year
Fifth
year
IPO firms
Size-matched
Notes: The returns are equally-weighted average returns for all IPOs on Nasdaq, the Amex and the NYSE at the start of a
period. For each year, the portfolios are rebalanced to equal weights. If an issuing firm is delisted within a year, its return for
that year is calculated by compounding the CRSP value-weighted market index for the rest of the year. The size-matched
returns are obtained by matching each IPO with the non-issuing firm of the same or next higher market capitalisation (based
on the closing market price on the first day of trading for the IPO, and the market capitalisation at the end of the previous
month for the matching firms). The sample size is 8,625 IPOs for 1970-2008. IPOs with an offer price of less than
US$5.00, American Depository Receipts, Real Estate Investment Trusts, acquisition funds, closed-end funds and unit offers
have been excluded. See source for further details.
Source: Professor Jay Ritter’s IPO data website, http://bear.warrington.ufl.edu/ritter/ipodata.htm, accessed on 6 January 2011

• Compared to IPO underpricing, there are fewer
theoretical explanations of the bad long-term
performance of IPOs.
• However, this phenomenon has also been linked
to corporate governance.
• As managerial ownership decreases after the
IPO, there is a reduction in their incentives.
• The existing empirical evidence suggests that
there is no link between firm performance
and ownership or control held by the
managers post-IPO.
in IPOs (Continued)

• However, Marc Goergen and Luc Renneboog
find that the evolution of ownership and
control in British and German IPOs can be
explained by firm characteristics such as
– risk,
– growth,
– size, and
– performance.
(Continued)

Problems of Asymmetric Information
and Ways to Mitigate Them
• At the time of the IPO, very little is know about
the firm.
• What are the likely consequences of the
pronounced asymmetry of information in IPOs?
• George Akerlof studied the consequences of
asymmetric information in markets.
• One market he studied is the market for second-
hand cars.
• It is very difficult for the buyer to judge the
quality of a second-hand car.

Problems of Asymmetric Information and
Ways to Mitigate Them (Continued)
• Hence, the danger is high that the buyer may
end up with a lemon.
• The main consequence of the difficulty of
assessing the quality of a good in a market is
that the prices in the market will reflect the
average quality of the goods in that market.
• This will have severe consequences for sellers
of above-average quality goods in the market
as the price they will be able to receive will
be too low.

• The quality of firms going public is also difficult to
assess.
• The consequence will be that entrepreneurs with
above-average quality firms will receive a price
for their firm which is too low.
• So how can they credibly signal to the market
that their firm is of superior quality?
• They can do so by third-party certification such as
via
– the use of a highly reputable investment bank, and
– venture capital financing.

• In addition to third-party
certification, entrepreneurs can also signal their
superior quality via the ownership they retain in
the firm after the IPO.
• Hayne Leland and David Pyle’s model predicts
that outside investors perceive the ownership
retained by the entrepreneur as a credible signal
of firm quality.
• The higher the percentage of ownership
retained the higher will be expected firm value.
• The signal is credible as it is costly for the
entrepreneur to retain a large stake in the firm.

• In addition to retaining a large stake in the IPO, the
entrepreneur may also commit himself not to sell
his shares after the IPO for a specific period.
• Such a commitment is called a lock-in agreement
(lock-up agreement).
• Armando Gomes extends the Leland and Pyle
model from a static context to a dynamic one.
• He argues that in countries with weak investor
protection the entrepreneur can build up a
reputation as a good manager over time by keeping
a stake in the firm.

• If the manager were to extract private
benefits of control from the firm, the
minority shareholders would discount the
price of the firm.
• The manager would then be punished by a
reduction in the value of his stake.

The Power of the CEO
• The CEO frequently assumes a key position in
the firm.
• This is even more so the case in IPO firms.
• Sydney Finkelstein proposes the following
four dimensions of CEO power
1. structural power,
2. ownership power,
3. expert power, and
4. prestige power.

