the reputation of underwriters, the bonding hypothesis, and the impact on the information environment of u.s cross-listed firms

Using a sample of cross-listed firms from 1980 to 2004, I find that those that raise equity and hire a reputable underwriter, within three years after cross-listing, observe higher analy

THE REPUTATION OF UNDERWRITERS, THE BONDING HYPOTHESIS, AND

THE IMPACT ON THE INFORMATION ENVIRONMENT OF

U.S CROSS-LISTED FIRMS

The Ohio State University

Graduate Program in

ABSTRACT

The first essay of this dissertation tests whether hiring a reputable underwriter to sponsor equity offerings of foreign firms, that occur when they cross-list on a U.S stock exchange, is a “reputational bonding” mechanism In line with the Bonding Hypothesis

of Stulz (1999) and Coffee (1999, 2002), I find that foreign firms that cross-list in the U.S and undertake IPOs are more likely to employ reputable underwriters if the firms come from countries with poor shareholder protection The additional monitoring provided by reputable underwriters may help overcome the skepticism of U.S investors, and explains the higher valuation these firms obtain after the offering There is, however,

a price to be paid for this bonding benefit I find that issuers from countries with low shareholder protection tend to be more underpriced if they are sponsored by prestigious underwriters

In the second dissertation essay, I examine whether the decisions to raise equity and hire a reputable underwriter to conduct the offering impacts the information environment of foreign firms cross-listed on a U.S stock exchange Using a sample of cross-listed firms from 1980 to 2004, I find that those that raise equity and hire a reputable underwriter, within three years after cross-listing, observe higher analyst coverage and more accurate earnings forecasts

ii

Furthermore, I conclude that these improvements in the firm’s information environment are likely to positively affect firm value – the empirical evidence shows a positive relation between analyst coverage/forecast accuracy and Tobin’s q More importantly, the valuation of firms sponsored by top underwriters tends to be more sensitive to improvements in forecast accuracy Overall, the results of this essay complement the findings of Lang et al (2003) and shed some light on the monitoring role

of reputable underwriters via their impact on firm’s information environment

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ACKNOWLEDGMENTS

I would like to thank my advisors Andrew Karolyi and Anil Makhija and my committee member Henrik Cronqvist for their constant guidance, encouragement, and insightful comments Their contribution was fundamental in all stages of my research I

am also grateful to Rüdiger Fahlenbrach for his comments and cooperation

I also thank René Stulz, the seminar participants at the Ohio State University, and

my colleagues who participate at the doctoral seminars for their helpful comments and suggestions A special thanks to Roger Loh, Angie Low, Taylor Nadauld, and Carrie Pan for their interest in my research and helpful suggestions

Finally, I thank the University of Minho and the Fundação para a Ciência e a Tecnologia (FCT) for financial support

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VITA

January 21, 1974……… … Born in Valongo (district of Porto), Portugal

1997 … “Licenciatura” in Economics, Faculdade de Economia do Porto, Portugal

2002 Master of Science in Business Administration – Finance, Universidade do Minho, Portugal

FIELDS OF STUDY

Major Field: Business Administration

Concentration: Finance

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TABLE OF CONTENTS

ABSTRACT ii

ACKNOWLEDGMENTS iv

VITA v

LIST OF TABLES ix

LIST OF FIGURES xi

CHAPTER 1: Introduction 1

CHAPTER 2: The reputation of underwriters: A test of the Bonding Hypothesis 6

2.1 Introduction 6

2.2 Literature review and hypotheses 12

2.2.1 Cross-listing and the Bonding Hypothesis: the role of underwriter reputation12 2.2.2 Benefits of hiring a reputable underwriter 14

2.2.3 IPO underpricing and the cost of reputable underwriters 15

2.2.4 Main Hypotheses 19

2.3 Data 20

2.4 Descriptive statistics and univariate analysis 24

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2.5 Multivariate analysis 30

2.5.1 The likelihood of hiring a reputable underwriter 30

2.5.2 Robustness checks 36

2.5.3 The value of hiring a reputable underwriter 42

2.5.4 The cost of hiring a reputable underwriter 46

2.6 Other Analyses 49

2.6.1 Seasoned equity offerings: Later SEOs 49

2.6.2 Private placements 52

2.7 Conclusions 53

CHAPTER 3: The impact of hiring a reputable underwriter on the information environmnet of cross-listed firms 56

3.1 Introduction 56

3.2 Data and descriptive statistics 65

3.3 Multivariate Analysis 71

3.3.1 The impact of raising equity and hiring a reputable underwriter on a firm’s information environment 71

3.3.2 Robustness Checks 77

3.3.3 Forecast accuracy: “star” versus “non-star” analysts 82

3.3.4 Underwriter reputation, analyst coverage and forecast accuracy, and their impact on firm value 84

3.4 Other Analysis 88

3.4.1 Univariate analysis: Differences before and after cross-listing 88

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3.4.2 Alternative hypotheses 91

3.5 Conclusion 95

CHAPTER 4: Conclusions 98

LIST OF REFERENCES 101

APPENDIX A: List of variables used in Chapter 3 108

APPENDIX B: Estimation procedure to mitigate sample selection bias 111

APPENDIX C: Tables 113

APPENDIX D: Figures 157

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LIST OF TABLES

Table 1: Summary Statistics 113

Table 2: Tests of equality of means: Variables segmented by CM measure of underwriter reputation and by Anti-self-dealing (ASD) index 116

Table 3: Probit regressions: The probability of hiring a reputable underwriter 119

Table 4: Robustness check of the probability of choosing a reputable underwriter – Heckman model 122

Table 5: Regressions of Tobin’s q 123

Table 6: Multifactor regressions using calendar-time returns 125

Table 7: Regressions of first-day returns 127

Table 8: Two-stage OLS regressions of first-day returns 129

Table 9: Regressions of Gross Spreads 131

Table 10: Probit regressions: Later SEOs 133

Table 11: Summary statistics: Private placements 135

Table 12: Probit regressions: Private placements 136

Table 13: Sample size and summary statistics 138

Table 15: Firm-level regressions of analyst coverage and forecast accuracy one year after raising equity/cross-listing 141

