New Research: What Happened in 1998? The Demise of the Small IPO and the Investing Preferences of Mutual Funds

Robert Bartlett (University of California, Berkeley – School of Law), Steven Davidoff Solomon (University of California, Berkeley – School of Law) and I have recently posted a paper to SSRN that explores the impact of mutual fund liquidity preferences on small-cap IPOs.  The work follows research by Steven Davidoff Solomon and me on the lifecycle of small-cap firms.

Here’s the abstract of the new paper:

The decline of the small initial public offering (IPO) occurred abruptly. In 1997, the number of IPOs raising less than the inflation-adjusted mean proceeds of 1990 was nearly half of all IPOs. By 1999, this percentage had fallen to just 10%, remaining below this level for most of the ensuing decade.

This paper presents a novel demand-side theory for the sudden and prolonged demise of small IPOs that focuses on the investment preferences of large mutual fund investors. We theorize that the rapid increase after 1990 in assets under management among the largest funds induced portfolio managers to take larger investment positions, heightening concerns about liquidity risk within their investment portfolios — concerns that naturally implicated smaller IPOs in light of their greater illiquidity. When global events in 1998 sparked a dramatic “flight to liquidity” and a surge in mutual fund redemptions, the amplified attention to liquidity risk caused demand for small IPOs to drop precipitously among the largest funds, prompting a vicious cycle of illiquidity-begets-illiquidity which has continued well past 1998.

To test this theory, we examine mutual fund investments in 6,110 IPOs between 1990 and 2014 using portfolio-level position information for 37,052 individual mutual funds. Our central identification strategy exploits the sudden increase in liquidity concerns brought about by the “Panic of 1998”: an abrupt collapse in the demand for illiquid equities triggered by Russia’s debt default in August 1998. Using a difference-in-difference strategy, we find that the largest quartile of mutual funds invested in more IPOs than smaller funds both before and after 1998. However, after 1998 the largest mutual funds invested in significantly fewer small IPOs and IPOs having a higher measure of illiquidity relative to investments by smaller funds, consistent with large funds being more sensitive to the liquidity risk of smaller offerings. Additionally, conditional on investing in an IPO, the largest funds also demonstrated a decisive shift towards purchasing larger, more liquid IPOs after 1998 than did smaller funds. In light of recent regulatory efforts to reinvigorate the small IPO market, our results highlight the need to consider more than “supply side” considerations such as regulatory burdens facing new issuers. Without first addressing the growing liquidity concerns of large institutional investors, efforts to revive the small IPO are unlikely to succeed.


The paper can be downloaded here.  Comments are welcome.

Coudert & Mignon: Reassessing the empirical relationship between the oil price and the dollar


This paper aims at reassessing the empirical relationship between the real price of oil and the U.S. dollar real effective exchange rate over the 1974-2015 period. We find that changes in both variables are now linked by a negative relationship, going from the dollar exchange rate to the real oil price. However, the same relationship is found positive when ending the sample in the mid-2000s, in line with the previous literature. To understand and investigate this evolution, we rely on a nonlinear, smooth transition regression model in which the oil price-dollar nexus depends on the dynamics followed by the U.S. currency. Our results show that the relationship is negative most of the times but turns positive when the dollar hits very high values, as in the early eighties.


Available for download here.


Iankova & Tzenev: Determinants of Sovereign Investment Protectionism – The Case of Bulgaria’s Nuclear Energy Sector


Foreign direct investment (FDI) by entities controlled by foreign governments (especially state-owned enterprises) is a new global phenomenon that is most o!en linked to the rise of emerging markets such as China and Russia. Host governments have struggled to properly react to this type of investment activity especially in key strategic sectors and critical infrastructure that ultimately raise questions of national security. Academic research on sovereign investment as a factor contributing to the new global protectionist trend is very limited, and predominantly focused on sovereign investors  from China. this study explores the speci$cs of Russian sovereign investment in the former Soviet Bloc countries, now members of the European Union, especially in strategic sectors such as energy. We use the case of Bulgaria’s nuclear energy sector and the involvement of Russia’s state-owned company Rosatom in the halted Belene nuclear power plant project to analyze the dynamics of policy and politics, political-economic ideologies and historical legacies in the formation of national stances towards Russia as a sovereign investor. Our research contributes to the emerging literature on FDI protectionism and sovereign investment by emphasizing the signi$cance of political-ideological divides and the heritage of the past as determinants of sovereign investment protectionism.

Available for download here.


Armstrong, Reinhardt & Westland: Are Free Trade Agreements Making Swiss Cheese of Australia’s Foreign Investment Regime?