The Power of the CEO (Continued)
• Structural power is the power the CEO derives
from his position within the firm’s hierarchy or
organisational structure.
• It enables the CEO to control the behaviour and
actions of his subordinates, thereby reducing
uncertainty.
• This power may enable the CEO to push through
decisions in case the top management is split.
• A more indirect manifestation of structural
power is the superior information the CEO has
about the firm.

• Ownership power is derived from the CEO’s
ownership stake in the firm.
• It tends to increase with the size of the CEO’s
ownership stake.
• If the CEO is the founder or related to the
founder this may further amplify his power
over subordinates and board members.

• The CEO’s expert power stems from
– his knowledge of the technologies the firm
uses, and
– his ability to deal with the firm’s stakeholders as
well as other environmental factors the firm
faces.
• At the extreme, the CEO’s skill set may make
him indispensable and put in danger the
survival of the firm should he die or leave.

• Prestige power is derived from the CEO’s
reputation and status within the institutional
environment he operates in.
• The CEO’s prestige power increases with his
stakeholders’ perception of his influence.
• For example, CEOs who sit on other firms’
boards are likely to have high prestige power.
• CEOs with high prestige power may be part of
managerial elites that are admired and
whose actions are copied by less prestigious
managers.

• The firm’s legitimacy is also likely to depend
on the CEO’s prestige power.
• The CEO’s prestige power is likely to benefit
the firm via the information he is able to
collect via his network of contacts.

• A fifth dimension of power, in addition to
Finkelstein’s four dimensions, is
–5. control power.
• Control power measures how pivotal the CEO
is in the voted decision, i.e. how often he will
be part of a winning coalition.
• For example, a company has the following
three shareholders
– shareholder A with 40% of the votes,
– shareholder B with 30%, and
– the CEO with 25%.

• Neither of the three large shareholders has a
majority.
• While the CEO is the smallest of the three
large shareholders, there are three winning
coalitions he can form:
– A and CEO (65%),
– B and CEO (55%), and
– A, B and CEO (95%).
• The only other winning coalition is A and B
(70%).

• Hence, the CEO is pivotal in three out of four
winning coalitions and his control power
index is 0.75.
• This is the so called Shapley value which
measures the pivotal role of a shareholder.

Spinning of IPOs
• Jay Ritter discusses the practice in the USA of
“spinning” initial public offerings (IPOs).
• IPOs tend to be underpriced, i.e. the shares
are issued at a price which on average is
lower that the closing price on the first
trading day.
• If there is sufficient competition between
investment banks taking companies
public, one would expect that underpricing
would be much lower or non-existent.

Spinning of IPOs (Continued)
• Ritter found evidence that investment banks
used the underpriced shares as bribes.
• The underpriced shares were allocated to
customers of the investment banks to obtain
further fee-earning business from them.
• The underpriced shares were also allocated
to the executives of the underpriced IPO
firms.

• Xiaoding Liu and Jay Ritter found that
firms with executives that had been
“spun”
– Were more underpriced (by 18% (!) on
average)
– Were less likely to switch investment
banks in the future.
• Some of the data on “spinning” of IPOs
were used to prosecute the executive of
Credit Suisse First Boston (CSFB), Frank
Quattrone
– Accounts of executives who were “spun”
were referred to as “Friend of Frank”.
• Most other major investment banks
had been involved in the practice too.
Spinning of IPOs (Continued)

The Role of Venture Capitalists in IPOs
• Venture capitalists (VCs) provide risk capital
to young firms that may find it difficult to tap
into other sources of finance.
• However, they also provide management
guidance as well networking opportunities.
• They also frequently help firms build their
management teams, attract key staff, design
their organisational structure and establish
their market share.

(Continued)
• VCs frequently call for the replacement of the
entrepreneur by a professional manager thought
to add value to the firm.
• However, the entrepreneur is likely to be against
her replacement as
– she may be personally attached to her firm, and
– she may consider her replacement to be humiliating
and to damage her professional reputation.
• Nevertheless, the replacement of the founder
CEO is a frequent occurrence, becoming more
likely over time.

