Principal‐Principal Conflicts and IPO Pricing in an Emerging Economy

• Author: Chih‐Pin Lin,Cheng‐Min Chuang
• Date: 01 November 2011
• DOI: http://doi.org/10.1111/j.1467-8683.2011.00870.x
• Published date: 01 November 2011

Principal-Principal Conf‌licts and IPO Pricing in

an Emerging Economy

Chih-Pin Lin* and Cheng-Min Chuang

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: Recent research from the United States has advocated increasing ownership concentration and

aligning ownership and control to mitigate principal-agent conf‌licts for entrepreneurial f‌irms. By contrast, this study aims

to demonstrate that the major governance problem in an emerging economy is principal-principal conf‌licts, and that

increasing ownership concentration and aligning ownership and control will instead reinforce such conf‌licts and IPO

underpricing.

Research Findings/Insights: Using data from 525 IPO f‌irms in Taiwan, an emerging economy, this study f‌inds that

increasing family ownership and institutional ownership and introducing CEO duality increase IPO underpricing, while

employing independent outside directors mitigates IPO underpricing. These results are consistent with our hypotheses

concerning principal-principal conf‌licts.

Theoretical/Academic Implications: Our results are quite different from those of prior research using US data, in that

institutions are weaker in an emerging economy than in the United States, where principal-agent conf‌licts are the main

concern. Consequently, corporate governance research, particularly when conducted outside the US, should consider

institutional contexts, which agency theory fails to do. As such, institutional theory offers a promising approach.

Practitioner/Policy Implications: Government policies designed to address principal-agent conf‌licts, such as increasing

ownership concentration and aligning ownership and control, may make principal-principal conf‌licts worse and increase

IPO underpricing in an emerging economy. To mitigate principal-principal conf‌licts and IPO underpricing, regulatory

reforms need to reduce ownership concentration, separate ownership, and control, and strengthen formal institutions that

help minority shareholders monitor f‌irm decisions.

Keywords: Corporate Governance, Principal-Principal Conf‌licts, Emerging Economies, Institutions, Family Ownership

INTRODUCTION

To mitigate principal-agent conf‌licts, particularly for

entrepreneurial f‌irms, recent research from the

United States has advocated increasing ownership concen-

tration and aligning ownership and control, as by increas-

ing inside directors, increasing institutional ownership,

and introducing family controls (Anderson & Reeb, 2003;

Arthurs, Hoskisson, Busenitz, & Johnson, 2008; Connelly,

Tihanyi, Certo, & Hitt, 2010; Kroll, Walters, & Le, 2007;

Walters, Kroll, & Wright, 2010). By contrast, this study

aims to demonstrate that in an emerging economy where

formal institutions that protect property rights are weak,

principal-principal conf‌licts, rather than principal-agent

ones, are the more salient governance problem, and

increasing ownership concentration and aligning owner-

ship and control for entrepreneurial f‌irms will instead

incur principal-principal conf‌licts and deepen initial public

offering (IPO) underpricing.

In some countries, principal-agent conf‌licts result from

separation of ownership and control and dispersion of

ownership, such that managers have the power to pursue

their own goals at the expense of shareholders’ interests

(Berle & Means, 1932; Fama, 1980; Jensen & Meckling, 1976).

However, in countries where formal institutions that protect

property rights are weak, ownership is already overly con-

centrated, and managers are often aff‌iliated with controlling

shareholders (Claessens, Djankov, & Lang, 2000; Faccio &

Lang, 2002; La Porta, Lopez-de-Silanes, & Shleifer, 1999). In

this situation, a more serious problem is principal-principal

conf‌licts, which arise when controlling shareholders engage

*Address for correspondence: Chih-Pin Lin, Department of Business Administration,

Aletheia University, 32, Chin Li Street, Tamsui, New Taipei 251, Taiwan. Tel: 886-2-

26269113; Fax: 886-2-26260520; E-mail: cplin@mail.au.edu.tw

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Corporate Governance: An International Review, 2011, 19(6): 585–600

© 2011 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2011.00870.x

in the expropriation of minority shareholders (Peng, 2009;

Peng, Wang, & Jiang, 2008; Young, Peng, Ahlstrom, Bruton,

& Jiang, 2008).

The IPO is a crucial process through which an entrepre-

neurial f‌irm accesses capital markets to spur its growth.

However, IPO underpricing reduces the capital received

by IPO f‌irms through the IPO process. IPO underpricing

usually refers to the difference between the closing price on

the f‌irst trading day and the offer price, divided by the offer

price. Because an IPO f‌irm receives capital by selling shares

at a predetermined offer price, it receives less capital if the

offer price is much lower than the closing price on the f‌irst

trading day, which represents the price evaluated by market

investors. Because investors pay an offer price to purchase

IPO shares, IPO underpricing denotes the funds that IPO

f‌irms forego to market investors, which increase capital

costs and decrease the value of IPO f‌irms. Consequently, the

question of how to mitigate IPO underpricing has become a

crucial one for encouraging entrepreneurial activities, which

are believed to positively inf‌luence innovation and stan-

dards of living.

