Regulating IPOs: Evidence from going public in London, 1900–1913

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Regulating IPOs: Evidence from going public in London, 1900–1913 Carsten Burhopa , David Chambersb,⁎, Brian Cheffinsc a

Institut für Wirtschafts- und Sozialgeschichte, Universität Wien, Historisch-kulturwissenschaftliche Fakultät, Institut für Wirtschafts- und Sozialgeschichte, Universitätsring 1, A-1010 Vienna, Austria b Judge Business School, University of Cambridge, Trumpington Street, Cambridge CB2 1AG, UK c Faculty of Law, University of Cambridge, 10 West Road, Cambridge CB3 9DZ, UK Received 1 December 2012 Available online 26 July 2013

Abstract This study assesses the impact of self-regulation on equity markets by analysing IPO failure rates on the London Stock Exchange during 1900–13. Focussing on differences between Official Quotation (OQ) and Special Settlement (SS) methods of going public, we find that the failure rate of IPOs by way of SS was considerably higher even after controlling for firm characteristics and for the presence of underwriters and elite directors. Furthermore, overall market-adjusted returns for SS IPOs, including the relatively few IPO “winners”, were extremely poor. Our findings have implications for the literature on self-regulation of securities markets as well as long-standing debates on British capital market development before 1914. © 2013 Elsevier Inc. All rights reserved. Keywords: Equity listings; Financial development; Investor protection; Firm survival; Law and finance JEL classification: G14; G18; G24; G32; G38; K22; N23

1. Introduction Financial development matters for national economic performance (King and Levine, 1993) and industrial development (Rajan and Zingales, 1998), with both stock market development and the expansion of banking services being linked to faster growth (Levine and Zervos, 1998). In the nineteenth century, the bulk of the stock market capitalization in Europe and the United States initially reflected their origins as listing venues for sovereign bonds and railway securities before expanding to include industrial securities, ultimately including shares. In the twentieth century,

an active market for initial public offerings (IPOs) became a bellwether for the development of quoted equity markets (Fama and French, 2004). Yet, the broadening of the stock market to include the equities of industrial and commercial firms is, as Navin and Sears (1955) demonstrated in their classic study of the US stock market at the turn of the twentieth century, far from straightforward. In particular, as the pecking order theory tells us, equity financing is the most difficult for firms to accomplish in a world of asymmetric information (Myers and Majluf, 1984). In this paper we focus on IPOs occurring on the leading stock market in the world – the London Stock

⁎ Corresponding author. Fax: + 44 1223 339701. E-mail addresses: [email protected] (C. Burhop), [email protected] (D. Chambers), [email protected] (B. Cheffins). 0014-4983/$ - see front matter © 2013 Elsevier Inc. All rights reserved. http://dx.doi.org/10.1016/j.eeh.2013.07.003

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Exchange (LSE) – during the period from 1900 to the eve of World War I, when stock markets in major developed countries were becoming a focal point for dealing in shares of industrial and commercial companies. In particular, we analyse a hand-collected dataset of IPOs on the LSE between 1900 and 1913, focussing closely on differences between the failure rates of IPOs obtaining an Official Quotation (OQ) and of IPOs by way of “Special Settlement” (SS). More than two-thirds of the 825 IPOs on the LSE between 1900 and 1913 were executed by SS, which constituted the “junior” market of the LSE and was largely unregulated. In contrast, the LSE imposed various requirements on companies seeking an OQ. Our findings indicate that this bifurcation substantially affected IPO survival. The manner in which IPOs were regulated by legislation in the UK as the twentieth century got underway accounts for our emphasis on the LSE's regulatory approach. In Germany all public offerings were tightly regulated, at least by contemporary standards, due to legislative reforms occurring in 1884 and 1896 (Emery, 1898; Franks et al., 2006: 542; Burhop, 2011). In contrast, statutory regulation of public offerings was rudimentary in the UK. Correspondingly, to the extent that London Stock Exchange IPOs were regulated, this was left primarily to self-regulation by the LSE. We use our dataset to estimate both the failure rate afflicting London Stock Exchange IPOs and the associated proportional hazard rates to test statistically two main hypotheses. First, since SS IPOs were less regulated, we would expect their failure rate to have been higher than that of OQ IPOs, even once due allowance is made for firm characteristics, industry, geographic location and the overall state of the IPO market. Second, we hypothesize that certification mechanisms reduced the risk of failure due to statutory regulation being rudimentary. We focus specifically on underwriting of IPOs and the presence of “elite” directors – defined as peers and Members of Parliament for the purposes of our study – on the board of a company going public. A potential drawback of tight IPO regulation is that it will deter riskier ventures from going public and thereby limit the investment opportunity set. Correspondingly, we consider a third hypothesis, namely, that there may have been enough “winners” among the lightly regulated SS IPOs to offset the losses arising from the failures. In such a case investors who repeatedly bought shares in IPOs would earn overall returns to competitive with other quoted investments. The total absence of published share price data for SS companies before July 1916 prevents the estimation of

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initial returns or longer-run performance over the years immediately after the IPO across our sample period. However, for SS IPOs occurring between 1909 and 1913 – more than half of our full SS IPO sample – it is possible to compute the share price performance (including dividends) sufficiently proximate in time to the IPO to ascertain whether there were sufficient big “winners” to offset failures. Our results indicate that the overall failure rate of LSE IPOs carried out between 1900 and 1913 was similar to that experienced on present-day stock markets, despite the fact that regulation is now considerably more robust. Importantly, however, we find that, in accordance with our first hypothesis, the failure rate of SS IPOs was considerably higher than that of OQ IPOs even after controlling for firm characteristics and other variables. Our second hypothesis, in contrast, is refuted, in that the incidence of underwriting and the presence of elite directors failed to reduce the risk of IPO failure. Our third hypothesis is also refuted, in that among SS IPOs occurring between 1909 and 1913 the overall market-adjusted share price performance of these SS IPOs was poor. In this particular case, then, the average IPO investor would have benefitted from having less choice. Our study is important because the appropriate scope of regulation of securities markets is a contentious issue, yet the empirical literature on IPO regulation remains small and generally inconclusive (Mahoney and Mei, 2007: 3–4). In particular, we contribute to academic debate concerning the contribution of self-regulation to the effective functioning of equity markets. In the case of the United States empirical studies analysing the impact of the enactment of federal securities legislation in the mid-1930s, most notably Simon's (1989) study of IPO failure rates, offer insights. In the important case of London, the leading stock exchange in the world during the early twentieth century (Neal and Davis, 2006: 280), some claim that the LSE offered little protection to investors (e.g. Coffee, 2001). Others view the LSE as an integral part of a business ecosystem where values, standards and voluntary compliance bolstered enterprise, flexibility and shareholder protection (e.g. Hannah, 2007a). There has been, however, very little detailed empirical investigation on this point. Our findings in this paper indicate that while IPO failure rates were very low where, as in the case of OQ, self-regulation at least partially substituted for detailed statutory regulation, the entirely laissez-faire SS approach was disadvantageous for investors. This paper also links to the debate on capital market development in Britain before World War I.

