Deutsche Börse: Going Public and Being Public The Impact of the Listing Decision on the Cost of Capital An International Comparison

Transcription

1 Deutsche Börse: Going Public and Being Public The Impact of the Listing Decision on the Cost of Capital An International Comparison Authors: Prof. Dr. Christoph Kaserer Chair of Financial Management and Capital Markets & Center for Entrepreneurial and Financial Studies (CEFS) Technische Universität München Telephone: +49 (0) Fax: +49 (0) Prof. Dr. Dirk Schiereck Endowed Chair of Banking and Finance European Business School Telephone: +49 (0) Fax: +49 (0)

2 Acknowledgements: We gratefully acknowledge the helpful support from Martin Brixner, Jan Stolper, Stefan Thallmaier, Christian Voigt, Jochen H. Ziegler. Deutsche Börse AG is the sponsor of this study, which was performed by Christoph Kaserer and Dirk Schiereck. Thus, Deutsche Börse AG is not responsible for the content of this study and therefore excludes all liability for direct or indirect damages, losses or costs caused by the use of the information in this publication. Deutsche Börse AG further excludes all liability for faults or omissions within the study, which is published by Christoph Kaserer and Dirk Schiereck for general information purposes only. This publication does not contain any investment advice or an offer to trade, buy or sell Deutsche Börse shares or another bond or security traded on a market place of Deutsche Börse Group. November,

3 Table of contents 1. Executive Summary Introduction and framework General remarks on European public equity and corporate bond markets Some stylized facts on equity markets Some stylized facts on corporate bond markets The cost of capital framework The impact of direct listing transaction costs on the cost of equity The impact of indirect listing costs on the cost of equity Equity valuation The cost of going public Direct costs IPO flotation costs Admission fees Compliance costs (and returns) Digression: Flotation costs for corporate bonds Indirect costs The cost of being public Direct costs SEO flotation costs Listing fees Compliance costs Indirect costs Trading costs Introduction Data and descriptive statistics Analysis of bid-ask spreads Lessons learnt Adverse selection costs of raising equity Comparative results

4 List of figures Figure 1: Average domestic market capitalization in percent of GDP for different stock markets for the period Figure 2: Equity raised through SEOs by domestic firms in % of domestic market capitalization...10 Figure 3: New equity issues by domestic firms in % of domestic market capitalization...11 Figure 4: Equity floated through IPOs by domestic firms in m...11 Figure 5: Face value of outstanding corporate bonds issued by German non financial firms in m...12 Figure 6: Direct and indirect transaction costs associated with the listing decision...13 Figure 7: Ratio of market prices to reported earnings for equities listed at LSE or Deutsche Börse from 01/90 to 10/ Figure 8: Admission fees for different market tiers on LSE and Deutsche Börse as of April Figure 9: The impact of the listing venue on the firm s corporate governance framework...26 Figure 10: Quarterly underpricing in Germany over the period 1983 to Figure 11: Annual listing fees for different market tiers at Deutsche Börse and LSE as of April Figure 12: Range of the cost of capital factor for Frankfurt and London for different flotation ratios

5 List of tables Table 1: IPO flotation costs in Germany over the period 1993 to Table 2: Comparison of offering proceeds, total IPO flotation costs and non-underwriting costs in Frankfurt and in London over the period 1999 to Table 3: OLS-estimation model of total IPO flotation costs over the period 1999 to Table 4: Midpoint of admission fees in % of market capitalization for different size brackets...24 Table 5: Overview on the most important listing requirements at different market tiers...27 Table 6: Comparison of total underwriting fees and issue volume for corporate bond issues in Frankfurt and in London over the period 1999 to Table 7: OLS-estimation model of underwriting fees for corporate bond issues over the period 1999 to Table 8: Flotation costs for SEOs in different markets...31 Table 9: Economies of scale effect for SEO flotation costs...32 Table 10: Comparison of SEO underwriting fees in Frankfurt and in London over the period 1998 to Table 11: OLS-estimation model of SEO underwriting fees over the period 1998 to Table 12: Midpoint of annual listing fees in % of market capitalization for different size brackets...35 Table 13: Explicit trading costs sample of institutional investors, Q Q average (bp)...36 Table 14: New issues across time...37 Table 15: Sample adjustment of new issues...38 Table 16: Security characteristics of new issues...40 Table 17: Relative bid-ask spreads...41 Table 18: Multivariate regression model...42 Table 19: Robustness test: Foreign vs. UK IPOs...43 Table 20: Difference of effective cost of capital to investor s required return and market values according to equation (6) for the median issuer...45 Table 21: Range in the difference of effective cost of capital to investor s required return and market values according to equation (6) for the second and third quartile issuer

