Financial Markets
Firms and Stockmarkets

A CEPR workshop on ‘Firms and Stockmarkets’ took place in Toulouse on 24/25 May. The workshop was organized by Bruno Biais (Université de Toulouse) and Jean-Charles Rochet (Université de Toulouse and CEPR) and formed part of the CEPR research network on ‘Finance in Europe: Markets, Instruments and Institutions’, funded by the European Commission’s Human Capital and Mobility programme. Additional funding was provided by the Institut d’Economie Industrielle and the Institut Universitaire de France.

Do corporates perform better over the long term under a financial system dominated by banks or by market financing? This question was investigated by Enrico Perotti (Universiteit van Amsterdam and CEPR) and Ernst-Ludwig von Thadden (Université de Lausanne and CEPR) in ‘Comparative Advantage and Financial Transparency: Industrial Competition across Financial Systems’. Financial markets are more transparent because competitors can learn from publicly observable stock prices, whereas in a non-transparent bank-dominated system less information is disclosed. Comparing a firm’s best response in a Cournot model Perotti and von Thadden find that profits are higher under transparency because competitors benefit from the informativeness of prices, but profits are less volatile in the case of non-transparency. The authors offer perspectives on endogenous transparency, noting that lenders prefer low transparency while equity holders favour transparency.

In ‘The Czechoslovak Privatization Auction: An Empirical Investigation’ Pierre Hillion (INSEAD) and David Young (INSEAD) analysed the privatization process as a tâtonnement process in a Walrasian auction organized in 5 rounds simultaneously over 1491 companies. They stressed the role and aims of the auctioneer, the price-setting mechanism, and the bidding strategies of the auction's participants. In a mass, or voucher, privatization each participant is endowed with points, the value of which is determined during the auction. The main role of the institutional auctioneer is to transfer shares but not (as is usual) to help the price discovery process. The paper points out that the auctioneer adds noise to this process by underpricing shares to speed up the sale or overpricing to absorb points. The authors observed the demand of two distinct groups of participants, investment funds and individuals. The former are likely to be relatively well informed. At the first round of the auction shares are priced identically and the demand reflects the fundamentals of the firms. In later rounds the informed participants’ strategy is to avoid overpriced shares and search for underpriced ones.

Jean-Charles Rochet presented ‘An Optimal Mechanism to Sell Unseasoned Equity’ written jointly with Bruno Biais and Peter Bossaerts (CALTECH). The paper studies the sale of unseasoned equity to professionals and retail investors through an intermediary. Professional investors have private information about the firm and the intermediary has private information about the retail investor’s demand. Because of long-term repeated interactions. The intermediary and the professional investors have an incentive to act as a coalition. The optimal mechanism is equivalent to a price schedule, whereby the price is decreasing in the quantity allocated to each retail investor. The larger the value of the shares, the more the intermediary and the professional investors desire to purchase, the lower the number of shares they pass on to retail investors, the higher the price. The optimal mechanism is an auction-like IPO procedure commonly used in France, the ‘mise en vente’. Using data from this market, a structural test finds the actual pricing to be in accordance with theory. Evidence against the model appears to be related to an institutional upper bound on rationing.

The trade-offs between remaining private or going public is the focus of ‘A Theory of the Going Public Decision’ presented by Paolo Fulghieri (INSEAD and CEPR) written with Thomas Chemmanur (Columbia University, New York). They begin by assuming that a risk neutral entrepreneur receives private information about a positive Net Present Value (NPV) project that he wants to undertake. He can finance it either by selling shares privately to a venture capitalist or to a large number of investors, through an IPO. A significant fraction of the wealth of the venture capitalist is invested in equity of the risky project whereas investors in financial markets are fully diversified. There is a fixed cost of acquiring information. Hence, there is a trade-off between the replication of information acquisition costs and diversification. As a result, firms go public if public information is precise, and if risk exposure for the venture capitalist is high.

Marco Pagano (Universita di Napoli Federico II and CEPR) presented ‘The Choice of Stock Ownership Structure: Agency Costs, Monitoring and the Decision to Go Public’ written jointly with Ailsa Röell (ECARE, Université Libre de Bruxelles, and CEPR). Their paper studies the optimal design of the ownership structure of a company. The initial owner of a company faces a trade-off. He can choose between being overmonitored by selling his shares to a private and large shareholder, or by going public and incurring a large cost for listing the company in the stock market. The optimal ownership structure involves dispersion and monitoring. From the initial owner’s point of view the outside stakes must be sufficiently dispersed so as to avoid overmonitoring and so retain the benefits to him from the IPO.

