Democracy and the Pricing of Initial Public Offerings Around the World

By | July 23, 2021

The proliferation of democracy internationally has spurred a large volume of research on its benefits (and costs) over economic growth in recent decades. Some studies assess the impact of democracy over various aspects of macroeconomic growth; however, the same cannot be argued for the micro level, whereby the effect of democracy over corporate decisions has been largely ignored. 

To the extent that macroeconomic activity reflects the aggregation of decisions and actions at the micro level, it stands to reason that the widely documented democracy-effect at the macro level is present in corporate outcomes. We address this issue by examining the influence of democracy on initial public offering (IPO) pricing around the world. We argue that democracy can affect IPO underpricing by fostering an institutional environment capable of mitigating information asymmetry problems and improving corporate governance. To the extent that information flows freely and the level of information asymmetry is lower in democratic regimes, we hypothesize that higher levels of democracy will lead to a reduction in IPO underpricing. In addition, since incentives to adopt better governance mechanisms at the firm level increase with a country’s financial and economic development, corporate governance should be improved and agency problems should be less severe in more democratic countries—given democracy’s pro-growth potential.  

We examine the relation between democracy and IPO underpricing using a global sample consisting of 23,050 IPOs across 45 countries over the period 1990 to 2020; our proxy for democracy is institutional democracy obtained from the Polity V Project (2018), which captures the presence of institutions and procedures through which citizens can express effective preferences about alternative policies and leaders, the presence of institutionalized constraints on the exercise of power by the executive, and the guarantee of civil liberties to all citizens in their daily lives and in acts of political participation. This measure is an institution-based and not a perception-based indicator and allows us to examine the effect of institutional democracy (encompassing constitutional elements) to a large extent purified of perception.

Our results strongly suggest that democracy is negatively related to IPO underpricing, with a one standard deviation increase in our democracy variable associated with a reduction of 7.64 percentage points in IPO underpricing. We confirm that these findings are due to democracy affecting IPO underpricing via the information asymmetry channel (given the higher transparency levels observed in democratic regimes) and hold when controlling for regional waves of democratization and transitions to non-democracy as instrumental variables. We further demonstrate that the negative impact of democracy over IPO underpricing grows weaker with IPO-characteristics conducive to mitigating information asymmetry (certification by high-quality auditors; venture capital firms’ backing; specificity in the use of IPO proceeds).  

In addition, this negative impact is found to be amplified (moderated) among firms with higher free cash flow or operating expenses (greater asset turnover, asset utilization, and return on assets), suggesting that country-level democracy is particularly important for firms subject to high levels of principal–agent conflict. What is more, we showcase how cross-country differences in institutional structures affect the negative relation between democracy and IPO underpricing, a relation which grows weaker in countries characterized by stronger shareholder rights, stronger securities laws, and greater insider trading restrictions; we also find that this relation appears stronger in countries with higher levels of earnings opacity, with a civil law legal culture, and in emerging markets. These findings are consistent with the hypothesis that a higher-quality institutional environment will help reduce informational asymmetry and risks, and thus mitigate the magnitude of the relation between democracy and IPO underpricing. Finally, we also show that democracy’s adverse impact over IPO underpricing grows stronger (i.e., underpricing is deeper) during periods characterized by higher political uncertainty and higher sentiment. 

We contribute by showing that democracy can benefit economic growth through its impact in reducing the underpricing of IPOs, thus providing large-scale empirical evidence on the effect of democracy on corporate outcomes. To that end, our findings are of particular interest to investors seeking to identify investment opportunities beyond their home market, as they help endow them with actionable information on how political conditions impact underpricing in primary markets internationally. 

Huu Nhan Duong is an Associate Professor of Banking & Finance at Monash University  

Abhinav Goyal is a Professor of Corporate Finance at the Cork University Business School, University College Cork  

Vasileios Kallinterakis is a Senior Lecturer in Corporate Finance at the University of Liverpool 

Madhu Veeraraghavan is a Director at T.A. Pai Management Institute 

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