The Creation and Evolution of Entrepreneurial Public Markets

Shai Bernstein is Assistant Professor of Finance at Stanford Graduate School of Business; Abhishek Dev is a Researcher at Harvard Business School; and Josh Lerner is Jacob H. Schiff Professor of Investment Banking at Harvard Business School. This post is based on their recent paper.

One important channel through which financial development enables economic growth is through the funding of innovative and entrepreneurial projects—activities that have been long recognized as particularly hard to finance with outside capital. Well-developed public equity markets have been shown to be instrumental in filling this financing gap, allowing young and fast-growing companies to fund R&D activities. Recognizing the importance of entrepreneurial finance, a major focus of financial policymakers around the world has been on the creation of new stock exchanges for young and small-capitalization companies, often characterized by less restrictive listing requirements. Such exchanges, termed second-tier exchanges, have been heralded in many places as a way to promote the creation, financing, and retention of job-creating new ventures. Anecdotally, while there have been some highly visible successes (such as NASDAQ in New York, London’s Alternative Investment Market, and the Shenzhen-based ChiNext market), there have been many more failures (such as EASDAQ).

Using a novel data that that covers 281 stock exchanges across 113 countries, we seek to understand the drivers of the creation and success of these new second-tier markets, focusing specifically on the role of countries’ legal provisions for shareholder protection. We find that since 1990, there were more than 78 new second-tier introduced in 49 countries with the aim of facilitating capital flows to entrepreneurial companies. These exchanges attracted a significant volume of initial public offerings (IPOs) (although much less in terms of value, due to the smaller size of their listed firms) and appeared fairly cyclically. We also confirm that second-tier exchanges indeed had lower listing requirements when compared to first-tier stock exchanges.

The first question that we explore is what are the key triggers that lead to the creation of these second-tier markets. Nations with the high venture and patenting activity were strongly associated with a greater probability of creating second-tier exchanges. This along with the result that higher number of IPOs and proceeds raised in a country was strongly associated with higher likelihood of second-tier exchanges being introduced supports the idea that increases in demand for entrepreneurial capital lead to an increased possibility of second-tier exchanges entering the market. We also find that nations with higher financial market development, as measured by national market capitalization, were more likely to introduce new exchanges. In countries without robust debt and equity markets, investors may anticipate that new firms would be unable to get the resources necessary to grow quickly.

The introduction of exchanges does not, however, compete for the same IPO flow with the established exchanges in the country. We find no evidence of a substitution effect following the introduction of a second-tier exchange, neither in terms of the flow nor the composition of IPOs listed on existing first-tier exchanges. Overall, these results are consistent with the view that second-tier exchanges cater to a different segment in the market, which is otherwise unable to tap into the existing stock exchanges.

The second-tier markets create this niche by allowing small market-cap entrepreneurial firms to raise capital by lowering their listing requirements. However, lower listing requirements increase adverse selection concerns and the risk that investors may be expropriated by the entrepreneur. It can be argued that when minority shareholder rights are better protected by the law, investors should be more willing to provide capital to firms on exchanges with low listing requirements, as the risk of expropriation will be mitigated. Thus, stronger shareholder protection may increase the willingness of shareholders to invest in new listings and the valuations that they assign to these firms. This greater willingness will, in turn, attract more entrepreneurs to list their companies in the market. Thus, stronger shareholder protection may attract more entrepreneurs and investors to a newly formed second-tier exchange, and thus increase the likelihood of market introduction and ultimate success.

We find that higher shareholder protection is indeed associated with a greater likelihood of introduction of these exchanges. Moreover, shareholder protection strongly predicts the success of the new market. Second-tier markets in nations with stronger investor protection were more likely to remain active. Similarly, we find that countries with stronger investor protection attracted a higher volume of IPOs and greater IPO proceeds. Even in countries with high levels of venture capital activity, much patenting, broad availability of private credit, and high stock market valuations–all of which are also associated with more successful new exchanges as we discussed earlier–we find that shareholder protection remains a key predictor of success.

Exploring the mechanisms behind the seeming importance of shareholder protection to the success of these second-tier exchanges, we find that new second-tier exchanges in countries with better shareholder protection allow younger and less profitable companies to raise more capital. This result is consistent with the notion that better shareholder protection mitigates the risk of expropriation, allowing investors to invest in riskier firms. Indeed, these companies subsequently grow more quickly. Interestingly, we find that the listing requirements of the new second-tier exchanges in nations with high and low shareholder protection are similar. But countries with better shareholder protections are able to attract offerings from younger firms, even though they do not have lower listing requirements.

Our results suggest the importance of institutions in enabling the provision of entrepreneurial capital to young companies: these markets alone cannot boost entrepreneurial activity but need enabling institutions.

The complete paper is available for download here.

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