Political connections and the process of going public: Evidence from China

Abstract

We examine how political connections impact the process of going public. Specifically, we test how political connections impact the pricing of the newly offered shares, the magnitude of underpricing, and the fixed cost of going public. Based on the experience of the newly public firms from Chinese security markets and using multiple measures of political connections, we find robust evidence that the issuing firms with political connections reap significant preferential benefits in the process of going public. To be specific, we find that firms – irrespective of their ownership status – with greater political connections have relatively higher offering price, lower underpricing, and lower fixed costs during the going-public process.

Introduction

Political connections are shown to have significant impact on the overall economy and the economic life of individual firms (e.g., Claessens et al., 2008, Bunkanwanicha and Wiwattanakantang, 2008, Ferguson and Voth, 2008, Khwaja and Mian, 2005, Sun and Tong, 2003, Qi et al., 2000, Johnson et al., 2000, Faccio, 2006, Cheung et al., 2005, Fisman, 2001, Sapienza, 2004, Fan et al., 2007, Faccio et al., 2006, Charumilind et al., 2006). These studies have examined firms' political connections in various aspects, ranging from the firms' terms of borrowing, market valuation, long-term performance, bail out events, to the competing for government contracts.

However, how political connections bring value to firms during their respective process of going public – an important corporate event for firms entering capital markets – has not been examined extensively. Our paper attempts to bridge that gap by investigating the relation between political connections and firm value by examining the effect of political connections on the cost and pricing and therefore the valuation of Chinese firms going public during the 1990s. There are several reasons that make China a suitable laboratory to examine the impact of political connections on firm value in general and, in particular, on the value of firms going public. The first reason is that there are clear quantitative restrictions imposed by the government on firms during the going-public process. For example, there is a limit on the number of companies that can go public or a maximum number of shares that can be issued in a given year. In addition, the offer price is restricted by the firms' profitability and an assigned multiplier (P/E ratio), which is decreed by the government. The significance of the multiplier is that it is an important determinant of the offer price and therefore the amount of proceeds that can be raised. These government imposed restrictions on the going-public process clearly invite firms to seek values through political connections, therefore making the discussion relevant and important.

A second reason is that given the importance of the emerging Chinese financial markets in the global economy, the accompanying importance of the privatization of state-owned enterprises (SOEs) in general, and the need of firms to raise funds, it is important to have a complete understanding of the impact of political connections in the going-public process. Indeed, the fluctuations of Chinese stock markets, often triggered by the government policy changes, are affecting domestic investors and investors in other countries profoundly. For example, on February 27, 2007, because Chinese investors concerned that the government may actively seek to cool China's market, Shanghai's index plunged 8.8%, and this tumble was followed by 1.3% fall on India's Sensitive Index, 3.3% fall on Russia's RTS Index and by the nearly 400 points fall on the Dow industrials.³

Finally, due to the uniqueness of the China's security markets it is possible to identify several proxy measures for political connections. The first of these is the number of ex- and/or current government officials that belong to the board of directors. Most firms going public are state-owned enterprises (or SOEs) and can only be partially privatized so that the state maintains control. Consequently, an important characteristic of these firms for the present paper is that even after going public the board of directors of these firms is dominated by government officials. Thus, although all SOEs are, to some extent, politically connected, those that have high-rank current or ex-government officials on their boards would be characterized by stronger political connections.

The second proxy measure of political connections is the magnitude and strength of an underwriter's political connections. A characteristic of China's capital markets during the 1990s is that all bookrunners are state-owned. That is, most of these bookrunners are sponsored by state councils, the Central Bank or provincial governments. As a proxy for the magnitude and strength of a bookrunner's political connection, we use the extent of their involvement in taking the largest state-owned firms public. There are only about 30 out of approximately one hundred investment banks approved by the Chinese Securities Regulation Committee (CSRC thereafter) that can assume the role of bookrunner. Importantly, only five of these bookrunners were the lead in 59 of the 100 largest state IPOs, which account for almost 70% of total proceeds raised by these offerings. We make the assumption that it is the investment banks with the strongest political connections that are most likely to attract the most lucrative deals.

For the third proxy measure of political connections we use the type of state ownerships. Firms within China are characterized by different type of state ownerships. For example, there is state ownership that is directly controlled and managed by the government or its authorized agents, and state ownership that is managed by other state-owned enterprises (SOEs). Several studies of share issue privatization have examined the impact of state ownership on firm value (see, e.g., Vickers and Yarrow, 1988, Jenkinson and Myer, 1988, Jacquillat, 1987, Perroti and Guney, 1993, Dewenter and Malatesta, 1997). However, because of data limitations these studies could not account for the strength of political connections among SOEs. The Chinese experience allows us to address this weakness in the existing literature.

Although we use the type and the amount of state ownerships in defining the strength of the firms' political connections, we suggest that one should not link state ownership with political connections directly in Chinese markets given that, to some extent, all state-owned companies are politically connected. The political connections that we define in this paper would distinguish the firms' ability in extracting values from such relationships, a method which may reveal that those state-owned companies without strong political connections are actually not entitled with significantly higher benefits than those non-state firms.

Using a sample of 423 domestic IPOs during 1994–1999, we find that firms' political connections play a statistically significant and economically meaningful role in the process of going public. To be specific, if the issuing firms (i) have board members who in the past- or are currently working for the government at least at a level equal or higher than a city mayor; (ii) use bookrunners that participated actively in the largest state-owned IPOs; (iii) have majority of shares controlled by the central government or other SOEs; or (iv) have any combination of the three, they are more likely to receive a higher than the median P/E ratio (a multiplier to determine the offering price) from the government. This finding indicates that, all else equal, these firms would get a higher offer price because of their political connections. Importantly, we show that the political connections variables, e.g., the connected board members and the connected bookrunners, are not redundant measurements of the state ownership. Specifically, we find that without additional political connections, state-owned firms experience almost the same level of underpricing as those of the less connected non-state firms.

Our results indicate that the market recognizes that these connected firms are relatively more favorably priced than are less connected firms, and investors, despite the huge demand for new shares in the Chinese security markets, buy these shares in secondary markets at a price less significantly higher than the offer price thus resulting in lower underpricing. These connected firms also pay relatively lower fees during the going-public process. The evidence of the potential benefits of political connections is robust for both state-owned and non-state firms.

The remainder of this paper is organized as follows. Section 2 reviews the related literature. Section 3 briefly discusses the background of China's security markets and the measurements of political connections. Section 4 discusses the data and provides summary statistics. Section 5 presents evidence on the relationship between political connections and the pricing of IPOs, the level of underpricing, and the fees per dollar raised by issuing firms. Section 6 provides concluding remarks.