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The composition of our IPO sample is consistent with the finding that investors on the London Stock Exchange were offered a geographically diverse menu of investment choices (Edelstein, 1982; Goetzmann and Ukhov, 2006; Chabot and Kurz, 2010). Furthermore, our paper provides a novel twist to this long-standing debate oriented around the London Stock Exchange's bifurcated market structure. Various observers have bemoaned the operation of the UK's largely unregulated pre-1914 equity market (Kennedy, 1987; Armstrong, 1990; De Long, 1991). They maintain that due to public offerings being routinely ill-conceived or mismanaged investors refrained from backing worthwhile fledgling industrial and commercial enterprises that with proper financial backing could have helped to forestall Britain's economic decline. Others offer a more favourable assessment of pre-1914 UK equity markets (Hall, 1957; Sylla and Smith, 1995: 191–95; Michie, 1999; Hannah, 2007b, 2011). The UK is hailed as a leader in capital market development due at least in part to a flexible and competitive London Stock Exchange structure that encouraged companies to go public. Our results turn on the bifurcated IPO regime and potentially provide support for both characterizations of UK equity markets. Recent studies with respect to dividend policy (Braggion and Moore, 2011) and insider trading (Braggion and Moore, 2012) suggest it made little difference whether a publicly traded company was officially quoted or not. In contrast, our results indicate that this difference was very important for IPOs. Failures were a rarity among OQ IPO companies and relatively commonplace among SS IPO companies from which “winners” were not forthcoming with sufficient regularity to compensate. Our findings on OQ IPOs correspondingly tend to confirm the conjectures of those who characterize UK capital markets in favourable terms whereas our findings on SS IPOs are closer to what critics would predict. The layout of the paper is as follows. Section 2 provides an overview of the institutional features of pre-1914 equity markets in the UK and reviews academic debates concerning the effectiveness of self-regulation by stock exchanges and the operation of equity markets in the UK in the late nineteenth and early twentieth centuries. Section 3 sets out formally the hypotheses we test regarding IPO regulation. Section 4 describes the characteristics of our sample. Section 5 reports our findings on failure rates for OQ and SS IPOs both univariately and in a multivariate setting and subjects our results to a number of robustness checks. Section 6 analyses the impact of certification by elite directors and underwriters. Section 7 analyses whether there were a

sufficient number of SS IPO “winners” to cancel out the inferior failure rate. Section 8 discusses our main results before Section 9 concludes. 2. Self-regulation and UK equity markets Firms going public nowadays are typically regulated by a combination of company and securities laws as well as stock exchange rules specifying listing requirements. Legislation of this sort can be traced back to the late nineteenth century in some countries. Germany's stock corporation law of 1884 required firms not only to file publicly a balance sheet but also a profit and loss account on an annual basis (Franks et al., 2006: 540). The German Exchange Act of 1896 required every company applying for listing on a stock exchange to issue a prospectus, the character of which the German parliament prescribed in considerable detail (Emery, 1898: 313), and deemed those who organized an IPO and underwrote it to be liable for false statements or suppression of facts, either purposely or through gross negligence (Emery, 1898: 313). The UK was slower to use company legislation to force financial disclosure upon firms going public. Except for companies operating in specific industries such as railways, life insurance, gas and electric lighting (Sylla and Smith, 1995: 189), filing a balance sheet was not required until 1908 (Cheffins, 2008: 196) and companies were not obliged to present a profit and loss account to shareholders until the 1929 Companies Act (Cheffins, 2008: 274). Prospectus disclosure of non-financial information, such as contracts influencing whether or not an applicant would take up shares and corporate transactions to which directors were parties, was mandated as early as 1867 (Companies Act of 1867, §38). However, company promoters could side-step these requirements by distributing shares without a supporting prospectus and not until 1908 were firms obliged under the law to prepare “a statement in lieu of prospectus” containing much of the same information (Cheffins, 2008: 195–96). Throughout much of the twentieth century, the Listing Rules governing companies with shares quoted on the LSE (LSE Rules) were generally a step ahead of UK company law in regulating companies and assuaging concerns public investors might otherwise have had about purchasing shares (Cheffins, 2008: 76, 107–8). IPO regulation was tightened as part of this process, with the LSE requiring by 1970 a ten-year profits record before permitting a quotation (Michie, 1999: 533). From 1947 until the 1981 opening of the Unlisted Securities Market, the precursor to the present-day Alternative Investment Market (AIM), a company could only go public on the

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LSE by obtaining a quotation and adhering to various requirements prescribed by the LSE's Listing Rules (Cheffins, 2008: 332–33; Michie, 1999: 571–73). However, during the late nineteenth and early twentieth centuries the LSE was less forthcoming as a regulator. The Stock Exchange was typically not concerned with the quality of the securities the market handled, leaving its members free to deal in whatever financial instruments they chose (Michie, 1999: 86–87). Various observers critical of the UK's pre-1914 equity market cite lax regulation as a major problem. Kennedy has said British capital markets “operated in a legal environment which greatly amplified the information problems that are familiar features even of mid-twentieth century capital markets” and “made an indispensable contribution to a situation where (key industries)… stagnated until thoroughly overshadowed…. (1987: 125, 141).” Armstrong concurs, saying that during the late nineteenth and early twentieth centuries “British manufacturing was likely to stay small-scale and family dominated” because “investors were turned off home industrials and some sound firms shied away from going public because of the adverse publicity surrounding ‘company promotion’ (1987: 133).” Others offer a more favourable assessment of pre-1914 UK equity markets, including Hall (1957), Sylla and Smith (1995: 191–95), Michie (1999) and Hannah (2007b, 2011). Michie has said of the period between 1900 and 1914 “there appeared to be a greater interest in and a more active market in industrial securities in London than elsewhere (1999: 140).” Hannah refers to London being “by a large margin… the biggest stock exchange in the world in the early twentieth century” and draws attention to the Britain of that era hosting “an above-par number of large, quoted – and generally managerial and multinational – corporations (2007b: 644).” There is also a difference of opinion in the literature on the effectiveness of the London Stock Exchange as a supervisor of pre-1914 equity markets. To put matters into context, an overview of the regulatory matrix is in order. As far back as the 1820s the LSE was prepared not to recognize bargains in shares where proof was lacking that a company had been formed and that the directors were carrying out its objects (Neal and Davis, 2006: 287–88). As the nineteenth century drew to a close, notwithstanding the LSE generally eschewing an interventionist approach, its rules stipulated that a company seeking a quotation had to have articles of association in a form of which the Committee of the Stock Exchange approved (Cheffins, 2008: 75, 197).

