Political Uncertainty and Initial Public Offerings: Comparison
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CFirst, considering the importance of market timing in the firm’s decision to go public, it was seen that firms had shown an unwillingness to come up with an initial public offering (IPO) during periods of high political uncertainty. PSecond, political uncertainty has shown its influence in all the phases of the IPO process; however, political connections and donations mitigate this effect.

  • political uncertainty
  • political connection
  • IPO

1. Introduction

With the rise in democracy around the world, there has been a spur in the number of political parties formed. Political parties are representatives of individuals with similar ideologies, such as liberalism, communism, socialism, conservatism, or feminism. They emerge mainly because of differences in the caste system or in religion. Different countries have different party systems; China has a one-party system where only a single party can form the government. Countries like the US and the UK follow a two-party system. A multi-party system is where several parties or coalitions can have control over the government, such as in India, Sweden, and Ireland. Depending on their views and objectives, these parties frame their sets of policies; for example, a right-wing party might frame policies in favor of the growth of businesses, such as reducing tax rates, while a left-wing party might focus more on income equality and raising tax rates for the rich. These differences lead to policy-related uncertainties and policy reversals at the time of elections and political turnover. Along with this, uncertain events, such as financial shocks and crises (the dot-com bubble of the 2000s, the financial crisis of 2008), the pandemic, and the Russia-Ukraine war, have forced the government to bring about frequent amendments in the regulations and policies. Thus, ambiguities regarding who shall frame the government, what new policies shall be implemented, and how these policies shall affect the economy are referred to as political or policy uncertainties.
Political uncertainties crop up as policy changes, geopolitical reforms, political regime changes, the rise of opposition parties, elections, terrorism, and corruption (Bahmani-Oskooee and Nayeri 2020). The unpredictability of what changes (in a government’s future policies relating to fiscal, monetary, and regulatory aspects) will come up is referred to as economic policy uncertainty (EPU) (Al-Thaqeb and Algharabali 2019). Economic policy uncertainty (EPU) can arise from government changes, changes in the macro-economic environment, or situations of uncertainty such as pandemics, financial crises, or war.
Politics, elections, and government policies comprise a major component of the macroe-conomic environment in which the firms operate. Any changes brought in can impact a firm’s value and investment behavior, which delays economic recovery (Baker et al. 2016; Al-Thaqeb et al. 2022). A rise in these uncertainties leads to increased market volatility (Baker et al. 2019; Liu and Zhang 2015), poor firm performance (Feng et al. 2021; Iqbal et al. 2020; Trakarnsirinont et al. 2023), reduced mergers and acquisitions (Sha et al. 2020; Bonaime et al. 2018; Lee 2018; Paudyal et al. 2021), reduced flow of foreign direct investments (Avom et al. 2020; Choi et al. 2021; Hsieh et al. 2019; Zhou et al. 2021), increased cash holdings by firms (Goodell et al. 2021; Hankins et al. 2020; Javadi et al. 2021; Zhao and Niu 2022), reduced firm innovation activities (Lou et al. 2022; Cong and Howell 2018). Researchers in the past have focused on political uncertainty and its impact on investment decisions (Elmassri et al. 2016; Kong et al. 2022; Liu et al. 2020; Amore and Minsichilli 2018; Wadhwa and Syamala 2023). Political uncertainty has shown its impact in each stage of the IPO process (Colak et al. 2017), right from the decision of the firm to raise funds (Colak et al. 2017) to setting the offer price, listing the stock, first-day initial returns, and its long-run performance (Gupta et al. 2021; Meluzin et al. 2018).