Australia’s foreign investment regime plays an important role in Australia maintaining an open investment environment while providing the Australian community confidence that new investment projects are in the interest of the community. Until 2005, the foreign investment regime treated all investment sources on a non-discriminatory basis but since then some important preferential exemptions to screening have been introduced. Bilateral deals with the United States and New Zealand more than quadrupled the threshold to A$1.078 billion for investments that must be screened by the Foreign Investment Review Board (FIRB), and deals with South Korea and Japan promise the same treatment. There is expectation that a free trade agreement with China will also lift the threshold for Chinese investment. This represents a major liberalisation towards investment from those countries, given that a vast majority of investment is below the A$1 billion threshold. Some new rules regarding investment have also been introduced in those bilateral agreements which only apply to the signatories of those bilateral deals, however, the differential treatment is not at this stage too different or complex and there is scope for them to be unified and made consistent to all sources of investment. The piecemeal changes to the foreign investment regime through bilateral trade and economic agreements have occurred without a clear strategy set forth and further piecemeal changes threaten to impact the operation and function of the regime with implications for confidence in Australia maintaining an open investment environment.


Available for download here.


Wu: An Introduction to Chinese Local Government Debt

From the Introduction:

The growth of Chinese local government debt has accelerated over the last five years, reaching RMB 24 trillion2 ($3.81 trillion) in 2014, or 37.7% of GDP.3 Set against a backdrop of a Chinese economy that is growing at its lowest rate since the economic reform of the 1980s, the high debt levels have become a policy concern both within China and internationally. Chinese policymakers have taken several steps to mitigate the risks to the Chinese financial and fiscal systems, but further measures will likely be necessary. This paper describes key aspects of Chinese local government debt including the reasons for the buildup, statistics related to its distribution and impact, and policy actions that are being taken or proposed to address the buildup and avert defaults.


Available for download here.

Alshathr, Aronson & Nayar: Municipal Credit Ratings and Unfunded Pension Liabilities: New Evidence


This paper investigates whether a municipality’s unfunded pension plan liabilities are associated with the municipality’s credit rating. We answer this question by examining Moody’s credit ratings for municipalities located within the state of Massachusetts. Focusing on a specific state helps us to avoid heterogeneity problems that have plagued prior studies employing multi-state data. Using panel data, and the ordered probit and ordered logit methodologies, our results demonstrate a significant negative relationship between unfunded liabilities and Moody’s credit ratings. Furthermore, the standardized coefficients in both models are close in magnitude indicating robustness of the relationship. These results have public policy implications for municipalities.


Available for download here.

Reposted:Shareholder Activism as a Corrective Mechanism in Corporate Governance

As readers may be looking back on corporate and securities law articles from 2015, I want to again highlight a paper written by Bernard Sharfman and me on the issue of how (and in what cases) hedge fund activism can add value.  Here’s the abstract:


Under an Arrowian framework, centralized authority and management provides for optimal decision making in large organizations. However, Kenneth Arrow also recognized that other elements within the organization, beyond the central authority, occasionally may have superior information or decision-making skills. In such cases, such elements may act as a corrective mechanism within the organization. In the context of public companies, this article finds that such a corrective mechanism comes in the form of hedge fund activism, or, more accurately, offensive shareholder activism.

Offensive shareholder activism operates in the market for corporate influence, not control. Consistent with a theoretical framework that protects the value of centralized authority and a legal framework that rests fiduciary responsibility with the board, authority is not shifted to influential, yet unaccountable, shareholders. Governance entrepreneurs in the market for corporate influence must first identify those instances in which authority-sharing may result in value-enhancing policy decisions, and then persuade the board and/or other shareholders of the wisdom of their policies, before they will be permitted to share the authority necessary to implement the policy. Thus, boards often reward offensive shareholder activists that prove to have superior information and/or strategies by at least temporarily sharing authority with the activists by either providing them seats in the board or simply allowing them to directly influence corporate policy. This article thus reframes the ongoing debate on shareholder activism by showing how offensive shareholder activism can co-exist with — and indeed, is supported by — Kenneth Arrow’s theory of management centralization, which undergirds the traditional authority model of corporate governance.

This article also provides a much-needed bridge between the traditional authority model of corporate law and governance as utilized by Professors Steven Bainbridge and Michael Dooley and those who have done empirical studies on hedge fund activism, including Lucian Bebchuk. The bridge helps to identify when shareholder activism may be a positive influence on corporate governance.

The paper can be downloaded here.