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By 1902, the LSE expected the articles of a company seeking a quotation to limit the borrowing powers of directors, to circulate a balance sheet annually to shareholders and to require a director to disclose and not vote upon any contract with the company in which the director had a personal interest. The requirements were formally spelled out in the LSE listing rules by 1909, and, in addition to the requirements already mentioned, the articles of a company seeking a quotation had to compel annual circulation of the company's profit and loss account to the shareholders and the Stock Exchange (Cheffins, 2008: 197). Moreover, so as to inhibit market manipulation and promote liquidity, the LSE Rules prohibited from the 1850s until the 1940s the quotation of a class of securities unless two-thirds of the capital had been allotted to the public (Cheffins, 2008: 76, 332). Before agreeing to quote a security the Committee of the Stock Exchange would additionally require full information on the bona-fide character of the enterprise and would seek to ascertain whether the offering was of “sufficient magnitude and importance” to merit a full listing. A company therefore would never be granted a quotation automatically (Davis and Gallman, 2001: 191). According to Gibson (1889: 37–38), the Committee would decline “to admit to quotations the questionable enterprises of ‘shady’ promoters.” On the other hand, the Committee would not: “indicate any opinion, personal or official, as to the value of such issues, or their real genuineness or soundness. That is entirely beyond their province, and persons buying issues that have been ‘listed’ should scrutinize the property and investigate the value for themselves. Caveat emptor.” As the twentieth century opened, firms carrying out IPOs in London that were not inclined to become officially quoted and yet wanted their shares to be traded on the LSE could apply for a “Special Settlement” (Cheffins, 2008: 196). There also were occasions when companies seeking to have their shares traded on the LSE would seek a full quotation and relied on a Special Settlement as a back-up plan if things did not work out. We uncovered through searches of LSE applications for listing files 15 instances between 1900 and 1913 where those organizing an IPO had to turn to a Special Settlement because their application to join the main market failed. In 12 cases, the LSE Committee had concerns about the shares not being sufficiently widely distributed and in the remaining three cases no reason was provided for refusing a quotation. In none of these 15 instances was an application for an Official Quotation refused explicitly on grounds of inadequate disclosure

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or due to concerns about the merits of the company involved. As of 1900, the only explicit requirement the LSE imposed on a company seeking a Special Settlement was to ensure that there were sufficient share certificates ready for delivery (Gore-Browne and Jordan, 1902: 454). By 1909 the LSE Rules stipulated that a company applying to the LSE Committee for a Special Settlement had to file its prospectus and spell out the number of shares to be allotted to the public and others (Gore-Browne and Jordan, 1909: 488). The LSE Committee would not entertain such an application unless there were transactions to be settled and it had the power to keep off the market the shares of companies where undesirable practices had occurred. The occasions, however, when the Committee felt compelled to refuse an anticipated Special Settlement were “quite exceptional” (Times, 1913; Davis and Gallman, 2001: 191). Our own searches of the LSE application for listing files found no instances of refusals of Special Settlement. Such IPOs were therefore almost entirely unregulated. With Special Settlement IPOs to which the LSE Committee gave the green light, the Committee would fix a special day outside of the ordinary account calendar for all bargains in the new securities to be settled. After the Special Settlement day, the shares would become part of the normal account system of Stock Exchange dealings and jobbers would make a market in such securities but off the Official List. Share prices of Special Settlement companies were not published until 1916, when a Supplementary List of share prices was initiated. Otherwise, the Special Settlement sector resembled what would be regarded today as a “junior market” complementing the main market made up of officially quoted shares. For a sizeable number of companies this market indeed functioned, to use a term being deployed currently in debates about de-regulation of IPO activity, as an “on ramp” to an Official Quotation. As we will see below in Section 7, among the 196 companies in our sample that carried out Special Settlement IPOs between 1909 and 1913 that had not been acquired, liquidated for value, or gone bankrupt, by 1916 32 had graduated to the Official List of the LSE. Stock exchanges are said to have strong economic incentives to build up and preserve investor confidence, thus prompting them to self-regulate appropriately (Mahoney, 1997; Pritchard, 2003). Stock exchanges correspondingly can plausibly be assigned the lead role in formulating and enforcing listing rules applicable to companies with shares listed for trading. The adequacy of self-regulation in this context cannot be taken for granted, however. Stock exchanges may favour unduly

the interests of their members at the expense of other interests and even with the best of intentions may lack sufficient legal enforcement powers (Cheffins, 1997: 397–98, 412). For instance, an oft-cited justification for the introduction of the Securities Act of 1933 in the US, which required registration of securities sold to the public, mandated various types of disclosures and permitted buyers of securities to sue any person signing the registration statement (directors, underwriters, accountants, etc.) for “misleading” statements and “omissions of fact”, is that the New York Stock Exchange was unable to promulgate or enforce effective disclosure rules (Seligman, 1983: 54–55). Self-regulation as practised by the New York Stock Exchange with companies listed on the Exchange prior to 1933 may in fact have been far more effective than critics maintain (Mahoney, 1997: 1465–75). Research by Simon (1989) lends credence to this view, with failure rates for IPOs on the NYSE remaining largely unchanged following the enactment of the 1933 Act but improving on less regulated regional exchanges. Even granting that stock exchange enforcement of listing rules can theoretically substitute satisfactorily for statutory regulation, there is a division of opinion on how effectively the London Stock Exchange might have played this role before 1914. Coffee (2001: 34–44) argues that the public equity market developed more slowly in the UK than the US because during the opening decades of the twentieth century a laissez-faire London Stock Exchange refrained from adopting the role of the guardian of the public investor in the same manner as the New York Stock Exchange. Cheffins (2008: 75–76, 107–8, 196–97, 278–81), while acknowledging that regulation by the London Stock Exchange was an important marketoriented supplement to UK company law, suggests that prior to 1914 the LSE did not offer substantial direct protection to investors. Hannah, in contrast, identifies the London Stock Exchange as a body generally prepared to enforce the rules it had in place governing public offerings and as an integral part of a business ecosystem where values, standards and voluntary compliance bolstered enterprise, flexibility and shareholder protection (2007a: 415; 2007b: 654–55, 680). What sort of values and voluntary compliance might have reinforced the effectiveness of UK equity markets as the twentieth century opened? Firms will be motivated to provide voluntarily salient information concerning their business so long as a sizeable proportion of investors are sufficiently sophisticated to assume the worst in the absence of disclosure (Romano, 2002: 14–15). Sylla and Smith (1995) and Hannah (2007b) argue that voluntary corporate disclosure was quite extensive in the UK at the

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turn of the twentieth century, with Hannah stating that when companies legislation was amended to bolster disclosure requirements “this affected only a small rump of recalcitrant London-listed companies” (2007b: 656). He attributes the habit of voluntary disclosure partly to requests to companies to provide copies of accounts issued by Sir Henry Burdett, secretary to the London Stock Exchange from 1881 until the end of the nineteenth century, and subsequently by the professional team he built up (Hannah, 2007b: 654–55). Hannah cites director reputation as providing additional market-oriented support for the operation of early twentieth century UK equity markets (2007b: 666–73). Some public companies may have recruited titled directors to try to foster firm growth by way of political connections (Braggion and Moore, 2013). In the IPO context, though, the most obvious potential benefit would have been to list elite directors on the prospectus in order to reassure investors, who would reason that such directors would not want to compromise their reputations by being associated with a failed company. Hannah acknowledges that Gilbert and Sullivan operettas mocked “guinea pig” directors and cites examples of promoters paying gullible peers to bolster the credibility of risky IPOs. Hannah maintains, however, it is unwise to generalize from instances where things went wrong and suggests that many elite directors posted their reputational bond as a guarantee of company quality with positive outcomes. Investment banks acting as underwriters can also, in the absence of regulation, enhance the credibility of public offerings of shares (Easterbrook and Fischel, 1984: 688; Morrison and Wilhelm, 2007). Assuming that an investment bank is known as a reliable underwriter, it will have strong incentives not to squander its valuable reputation by deceiving or disappointing investors in relation to an IPO. An early example is Rothschilds, who played a prominent role in the establishment of the sovereign bond market in London in the 1820s (Flandreau and Flores, 2009). Still, while there were instances where first-tier merchant banks organized public offerings of shares on the London Stock Exchange between the late nineteenth century and 1945, this was a rare occurrence (Cheffins, 2008: 197–98, 284; Chambers and Dimson, 2009). 3. Hypotheses Following on from our overview of the institutional environment governing LSE IPOs in the early twentieth century and of the relevant academic literature, we now formulate hypotheses to further our understanding of