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Table 16: Firm-level regressions of analyst coverage and forecast accuracy – Heckman model 143 Table 17: Firm-level regressions of analyst coverage and forecast accuracy – Matched sample 146 Table 19: Regressions of Tobin’s Q 151 Table 20: Univariate analysis of differences in means before and after cross-listing 154 Table 21: Firm-level regressions of analyst coverage and forecast accuracy – Alternative hypotheses 155

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LIST OF FIGURES

Figure 1: Percentage of IPOs/SEOs by group of countries 157 Figure 2: Percentage of IPOS/SEOs per region and subperiod 159 Figure 3: Number of underwriters and percentage of top ranked (CM measure) 160 Figure 4: Number of underwriters and percentage of deals conducted by top ranked (CM measure) 161 Figure 5: Number of Foreign IPOs and average first-day returns per year 162 Figure 6: Percentage of Foreign IPOs and Foreign SEOs conducted by top underwriters

by group of countries with high and low ASD index 163 Figure 7: Firms by country 166

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CHAPTER 1

INTRODUCTION

Over the past two decades researchers have been investigating the reasons why foreign firms choose to list their stocks abroad and the consequences of that choice Karolyi (1998; 2006) reviews this literature in detail Early studies advocate that the main reason for foreign firms to cross-list in the U.S is to break down investment barriers created by segmentation in the financial markets that would otherwise constrain their investment policies

A more recent approach – the Bonding Hypothesis – initiated by Stulz (1999) and

Coffee (1999; 2002), argues that cross-listing on a U.S stock exchange is a mechanism through which managers and controlling shareholders of foreign firms “bond” themselves

to improve the corporate governance of their firms and offer a better protection to their minority shareholders Foreign firms, especially those from countries with poor protection of shareholder rights, are expected to benefit more from cross-listing in a market with more legal shareholder protection, more stringent disclosure requirements, greater shareholder activism, a more active market for corporate control, and better financial intermediaries

1

Most of the literature has focused on the mechanisms of “legal bonding” – especially emphasized by Coffee (1999; 2002) – such as the disclosure and enforcement action procedures imposed by the U.S regulators to all firms cross-listed on a stock exchange These requirements are expected to bring more transparency to the firm, and thereby subject managers and controlling shareholders to a stricter scrutiny In addition

to these legal requirements, foreign firms can also benefit from other sources of

“bonding” – “reputational bonding” – provided by the monitoring role of a number of

“gatekeepers” (informational intermediaries) that become available after the firm lists (Stulz, 1999) Examples of these “gatekeepers” are the American debt-rating agencies, auditors, security analysts, and investment banks involved in underwriting

cross-activities – the underwriters

This dissertation contributes to this literature by investigating the role of one mechanism of “reputational bonding”: the choice of a reputable underwriter to conduct an equity offering that occurs at the cross-listing event

In contrast with previous studies that focus on bonding mechanisms that apply uniformly to all cross-listed firms on a U.S stock exchange, this dissertation provides an important contribution by analyzing an additional mechanism that is primarily related to a firm’s decision

In the first essay, presented in CHAPTER 2, I examine the choice of a reputable underwriter to sponsor an equity offering that is simultaneous to the act of cross-listing, and the costs and benefits it imposes to the foreign firm I argue that these costs and benefits are affected by the extent of investor protection accorded in the home country of

2

the firm listing in the U.S Therefore, in line with the bonding hypothesis, listed firms facing more skepticism from U.S investors – for instance, those from countries with poor shareholder protection – are the ones with higher potential gains from the additional monitoring provided by prestigious underwriters This prediction should

cross-be stronger for firms seeking immediate cross-benefits by simultaneously cross-listing and raising equity Because these firms are not yet known in the U.S market, have no U.S analyst coverage, and no U.S institutional ownership, the monitoring role of reputable underwriters may be particularly important

Using a sample of foreign firms that cross-list in the U.S and issue equity at the same time (less than one month after cross-listing), between 1980 and 2004, I test the prediction that issuers from countries with weak shareholder protection are more likely to hire a reputable underwriter to sponsor their offerings The empirical results are

consistent with this version of the Bonding Hypothesis In line with the idea that the

benefits overweigh the costs, I find that (1) issuers from countries with poor shareholder protection that hire top underwriters have higher valuations one year after cross-listing and (2) these firms pay a price for this type of bonding, since their offerings are, on average, 20% more underpriced

Furthermore, I extend my analysis to other equity offerings: (1) subsequent equity offering of firms that have already been sponsored by a top underwriter when they issued equity at the time of cross-listing, and (2) private placements The results indicate that, conditional on having been “bonded” at the initial equity offering, firms with higher analyst coverage tend to downgrade to a less reputable, but cheaper, underwriter when

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they raise equity later As for private placements, there is no evidence that issuers from countries with poor shareholder protection are more likely to hire top underwriters This finding is consistent with the notion that in non-public issues the benefits of the additional monitoring provided by reputable underwriters is reduced or inexistent

CHAPTER 3 presents the second essay of this dissertation This essay is motivated by the study of Lang, Lins, and Miller (2003) and by the findings discussed in CHAPTER 2 Lang et al (2003) find that firms cross-listed on a U.S stock exchange have more analysts coverage and forecast accuracy than their peers that do not cross-list They link this result to the benefits of “legal bonding” – namely the increased transparency of the firm When firms are more transparent, information is more reliable and easier (meaning less costly) to gather; this brings more analyst coverage and improves forecast accuracy