1.1. Political Uncertainty

It was after the publication of John Kenneth Galbraith’s book and television series titled “The Age of Uncertainty”, that the term uncertainty came into the limelight and attracted the attention of researchers all around the world. Authors have given their different definitions of uncertainty. Rowe (1994) stated that uncertainty occurs due to a lack of available information. Jurado et al. (2015) described uncertainty as a situation of “conditional volatility” that could not be predicted by economic agents. The most common proxy used for measuring uncertainty in the empirical literature was stock market volatility (Arnold and Vrugt 2008). Jurado et al. (2015) and Bekaert et al. (2013) considered statistical forecasts and economic indicators to predict uncertainty rather than the responses of market participants. Baker et al. (2016) developed the most useful proxy for policy-related uncertainty. They created an index using policy keywords related to uncertainty appearing in the newspapers of 11 countries. EPU is considered a more robust technique for predicting exchange rate volatility when compared to other macro-economic variables (Ruan et al. 2023). Adeosun et al. (2023) used Baker’s EPU index to find out the impact of uncertainty and oil prices. Political uncertainty refers to the risk or uncertainty about changes in the future government, amendments to government policies, or the risk of frequent policy reversals. Political uncertainty can arise due to (a) a lack of clarity regarding which party will set up the government, (b) which policies shall be revoked and what new policies might be implemented, and (c) how would the new policy impact firms (Pastor and Veronesi 2012). Political uncertainties increase prior to elections. The uncertainty becomes even higher when the parties involved in the election have equal chances of winning (Jens 2017) or when the probability of the incumbent party getting re-elected reduces. It has been theoretically proved by Goodell et al. (2020) that any form of financial uncertainty during the election phase has a positive association with the probability of the incumbent party getting re-elected. Stock markets have shown increased volatility during high electoral uncertainty (Bowes 2018; Yu et al. 2018). Household participation in the stock market also shows a dip during such volatile times. Investors tend to reallocate their funds to safer assets (Agarwal et al. 2022). Firms become more skeptical regarding their investment decisions during macro-economic uncertainty rather than firm-level uncertainty (Rashid and Saeed 2017). Bernanke (1983) came up with a theoretical model proving that firms delay or postpone their investment decisions during high political or electoral uncertainties. Heightened EPU is also associated with a reduction in the quality and quantity of information provided by the firms and the intermediaries (Le et al. 2023) Firms’ financing activities also dampen as their cost of financing increases (Kim 2019). Debt financing is more influenced compared to equity financing (Lee et al. 2021). Firms usually delay their decision to go public, and a significant decrease in the number of IPOs is seen during elections. The effect of elections is more profuse in firms that have less geographically diversified businesses, firms in close contact with the government, and firms that are harder to value (Colak et al. 2017).

1.2. Initial Public Offerings

Firms constantly need funds to bear their expenses and fulfill their investment needs. These firms can raise capital by issuing equities through retained earnings or initial public offerings, allocating and transferring capital within the business units, which is also referred to as the internal capital market, getting loans from banks, or issuing debentures. Despite the varied sources for raising funds, IPOs remain one of the best ways for entrepreneurs (Ritter and Welch 2002). It is considered one of the most crucial steps in the life cycle of a firm as it comes under the scrutiny of the regulatory bodies and the public for the first time (Helbing 2019). The literature on IPOs has classified the process into three phases. Carbone et al. (2022) described the three phases as the input, process, and output of the firm’s journey of going public (Carbone et al. 2022). The first phase (pre-IPO) majorly involves the choice of whether the firm should go for an IPO or consider other methods of raising capital. The initial cost of capital, liquidity (Röell 1996), information considerations (Subrahmanyam and Titman 1999), and the willingness of the managers to diversify ownership (Pagano and Roell 1998) majorly influence this decision. The benefits of listing (higher visibility and recognition, higher liquidity, better access to other sources of financing) should be more than the costs involved (Carbone et al. 2022). The other factors that may affect the decision are periods of hot or cold markets (Altı 2005) and investor sentiments and their behavior (Szyszka 2014). Government policy changes and political uncertainty also influence IPO decisions. Periods of high uncertainties are not considered favorable in terms of timing for IPOs. A rise in asset prices, risk premiums, and the cost of capital leads to the undervaluation of the firm, hence making them reluctant to go for an IPO. Luo et al. (2017) proved the number of IPOs decreases during the time of political elections. The second phase begins once the firm goes public. This phase is further subdivided into three steps. The first step involves the hunt for external advisors, such as investment banks, underwriters, book runner lead managers, and auditors. Choosing reputable advisors has a positive impact on the underpricing and long-run performance of IPOs (Carter and Manaster 1990; Carter et al. 1998; Beatty and Ritter 1986). The second step involves the determination of the offer price. There are two principal methods of deciding the offer price—the fixed price method and the book-building method. In the fixed-price method, the firm fixes the rate at which shares will be offered. In the book-building process, the underwriter sets the offer price based on the bids received by investors (Khurshed et al. 2014). The third step measures the short-run performance of the IPO from the first day of trading until price stabilization. Researchers in the past have given several explanations for first-day initial returns (underpricing). Information asymmetry between the issuing firm and the underwriter (Baron 1982) and between the types of investors (Rock 1986) were considered a cause for underpricing. Grinblatt and Hwang (1989) and Allen and Faulhaber (1989) considered underpricing as a signaling tool for firm quality. Apart from these seminal works, researchers have now started finding out other reasons that may affect underpricing, such as ownership structures (Venkatesh and Neupane 2005), principal-agent conflicts (Arthurs et al. 2008), and corporate governance characteristics (Teti and Montefusco 2022). Macro-economic factors, like economic policy uncertainty, also impact the first-day initial returns. Boulton (2022) showed that IPOs issued during times of high EPU are more likely to be underpriced because of the greater information disparity. Their positive relationship substantially improves during elections. Colak et al. (2021) proved that the political risk arising due to excessive political intervention at a local level has a positive impact on IPO underpricing. Similar results were found by Marcato and Zheng (2021) and Song and Kutsuna (2022). The third phase (post-IPO) usually begins one month after the IPO is issued. It measures the long-run performance of the IPO. IPOs underperform in the long run. The divergence of investors hypothesis proposed by Miller (1977), the overreaction or fads hypothesis proposed by De Bondt and Thaler (1985, 1987), and the windows of opportunity hypothesis by Teoh et al. (1998) showed the reasons for long-run underperformance. The IPOs of firms (having politically connected CEOs) have shown relatively poor long-run performance compared to firms with no political connection because of the presence of bureaucracy (Fan et al. 2007).