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the impact of the different modes of self-regulation on IPOs. The departure point for our first hypothesis is that while there was minimal statutory regulation of IPOs in Britain as the twentieth century opened, firms seeking an Official Quotation had to fulfil certain requirements not imposed on firms seeking a Special Settlement. As we have seen, there were various instances where companies that failed to qualify for an Official Quotation obtained a Special Settlement instead and there likely were occasions where operators of companies either wanted to have a platform for shares to be traded without distributing two-thirds of the relevant share class to the public or surmised that applying for a quotation was futile because their company was not of “sufficient magnitude and importance” to qualify. Since a Special Settlement was easier to obtain than an Official Quotation, companies engaging in SS IPOs may have been more susceptible to failure than their OQ counterparts. Hence, our first hypothesis is: H1. The failure rate of IPOs receiving an Official Quotation on the LSE between 1900 and 1913 was lower than IPOs only achieving a Special Settlement. Even if H1 is confirmed factors other than the applicable regulatory scheme may well have dictated IPO outcomes. For instance, if the reputational bond posted by titled directors constituted a meaningful form of quality assurance then their presence should have reduced failure rates. Likewise, even if prestigious merchant banks typically were not involved with equity IPOs at the turn of the twentieth century, lesser-known underwriters may still have played a certification role. To the extent that this occurred, the failure rate should have been lower for underwritten IPOs than for other IPOs. We correspondingly hypothesize: H2. Companies which carried out IPOs with elite directors and/or with third-party underwriting arrangements in place were less likely to fail than companies that went public lacking these certification features. Confirmation of H1 might at first glance seem like an endorsement of regulatory intervention, in that the LSE's efforts would have dissuaded investors from backing undeserving companies and thereby have reduced the IPO failure rate. However, if oversight of the Official Quoted sector was simply forcing riskier investments off the market, investors would not obviously benefit in the event that a number of the riskier ventures may well have generated outsized returns that compensated for the greater likelihood of outright failure. Hence, it might have been the case that,

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notwithstanding a higher IPO failure rate, Special Settlement provided promising firms with a salutary opportunity to go public promptly. Our third hypothesis therefore is: H3. There was a sufficient number of Special Settlement IPO “winners” to offset the failures and generate total returns (including dividends) at least in line with the overall market. 4. The IPO sample To test our hypotheses concerning IPO failure, we make use of a hand-collected dataset of IPOs occurring on the LSE between 1900 and 1913. The IPO dataset is constructed from The Times Book of Prospectuses for equity issues and the Stock Exchange Official Intelligence, often referred to as Burdett's, as well as LSE records of applications for listing located at the Guildhall Library in London. Our dataset incorporates IPOs of preference shares as well as ordinary shares because during the time period we focus on preference shares were frequently issued and had equity-like characteristics. In our sample preference shares carried full voting rights in approximately four out of five instances and participated fully in profits with the ordinary shares on two out of five occasions. In keeping with previous IPO studies, we exclude, on the other hand, IPOs by firms already listed on another stock exchange and by investment trusts as well as “penny” IPOs, defined as shares with an offer price of 2 shillings or less. Our sample comprises a total of 825 equity IPOs – 264 firms obtaining an Official Quotation and the remaining 561 going public by way of a Special Settlement (Table 1). The total IPO proceeds were virtually similar for OQ IPOs (£68.7 m) and SS IPOs (£68.1 m). Across our sample period, the LSE shows evidence of hot (1909–10) and cold (1902–04) periods of IPO activity, which is consistent with a general tendency for firms to go public in waves (Lowry, 2003). LSE IPOs also displayed considerable geographic variation, based on the main centre of operations as described in the prospectuses. Only slightly more than half (149) of OQ IPOs and one-quarter (145) of SS IPOs respectively involved UK-based firms (Table 2). Among the remaining IPOs, a majority were enterprises based in self-governing Dominions or British colonies (Empire). Compared to OQ IPOs, SS IPOs were much more geographically diverse, with “Empire” companies and fully foreign companies both outnumbering domestically based companies.

Table 1 IPO activity on the London Stock Exchange, 1900–1913. OQ and SS are the Official Quotation and Special Settlement sectors of the London Stock Exchange respectively London All is the sum of OQ and SS IPOs. N is the number of IPOs and Proceeds is the total proceeds of IPOs at the offer price respectively in a given calendar year. Year

1900 1901 1902 1903 1904 1905 1906 1907 1908 1909 1910 1911 1912 1913 Total

All

OQ

SS

N

Proceeds £m

N

Proceeds £m

N

Proceeds £m

N

72 57 27 27 14 42 65 51 32 99 179 63 67 30 825

18.1 7.2 8.7 6.0 1.7 7.6 8.8 5.1 5.6 10.6 23.7 12.1 13.3 8.1 136.7

41 18 14 10 6 18 19 13 17 19 33 21 24 11 264

9.5 3.0 6.7 3.8 0.7 3.2 4.0 1.6 4.5 5.1 8.5 7.0 6.5 4.4 68.7

31 39 13 17 8 24 46 38 15 80 146 42 43 19 561

8.6 4.2 2.0 2.2 0.9 4.5 4.8 3.5 1.1 5.5 15.1 5.1 6.8 3.8 68.2

28 15 15 25 34 35 43 7 12 34 26 18 28 15 335

Source: see text.

Prospectuses issued by companies going public on the LSE invariably provided some details on the nature of the business. Based on these disclosures, the allocation across industrial sectors varied considerably between Official Quotation and Special Settlement IPOs (Table 2). Among OQ IPOs 58% of the companies operated in the commercial and industrial and the Table 2 Geographic and sector breakdown of IPOs 1900–13. OQ and SS are the Official Quotation and Special Settlement sectors of the London Stock Exchange respectively. N is the number of IPOs. OQ

SS

N

%

N

%

(i) Geographic breakdown Domestic Empire Foreign

149 53 62

56 20 23

145 209 207

26 37 37

(ii) Sector breakdown Commercial, industrial Financial Iron, coal, steel Mining (colonial & foreign) Oil Tea, coffee, rubber plantations Breweries Other NEWECON

133 32 21 4 8 39 0 27 37

50 12 8 2 3 15 0 10 14

136 44 13 77 58 191 3 39 110

24 8 2 14 10 34 1 7 20

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iron, coal & steel sectors, compared with 26% of SS IPOs. The pattern was reversed with mining and oil companies. While one in four SS IPOs involved firms operating in these resource sectors only 5% of LSE OQ IPOs did. A further 34% of SS IPOs were firms operating tea, coffee and rubber plantations, compared with 15% of OQ IPOs. Well over half (160) of the London IPOs in the hot market of 1909–10 were of plantation companies, mainly rubber, seeking to capitalize on investor excitement about the prospects for automobile and motorcycle tire manufacturing. Finally, companies from a modern sector such as chemicals, cars, armaments, electrical engineering and steel, (NEWECON) had a slightly higher representations among SS (20%) than OQ IPOs (14%). LSE IPOs also exhibited variation in terms of age and size depending on whether the companies involved secured an Official Quotation at IPO. According to their prospectuses, OQ IPO companies had been in business on average for nearly 23 years before the IPO (AGE) (Table 3). The average age of SS IPOs was only six years and almost half of these firms had just been established. There were similar disparities in firm size. Prospectuses provided sufficient information to calculate the market capitalization of shares outstanding post-IPO valued at the offer price (SIZE). OQ IPOs were on average more than twice as large as SS IPOs (Table 3). OQ and SS IPO companies did not differ on all dimensions. In both segments of the market, approximately one quarter of firms had at least one elite director on the board where elite is defined by being an M.P. or