In this essay, I examine the impact on a firm’s information environment of other actions, taken voluntarily by the firm, in addition to the legal requirements that apply to all firms cross-listed on a U.S stock exchange In particular, motivated by the findings in CHAPTER 2, I analyze whether hiring a reputable underwriter to sponsor an equity offering that happens after cross-listing affects firm’s analyst coverage and forecast accuracy The prior is that prestigious underwriters, and their team of reputable analysts, auditors, lawyers, etc., are able to generate more accurate information about the firm, and thereby, subject managers and controlling shareholders to a more strict scrutiny Better-governed firms are able to attract more analyst following and the higher quality of the information disclosed helps them to make more accurate forecasts

4

Using a sample of cross-listed firms on a U.S stock exchange between 1980 and

2004, I find that those that raise equity (within three years after cross-listing) and hire a reputable underwriter to conduct the offering have, on average, more analyst coverage (although the effect is only partially robust) and, especially, higher forecast accuracy Moreover, not only top underwriters bring more “star” analysts into play, but also they improve the quality of the information disclosed by the firm in a way that even the average “non-star” analyst is able to issue better forecasts Finally, consistent with Lang

et al (2003), I find that both analyst coverage and forecast accuracy positively affect Tobin’s q More importantly, I find that the value of firms sponsored by top underwriters

is more sensitive to accuracy of analysts’ forecasts than the average This result helps understand one possible mechanism through which prestigious underwriters bring additional value to the firm

To the best of my knowledge, empirical tests on the role of reputable underwriters

as a mechanism of “reputational bonding”, as well as their impact on firm's information environment, have not yet been covered in the literature This dissertation is my contribution to fill this gap

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CHAPTER 2

THE REPUTATION OF UNDERWRITERS: A TEST OF THE BONDING

HYPOTHESIS

2.1 Introduction

There is a large literature on why foreign firms cross-list in the US.1 One stream

of this literature argues that the main advantage of cross-listing is that it breaks down investment barriers created by segmentation in financial markets (Errunza and Losq, 1985; Alexander, Eun and Janakiramanan, 1987; Foerster and Karolyi, 1999) A more recent stream of the literature, initiated by Stulz (1999) and Coffee (1999; 2002), offers

an alternative explanation, the Bonding Hypothesis According to the Bonding

Hypothesis, cross-listing in the U.S is a mechanism by which managers and controlling

shareholders of foreign firms purposely subject the firm to superior legal, regulatory, and other institutional monitoring, and thereby offer better protection against expropriation to minority shareholders

Foreign firms, particularly those from countries with weak protection of minority shareholders, are expected to see improvements in their corporate governance because of

1 See Karolyi (1998; 2006) for detailed surveys

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the better legal protection of shareholder rights, more stringent disclosure requirements, greater shareholder activism, an active market for corporate control, and more effective financial intermediaries While the act of cross-listing in a U.S stock exchange automatically subjects the firm to a number of institutional requirements, such as the mandatory disclosure requirements of the SEC, the foreign firm can also voluntarily opt for certain bonding activities A study of these choices provides a setting to understand

the “reputational bonding” decisions of foreign firms, and to test the Bonding Hypothesis

In particular in this paper, I examine the choice of underwriter, and the monitoring benefits versus the costs it imposes on the foreign firm In contrast with previous tests of

the Bonding Hypothesis, which focus on bonding mechanisms that apply uniformly to all

cross-listed firms on a US stock exchange, this paper provides an important contribution

by analyzing an additional mechanism that is primarily related to the firm’s choice

The main benefit of hiring a reputable underwriter is the additional monitoring that the investment bank is able to provide and the consequent reduction of the firm’s cost of capital Prestigious underwriters can more effectively scrutinize the firm because they have more qualified research teams Fang and Yasuda (2005), for example, show that more qualified analysts deliver more accurate analysis Furthermore, top underwriters have a large clientele of institutional investors, which in turn monitor firms’ managers (Kahn and Winton, 1998; Gillan and Starks, 2000; Woidtke, 2002) and attract more analyst coverage (O'Brien and Bhushan, 1990) This boost in the number and quality of analysts improves firms’ information environment, which has a positive impact

on firm value (Lang et al., 2003) Finally, in the spirit of the investor recognition

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hypothesis of Merton (1987), firms sponsored by more reputable underwriters gain more

“visibility” in the market, which increases the demand for their stock and, therefore, leads

to higher valuations

The benefits of improved monitoring provided by the investment bank must be weighed against the additional costs When firms hire an underwriter they pay explicit (gross spread) and implicit (underpricing) costs (Chen and Mohan, 2002) Gross spreads are usually calculated as the ratio between managers’ fees and the total proceeds raised in the offering While it may be argued that reputable underwriters should charge higher spreads because they provide better quality services, the empirical evidence does not support this claim Chen and Ritter (2000) note that the spread tends to be always around 7%, suggesting that there is not much competition between prestigious and non-prestigious underwriters in terms of gross spreads In fact, Chen and Mohan (2002) and Chen, Fauver, and Yang (2006) find that reputable underwriters tend to charge lower gross spreads than less reputable ones Although this finding may seem counter-intuitive, the authors argue that this is so because reputable underwriters tend to sponsor larger deals with greater economies of scale The other cost incurred by the firm comes in the form of underpricing, which is an important part of the underwriter’s compensation (Loughran and Ritter 2004; Cliff and Denis 2004) Cliff and Denis (2004) mention that underwriters have strong incentives to underprice Through underpricing, investment banks can please their preferred clients and stimulate future business Moreover, underpriced initial public offerings are usually followed by high aftermarket trading volume, which is a source of trading commission to the underwriter For the issuer,

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however, underpricing is an implicit cost since it reflects the difference between the price

at which the shares are sold and the firm’s fundamental value

I argue in this paper that the costs and benefits of the choice of a reputable underwriter are affected by the extent of investor protection accorded in the home country of the firm cross-listing in the U.S Thus, according to the bonding hypothesis, cross-listed firms facing more skepticism from American investors (i.e., firms coming from countries with poor shareholder protection) are the ones with greater potential gains from the additional monitoring provided by prestigious underwriters Furthermore, the prediction of the choice of a reputable underwriter is stronger if these firms are seeking immediate benefits by simultaneously raising equity and cross-listing in the U.S So, I

study foreign firms with Initial Public Offerings, IPOs (firms that become public at the

same time in US and in their home markets), as well as other firms (which stocks have

already been publicly traded in their home markets) with Seasoned Equity Offerings,