2. Political Uncertainty and Initial Public Offerings

Political, Electoral, and Policy Uncertainty and IPOs

Political and election uncertainty affects policy and financial uncertainty (Goodell et al. 2020). Uncertainties crop up regarding who shall form the government, which new policies will come up, and how these policies will impact the firms. Political uncertainty adversely affects asset prices and risk premiums (Pastor and Veronesi 2012; 2013). Based on this argument, firms will be valued at a lower rate, and their cost of capital shall increase (Liu and Wang 2022). This shall have a detrimental effect on firms going for IPOs. The effect will be more prominent for younger firms as investors already have a lack of clarity on their financials and valuations (Sehgal and Singh 2008). Political uncertainty can elevate this problem of information asymmetry, and hence, firms will be unwilling to come up with an IPO during such times when their shares would be valued at a lower rate, and the cost of raising capital would be higher (Colak et al. 2017). Another reason for firms’ reluctance to go public during elections is due to being unsure about the policy changes that might come up if the government changes. Periods of higher economic policy uncertainty have shown a negative association with the number of firms going for IPOs. The graph shown in Figure 1 highlights the adverse relationship between policy uncertainty and the number of IPOs in India. The policy uncertainty data have been taken from the EPU index constructed by Baker et al. (2016).
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Figure 1. Graph on economic policy uncertainty and the number of IPOs issued.
Contrary to their findings, Luo et al. (2017) found out that, in China, the number of firms going for IPOs increases during elections. The reason stated by them was that government officials’ political promotions depend on the growth of the economy, hikes in GDP, capital market development, or other welfare programs. Hence, with an incentive to get promoted before elections, government officials might amplify the IPO process, thereby increasing the number of IPOs during the time of elections (Piotroski and Zhang 2014). One of the major reasons for underpricing cited in the literature was information asymmetry (Baron 1982; Rock 1986). Political uncertainty prevailing in the market distorts the quality of information available regarding the firm (Lei and Luo 2023). Firms may either improve corporate disclosure to limit information asymmetry or may take advantage of this uncertainty by reducing the level of information available or manipulating the financial accounts through window dressing (Chen et al. 2017). Regarding the firms going for an IPO, increased information asymmetry leads to higher underpricing. The positive relation is, however, reduced in the presence of reputed venture capitalists, underwriters, and auditors (Boulton 2022). Firms take advantage of political information uncertainty to inflate their offer prices. Higher information asymmetry creates a divergence of opinion in the minds of the investors. As per the divergence of opinion theory proposed by De Bondt and Thaler (1985, 1987), the divergence of opinion creates an initial overoptimism, thereby improving the short-run performance of the IPOs. However, as the shares trade in the stock markets, more information becomes clearly available to the investors, and their overoptimism subsides, leading to poor long-run performance (Liu and Wang 2022).

Political Connections

One of the most common ways firms use to reduce the impact of political uncertainties is through setting political connections. Firms can set up political connections by having a board of directors, a venture capitalist, or underwriters who are associated with a political party. The probability of firms getting their IPO approval from the regulatory body increases if the firm has a strong political connection (Chen et al. 2017). The fees required for getting themselves listed in the stock market are also considerably less compared to those firms that are not politically connected. By using a sample of Chinese firms, it was seen that politically connected firms set high offer prices and are less underpriced (Francis et al. 2009). Contrary to this, Liu et al. (2020) stated that state-owned firms controlled by the government offer underpricing compared to non-state-owned firms. Rudy and Cavich (2020) proved that firms engaging in corporate political activity prior to their decision to go public reduce information asymmetry regarding the value of the firm, thereby reducing underpricing. Similarly, political donations also act as a non-market strategy used by the issuers to fight ex-ante uncertainty and gain the confidence of investors about the firm’s financial soundness (Gounopoulos et al. 2021).

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