• So how do VCs manage to replace the
entrepreneur?
• They do so via the voting rights they hold and
these are frequently amplified by board
representation.
• They also often have shareholder agreements
and employment contracts which enable them
to terminate the founder’s ownership and
employment.
• Often, the entrepreneur’s shares are vested.
• Vested shares are shares held by the firm on the
behalf of the entrepreneur.
(Continued)

• The entrepreneur only obtains legal ownership
once specific conditions have been met.
• VCs also typically provide their financing in the
form of stage financing.
• Stage financing is financing that is provided
gradually as the firm achieves specific
performance mile stones.
• The mile stones are typically linked to major
stages in the firm’s life cycle such as the
development of a prototype.
(Continued)

• Hence, VCs create value via the support, the
expertise and the networks they offer the firm.
• They are also frequently seeking a successor to
the founder who is expected to improve the
firm’s value.
• They also tend to be involved in the design of
the firm’s governance structure and the
improvement of the founder CEO’s incentives.
• However, there is also evidence suggesting that
VCs, in particular young VCs, may be subject to
conflicts of interests.
(Continued)

• Paul Gompers has proposed the grandstanding
hypothesis.
• Young VCs, intend on establishing their
reputation, take their portfolio firms public early to
create a track record of successful investments.
• Venture-capital firms are normally in the form of
partnerships with the silent partners, typically
institutional investors, providing the funding.
• To guarantee future funding, the VCs will need to have
at least one successful IPO.
(Continued)

• They may do so by rushing their portfolio firms
to the stock exchange.
• The cost from doing so comes in the form of
higher underpricing as younger firms have been
shown to be more severely underpriced.
• However, this cost is shared by all the
shareholders whereas the benefits only accrue
to the VC.
• Given that CEOs frequently hold shares in their
firm, how do the VCs convince them to take
their firm public early?
(Continued)

• Michelle Lowry and Kevin Murphy argue that
VCs grant CEOs stock options at the IPO with an
exercise price equal to the deliberately low offer
price.
• Lowry and Murphy do not find a link between
IPO underpricing and the expected gains from
the CEO’s stock options.
• However, Salim Chahine and Marc Goergen find
evidence of such a link when they adjust for the
power of the VC and the CEO as well as the
power of the board of directors.
(Continued)

• Nevertheless, despite these conflicts of
interests the evidence suggests that VCs still
create value in their portfolio firms.
(Continued)

Models of CEO Succession
1. External candidate
2. President and/or CEO
3. Horse race
4. Inside-outside model

Conclusions
• The separation of ownership and control in
IPO firms.
• Asymmetric information and firm quality.
• Finkelstein’s dimensions of CEO power
applied to IPO firms.
• Spinning of IPOs.
• The role of VCs in IPO firms: value creation
versus conflicts of interests.
• Models of CEO succession

Core Readings
• Goergen, M. (2012) International Corporate
Governance, Pearson, Ch.12-14;
• David & Tayan, Brian (2011) Corporate
Governance Matters, FT Press/Pearson New
Jersey, Ch.7-9,11
• Monks & Minow (2011) Corporate
Governance, 5th Edition, Wiley. Ch.4

Next Week’s Ideas for Discussion
• Petit, Vale´rie and Bollaert, Helen (2012)
Flying Too Close to the Sun? Hubris
Among CEOs and How to Prevent
it, Journal of Business Ethics, 2012: 108:
pp.265–283.

Casestudy 5 : Gertsner’s Pay
Package at IBM
Read and prepare the
Casestudy on Gertsner’s
Pay Package at IBM
(Monks & Minow (2011))
for discussion next class.
Identify the corporate
governance issues faced.
You are required to:
–Map out the stakeholder
power/interest issues.
–Evaluate the executive
compensation & incentives
scheme and model of
executive succession
planning.
–Propose a more equitable
scheme and model to
satisfy all stakeholders.

Bcu msc cg week 11 leadership 260812

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