SEOs, at the time when they cross-list in the U.S These firms are typically not yet known in the U.S market, have no U.S analyst coverage, nor do U.S institutional shareholders provide any guarantees to other investors Thus, the monitoring role of reputable underwriters seems to be especially important

I test my version of the Bonding Hypothesis – cross-listed issuers from countries

with low shareholder protection are more likely to be sponsored by reputable underwriters – using a sample of equity offerings issued in the U.S., around the cross-listing event, by foreign firms between 1980 and 2004 I run a probit analysis and find supporting evidence for my hypothesis regarding the choice of a reputable underwriter

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In particular, issuers from countries with low shareholder protection are, roughly, 15% to 20% more likely to be sponsored by a reputable underwriter than their peers Consistent with the notion that the benefits outweigh the costs, I find that firm value appreciates, since issuers from countries with weak shareholder protection have higher Tobin’s q one year after the offering I also find that there is indeed a cost associated with this choice Issuers from countries with poor shareholder protection and sponsored by reputable underwriters tend to be more underpriced However, as for long-term performance (over

3 years after the offering) there is no evidence that this particular group of firms outperforms their peers, suggesting that the benefits of bonding may decay and not be long lasting To the best of my knowledge, the role of underwriter reputation, as a vehicle

of the bonding hypothesis, has not yet been tested

I also extend my analysis to other equity issues, later SEOs, of the same group of firms after they have cross-listed and issued equity simultaneously These firms face a different environment because they already have a history of stock prices in the U.S market, other sources of public information including more analyst forecasts (Lang et al., 2003), and a base of U.S institutional investors Therefore, the skepticism of other U.S investors, stemming from the level of shareholder protection of the country where the firm comes from, should be considerably mitigated Nevertheless, there still may be more or less opportunities and incentives for these firms to further bond through the services of a prestigious underwriter at the later SEO For instance, conditional on having been “bonded” (i.e., having been already sponsored by a reputable underwriter) at the first equity issue around cross-listing, firms with higher analyst coverage and/or

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institutional ownership may want to downgrade and choose a less reputable, but cheaper, underwriter in a later offering In contrast, those that are not satisfied with the improvements in their information environments may want to retain a top underwriter

My evidence suggests that this is true for analyst coverage, but there is no evidence that the same happens with respect to institutional ownership

Finally, I test whether underwriter reputation matters as a bonding mechanism for firms raising equity through private placements Since the offer is not public, we can argue that the benefits from additional monitoring are reduced or non-existent; in other words choosing a reputable underwriter for bonding purposes could be too costly An alternative to this argument is to consider that the monitoring provided by a reputable underwriter could be more valuable in private placements, since in this type of deals the issuer does not have to follow the SEC regulation Empirical evidence seems to support the first argument: I do not find that reputable underwriters conduct more private placements of firms from countries with poor shareholder protection

The remainder of the chapter is organized as follows: Section 2.2 discusses the literature and derives the main hypotheses Section 2.3 describes the data, and Section 2.4 reports descriptive statistics and univariate tests In Section 2.5, I discuss the results

of the multivariate analysis and present findings from robustness checks In Section 2.6,

I analyze SEOs and private placements Finally, Section 2.7 concludes

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2.2 Literature review and hypotheses

2.2.1 Cross-listing and the Bonding Hypothesis: the role of underwriter reputation

The traditional literature of cross-listings supports the segmentation hypothesis

This hypothesis suggests that the main advantage of cross-listing is that it breaks down investment barriers that would otherwise exist due to segmentation in financial markets

By reducing these barriers international issuers can allocate their shares more easily to U.S investors; consequently, the demand for equity increases, which allows firms to reduce their cost of capital Errunza and Losq (1985), Alexander et al (1987), and Foerster and Karolyi (1999) provide evidence consistent with these arguments

Stulz (1999) challenges the segmentation hypothesis by arguing that it does not contemplate other important factors that affect the firm’s cost of capital In particular, information asymmetry issues that arise when managers cannot reliably communicate the value of their firms to outside investors, or agency conflicts that exist between managers and shareholders when managers have latitude to misuse the firm’s capital in pursuing their own goals rather than shareholders interests This line of arguments suggests that the quality of a firm’s corporate governance plays an important role in determining the magnitude of its cost of capital By cross-listing their shares in a market with more stringent protection of shareholder rights, firms will experience improvements in several external and internal governance mechanisms: better certification in the capital markets provided by financial intermediaries, more legal protection of minority shareholders, stricter disclosure requirements, more shareholder activism, and more competition in the

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market for corporate control Because these improvements reduce both the information asymmetry between insiders and outsiders to the firm as well as the likelihood of agency conflicts, the cost of capital of cross-listed firms tends to decrease Firms coming from countries with poor levels of shareholder protection are expected to experience more improvements in their governance mechanisms and, therefore, larger reductions in the

cost of capital The Bonding Hypothesis of Stulz (1999) relies on these arguments

Coffee (1999; 2002) emphasizes the “legal bonding” In other words, cross-listed firms are subject to a more stringent legal environment, since they have to harmonize their financial statements with GAAP rules and SEC disclosure requirements; furthermore, they become potential targets of the SEC enforcement powers and class actions imposed

by shareholders

Both Stulz and Coffee mention the importance of the role played by certified intermediaries, such as underwriters, auditors, analysts, or debt-rating agencies in reducing the gap of information between shareholders and managers as well as providing additional monitoring that reduces potential agency conflicts