Do IPOs change the profitability of firms is the question Oved Yosha (Tel Aviv University) asked in the paper ‘The Consequences of Going Public: An Empirical Investigation’ written jointly with Hedra Ber (Bank of Israel) and Yishe Yafeh (Hebrew University of Jerusalem). They find that American, Israeli, and Italian firms suffer from a decline in their profitability following an IPO, owing to changes in managers’ behaviour. One-third of the decline in profitability stems from an increase in General Administration Expenses. This is attenuated by the presence of large shareholders. The authors show that universal banks are not the cause of this phenomenon.

Fausto Panunzi (Università di Pavia and IGIER, Milano) presented ‘Large Shareholders, Monitoring and the Value of the Firm’ written with Mike Bukart (London School of Economics and Stockholm School of Economics) and Denis Gromb (MIT and CEPR). They argue that there is a trade-off between the monitoring which takes place in a concentrated ownership structure and managers’ initiative in a more dispersed structure. The optimal ownership structure balances the gains from the two. The optimal contract offered to the manager includes monetary incentives as well as monitoring. When the manager’s private benefits are too big, there will be only monitoring. The choice of ownership structure and the entrepreneur's preference for private benefits influence the entrepreneur’s decision to go public. If the entrepreneur sells his shares to a large shareholder, he will bear higher control cost and have to renounce private benefits. Lastly, they study dynamic aspects of the costs and benefits of ownership concentration which can be interpreted as the trade-off between a more accurate evaluation of the firm (concentrated ownership) and the provision of incentives through performance-based evaluation (dispersed ownership).

In the paper ‘IPO-mechanisms, Monitoring and Ownership Structure’ by Joseph Zechner (Universität Wien and CEPR) and Neal Stoughton (University of California, Irvine) analyse the effect of different IPO-mechanisms on the structure of share ownership and explore the role of underpricing and rationing in determining investors’ shareholdings. In their model rationing is positively related with underpricing. They point out that rationing small investors is done to encourage more concentrated holdings: large shareholders, such as pension funds, are thought to be better monitors of firms’ performance. A Walrasian auction leads to zero underpricing but at the same time the absence of monitoring lowers the intrinsic value of the firm. As a result they find that the optimal mechanism involves a negotiated offer schedule between the issuer and large investors.

Colin Mayer (School of Management, University of Oxford, and CEPR) presented ‘The Role of Large Share Stakes in Poorly Performing Companies’ written jointly with Julian Franks (London Business School and CEPR) and Luc Renneboog (London Business School). This paper considers how corporate control is exercised in poorly performing firms in the UK. The data includes UK stock returns over the period July 1984 to June 1985. The paper shows that there is no relation between takeovers and poor performance. The authors study whether corporate governance depends on the structure of share ownership and the composition of corporate boards. They find that there is a strong relation between board turnover in poorly performing firms and large shareholdings. If ownership is not dispersed, there is a higher level of board turnover, which is consistent with the literature on free-rider problems and concentrated ownership. Moreover, in case of financial difficulties, the concentration of shares increases in poorly performing companies while it decreases in average performing firms. The authors assert that corporate governance is facilitated when non-executive directors are on the board and when the role of chairman and chief executive officer are separated.

In ‘Ownership Structure as Determinant of IPO Underpricing: a Theory of the Decision to Go Public for Venture Capital Backed Companies’, Ernst Maug (London Business School) analyses venture capital backed companies in which large shareholders monitor the firm. The venture capitalist can sell a part of his/her stake in an IPO. On the one hand this reduces the monitoring costs by obtaining information about the firm through prices. On the other hand the venture capitalist faces underpricing during the IPO. The author shows that underpricing is increasing in the liquidity of the market and the uncertainty over final payoffs of the firm and decreasing in the remaining stake of the venture capitalist after the IPO.

Kristian Rydqvist (Stockholm School of Economics) presented ‘The Stock Market as a Valuator and the Decision to Go Public’ written with Tore Ellingsen (Stockholm School of Economics). This paper develops a model in which a founder of a firm decides either to sell shares through a public offer or a private placement. If he chooses a public offer, he can sell additional shares in a seasoned offer. Moreover the market will play the role of a valuator thanks to the presence of informed traders. The paper demonstrates that the IPO is underpriced, the announcement of a seasoned offer is bad news and IPOs coincide with high stock prices. The paper also shows that a founder goes public if the expected revenue of the seasoned offerings offset the cost of the IPO. This result is consistent with empirical results for the Swedish stockmarket.