6 1. Executive Summary The authors have undertaken an independent analysis of the impact of the decision on the listing venue on the cost of capital of the firm. The first aim was to give an indication how a listing at Deutsche Börse might affect the firm s cost of capital. For that purpose we developed an analytical model telling us how the after transaction cost of capital is affected by different cost items companies have to pay at the occasion of their going public as well as for being a listed company. However, in order to allow for some benchmarking, we decided to compare the results with the transaction costs incurred at other European stock exchanges. Most importantly, a comparison with the London Stock Exchange is presented. As a general remark it should be noted that in an international comparison the German capital market is relatively small, given the size of the German economy. To some extent this is due to Germany s unfunded public pension schemes, although defective investor protection schemes in the past may also have had some influence. However, in terms of relative equity raising activities by domestic listed firms the German stock market is quite strong. Over the period German listed firms raised on average new equity equal to 1.4% of their market capitalization; for the UK this figure was equal to 0.9% and for the US only 0.7%. Hence, for listed firms the role of the German stock market as an equity financing channel is at least as important as for other presumably more equity oriented countries. Now, the most important results of this study can be summarized as follows: The cost of going public 1. The average of the total IPO flotation cost over the period 1999 to 2006 was 8.7% of gross offering proceeds in Frankfurt and 11.7% in London. The value weighted average is 5.8% in Frankfurt and 7.4% in London. While there is only a small difference across the different market tiers in Frankfurt, it turned out that the difference between the LSE Main Market and AIM is quite substantial. In fact, the total flotation cost at AIM was on average 17.3%, and even the value weighted average was 9.6% of gross offering proceeds. Also from a statistical point of view it turned out that total flotation costs at AIM are significantly higher than in Frankfurt. 2. Total flotation costs can be split-up into underwriting fees, i.e. fees paid to the investment banks, and non-underwriting fees, i.e. fees paid to lawyers and auditors as well as other expenses incurred during the offering process. While it seems that underwriting fees are very similar across all the market tiers under investigation in this study, it turned out that non-underwriting fees are perceivably higher in London than in Frankfurt. In fact, over the period 1999 to 2006 median non-underwriting fees were equal to 2.5% in Frankfurt, while they were equal to 4.5% in London. Although we don t have a straightforward explanation for this phenomenon it might be related to differences in the cost of complying with listing rules and disclosure requirements as well as with differences in the admission fees. 3. However, we do not find perceivable differences in the formal listing rules and disclosure requirements applying to both exchanges. This is not surprising as the set of financial market rules firms have to comply with are determined, at least to a large ex- 6

7 tent, by European financial market law. This is true, at least, for those firms listed on the regulated market. It should be emphasized, however, that Deutsche Börse deliberately raised the listing and disclosure requirements for the firms applying for a listing in the Prime Standard beyond the minimum prescribed by law. In fact, the firms have to publish quarterly reports and have to implement a high investor relation standard. Apart from this exchange specific differences it should be noted that corporate governance rules are also determined by corporate law. Hence, it may well be that there are still significant differences across Europe leading to a different cost of compliance. 4. Admission fees differ quite substantially across the European stock exchange landscape. For instance, comparing the Frankfurt Prime Standard with the London Main Market for the size bracket from 50 to 250 m market cap, the difference in admission fees expressed as a percentage of market cap is in the order of almost one magnitude. 5. As a corollary, we find underwriting fees for corporate bonds to be around 0.5% of gross proceeds in both stock exchanges. 6. As far as indirect costs are concerned, e.g. underpricing, we do not find a significant difference for London IPOs with respect to Frankfurt IPOs. Moreover, for economic reasons we have strong reservations against the notion that underpricing is regarded as a manageable cost item. The cost of being public 7. According to former research average total SEO flotation costs used to be 1.6% in Frankfurt and 5.8% in London. According to the empirical evidence presented in this study median total flotation costs are 3.3% in Frankfurt and 4.5% in London. 8. It turns out that there has been a substantial change in Germany as far as SEO underwriting fees are concerned. According to the data presented in this study median underwriting fees are equal to 3%, while a study looking at the period 1993 to 1998 recorded median underwriting fees of 1% in Germany. It may be that the upward shift in underwriting fees may be related to the fact that bookbuilding offerings have become more popular in Germany over the last years. As it is extremely difficult to gather information on non-underwriting fees for SEOs in London we had to rely on former research pointing out that median non-underwriting fees for SEOs in Germany are equal to 0.3% of gross proceeds, while for the UK they are equal to 2.5%. Although we don t have a clear explanation for this phenomenon it might be related to differences in the cost of complying with listing rules and disclosure requirements. 9. The difference in listing fees is quite substantial, although not as pronounced as for admission fees. While the Frankfurt market tiers as well as the AIM have constant listing fees in the range of to , the Main Market in London has fees that are linear in market cap within a given range. The upper limit on listing fees at the Main Market is 5 times as the constant listing fees at the Prime Standard. However, the relative impact of listing fees on the overall cost of capital is rather neglectible. 10. While investors maximize net stock returns, companies have to calculate with gross returns as required costs of capital. The difference between gross returns and net returns contain trading costs. These trading costs consist of explicit and implicit cost components. We show that at the Prime Standard (Entry Standard) in Frankfurt the 7