Table 3 IPO characteristics. OQ and SS are the Official Quotation and Special Settlement sectors of the London Stock Exchange respectively. All values are simple averages. SIZE is the equity market capitalisation at the IPO offer price. AGE is the number of years since establishment or incorporation, whichever is earlier, to the year of IPO. TRACK RECORD is the number of years of historic profits or dividends paid. TRACK RECORD disclosed and ASSET VALUE disclosed are the proportions of IPOs which disclosed historic profits or dividend record and a balance sheet or asset valuation respectively. N = 825. IPO characteristic

OQ

SS

SIZE (£000) AGE (years) Disclosure (If age N0)

555 22.6 3.7 79% 64%

252 5.9 1.5 40% 50%

TRACK RECORD (years) TRACK RECORD disclosed ASSET VALUE disclosed

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a peer.1 Similarly, in the case of underwriting, almost the same proportion of OQ IPOs (37%) and SS IPOs (35%) were underwritten by third parties. On the other hand, a larger proportion of SS IPOs lacked any form of underwriting (50% vs. 37%) because related parties of the newly listed firm (directors and vendors) underwrote 25% of OQ IPOs as compared with 15% of SS companies. The London underwriting market was highly fragmented, with 126 different firms underwriting the 302 IPOs that were underwritten by a third party in our sample (Table 4). The most prolific – Emile Erlanger & Co., a French bank, Linton Clarke & Co., a stockbroker, and Central Industrial Trust – each handled only six IPOs. Only four IPOs were organized by first-tier merchant banks, one each by Brown Shipley & Co, C.J. Hambro & Co., J. Henry Schroder & Co. and Speyer Brothers, confirming that leading London-based merchant banks did not engage seriously with equity IPO underwriting until after 1945 (Chambers, 2009). 5. IPO failure 5.1. Baseline results In order to track the fate of the IPOs in our sample, we searched both LSE price lists as well as Burdett's and the London Gazette. We ascertained for each IPO whether the company was delisted within five years of the IPO. If this occurred and investors failed to receive any sort of pay-off we deemed the company to have failed (FAIL). In the case of OQ IPOs, the existence of share price lists makes checking for a delisting event straightforward. Share prices of Special Settlement companies were not published, however, by the LSE until July 1916. Correspondingly, we counted as IPO failures those SS firms that failed to pay dividends, were delinquent in filing company accounts and disappeared from the publications we consulted during the five years following the IPO. We did not treat all firms delisted within five years of their IPO as having failed. One other possible outcome was to be acquired for value (ACQUIRED). The other was liquidation with shareholders either being entitled to cash payments reflecting undistributed profits or being offered securities of value in exchange for their For the sake of consistency we define “elite” directors in the same way as Braggion and Moore (2013) even though we are interested in their certification role rather than the value of their political connections. 1

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shares (LIQUIDATED). The remaining firms we deem to have survived (SURVIVE). Studies of IPOs carried out during the concluding decades of the twentieth century and in the 2000s exhibit considerable variation, but pretty much universally report a failure rate of 10% or more (Carpentier and Suret, 2011: 104). The failure rate of IPOs on the LSE before 1913 of 13% (109 out of 825) was comparable. This failure rate conceals, however, a sizeable discrepancy between the failure rate of OQ and SS IPOs. In the case of IPOs obtaining an Official Quotation in London, only 5 of the 264 companies were subsequently delisted within five years of the IPO, a failure rate of just 2% (Table 5). Eight companies, or 3%, were acquired and one was liquidated with shareholders being entitled to a cash payment. In contrast, the failure rate of London SS IPOs was almost one in five (104 of 561). A further 47 SS IPOs were acquired and 11 were liquidated for value. Hence, H1 is tentatively confirmed. While the failure rate of LSE IPOs occurring between 1900 and 1913 was considerably lower for OQ than SS IPOs, the difference is not necessarily attributable to a difference in regulatory approach. Factors other than regulation, such as firm size, industry classification and geographic location, could instead be dictating IPO failure patterns. London IPO prospectuses provided information on a range of such variables which might influence IPO failure. Correspondingly, we test whether regulation still affected the observed IPO failure rates after introducing various control

Table 4 IPO underwriting 1900–13. Market share is measured by number of IPOs. No. of underwriters is the number of entities underwriting an IPO in this period in each category. Not disclosed signifies that the prospectus did not reveal underwriter identity. N = 825. OQ

Underwritten Broker Investment trust Syndicate Foreign bank Corporate Merchant bank Other Not disclosed Not underwritten Directors/vendors Total

SS

No. IPOs

No. IPOs

37% 12% 5% 4% 2% 0% 1% 2% 8% 37% 25% 100%

35% 6% 8% 8% 1% 1% 0% 0% 13% 50% 15% 100%

No. of underwriters

60 22 1 4 21 4 14 –

126

Table 5 Firm survival over the 5 years following IPO 1900–13. OQ and SS are the Official Quotation and Special Settlement sectors of the London Stock Exchange respectively. FAIL indicates delisting of OQ firms or the disappearance of SS firms where investors failed to receive any sort of pay-off by the fifth anniversary of the IPO. ACQUIRED indicates the merger or acquisition of a firm by the fifth anniversary of its IPO. LIQUIDATED indicates the liquidation of a firm where shareholders receive some consideration by the fifth anniversary of its IPO. SURVIVE indicates all firms which did not fail or were not acquired or liquidated for value by the fifth anniversary of their IPO. No. IPOs

FAIL

ACQUIRED

LIQUIDATED

SURVIVE

264

5 2% 104 19%

8 3% 47 8%

1 0% 11 2%

250 95% 399 71%

561

variables by running a probit regression on the whole sample of 825 London IPOs as follows: FAILi ¼ β’X

ð1Þ

and    Pr FAILi ¼ 1jXÞ ¼ ∅ X′ β

ð2Þ

where FAILi takes the value one when the ith IPO fails by its fifth anniversary and zero otherwise and the vector X of explanatory variables is represented by SIZE, AGE, TRACK RECORD, ASSET VALUE, SS, NATRES, EMPIRE, FOREIGN, HOT, COLD, and NEWECON. SIZE is the equity market capitalisation at the IPO offer price. AGE is the number of years since establishment or incorporation, whichever is earlier, to the year of IPO. TRACK RECORD and ASSET VALUE measure disclosure, the former capturing the number of years where historic profits or dividends paid were divulged and the latter reflecting whether a company disclosed a balance sheet or asset valuation in its prospectus. SS is a dummy variable equal to one if an IPO is carried out by Special Settlement. NATRES, proxying industry risk, is a dummy variable equal to one if the IPO is a mining, oil or rubber plantation company. The EMPIRE dummy variable equals one if an IPO is based in a self-governing Dominion or British colony and the FOREIGN dummy equals one if an IPO is neither a domestic nor an Empire firm. Both variables proxy geographic risk. HOT and COLD are dummy variables taking the value 1 if the IPO occurred during a period of high or low intensity of IPO activity. NEWECON is a dummy variable taking the value 1 if the firm comes from a modern industrial sector.