In contrast with the SEC rules that apply to all firms cross-listed on a U.S exchange market, hiring a prestigious underwriter to conduct an equity offer is a voluntary decision That decision will depend on how firms weigh the costs and benefits

of hiring a top underwriter

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2.2.2 Benefits of hiring a reputable underwriter

In the context of the Bonding Hypothesis of Stulz (1999) and Coffee (1999; 2002)

explained above, the main benefit of hiring a reputable underwriter to conduct an equity offering comes from the additional monitoring it is available to provide Prestigious investment banks, involved in underwriting activities, can provide more effective monitoring for several reasons First, their research teams tend to be more qualified and, therefore, they are more able to scrutinize the firm For instance, Fang and Yasuda (2005) find evidence that qualified analysts (“All-star” analysts) deliver more accurate recommendations

Second, reputable underwriters are more likely to have a larger clientele of institutional investors to which they can allocate significant amounts of the firm’s stock Institutional investors are themselves effective monitors of firms’ managers, as it is well documented in the literature (e.g., Kahn and Winton (1998), Gillan and Starks (2000), Woidtke (2002), among others) Furthermore, they are also able to attract more analyst coverage (O'Brien and Bhushan, 1990), not necessarily affiliated with the underwriter According to Lang et al (2003), this will help improve firms’ information environment and, consequently, increase their market value

Finally, deals sponsored by prestigious underwriter attract more attention in the market and give firms more publicity According to the investor recognition hypothesis

of Merton (1987), this generates higher demand for the firm’s equity, which has a positive impact on its market value

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In sum, if underwriter reputation is an effective channel of the Bonding

Hypothesis, it should generate a positive impact of firm value

2.2.3 IPO underpricing and the cost of reputable underwriters

Hiring an underwriter to conduct an equity offering involves basically two types

of costs: an explicit cost – gross spread – and an implicit cost – underpricing (Chen and Mohan, 2002) Gross spreads are the fees issuers pay to underwriters Usually, gross spreads are calculated as the ratio of total manager’s fees divided by the total proceeds raised in the offer Since reputable underwriters are expected to provide better services (better analyst coverage, better stock allocation, etc.), it may be argued that they should charge higher spreads However, there is no such evidence in the literature Chen and Ritter (2000) show that gross spreads tend to be clustered around 7%, indicating that underwriters do not differentiate themselves by the percentage of fees they charge Chen and Mohan (2002) find a quite surprising result: prestigious underwriters tend to charge lower gross spreads than non-prestigious ones They argue that this is so because top underwriters tend to sponsor larger deals with greater economies of scale In a sample of ADR gross spreads, Chen et al (2006) also find a negative relation between underwriter reputation and gross spread, yet that result is weakly significant, both statistically and economically

Although the literature on gross spreads is relatively scarce, the relation between underpricing and underwriter reputation has been well covered over more than a decade, especially in the context of IPOs Nonetheless, empirical evidence is mixed, showing an

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unstable pattern over time For instance, evidence from the 1980s refutes the idea that underpricing is part of the cost associated with hiring an underwriter, since it suggests a negative relation between IPO underpricing and underwriter reputation (Beatty and Ritter, 1986; Rock, 1986; Carter et al., 1998)

Several studies show, however, that in the 1990s, and especially during the period 1999-2000 (the so-called “internet bubble”), highly reputable underwriters underpriced more, on average, than less reputable ones (Beatty and Welch, 1996; Kumar, McGee and Womack, 1998; Cooney, Singh, Carter and Dark, 2001; Ritter and Welch, 2002; Loughran and Ritter, 2004; Aggarwal, Purnanandam and Wu, 2005) The literature still struggles to understand the reasons behind this change Loughran and Ritter (2004) document average IPO underpricing of 7% in the 1980s, 15% in 1990-1998, jumping to 65% in 1999-2000, and decreasing to 12% thereafter Their explanation for this pattern

of IPO underpricing is that issuer’s objective function has changed overtime; in other words, issuing firms became less reluctant to accept high underpricing, especially from prestigious underwriters This may have happened for two mains reasons: (1) firms became more focused on “high-impact” analyst coverage provided by reputable underwriters, for which they pay through higher underpricing (the “analyst lust” hypothesis), and (2) beginning in the 1990s underwriters set up private brokerage accounts on behalf of issuing firms executives in order to allocate them hot IPOs; from the firm’s insiders perspective, this creates a taste for high underpricing This argument might, however, raise some skepticism, since it is only suggested but not directly tested

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The “analyst lust” hypothesis of Loughran and Ritter (2004) and Cliff and Denis (2004) implicitly suggests that an important part of the underwriter’s compensation comes from underpricing, which is a cost for issuers (difference between the offer price and the firm’s fundamental value) Cliff and Denis (2004) point out that underwriters have incentives to underprice equity offerings By doing so, they can please their preferred clients and encourage them to do future business; also, underpriced IPOs are traditionally followed by high aftermarket trading volume, which generates a considerable amount of trading commissions

In contrast with this idea, Rock’s (1986) model, and also the book building models of Benveniste and Spindt (1989) and Sherman and Titman (2002), argue that underpricing is essentially a way to compensate informed investors (not underwriters) for revealing their superior information, leaving underwriters with a negligible portion of the profits Given the very high levels of underpricing in the 90’s (especially from the late 90’s up to 2000), Ritter and Welch (2002) refute this hypothesis by arguing that such high underpricing cannot be explained simply by book building; instead, underwriter compensation seems to be a more plausible explanation Other studies, such as Loughran and Ritter (2002) and Hoberg (2006), also assume that underwriters benefit from selling underpriced shares and collecting part of the returns from IPO investors

Although Ljungqvist, Marston and Wilhelm (2006) find no evidence consistent with the “analyst lust” hypothesis, several other studies seem to support it For instance, Cliff and Denis (2004) using a sample of IPOs from 1993 to 2000 find evidence of a positive relation between underpricing and analyst coverage by the lead underwriter In