8 overall trading costs are significantly lower compared to Main Market (AIM) in London, using recent trading data of new equities. The explicit trading costs (brokerage commissions and fees) at the London Stock Exchange are significantly higher due to the stamp duty. The average cost advantage of a German listing compared to UK reaches 22 basis points. The firm characteristics of new listings in Germany and the UK show some remarkable differences. Comparable in size, new equities at the Main Market have lower trading volumes and a higher ratio of days without any trading than Prime Standard IPOs. The new issues at the AIM have significantly higher average market values than Entry Standard IPOs but average trading volumes are remarkably lower and days without trading more often. Controlling for these firm characteristics the implicit trading costs (measured by the bid-ask spreads) are the lowest at the Entry Standard followed by the Prime Standard. Consistent with other studies we find extremely high implicit trading costs at the AIM. Hence, it seems that AIM is an unattractive expensive listing alternative from a trading cost perspective inducing higher costs of capital compared to an IPO in Germany Impact on the cost of capital 11. In this study we develop an analytical model predicting the impact of the cost of going and being public on the effective cost of capital of a company. Using the empirical results obtained in this study we find that the effective cost of capital for a company listed in Frankfurt is most likely to be in the range of 2 to 6 percent higher than the return required by the investors buying its shares. For a company listed in London this markup is in the range of 3 to 8 percent. Using some simplifying assumptions this translates into a difference in market values in the range of 0.8% to 2.4%. 12. The effect of different trading costs is not incorporated in these figures. As it is not clear how a given difference in trading costs is reflected in the effective cost of capital we do not present a numerical result. However, there is no doubt that an increase in the liquidity of the stock reduces trading costs and, hence, reduces the cost of capital of the firm. Given that we have shown that trading costs are substantially lower in Frankfurt compared with London, it is clear that the increase in the cost of capital induced by trading costs will be higher for London than for Frankfurt. 8

9 2. Introduction and framework 2.1 General remarks on European public equity and corporate bond markets Some stylized facts on equity markets It is well known that the German equity market is small relative to the size of the German economy. This relative size is commonly measured as the ratio of the market capitalization of listed domestic firms to the gross domestic product (GDP). As can be seen from Figure 1, the average of this ratio over the period was less than 50% for the German stock market, while it was more than 80% for the Euronext market and close to 135% for the US (UK: 145%). Nasdaq/Nyse/Amex 134,24% Euronext 84,78% London Stock Exchange 142,89% Deutsche Börse 48,33% 0% 20% 40% 60% 80% 100% 120% 140% 160% Figure 1: Average domestic market capitalization in percent of GDP for different stock markets for the period Source: WEF, OECD There is an ongoing debate with respect to the reasons for this large difference. Most prominently, the legal system in terms of investor protection is discussed as well as the fact that Germany s unfunded public pension scheme prevents a consistent part of economic savings from being channelled through the stock market. 1 It is therefore clear that in absolute terms 1 For a more detailed discussion of this issue cf. La Porta/Lopez-de-Silanes/Shleifer/Vishny (2000), Investor protection and corporate governance, Journal of Financial Economics 58, pp. 1-25, or Wenger/Kaserer (1998), German Banks and Corporate Governance: A Critical View, in: Comparative Corporate Governance. The State of the Art and Emerging Research, Hopt/Kanda/Roe/Wymeersch/Prigge (ed.), Clarendon Press, pp

10 the financing role of the German equity market is not as pronounced as the role of other markets, like those in the Anglo-Saxon world. However, in terms of relative equity raising activities by domestic listed firms the German stock market is consistently stronger than the UK stock market. In fact, as can be seen from Figure 2, over the period German listed firms raised on average new equity equal to 1.4% of their market capitalization; for the UK this figure was equal to 0.9% and for the US only 0.7%. Hence, for German listed firms the role of the stock market as an equity financing channel is at least as important as for listed companies in other presumably more equity oriented countries. 3,5% 3,0% 3,2% 3,1% 2,5% 2,6% 2,0% 1,5% 1,5% 2,2% 1,3% 1,9% 1,4% Deutsche Börse London Stock Exchange Euronext Nasdaq/Nyse/Amex 1,0% 0,5% 1,0% 0,7% 0,9% 0,7% 0,0% Figure 2: Equity raised through SEOs by domestic firms in % of domestic market capitalization Source: WFE, OECD, own data A similar, yet not so clear picture can be drawn for new equity issues. In fact, from Figure 3 it follows that relative going public activity in Germany consistently increased since Even for the period the ratio of equity floated through new issues to domestic market capitalization was almost the same for Frankfurt and London. This is quite surprising, as the German IPO market suffered from a serious downturn in However, it has to be pointed out that since 2001 also normalized going public activity at Deutsche Börse is smaller than at LSE. By and large, these figures make clear that the financing role of the German stock exchange is appealing, provided that the smaller size of the market as a whole is taken into account. Of course, by looking at IPO activity in absolute terms the London market is outperforming the German market since the downturn in 2001, as can be seen in Figure 4. 10

11 2,0% 1,8% 1,6% 1,7% 1,4% 1,2% Deutsche Börse 1,0% 0,8% 0,6% 0,4% 0,2% 1,0% 0,9% 0,3% 1,1% 1,0% 0,9% 0,7% 0,5% 0,5% 0,5% 0,4% London Stock Exchange Euronext Nasdaq/Nyse/Amex 0,0% Figure 3: New equity issues by domestic firms in % of domestic market capitalization Source: WFE, OECD, own data Deutsche Börse LSE-MM Figure 4: Equity floated through IPOs by domestic firms in m Source: Thomson Financial, own data 11