Regression number

LOG (SIZE £M)

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13)

− 0.056*** − 0.051*** − 0.042*** − 0.044*** − 0.026** − 0.031** –0.033*** − 0.033*** − 0.033*** − 0.033*** − 0.034*** − 0.018 − 0.018

AGE

− 0.002** − 0.000 − 0.000 − 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000

TRACK RECORD

− 0.034*** − 0.026*** − 0.016 − 0.025** − 0.025** − 0.026** − 0.026** − 0.026** − 0.025** − 0.037*** − 0.033***

ASSET VALUE

− 0.080*** − 0.070*** − 0.052** − 0.047* − 0.047* − 0.047* − 0.046* − 0.046* − 0.099*** − 0.121***

SS

0.130*** 0.142*** 0.141*** 0.141*** 0.141*** 0.141*** 0.141*** 0.177*** 0.190***

NATRES

− 0.089*** − 0.092*** − 0.091*** − 0.088*** − 0.087*** − 0.087*** − 0.067* − 0.069*

NEW ECONOMY

0.040 0.039 0.039 0.038 0.038 0.062* 0.064*

EMPIRE

− 0.009 − 0.013 0.012 − 0.012 − 0.047 − 0.060

FOREIGN

− 0.005 − 0.003 − 0.004 − 0.018 − 0.020

HOT MARKET

− 0.012 − 0.018 − 0.034 − 0.025

COLD MARKET

− 0.024 − 0.038 − 0.050

Pseudo R2 0.035 0.044 0.066 0.080 0.118 0.137 0.139 0.140 0.140 0.140 0.141 0.142 0.150

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Table 6 Probit regressions (marginal effects). Probit regressions include a constant (not reported) and are estimated by maximum likelihood. All regressions are based on 825 observations. The dependent variable takes the value 1 if an IPO fails by its fifth anniversary of going public, and zero otherwise in regressions (1) to (11) and takes the value 1 if an IPO either fails, is acquired or is liquidated by its fifth anniversary of going public, and zero otherwise in regressions (12) and (13). SIZE is the equity market capitalisation of the IPO at the offer price expressed in £million. Based on voluntary disclosure at IPO, TRACK RECORD is the number of years of historic profits or dividends paid, and ASSET VALUE is a dummy variable taking the value 1 if there is a balance sheet or asset valuation. SS, NATRES, EMPIRE, FOREIGN, UNDERWRITTEN, HOT, COLD, and NEWECON are dummy variables indicating respectively whether or not the IPO obtained a Special Settlement quotation, was a natural resource firm, a British empire firm, a foreign firm (neither a UK or British Empire firm), whether or not the issue was underwritten by a third party, whether it has been issued during a period of very high (hot) or very low (cold) periods of activity, and whether the IPO was active in a new economy (e.g., electricity). ***, **, and * denote significance at 1%, 5%, and 10% level, respectively.

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Our results are reported in Table 6. In line with studies using modern data, larger firms were more likely to survive (regression 1). While UK legislation did not compel companies carrying out IPOs to disclose financial data, prospectuses in fact were often not silent on this point. Of those firms which started life before the IPO and therefore had historical financial data to disclose, a substantial proportion (79% of OQ companies and 40% of SS companies) provided at least some historic profits data (TRACK RECORD) and a similar fraction (60% of OQ companies and 50% of SS companies) disclosed an asset valuation (ASSET VALUE) (Table 3), typically by way of an abridged balance sheet.2 Firms engaging in these forms of disclosure had a higher likelihood of survival (regressions 3 and 4). Pivotally, even controlling for SIZE, AGE, TRACK RECORD and ASSET VALUE, SS IPOs were much less likely to survive than OQ IPOs (regression 5). The SS dummy variable is both economically and statistically significant, implying that Special Settlement lowers the probability of survival by about 13% as compared to an Official Quotation, other things being equal. How did exposure to natural resources affect matters, controlling for firm characteristics, disclosure and the choice of route to listing? Surprisingly, notwithstanding nearly 60% of SS IPOs being natural resource companies, a company being from the natural resource sector (NATRES) actually reduced the probability of failure by about 9% (regression 6). The fact that a firm operated in a new economy sector did not affect survival (regression 7), which implies that there was nothing intrinsically risky about new economy ventures. Similarly, overseas firms (EMPIRE, FOREIGN) were no more likely to fail than domestic firms, once other risks are controlled for (regressions 8 and 9). Likewise, while modern-day IPOs that occur during a hot market have a tendency to underperform over the following three to five years (Loughran and Ritter, 1995), the state of the IPO market at the time of a firm going public between 1900 and 1913 had little effect on the probability of such a firm surviving (regressions 10 and 11) (Table 6). 5.2. Robustness checks We now subject our finding that the failure rate of SS IPOs exceeded that of OQ IPOs by a substantial margin to a series of robustness checks. First, we reestimate our 2 The correlation between TRACK RECORD and ASSET VALUE is 0.19. Thus, firms tended to publish both types of information, but the two kinds of disclosure are imperfectly correlated.

fully specified probit regression model employing a broader definition of the FAIL dependent variable to include those IPO firms either acquired by another firm (ACQUIRED) or liquidated and resulting in shareholder payouts (LIQUIDATE). Our main findings remain qualitatively unchanged (regressions 12 and 13). The size, however, of the coefficients on the SS and of ASSET VALUE dummies increased to approximately 10% and 20% respectively. For our second robustness check, we attempt to control for any bias arising from firms self-selecting into an IPO by way of Special Settlement. Following Wynand and van Praag (1981) we simultaneously estimated two non-linear equations. In the first equation, we estimated a probit model explaining the selection into the Special Settlement method of going public. In the second equation, we estimated the failure probability. Since all variables regarding firm-specific and industry characteristics and the state of the IPO market potentially simultaneously affect both outcomes – the choice of SS versus OQ and IPO survival – we consider in both equations the full set of information available to us. In order to estimate such a model, we need an instrumental variable which is significantly correlated with the dependent variable of the first equation but uncorrelated with that of the second equation. Firm AGE fulfils this role since it does not explain IPO failure (Table 6, regressions 3 to 13), but is correlated with the decision to list shares by way of Special Settlement, with older firms being less likely to opt for such a listing (Table 6, regression 1). Once we have controlled in this way for selection bias, SIZE, TRACK RECORD, ASSET VALUE and NATRES remain negatively correlated with failure (Table 7, regressions 2 and 3). In particular, comparing regression (3) with regression (12) in Table 6, the marginal effects of the coefficients on TRACK RECORD and ASSET VALUE are larger. Hence, correcting for selection bias among SS IPOs, firms disclosing more information to investors in their prospectus about their profit record and their asset backing experience a lower probability of failure. Our third and final robustness check involved, following the methodology adopted in previous studies of IPO failure (Hensler et al., 1997; Jain and Kini, 2000; Espenlaub et al., 2012), deploying a proportional hazard model to analyse the time taken to failure. We used a non-parametric Kaplan–Meier survival model following Espenlaub et al. (2012) to estimate in each month over the five years following the IPO the hazard rate, defined as the ratio of IPOs failing during a given month

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71

Table 7 Sample selection regression of IPO failure on the LSE. See Table 6 for description of variables.

