Academic journal article Journal of Corporation Law

Political Uncertainty and the Market for IPOs

Academic journal article Journal of Corporation Law

Political Uncertainty and the Market for IPOs

Article excerpt


Political uncertainty1 affects financial markets. A robust academic literature examines the impact of political uncertainty on a range of macroeconomic matters such as economic growth, inflation, capital flows, stock return volatility, and asset prices.2 Indeed, Standard & Poor's, a major credit rating agency, cited political uncertainty as one of the key reasons for its unprecedented downgrade of U.S. Treasury debt in 2011. According to David Beers, Standard & Poor's managing director of sovereign credit ratings, the "'degree of uncertainty over the political policymaking process . . . [was] incompatible with the AAA rating.'"3

More recently, and especially in the wake of the Great Recession, the impact of political uncertainty on firm-specific corporate activity has become a prominent subject of public discourse. This issue has emerged as a talking point for politicians, 4 has been covered at length by major news outlets and the financial press, 5 and has been the subject of academic inquiry.6 Collectively, this commentary oversimplifies the impact of political uncertainty on corporate activity. Analysts focus almost entirely on firms' investment decisions-that is, how companies deploy their resources by hiring employees, investing in research and development, and funding other capital outlays.7 There has, however, been virtually no attention paid to the impact of political uncertainty on firms' financing decisions.8 In particular, the literature largely ignores a key question related to the life - cycle of developing companies: how does political uncertainty impact the market for initial public offerings (IPOs)? This omission is rather significant because the vibrancy of the IPO market is a key determinant of venture capital financing, which is a critical source of funding for early-stage companies.9

This Article develops a simple theory and model of the market for IPOs under conditions of political uncertainty. Our analysis contributes to two related literatures. First, we broaden the understanding of political uncertainty's firm-specific effects by developing empirically testable hypotheses concerning firms' financing decisions. Our theory and model is timely because, as Pastor and Veronesi recently commented, "our ability to interpret the impact of political news on financial markets is constrained by the lack of theoretical guidance."10

Our model generates four central predictions: (i) as political uncertainty increases, the frequency of IPOs decreases; (ii) IPOs conducted during periods of heightened political uncertainty are, on average, of higher quality and generate greater return on investment in the secondary market than those conducted during periods of lower political uncertainty; (iii) political uncertainty increases the cost of capital for IPO firms; but (iv) underpricing, the difference between the IPO price and the first-day trading price on the secondary market (i.e., the amount "left on the table" by IPO firms), is less pronounced during periods of heightened political uncertainty. We demonstrate that each of these predictions is consistent with the available empirical evidence.

Second, we also add to the developing literature on IPO decision-making. The IPO market is strongly cyclical; "hot" phases with a high volume of IPO activity alternate with "cold" phases, in which the frequency of IPOs plummets.11 A growing body of work seeks to explain this phenomenon and model firms' strategic decisions concerning IPOs. There are few empirical studies of the going public decision-making process,12 but several theoretical studies hypothesize three determinants of IPO activity: business conditions, investor sentiment, and asymmetry of information between private firm managers and public investors.13 Based on these hypotheses, commentators have made predictions about several aspects of the IPO cycle, such as IPO frequency, average firm quality, and issue pricing. …

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