12 2.1.2 Some stylized facts on corporate bond markets It is well known that bond markets are quite different from stock markets. Most importantly, trading of bonds is much more fragmented and, as a consequence, takes place to a great extent outside the exchange. For instance, it is estimated that in Germany only 5% of bond transaction volume is traded via a stock exchange. OTC-markets organized by banks as well as MTS Germany play an important role in bond trading. 2 At a European basis, trading desks of London-based investment banks cover a large part of trading in Eurobonds. Due to this specific structure of the bond market, corporate bond issues in many cases are international. As a consequence, the firm s decision where to list the stocks is disentangled from the decision where and how to offer its bonds. Thus the cost of corporate bond listing should have no influence on the choice of the stock s listing venue. It is mainly for this reason that corporate bonds only have a minor role in this study. Figure 5: Face value of outstanding corporate bonds issued by German non financial firms in m Source: Deutsche Bundesbank Nevertheless, one stylized fact should be mentioned here. Traditionally, German firms were relying heavily on debt financing by banks. Corporate bonds only had a minor role as a financing instrument. However, since the introduction of the Euro in 1999 this has begun to change substantially (see Figure 5). As of May 2006, total face value of corporate bonds issued by German non-financial firms was about 115 bn ; this is almost equal to a triplication since the beginning of the year Nevertheless, in terms of the size of the German economy financing through corporate bonds is still small. According to figures disclosed by 2 Cf. Wagner (2004), Germany, in: Batten, J. A., Fetherston, T. A., Szilágyi, P. G. (eds.): European Fixed Income Markets, Wiley, Chichester, pp

13 Deutsche Bundesbank the size of the corporate bond market in Germany was 6% of GDP in 2003, while in the UK it was equal to 26% The cost of capital framework In order to set-up a consistent framework for the impact of the cost of going or being public on the overall cost of capital of a company, some basic considerations are outlined here. This framework has one important goal: it must be able to put different cost items in relation to each other by quantifying their impact on the overall cost of capital of the company. This is vital, as different markets might have cost advantages for some items and disadvantages for others. Comparing these markets necessarily implies the need to figure out what the overall impact on the firm s cost of capital will be. Unfortunately, pertinent studies do not specify this kind of trade-off. 4 As a consequence, their comparison of the impact of listing the shares on different markets on the firm s cost of capital does not allow to come up with any general conclusions. Figure 6: Direct and indirect transaction costs associated with the listing decision 5 If a company decides to go public, then it incurs two different types of costs, as it is shown in Figure 6: (a) the costs associated directly with the IPO, i.e. the costs of going public, and (b) the costs associated with being a listed firm including the costs associated with a future seasoned equity offering (SEO). According to the financial economics literature these costs are split-up in direct and indirect components. As a direct cost all expenses related to the listing decision are considered. Most importantly, underwriting fees paid to the lead investment bank as well as to lawyers and auditors are some of the items belonging to the direct costs. Also, 3 Cf. Deutsche Bundesbank (2004), Neuere Entwicklungen am Markt für Unternehmensanleihen, Monatsbericht April 2004, pp Cf. Oxera (2006), The Cost of Capital An International Comparison, Oxford. 5 Cf. also Oxera (2006), The Cost of Capital An International Comparison, Oxford, p

14 fees paid to the stock exchange, advertising and press costs and expenses incurred to comply with disclosure and corporate governance rules belong to the direct costs. As an indirect cost the impact of the listing decision on the equity valuation is considered The impact of direct listing transaction costs on the cost of equity From the stockholders point of view the firm s management should design the new equity issue in a way that the firm s cost of capital is minimized. This is equivalent to saying that the present value of all future distributions to the stockholders is maximized. To put this consideration in a more formal framework the following definitions are introduced: FCFE t = Free cash flow to equity gross of listing fees, disclosure costs and flotation costs, a firm is expected to generate in period t k e k e c g t F IPO f IPO F t SEO f SEO L t l γ α = Investors required net return on equity investment in firm i = Effective cost of equity when raising capital on public markets (i.e. net of transaction costs) = Growth rate for FCFE t in period t = Total direct IPO flotation cost = Total cost spread on gross IPO proceeds = Total direct SEO flotation cost incurred by a firm in period t = Cost spread on gross SEO proceeds = Net listing and professional fees as well as disclosure costs paid by a firm for being listed in period t = Cost spread for listing fees and disclosure costs on the firm s market cap = Ratio of yearly SEO proceeds to the firm s market cap = Ratio of IPO proceeds to market cap Under this perspective and by applying a standard textbook discounted cash flow (DCF) approach, the equity value of a firm at the IPO date can be written as follows: t = 0 SEO (1) V = ( FCFE L F ) t t t (1 + k ) e t Now, one has to consider that a firm floating a ratio α of its equity on the stock market generates proceeds of αv-f IPO =αv(1-f IPO ). Hence, the net of IPO costs valuation of the firm s equity is equal to V(1-αf IPO ). From the perspective of the owner, the effective cost of equity incurred when raising capital on public markets can be derived by setting the present value of free cash flows to equity gross of any type of flotation costs equal to the after IPO equity valuation of the company minus the IPO flotation costs. This can be written as follows: IPO (2) V ( 1 α f ) = t= 0 FCFE (1 + k t c e ) t Now, by dividing both sides of equation (2) with the expression (1-αf IPO ) and then setting the resulting right hand side of equation (2) equal with the right hand side of equation (1) it follows: 14