CONSTANT AGE LOG (SIZE) TRACK RECORD ASSET VALUE NATRES NEWECON EMPIRE FOREIGN HOT COLD LOG LIKELIHOOD AIC/N rho

Selection equation (SS = 1)

Failure equation (FAIL = 1 and SS = 1)

Total marginal effects of (1) and (2)

(1)

(2)

(3)

− 0.230 − 0.004** − 0.405*** − 0.069*** − 0.266** 0.730*** 0.290** 0.056 − 0.000 − 0.051 − 0.120

− 1.248*** − 0.254*** − 0.209** − 0.513*** − 0.249 0.183 − 0.064 − 0.015 − 0.033 − 0.012 − 638.0 1.60 0.722

0.000 − 0.041** − 0.053** − 0.122** − 0.121*** 0.030 − 0.022 − 0.004 − 0.006 0.005

All regressions based on 825 observations.

to the number of IPOs still alive at the beginning of the month. The resulting survival function is then the product of all past hazard rates. Mackay said of companies going public during the South Sea Bubble of 1720 that “some of them lasted for a week, or a fortnight, and were no more heard of, while others could not even live out that short span of existence (Mackay, 1852, ch. 2, 15).” The survival time results presented in Fig. 1 suggest that the failing IPOs in our sample were not “Bubble” companies in the sense Mackay used the term. During the first 12 months following an IPO, hazard rates remain low at less than 0.25% per month; thereafter, hazard rates rise and fluctuate between 0.25 and 0.5% per month. Hence, the IPOs in our sample were more likely to fail from year two to year five after the IPO rather than during the first year immediately after the IPO. To ascertain the extent to which going public by way of Official Quotation or Special Settlement related to hazard rates we estimate a semi-parametric Cox hazard model estimated by maximum likelihood (following Hensler et al., 1997; Jain and Kini, 2000; Espenlaub et al., 2012). Although interpreting or comparing the size of coefficients over different specifications is usually infeasible with survival time models, the sign of coefficients has clear meaning with a positive sign implying an acceleration of failure probabilities. The main results of this model corroborate those of the probit model (Table 8). In particular, IPOs which disclose ASSET VALUE survive longer, while SS IPOs had on average a significantly shorter life.

6. Certification by underwriters and elite directors The reputation of board members and the underwriting of an IPO by a third party may be proxies for the quality of an IPO. Thus, our hypothesis H2 is that IPOs underwritten by a third party or IPOs having an elite director on the board may have a lower failure probability. To the extent that H2 is correct, then if OQ IPO firms were more likely than SS IPO firms to have an elite director or to be underwritten, these patterns may account for the difference in failure rates across the two markets. To investigate this possibility, we include dummy variables in our probit regressions. The results are presented in Table 9. The coefficients on UNDERWRITTEN are statistically insignificant (Table 9, regression 1), indicating that underwriting did not improve an IPO's survival prospects on the LSE. This aspect of H2 correspondingly is refuted, which is not particularly surprising given the absence of first-tier merchant banks from the IPO market. When intermediaries did underwrite LSE IPOs they were typically staking little reputational capital and thus had little incentive to scrutinize IPO quality carefully. Indeed, as late as 1931, a government-sponsored committee investigating banking, finance and credit offered a damning judgement of those acting as underwriters for public offerings occurring on the LSE, saying “the public is usually not guided by any institution whose name and reputation it knows” (Macmillan, 1931: Minutes of Evidence, Q.1308). Turning to elite directors, regressions 2 to 5 in Table 9 indicate that their presence had no meaningful

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C. Burhop et al. / Explorations in Economic History 51 (2014) 60–76 100%

1.00%

96%

0.75%

92%

0.50%

88%

0.25%

84%

0.00% 1

7

13

19

25

Survival rates

31

37

43

49

55

Hazard rates

Fig. 1. Survival rates (left-hand scale) and hazard rates (right-hand scale) of IPOs during the first 60 months after going public.

impact on failure rates. This aspect of H2 correspondingly is also refuted. Hannah may be correct as a matter of principle to suggest that with titled directors it is inappropriate to generalize from a few instances where things went wrong. Nevertheless, our data shows that at least for IPOs carried out between 1900 and 1913 investors could safely ignore whatever reputational bond elites serving as directors were seeking to provide. 7. Was special settlement beneficial for investors? Theoretically, a “junior” market such as the Special Settlement sector can perform a salutary “incubator” function, providing timely access to risk capital for fledgling enterprises. In addition, overall risk-adjusted returns from IPOs on a junior market with a sizeable

Table 8 Survival analysis of IPO failure on the LSE. See Table 6 for description of variables. Semi-parametric Cox proportional hazard model LOG (SIZE) TRACK RECORD ASSET VALUE SS NATRES NEWECON EMPIRE FOREIGN AGE HOT COLD LOG LIKELIHOOD AIC/N Pseudo R2

− 0.028 − 0.019 − 0.154* 0.227*** − 0.077 0.087 − 0.109 − 0.050 − 0.000 − 0.026 − 0.063 5.355 13.01 0.002

All regressions based on 825 observations.

failure rate can conceivably match or exceed the overall market to the extent that a sufficient number of companies generate outsized returns to compensate for the failed risky ventures. This is the last of our hypotheses, H3, outlined in Section 3. Share prices for Special Settlement companies first appeared in a Supplementary List attached to the LSE's Daily Official List in July 1916, outside the period covered by our study. To test our H3, for each SS IPO we estimate buy-and-hold returns comprising both the cumulative capital gain (loss) and all dividends received from the listing date to July 1916. In order to make manageable the task of tracking down what happened to each IPO, we focus on those IPOs occurring in the years most proximate to July 1916, namely, the 325 SS IPOs occurring from 1909 to 1913. Among these 325 companies, as of mid-1916 119 appeared in the first Supplementary List, 32 had graduated to the Official List, 45 were listed in Burdett's but were not included in the Supplementary List, 19 had been acquired for value, eight had been liquidated for value, 65 had gone bust and 37 were “living dead”. For the purposes of calculating total returns we assume that the living dead were worthless and ascribe to the 45 IPOs with no price quote but with an entry in Burdett's a share price equal to par value plus any dividends received. We report both equally-weighted (EW) and valueweighted (VW) mean returns for each of the five IPO cohorts from 1909 to 1913 (Table 10). Mindful of the disruptive effects of World War I, we also estimate market-adjusted returns with reference to the broad value-weighted London stock market index of Moore (2010). There were a few individual winners – ten IPOs generating gains of between 150% and 250%. However, the overall average performance for the annual SS IPO cohorts was disastrous in comparison the market, which

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73

Table 9 IPO certification by underwriters and elite directors. See Table 6 for description of variables. Probit regressions

LOG (SIZE) TRACK RECORD ASSET VALUE SS NATRES NEWECON UNDERWRITTEN ELITE DIRECTORS ELITE DIRECTORS*SS ELITE DIRECTORS*NEWECON ELITE DIRECTORS*NEWECON*SS

(1)

(2)

(3)

(4)

(5)