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other words, underpricing is the price issuers pay for more aggressive analyst coverage Among other reasons, the authors argue that issuers seek analyst coverage because it gives more publicity to the company, leads to greater recognition of the IPO firm, and also because post-IPO recommendations that boost stock prices may be especially important for those who want to sell their shares after the lock-up period Along the same line of arguments, Krigman, Shaw and Womack (2001) document that firms switching underwriters from the IPO to subsequent equity offerings do so to buy more analyst coverage even if it means selling their shares at a lower price

Finally, Hoberg (2006) finds evidence consistent with the “analyst lust” hypothesis (meaning more aggressive coverage) only for IPOs that occurred in the late 90’s However, in contrast with the studies mentioned earlier that advocate a non-stationary relation between IPO underpricing and underwriter reputation, Hoberg finds a persistent positive relation over a period of time that comprises both the 80’s and 90’s This persistent positive relation reinforces the idea that underpricing is the cost issuers pay for having better analyst coverage provided by more informed analysts This is not exactly the same as the “analyst lust” hypothesis, since it does not focus on the amount of analyst coverage, but on the quality of the analysis The idea behind this argument is that better informed underwriters have better informed analysts who are able to make more accurate earnings forecasts and, therefore, generate more value; in the author’s words,

“valuation skills are universally profitable” (p 28)

Overall, there is evidence (especially from the 90’s and after) that IPO underpricing is a cost that issuers pay for hiring more prestigious underwriters

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2.2.4 Main Hypotheses

In this paper I argue that the costs and benefits of hiring a prestigious underwriter are affected by the extent of shareholder protection accorded in the home country of firms cross-listing in the U.S Therefore, according to the bonding hypothesis, cross-listed firms facing more skepticism from American investors (i.e., firms coming from countries with poor shareholder protection) are the ones that benefit the most from the additional monitoring provided by reputable underwriters Furthermore, the prediction of hiring a reputable underwriter is stronger when these firms are simultaneously raising equity and cross-listing in the U.S Thus, I study cross-listed firms with IPOs (firms that were not publicly traded in any market before cross-listing), as well as other foreign firms (which stocks have already been publicly traded in their home markets) with SEOs at the time when they cross-list At the time these firms raise equity they are not yet known by U.S investors, they don’t have U.S analyst coverage, nor do U.S institutional shareholders provide any guarantees to other investors Therefore, the monitoring role of reputable underwriters seems to be particularly important

The first main hypothesis tested in this paper is whether issuers (of either IPOs or

SEOs happening at the cross-listing time) from countries with low shareholder protection are more likely to be sponsored by reputable underwriters

If underwriter reputation is a mechanism of the Bonding Hypothesis, then it

should generate a positive impact on firm value This would be consistent with the idea

that benefits from this type of bonding outweigh its costs Thus, the second main

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hypothesis of this paper tests whether issuers from countries with low shareholder protection that hire prestigious underwriters to sponsor their equity offerings have a higher valuations (Tobin’s q) after the offering

The third main hypothesis tests whether there is a cost associated with this type of bonding, i.e., whether issuers from countries with low shareholder protection that hire

reputable underwriters to sponsor their offerings tend to be more underpriced

2.3 Data

The data set used in this study comprises equity offerings, in the U.S markets, of cross-listed firms over the period 1980-2004 It includes American Depositary Receipts (ADRs) and also other firms (mainly from Canda and Israel) that cross-listed directly in

the U.S The Thomson Financial Securities Data Co (SDC) is the primary source of data

on IPOs and SEOs I designate by “Foreign IPOs” the deals that are identified by SDC as original IPOs, i.e., firms that were not publicly traded in the domestic market prior to the offering in the U.S market These firms become public in both U.S and domestic market ate the same time they cross-list2 SEOs are offerings issued by firms that were already publicly traded in their domestic markets I further distinguish “Foreign SEOs” – those that occur very close (within one month) to the cross-listing date – from “Later SEOs” –

2 There are some cases of firms (especially Israeli firms) that become public only in the U.S and not in their home market

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those that occur more than one month after cross-listing3 Because the predictions, in the context of the bonding hypothesis, are similar for Foreign IPOs and Foreign SEOs, I test the main hypotheses of this paper on a joint sample of these two types of issuers Throughout the paper, unless otherwise specified, I refer to this joint subsample simply as IPOs

Data on equity offerings are downloaded from SDC using the following filters: only offerings with proceeds greater than $2 million are considered; financials (SIC 6000-6999), utilities (SIC 4900-4949), rights offers, shelf-registration issues, mutual conversion issues, best-efforts, and limited partnership issues are screened out This brings to a total of 1166 offerings (548 Foreign IPOs and 618 Foreign and Later SEOs) I further eliminate 41 offerings that are classified as unit offers To do so, I followed the corrections proposed by Ritter (available from his website) to minimize the errors affecting SDC data with respect to the classification of unit offers Additionally, I

eliminate firms that could not be found on the Center for research in Security Prices

(CRSP), as well as firms with no data from CRSP for a period larger than six months after cross-listing With respect to ADR firms, I cross-validate SDC data with data on

capital raisings from the Universal Issuance Guide, available at the Citibank website

After this screening there are 435 Foreign IPOs and 519 Foreign and Later SEOs Some of the issuing firms are from countries that are not classified in the Djankov, La Porta, Lopez-de-Silanes and Shleifer’s (2007) anti-self-dealing index (from now on ASD

3 The subsample of “Later SEOs” includes both (1) offerings of firms that cross-listed and only raised equity more than one month later, and (2) subsequent equity offerings, that occurred more than one month after cross-listing, issued by firms that belong to the group of Foreign IPOs and Foreign SEOs