15 (3) FCFE SEO ( FCFE L F ) t t t = = = + ( ) t 0 c t IPO (1 k ) 1 t 0 (1 + ) t e αf ke This equation implicitly defines a relation between the effective firm s cost of equity and the required investor s return. By using some simplifying assumptions this relationship can be expressed also in analytical terms. For that purpose we consider a constant growth firm with a constant debt ratio. For this firm expected free cash flow is constantly growing over time with the rate g. Moreover, assuming that listing and disclosure costs as well as flotation costs for SEOs can be expressed as a constant ratio of the firms market capitalization, 6 the following relationship results from equation (3): (4) FCFE FCFE L F = c IPO ( k g )( 1 αf ) ( k g ) e e SEO Note that according to equation (2) the left hand side of (4) is nothing else than the firm s market capitalization at the IPO date. Hence, taking the above introduced definitions into account, the effective cost of equity of a listed firm can be written as follows: g + l + γf c e (5) ke = g + IPO k 1 αf SEO Equation (5) implicitly defines a rate of substitution between different cost items associated with the listing of the firm. Hence, the management, before taking the decision where to list the firm s share, could figure out the impact of the listing venue on the effective cost of equity of the firm. Then, it could well be that although the IPO flotation cost f IPO might be higher at stock exchange A in comparison with stock exchange B, the management nevertheless decides to list on B because of perceivable lower follow on costs as expressed by the listing and disclosure cost item l and the SEO flotation cost item f SEO. Moreover, equation (5) makes also clear that the rate of substitution between any of these two cost items and the cost of equity k e is equal 1. Note, under the assumptions made here k e g can be regarded as the inverse of a valuation multiple. Hence, if for whatever reason the valuation multiple on stock exchange A is equal 25 while it is equal to 20 on stock exchange B, i.e. there is valuation difference of 25%, the effective cost of equity when listing on B would be the same, if the sum of the cost items l and γf SEO is higher by 1 percentage point on stock exchange A compared with stock exchange B, all else being equal. This is interesting, as a 1% difference in the cost of being public outweighs a 25% valuation difference. The reason for this result is the fact that a valuation multiple of 25 respectively 20 translates into a cost of capital difference of 1%. 7 Hence, even seemingly small differences in the costs associated with the listing of the firm could have a noticeable impact on the firm value. An alternative way to write the result presented in equation (5) is in terms of the ratio of the inverse of the effective multiple net of any costs associated with the listing to the inverse of the multiple applied by the investors. It follows from (5) that this ratio equals t (6) k k c e e g g 1 = 1 αf IPO l + γf 1+ ke g SEO 6 Specifically, we assume L t=lx and F t SEO =γf SEO X with X=FCFE/[(k c e-g)(1-αf IPO )]. 7 In order to see this note that in this example 1/(k e A -g)=25 and 1/(k e B -g)=20. From this it follows that k e B -k e A =

16 In order to get a better understanding of this ratio assume that for a particular market it equals This means that shareholders are losing approximately 5% of the market valuation of this company due to the costs associated with the listing of the firm. Moreover, assume that there is another stock exchange where this ratio is equal to In this case, stockholders would gain approximately 1% ( 1.05/1.04-1) of the company s market valuation, if they choose to list on the second exchange instead of the first The impact of indirect listing costs on the cost of equity As an indirect cost the impact of the listing decision on the equity valuation is considered. For instance, it could be argued that because of adverse selection or moral hazard issues the firm has to offer its stocks at a discount, leading to the well known phenomenon of underpricing, in case of an IPO, or a negative announcement reaction of the stock price in case of a SEO. 8 Although these kind of indirect costs have to be taken into account for the decision whether to raise equity on public markets, it is rather questionable whether the listing location may have any influence on these indirect costs. According to recent evidence presented by behavioral economists, it is even questionable whether companies are able to manage underpricing at all. In fact, there is evidence that the underpricing phenomenon is driven by market sentiment, at least to some extent. In fact, new shares issued during hot market periods are more likely to suffer from long-run underpricing than shares offered in less optimistic markets. 9 Similar considerations apply to the stock market reactions to SEO announcements. Although we will present pertinent empirical evidence in this study, we strongly doubt that they should be considered as a manageable cost associated with the listing venue. Evidently, the situation is totally different as far as trading costs are concerned. The transaction costs that are induced by the investors buy and sell orders reduce the gross returns of equity investments. As investors maximize the net returns of their portfolio trades, transaction costs influence the required gross returns of companies that raise equity via the stock market. 10 The higher the transaction costs the higher the required gross returns for equity raising companies. Domowitz/Steil (2001) estimate that a 10% increase in transaction costs will lead to a 1.4 to 1.7% increase in the post-tax cost of equity capital. Consistently with this estimate a number of empirical studies can observe a positive relationship between returns and trading costs. 11 Finally, it is argued that firms might refrain from going public because disclosure requirements will reduce the informational advantage a firm might have against its competitors. In fact this is an important argument in favour of mandatory disclosure rules as opposed to mar- 8 These are two well documented phenomena in corporate finance; for an overview cf. Berk/De Marzo (2007), Corporate Finance, Boston et al., pp. 757 n. 9 Cf. Ljungqvist/Nanda/Singh (2006), Hot markets, investor sentiment, and IPO pricing, Journal of Business 79, pp , and Lowry/Schwert (2002), IPO market cycles: bubbles or sequential learning?, Journal of Finance 57, pp See e.g. Amihud/Mendelson (1986), Asset Pricing and the Bid-Ask Spread, Journal of Financial Economics 17, pp Consistent with the liquidity hypothesis the following authors provide supporting empirical evidence: Amihud/Mendelson (1989), The Effects of Beta, Bid-Ask Spread, Residual Risk, and Size on Stock Returns, Journal of Finance 44, pp , Eleswarapu (1997), Cost of Transacting and Expected Returns in the Nasdaq Market, Journal of Finance 52, pp , Brennan/Subrahmanyam (1996), Market Microstructure and Asset Pricing, Journal of Financial Economics 41, pp , Amihud/Mendelson/Lauterbach (1997), Market microstructure and securities values: Evidence from the Tel Aviv Stock Exchange, Journal of Financial Economics 45, pp , Domowitz/Glen/Madhavan (2001), Liquidity, Volatility and Equity Trading Costs Across Countries and Over Time, International Finance 4, pp