Both principal-agent and principal-principal conf‌licts may

increase IPO underpricing. Principal-agent conf‌licts may

increase IPO underpricing if top managers shirk negotia-

tions with the underwriter and monitoring the pricing

process (Arthurs et al., 2008; Ljungqvist & Wilhelm, 2003).

Principal-principal conf‌licts may also reinforce IPO under-

pricing because controlling shareholders may strategically

underprice IPO shares to create oversubscription, allow a

lottery system, and ration the share allocation process to

prevent other blockholders from purchasing large-block

shares and weaken the control of incumbent controlling

shareholders, although underpricing is detrimental to

minority shareholders (Brennan & Franks, 1997; Smart &

Zutter, 2003).

Therefore, when principal-agent conf‌licts are the most

serious problem, increasing ownership concentration and

aligning ownership and control – for example, by increasing

family ownership and institutional ownership, adopting

CEO duality, and increasing inside directors – may increase

f‌inancial incentives for shareholders to monitor managers

and reduce managers’ shirking behavior, thus mitigating

principal-agent conf‌licts and IPO underpricing. However,

when principal-principal conf‌licts are more salient, increas-

ing ownership concentration and aligning ownership and

control as described above may indeed increase controlling

shareholders’ power to further expropriate minority share-

holders, thereby reinforcing principal-principal conf‌licts and

IPO underpricing.

Because institutions that protect property rights and

minority shareholders are weak in an emerging economy,we

argue that principal-principal conf‌licts are the most serious

problem and that increasing ownership concentration and

aligning ownership and control will increase principal-

principal conf‌licts and IPO underpricing. Using data from

525 IPO f‌irms in Taiwan, we f‌ind that increasing family

ownership and institutional ownership reinforces rather

than mitigates IPO underpricing, implying that principal-

principal conf‌licts dominate IPO pricing in an emerging

economy.Additionally,CEO duality, which may increase the

convergence of ownership and control, reinforces principal-

principal conf‌licts and IPO underpricing. We also f‌ind that

independent outside directors can mitigate principal-

principal conf‌licts and IPO underpricing. Overall, this study

f‌inds that principal-principal conf‌licts, rather than principal-

agent ones, shape IPO pricing in an emerging economy.

As a consequence, regulatory reforms regarding corporate

governance in emerging economies – and, indeed, in most

countries – should be aimed at reducing ownership concen-

tration, separating ownership and control, and protecting

property rights and minority shareholders. Applying solu-

tions developed in Anglo-American countries that propose

increasing ownership concentration and aligning ownership

and control to mitigate principal-agent conf‌licts (Arthurs et

al., 2008; Hitt, Ireland, & Hoskisson, 2007:311; Kroll et al.,

2007; Walters et al., 2010) may be useless, or even disastrous,

in an emerging economy, where the main corporate gover-

nance problems are principal-principal conf‌licts.

This study contributes to the literature on corporate gov-

ernance and IPO underpricing by linking principal-principal

conf‌licts and IPO underpricing in an emerging economy.

Although past research has identif‌ied a variety of phenom-

ena as principal-principal conf‌licts, such as controlling

shareholders engaging in insider trading (Chang, 2003),

placing unqualif‌ied family members in key positions, and

tunneling f‌irm assets to aff‌iliated f‌irms, few studies have

regarded IPO underpricing as a consequence of principal-

principal conf‌licts (Young et al., 2008). Similarly, although

past research has identif‌ied a variety of reasons for IPO

underpricing, such as principal-agent conf‌licts (Arthurs

et al., 2008) and an irrational market bubble (Ljungqvist

& Wilhelm, 2003), few studies have regarded principal-

principal conf‌licts as one of them. Gomes (2000) argued that

controlling shareholders are unlikely to expropriate minor-

ity shareholders through IPO underpricing due to reputa-

tion effects, but his arguments are based on the assumption

that reputation effects can work eff‌iciently. However, in

countries where market-supporting institutions are weak,

f‌irms are not transparent, and information regarding expro-

priation is hidden and cannot be ref‌lected in reputation,

making reputation an ineff‌icient governance mechanism

(Young et al., 2008).

Data from Taiwan provide a good opportunity to study

principal-principal conf‌licts and IPO underpricing. As a

typical advanced emerging economy, Taiwan is a base for

intensive economic and entrepreneurial activities, and thus

many IPOs; however, market-supporting institutions in

Taiwan have not developed as fast as these economic

and entrepreneurial activities (Lin, Lin, & Huang, 2011; Luo

& Chung, 2005). Ownership concentration, family control,

cross-holding, and pyramiding are common practices, as in

other emerging economies – and, indeed, as in most coun-

tries outside the United States (La Porta et al., 1999), suggest-

ing that the results of this study can be generalized to other

countries.

THEORY AND HYPOTHESES

IPO Underpricing and Principal-Agent Conf‌licts

As described above, IPO underpricing usually denotes the

difference between the closing price on the f‌irst trading day

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Volume 19 Number 6 November 2011 © 2011 Blackwell Publishing Ltd