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index) These firms were eliminated from the sample leading to a loss of 29 Foreign IPOs and 6 SEOs Finally, I exclude two Foreign IPOs – one with an extremely high first-day return and another one with extremely low first-day return – and six Later SEO deals – two with extremely low and four with extremely high close-to-offer returns This leads to a total of 404 Foreign IPOs, 98 Foreign SEOS, and 409 Later SEOs The subsample of Later SEOs includes 273 subsequent offerings of firms that belong to the group of Foreign IPOs and Foreign SEOs, and 136 offerings of firms that cross-listed and only later (more than one month after cross-listing) raised equity

Data on offer prices, issue dates, number of primary and secondary shares offered, venture capitalist-backed deals, gross spreads, and proceeds of the deal are collected from SDC Thomson Financial The number of shares outstanding and stock prices are obtained from CRSP From Compustat I collect the value of total assets, net sales, total equity, capital expenditures, operating cash flow, and capital expenditures

To calculate the firm’s age at the time of the IPO I collected founding dates from several different sources The first source is SDC, which provides some data on founding dates as they appear in the Moody’s books However, for most of the companies in the IPO subsample these data are missing The second source is the firm prospectus filed with the SEC at the time of the equity offering Finally, when this information is also missing in the prospectus I use Lexis Nexis as a last effort to complete the data

Ownership data – percentage of shares held by the largest shareholder, type of the largest shareholder, number of blockholders (owners of more than 5% of the firm’s capital), and total percentage of blockholder ownership – were hand-collected from 20-Fs

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and proxy statements as of the end of the first fiscal year after the issue, or, when it is missing, the most recent data available within three years of the issue As an alternative

to these measures I also collected the percentage of shares “closely held”4 from Worldscope

To proxy for the level of protection of shareholder rights I use the ASD index of Djankov et al.(2007), which covers 72 countries

I use two measures of underwriter reputation: Carter and Manaster (1990) (from now on CM rank or measure) and a measure based on underwriter market share as suggested by Megginson and Weiss (1991) (from now on MW rank or measure) The

CM measure ranks underwriters from 1 to 9 according to the number of times they lead

an IPO as well as the frequency and ordering by which they appear in other syndicates of underwriters The data the authors use to compute the ranking come from the tombstone announcements of U.S IPOs This ranking does not change every year, however it is updated at two points in time during the period covered in this study For instance, prior

to 1985 the ranking comes from Carter and Manaster (1990), from 1985 to 1991 I use the update of Carter et al (1998), and from 1992 to 2004 the ranking comes from Loughran and Ritter (2004) The MW measure ranks underwriters by their market share in terms of

4 This variable includes shares held by insiders (senior corporate officers and directors and their immediate families), shares held in trusts or by another corporation, excluding nominees, shares held by pension/benefit plans, and shares held by individuals who hold more than 5% of the total shares outstanding Whenever a firm has more than one class of shares, “closely held shares” are based on the total number of shares As for Japanese firms this variable represents the total holdings of the ten largest shareholders As pointed out by Doidge, Karolyi and Stulz (2007) one major problem of these data is that they rely on unmonitored information disclosed by firms

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the proceeds raised in all US equity issuances5 This measure is calculated every year as

in Dunbar (2000) For each deal the reputation of the underwriter corresponds to its market share in the previous year The lead manager (underwriter) is given full credit for the operation Whenever there is more than one lead underwriter I equally divide the proceeds of the offering by each one of them I track down the major mergers and acquisitions of investments banks, described by Ljungqvist et al (2006), and calculate the market shares accordingly

In this study I only use the reputation of the lead underwriter In cases where there is more than one lead underwriter I collect the measure of the most prestigious one The dummy variables top CM rank and top MW rank are based upon the raw values of these measures: top CM rank is 1 whenever the CM measure given to the lead underwriter is 9, and zero otherwise; top MW rank is 1 whenever the MW measure is higher than its annual median, and zero otherwise

These two measures are positively correlated Over the entire period, the correlation between top CM rank and top MW rank is 78% in the subsamples of IPOs

2.4 Descriptive statistics and univariate analysis

Figure 1 shows how IPOs and SEOs are segmented in terms of ASD index – the proxy for shareholder protection The breaking point that distinguishes high from low ASD country is the median value of the index, 0.65 Clearly there are more firms from

5 The proceeds raised in equity offerings of American firms are also used to calculate the underwriter markets shares I apply the same screening criteria explained in the beginning of this section to SEOs and IPOs of American firms

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countries with high ASD index issuing equity in the U.S across all subperiods Overall, firms from high ASD index countries issued 67% of all Foreign IPOs and 60% of all Foreign SEOs and Later SEOs This is not surprising since most of the firms cross-listed

in the U.S come from common law and Western European countries, which, on average, have high ASD indexes Figure 2 breaks down the percentage of Foreign IPOs and Foreign plus Later SEOs by region and subperiod; it shows that, on average, among all cross-listed firms, firms from common law countries dominate the market of equity issues in the U.S Overall, firms from common law countries account for 33% of the Foreign IPOs and 48% of all SEOs, followed by Western European firms with 22% and 23%, respectively

The total number of underwriters conducting all equity offerings is 272 Figure 3 shows the number of underwriters and the percentage of them in the top CM rank The number of underwriters conducting equity offerings (both IPOs and SEOs) increased dramatically in the 1990s relative to the 1980s, however the percentage of them in the top

CM rank only decreased slightly (from 22% to 17%) During the periods 1999-2000 and 2001-2004 the percentage of top ranked underwriters is higher than 30% Figure 4 shows the number of underwriters per subperiod and the percentage of deals conducted by those

in the top CM rank Except for the period 2001-2004 the percentage stays between 53% and 55%; in 2001-2004 it rises up to 72%

In terms of industry composition, the main top underwriters show a similar pattern: high-tech industry has the highest percentage of deals, followed by manufacturing, health care and pharmaceutical, then consumer durables, non-durables

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wholesale and retail, and finally construction, mines and business services6 There are only few exceptions: Deutsche Bank, which is specialized in tech firms and Salomon Brothers, which has a slightly higher percentage of firms from manufacturing, health care and pharmaceutical, rather than high-tech firms