17 ket self-regulation. 12 However, we do not address this issue as it is extremely difficult to give any indication with respect to the value impact of this type of indirect listing costs. 2.3 Equity valuation One of the most important drivers for the listing decision are market multipliers. According to evidence presented by behavioural economists, cycles on IPO markets could to some extent be explained by perceived under- or overvaluation in terms of multipliers. 13 Different market multipliers might also drive the decision on the listing venue. In fact, if equity in a specific industry is valued at 20 times earnings at one stock exchange, while the other is valuing the same type of equity at 25 times earnings, stockholders could increase their IPO proceeds ceteris paribus by 25%, if they decide to list on the latter stock exchange instead of the former. However, from a theoretical point of view it is unlikely that such differences in market valuation will persist, as this might create arbitrage opportunities for internationally active investors. In fact, stocks with the same market risk implied by the distribution of their after corporate tax free cash flows should generate the same return. Otherwise arbitrage opportunities arise, as investors could set-up hedge portfolios with stocks considered as close substitutes. Iit is well known that markets are not perfectly arbitrage free, especially if mispricing could only be exploited in the long-run. 14 As a result, one cannot rule out that perceivable valuation differences exist. In this regard it is often argued that industry expertise may be clustered in some financial centres, leading to a higher valuation of companies belonging to given sectors. Although this argument may be plausible, at the end of the day it is an empirical question, whether differences in international equity valuation persist. There is some interesting ongoing academic research related to this topic showing that although there might be a systematic impact of the corporate governance system on the firm s cost of capital, this difference is unlikely to persist in integrated capital markets. 15 Of course, it is not the aim of this study to analyze whether there are any systematic differences in company valuation between the Frankfurt and other European stock exchanges. However, because of the dense integration of European capital markets valuation differences are rather unlikely to persist. Moreover, if the valuation difference is the consequence of a defective domestic corporate governance system, the firm would not be able to reduce this valuation difference by listing its stocks at the foreign exchange as long as the company is subject to the domestic corporate governance system via its status of incorporation. 16 As a first indication that differences in firm valuation between Germany and UK should not be persistent we take a look at market or industry-specific price-earnings-ratios. At a first glance Figure 7 does not indicate that there might be any systematic difference in the priceearnings-ratios of domestic stocks traded at the London and Frankfurt stock exchange over the period 1990 to If there is a private cost on disclosing information that is higher than the social cost associated with that, firms would systematically disclose too less information in a free market equilibrium. Hence, there is a need for regulation. For this debate cf. Fox (1999), Retaining Mandatory Securities Disclosure: Why Issuer Choice is not Investor Empowerment, Virginia Law Review 85, pp , and Romano (1998), Empowering Investors: A Market Approach to Securities Regulation, in: Hopt, K. J., H. Kanda, M. J. Roe, E. Wymeersch and S. Prigge (ed.) Comparative Corporate Governance - The State of the Art and Emerging Research, S , Oxford. 13 Cf. Ljungqvist/Nanda/Singh (2006), Hot markets, investor sentiment, and IPO pricing, Journal of Business 79, pp , and Lowry/Schwert (2002), IPO market cycles: bubbles or sequential learning?, Journal of Finance 57, pp Shleifer/Vishny (1997), The Limits of Arbitrage, Journal of Finance 52, pp Cf. Hail/Leuz (2005), International Differences in the Cost of Equity Capital: Do Legal Institutions and Securities Regulation Matter? ECGI - Law Working Paper No. 15/2003, available at SSRN: 16 Cf. for these considerations section

18 Jan 90 Jan 91 Jan 92 Jan 93 Jan 94 Jan 95 Jan 96 Jan 97 Jan 98 Jan 99 Jan 00 Jan 01 Jan 02 Jan 03 Jan 04 Jan 05 Jan 06 PE All industries PE Basic materials PE Industrials PE Consumer goods PE Financials 18