− 0.033*** − 0.024** − 0.046* 0.141*** − 0.094*** 0.041 0.015

− 0.033*** − 0.024** − 0.046* 0.141*** − 0.092*** 0.039

− 0.033*** − 0.024** − 0.046* 0.144*** − 0.092*** 0.039

− 0.031** − 0.024** − 0.048* 0.146*** − 0.095*** 0.001

− 0.031** − 0.025** − 0.044 0.139*** − 0.096*** 0.006

0.021 − 0.013

− 0.019

0.010

0.014

0.114** 0.122**

diversified IPO investor would have been better off if this particular deregulated “on ramp” was not available.

in fact performed reasonably well given the circumstances (1913: − 2.3%; 1914: − 4.4%; 1915:+4.4%; 1916:+9.9%). The 1910 cohort of 144 IPOs fared worst, as the companies underperformed the market by 58% and 67% on an EW and VW basis respectively, and the 1911 and 1912 cohorts were nearly as bad. Only the 1909 cohort came close to matching the market on an EW basis (− 2.5%) but on a VW basis even this cohort underperformed the market by 24.6%. Hence, we reject our third hypothesis (H3). Our results indicate that while theoretically a lightly regulated “junior” market can deliver a sufficient number of IPO “winners” to compensate for a sizeable number of IPO failures, judging by the poor performance of the 325 IPOs occurring between 1909 and 1913 the Special Settlement market failed to meet this standard. A regulatory regime that screens out a substantial number of IPOs reduces the investment opportunity set available to investors, a potentially disadvantageous outcome. However, in the case of companies going public by way of a Special Settlement on the LSE as the twentieth century opened, the average

8. Discussion As Section 5.1 revealed, the failure rate for LSE IPOs between 1900 and 1913 was broadly in line with failure rates on much more tightly regulated modern-day stock markets. As far as this goes, our findings lend support to the notion that stock exchanges will, left to their own devices, self-regulate appropriately. However, we also discover that the failure rate was considerably higher for SS IPOs, where the LSE was pretty much entirely laissez-faire in its approach, than it was for OQ IPOs, where the LSE did exercise some oversight. Moreover, the underperformance of SS IPOs relative to the broad market was substantial, with the differential being sizeable enough to allay concerns about benchmarking performance based on share prices first reported during the middle of World War I. Correspondingly, even if self-regulation by a stock exchange can “work” in principle, it would seem that self-regulation as applied to

Table 10 Long-run performance of special settlement IPOs. The table below shows both equally-weighted (EW) and value-weighted (VW) buy and hold returns including dividends for each IPO cohort up to July 1916 when prices were first quoted in the Supplementary List. Market-adjusted returns adjust the buy and hold raw returns for the returns on a broad LSE index as defined by Moore (2010). IPO

Cohort

Performance to July 1916

1909

1910

1911

1912

1913

No. IPOs EW IPO raw returns VW IPO raw returns VW LSE market returns EW market-adjusted IPO returns VW market-adjusted IPO returns

79 0.262 0.040 0.287 − 0.025 − 0.246

144 − 0.388 − 0.479 0.191 − 0.578 − 0.670

41 − 0.426 − 0.433 0.148 − 0.573 − 0.581

43 − 0.397 − 0.424 0.120 − 0.516 − 0.544

18 − 0.141 − 0.146 0.076 − 0.217 − 0.222

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SS IPOs in this period was a case of “too much of a good thing.” Why did the Special Settlement system persist in its unregulated form, given the problems apparently afflicting it? One consideration may have been that those contemplating buying shares in a company going public by way of a Special Settlement could “self-protect” with relatively elementary due diligence. Our results indicate that among SS IPOs the failure rate was considerably lower for those companies that disclosed information about historic profits and an asset valuation. Correspondingly, concerns regarding the Special Settlement market might well have been mitigated because investors who were sufficiently prudent to focus on companies that engaged in disclosure not mandated by statute faced less risk of IPO failure than investors prepared to gamble on companies going public without providing basic financial information. A lack of awareness of just how bad things were may also help to explain the durability of the Special Settlement method. Since stock prices were not disseminated until 1916, neither investors nor Stock Exchange officials may have realized how poorly SS IPOs were faring collectively. Moreover, when share prices became available in 1916, investors would have been aware that World War I did not provide the best of environments for investors in risky projects and thus may not have blamed the Special Settlement method for the poor performance of these IPOs. In any case, IPO investors were set to repeat their unfortunate experience in the new issue boom of 1928–29 and once again suffered substantial losses (Harris, 1933). Competitive pressure may also have played a role. If the LSE had exercised close control over the Special Settlement procedure, trading activity in tea and rubber companies may have been lost entirely to the Mincing Lane Tea and Rubber Broker's Association, formed in 1909 to provide a market in plantation company shares (Michie, 1999: 82, 85, 271). Given the dearth of regulation of public offerings by UK company law, investors may have been seriously at risk whatever stance the LSE took concerning IPOs. 9. Conclusion This study aims to contribute to the academic debate surrounding the contribution of self-regulation to the effective functioning of equity markets. Our analysis, focusing on the leading stock exchange in the world during the early twentieth century, indicates that even in the absence of detailed statutory regulation failure rates can be extremely low if some oversight is exercised, as occurred with OQ IPOs. However, the experience with

Special Settlement companies suggests that when selfregulation operates in a way that substitutes rather than merely complements statutory regulation, investors can be disadvantaged if a stock exchange is entirely laissez-faire in its approach. This paper is also relevant to the long-running debate regarding the contribution of capital market development to the British economy before World War I. Our main result documenting the relative success of OQ IPOs and the failure of SS IPOs draws attention to the system of two-tier regulation by the LSE before 1914. The contrasting outcomes lend credence to the claims made by both sets of protagonists. On the one hand, those proclaiming the virtues of the UK's flexible and competitive equity markets can point to the low overall failure rate of IPOs and of OQ IPOs in particular. On the other, those claiming that a dearth of statutory regulation and effective certification of IPOs yielded detrimental results can draw attention to the high failure rate of ventures that were allowed to float by way of Special Settlement. This is by no means a trivial point, given that between 1900 and 1913 the total proceeds from SS IPOs were equivalent to those of OQ IPOs. In a deregulated environment for IPOs, the market can in principle come up with solutions such as certification by underwriters or by elite directors which can substitute for the absence of regulatory oversight. Our study shows that at least in the case of LSE IPOs occurring between 1900 and 1913 these corrective mechanisms failed to function in the manner anticipated as neither the presence of underwriters nor elite directors served to improve failure rates. On the other hand, investors in Special Settlement IPOs could self-protect themselves at least to some degree by buying shares in those companies that disclosed information about historic profits and provided an asset valuation. In so doing, these investors would have reduced considerably the risk of losing their investment by way of IPO failure. A final point is necessary to put our Special Settlement results into proper context. Early-stage firms going public on the LSE by way of a Special Settlement before 1913 and again in the 1920s (Chambers, 2010) did so in a largely unregulated environment. A modern junior or “on ramp” market will in all likelihood function differently. For instance, the LSE's AIM, established in 1995, requires companies that go public today to appoint a nominated adviser (“Nomad”) from among a pre-screened group of London brokerages, which then takes responsibility for ensuring that there has been full disclosure to the market (Gerakos et al., forthcoming, Appendix I). The

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