Table 1 shows some summary statistics that characterize the subsamples of Foreign IPOs (panel A), Foreign IPOs plus Foreign SEOs (panel B) and Later SEOs (panel C) First-day returns are the proxy for IPO underpricing; they measure the percent change between the offer price and the first closing stock price after the offering The average underpricing of Foreign IPOs, for the entire period, is 17.6%, more than three times its median, which can be explained by the high levels of underpricing in 1999-

2000 Including Foreign SEOs drops the average to 15.3% Even higher numbers are found by Loughran and Ritter (2004) on a sample of U.S IPOs from 1980 to 2003: they report an average first-day return of 18.7% and a median of only 6.3%; they also report high levels of underpricing (65%) in 1999-2000 Figure 5 shows in more detail the evolution of the underpricing of Foreign IPOs and the number of offerings over time The subperiods 1990-1998 and 1999-2000 account for the biggest number of Foreign IPOs There are only 47 offerings in the 1980s, whereas in the 1990s (excluding 1999)

265 foreign firms went public in the U.S The years 1999-2000 (known as the “internet bubble”) account for 49 IPOs The average level of underpricing also increases from 7.7% in the 1980s to 13.7% in the 1990s In 1999-2000 it rises dramatically up to 52.8%,

on average, and then drops to levels below the mean observed in the 1990s This pattern

6 This table is not shown in the paper but it can be provided upon request

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is consistent with the literature of U.S IPOs documented by Loughran and Ritter (2004) among others, as explained in section 2.2.3

The average size of Foreign IPO issuers, measured by the value of their total assets, is $1141 million and the average offering size (total proceeds) is $362 million The money left on the table in Foreign IPOs (first-day return times the number of shares offered) is, on average, $20.5 million Again, these values are comparable to the ones reported by Loughran and Ritter (2004) on a sample of U.S IPOs

More than 50% of the IPOs are “pure” IPOs, i.e., no inside shares (shares belonging to the executives of the firm) are offered The average age of foreign firms becoming public in the U.S from 1980 to 2004 is around 12 years (13 when including Foreign SEOs) and the average Tobin’s q ((total assets - book value of equity + mkt value

of equity)/total assets), measured at the end of the first fiscal, is 1.4 As in Chen and Ritter (2000) I find an average gross spread of 7% for my sample of Foreign IPOs Consistent with the literature of IPO long-term performance (Carter et al., 1998), the long-term abnormal returns (three-year buy-and-hold return minus the CRSP value-weighted index) is negative, -22.8%

Sales growth is the percent change in net sales from the last fiscal year before the offering to the first fiscal year-end after the offering On average, sales growth is around 50% for the subsample of Foreign IPOs and 47% after adding Foreign SEOs The need for external equity financing is calculated as in Rajan and Zingales (1998): (capital expenditures - operating cash flow)/operating cash flow; accounting variables are from the end of the fiscal year before the offering As expected the value for this variable is

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relatively high (around 1.0), since these are firms that are raising equity Cash holdings is the total amount of cash and cash equivalents, as of the last fiscal year-end before the offering, divided by the total assets On average, the cash holdings of the IPO issuers are about 15% of the total assets

For the subsample of Later SEOs, the average underpricing – close-to-offer return – for the entire period (1980-2004) is 3% and the median is 1.7% This is similar to what other authors find using samples of SEOs of U.S firms For instance, Corwin (2003) finds an average SEO underpricing of 2.21% from 1980 to 1998 and Mola and Loughran (2004) document an average of 3% from 1986 to 1999 Total assets, market capitalization, and Tobin’s q are measured before the offering The average proceeds raised in SEOs is $521.32 million, and the average money left on the table reached $4.3 million Pre-market cumulative excess returns over the 5-day period prior to the offer are negative (-1.09%) reflecting the partial price adjustment before the offer price is known Consistent with Spiess and Affleck-Graves (1995), long-term abnormal returns during the three-year period after the SEO are negative: -11.82% on average Table 2 shows univariate tests for the equality of means of firm-specific and deal-specific variables segmented by CM measure of underwriter reputation7 and ASD index of Foreign IPOs (panel A), Foreign IPOs plus Foreign SEOs (panel B), and Later SEOs (panel C) In the first column, variables are segmented by high and low underwriter reputation On average, for the entire sample period, the long-term mean abnormal return of all types of equity offerings is higher when reputable underwriters sponsor the deal However, we

7 Although this analysis uses CM ranks as a measure of underwriter reputation, the results are qualitatively the same when the categorization is made upon MW ranks

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cannot simply conclude, from this result, that the monitoring provided by prestigious underwriters has a positive impact on firm’s long-term performance One of the main problems of the univariate analysis is the assumption of independence among firm-specific and deal-specific variables, which is very unlikely to be the case In fact, top and bottom underwriters may be specialized in different types of firms, which, in turn, may drive the evidence found in long-term abnormal returns For instance, prestigious underwriters seem to do more business with large firms: the average total assets of firms which offerings are conducted by reputable underwriters is higher than the average of those sponsored by less reputable ones This difference is significant across all panels

The second column of the table shows the variables segmented by high and low ASD index Among Foreign IPOs, there are no significant differences, in terms of size,

of firms coming from countries with low and high ASD index However, after including Foreign SEOs there is evidence that issuers from countries with poor shareholder are significantly larger There is also evidence that more secondary shares tend to be offered

in Foreign IPOs/SEOs when issuers are from countries with low ASD index As for the Later SEO subsample evidence suggests that firms coming from countries with low ASD index are relatively larger and less volatile

Figure 6 shows the distribution of the joint subsample of Foreign IPOs and Foreign SEOs between top and bottom underwriters, within each group of countries (high and low ASD index), without controlling for any other dimension It is clear that, overall, firms coming from countries with poor minority shareholder protection choose reputable underwriters more frequently to sponsor their equity offerings The only

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