19 Deutsche Börse London Stock Exchange 0 PE Technology Figure 7: Ratio of market prices to reported earnings for equities listed at LSE or Deutsche Börse from 01/90 to 10/2006 Source: Thomson Financial It is quite interesting, by the way, that the average price-earnings-ratio in both markets since 1990 is very close to 23. For Germany the average is 23.54, for the LSE Assuming a long term real growth rate of 1%, a multiple of 23 translates into an expected equity market return of 4,35%+1%=5,35%. Assuming a long-term real interest rate of 2% the equity premium might be in the range of about 3%. 17 Due to the close multiples in both markets the equity premium will be close to each other as well, at least as long there is no reason to assume that long-term real growth or long-term real interest rates perceivably different. 3. The cost of going public 3.1 Direct costs IPO flotation costs It has been shown in Figure 6 that the direct cost of going public can be split-up in underwriting fees, professional fees, initial listing costs, compliance costs, and advertising and other costs. While underwriting fees regularly are disclosed in the prospectus, it is not that clear how to get reliable information on the other cost items. However, in some cases the prospectus gives information about underwriting and non-underwriting costs. It can be assumed that non-underwriting fees reflect professional fees, initial listing costs, advertising costs, and other expenses directly related to the IPO. Of course, to the extent that an IPO generates internal costs, e.g. because the financial department of the company has to be increased due to new disclosure rules it has to comply with, they are not disclosed in the prospectus. Hence, one should be aware that a comprehensive estimation of non-underwriting flotation costs is certainly not possible. 17 According to a recent paper of Dimson/Marsh/Staunton (2006), The Worldwide Equity Premium: A Smaller Puzzle (April 7, 2006), EFA 2006 Zurich Meetings, Paper Available at SSRN: the historical equity premium on world equity markets over the period 1900 to 2005 was 4.04%. According to this research the historical equity premium for Germany was 5.28% and for UK was 4.06% (geometric averages). However, there are some compelling arguments presented in this paper why in the future equity premiums may be lower. 19

20 This may be the reason why most of the empirical studies dealing with flotation costs on the UK market restrict themselves to the analysis of underwriting fees only. For instance, Torstila 18 on the basis of a sample of 56 UK IPOs covering the period 1986 to 1999 finds the median underwriting spread to be 3.6%. The equally weighted average in his sample is 3.8%, the value weighted average 2.2%. Using a more recent sample of 84 IPOs covering the period 2003 to 2005, Oxera 19 finds an average spread of 3.6%. According to this study, the average spread on the LSE main market is 3.3%, while for the LSE AIM it is equal to 3.7%. They conclude that the underwriting spread in UK is in the range of 3 to 5%, depending on the size and riskiness of the issue. Unweighted mean Value weighted mean Median Official Market Regulated Market New Market All Observations Observations Observations Observations Underwriting costs 4,58% 39 4,70% 24 5,52% 46 5,01% 109 Non underwriting costs 3,01% 40 2,60% 24 3,29% 46 3,04% 110 Total flotation costs 7,30% 40 6,69% 29 8,83% 48 7,77% 117 Underwriting costs 3,16% 39 3,75% 24 4,33% 46 3,31% 109 Non underwriting costs 2,35% 40 1,78% 24 2,41% 46 2,33% 110 Total flotation costs 5,51% 40 6,34% 29 7,09% 48 5,72% 117 Underwriting costs 4,40% 39 4,48% 24 5,34% 46 5,00% 109 Non underwriting costs 1,85% 40 1,71% 24 2,56% 46 2,16% 110 Total flotation costs 6,10% 40 6,67% 29 8,30% 48 7,30% 117 Notes: Data is from Kaserer/Kraft (2003), Journal of Business Finance and Accounting 30, and from our own database; period under consideration: Table 1: IPO flotation costs in Germany over the period 1993 to 1998 According to a comprehensive study of Kaserer/Kraft 20 of 117 German IPOs covering the period 1993 to 1998 the median underwriting spread is 5.0%, the unweighted average is 5.0% too, while the value weighted average is 3.3%, as can be seen in Table 1. Taking once again into account that underwriting fees depend on the size, the riskiness, and other IPO specific factors, it could be safely argued from Table 1 that the underwriting spread in Germany most likely is in the range of 3 to 5%. As far as the non-underwriting fees are concerned Table 1 shows that they average to 3%, while the median is 2.2% The value weighted average is 2.3%. Hence, according to 18 Torstila (2001), What determines the IPO gross spreads in Europe, European Financial Management 7, pp Oxera (2006), The cost of capital: An international comparison, Oxford. 20 Kaserer/Kraft (2003), How issue size, risk, and complexity are influencing external financing costs - German IPOs analyzed from an Economies of Scale Perspective, Journal of Business Finance and Accounting 30, pp

21 Kaserer/Kraft (2003) average total direct flotation costs, excluding internal compliance costs, in Germany are equal to 7.8%, while the median is equal to 7.3%. The value weighted average of total flotation costs is equal to 5.7%. By and large, one can say that total flotation costs in Germany are in the range of 5 to 8%. This has to be compared with total flotation costs for the UK of 5.5 to 11% estimated by Oxera (2006). 21 However, in order to make a better empirical assessment of the recent IPO flotation cost in Frankfurt and in London new data has been collected. Specifically, we recorded information on total IPO flotation costs from prospectuses offered by the Thomson Financial SDC database. A total of 359 IPOs taking place in Frankfurt or in London over the period 1999 to 2006 could be put together in this way. Results are presented in Table 2. It is confirmed that total IPO flotation costs are substantially higher in London than in Frankfurt. This is especially true when comparing AIM with any market tier in Frankfurt. According to this dataset these average total flotation costs are equal to 8.7% in Frankfurt and 11.7% in London. The median is 8% for Frankfurt and 9.7% for London, while the value weighted average is 5.8% resp. 7.3%. While these figures do not much vary across the different market tiers in Frankfurt, there is a quite substantial difference between the Main Market and AIM. The average total flotation cost at AIM is 17.3% and even the median is still 13.8%. As a first result we can conclude that average total flotation costs in London are substantially higher than in Frankfurt. However, by putting together the results presented by Kaserer/Kraft (2003) and Torstila (2001) one might come to the conclusion that underwriting fees in Frankfurt and in London are not that different. Hence, the difference may be driven by the nonunderwriting fees. In order to test this presumption we collected information on nonunderwriting fees for a sub-sample of the firms used in the upper panel of Table 2. Results are presented in lower panel of Table 2. For this sub-sample, average non-underwriting fees are 4.93% in London compared with 3.15% in Frankfurt. By and large, this result is in line with the results presented by Kaserer/Kraft (2003) as well as with the statement in the report of Oxera (2006), quoting that non-underwriting costs for an IPO in UK are in the range of. 2.5 to 6%. 22 Taking in mind that the difference in the average total flotation costs was 2 percentage points, one can see that more than 90% of this difference is explained by the difference in non-underwriting fees. 23 The same holds true with respect to the median. The difference of 1.8 percentage points in the median total flotation costs relates to a difference of 2 percentage points in the median non-underwriting fees. So it can safely be argued that the difference in total flotation costs is mainly driven by higher non-underwriting fees in London. This is in line with further results presented in section 4.1, where it will be shown that in the context of SEOs non-underwriting fees in UK are consistently higher than in Germany. Although we cannot give a detailed explanation for the real economic drivers behind this result, it is not implausible to presume that this difference might be related to different costs of compliance. Finally, it should be noted that the median size of IPOs in Frankfurt and in London are quite similar, except the AIM offerings, where the median size is substantially smaller than at the Frankfurt Entry Standard. The average offering proceed at AIM, however, is close to the average at the Entry Standard. 21 Oxera (2006), The cost of capital: An international comparison, Oxford, p Oxera (2006), The cost of capital: An international comparison, Oxford, p The reader should note that although non-underwriting fees could only be recorded for a sub-sample of the firms results are not driven by a selection bias. In fact, the average flotation costs for this sub-sample are very close to the averages calculated on the basis of the whole sample of 359 firms. 21

22 N Unweighted mean Value weighted mean Median Min Max Std.dev. London Gross offering All ,893 30,731 0, , ,909 pro- Main Market ,356 51,551 0, , ,023 ceeds (m ) AIM 63 8,447 2,559 0,185 81,000 14,050 Total flotation costs All ,67% 7,35% 9,75% 1,25% 49,67% 8,16% Main Market 158 9,43% 7,29% 8,27% 1,25% 45,45% 6,06% AIM 63 17,28% 9,58% 13,83% 3,06% 49,67% 9,94% Non-underwriting costs All 48 4,93% 4,68% 4,51% 0,00% 12,50% 2,91% Frankfurt Gross offering All ,106 47,441 1, , ,516 pro- ceeds (m ) Total flotation costs Prime/General ,824 90,390 4, , ,375 Neuer Markt ,870 46,750 9, , ,594 Entry 13 13,795 13,500 1,842 47,700 11,626 All 138 8,72% 5,76% 7,98% 2,56% 27,33% 3,78% Prime/General 52 8,92% 5,49% 7,75% 2,56% 27,33% 5,03% Neuer Markt 73 8,54% 6,14% 8,29% 4,06% 15,72% 2,91% Entry 13 8,93% 9,14% 8,88% 5,28% 12,28% 2,09% Non-underwriting costs All 35 3,15% 2,69% 2,47% 0,33% 9,29% 2,50% Table 2: Comparison of offering proceeds, total IPO flotation costs and non-underwriting costs in Frankfurt and in London over the period 1999 to Source: Thomson Financial, own calculations Of course, this kind of one-dimensional cost comparison has to be interpreted very carefully. First, taking the standard deviation into account one can see that all this differences are not significant in the statistical sense. Moreover, it cannot be ruled out that the differences in the flotation costs are due to systematic difference in the riskiness or other firm characteristics of Frankfurt IPOs with respect to London IPOs. Hence, in order to figure out whether the difference can really be attributed to the listing venue, one has to set up an economic model explaining a significant part of the cross-sectional variation in IPO flotation cost. Under the assumption that this model captures all the relevant factors influencing flotation costs, it can be tested whether the listing venue has an impact. We do so be relying on models used in the academic literature. 25 We extend these models by introducing dummy variables for the different market tiers in London and in Frankfurt. Results for two different specifications of this model are presented in Table 3. First of all, it can be seen that the model is economically meaningful as it explains 44% of cross-sectional variation in flotation costs. 26 Second, as shown by Kaserer/Kraft (2003), flotation costs are affected by a fixed component as well as by decreasing marginal costs. Hence, the average size of the IPO has an impact on its flotation 24 The reader should note that the Frankfurt market segment Prime/General includes also issues on the official and regulated market taking place before Cf. Kaserer/Kraft (2003), How issue size, risk, and complexity are influencing external financing costs - German IPOs analyzed from an Economies of Scale Perspective, Journal of Business Finance and Accounting 30, pp , with additional references. 26 It should be noted that the estimation of the model is neither affected by multicollinearity nor by heteroscedasticity. 22