The Effects of Introducing a New Stock Exchange on the IPO process

The Effects of Introducing a New Stock
Exchange on the IPO process
Jörg Kukies*
* University of Chicago, Graduate School of Business
I wish to thank Steven Kaplan, Raghuram Rajan, Per Strö mberg and Luigi Zingales as well as participants
in the JFI Symposium New Technologies, Financial Innovation and Intermediation at Boston College for
helpful comments. I also thank Hoppenstedt Verlag GmbH, Deutsche Börse AG, Deutsches Aktieninstitut,
the Federation International de Bourses de Valeur and Investor Relations departments at over 200 German
firms for providing data. I am grateful to the NASDAQ Education Foundation for providing me with
financial support during my Ph.D. studies. Comments would be greatly appreciated and can be sent to
pjkukies@gsbphd.uchicago.edu.

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Abstract
This paper analyzes the effect of introducing new stock exchanges (New Markets) with strict disclosure
rules on the number and characteristics of IPOs. I find that the number of IPOs increases significantly after
the creation of such markets in a cross-section of 42 countries. Using data on privately held companies, I
find that the New Market in Germany allows small, young firms from industries with high research
intensity to go public.
I Introduction
In the recent literature, La Porta et. al. (1997) argue that the legal framework,
specifically the extent of investor protection, is a crucial determinant of IPO activity and
other measures of the importance of equity markets. On a similar note, Coffee (1999)
emphasizes the role of legal systems, specifically the protection of minority shareholders,
in the development of active equity markets. However, Coffee also argues that higher
disclosure standards, by reducing agency costs and controlling opportunistic behavior by
majority shareholders, can facilitate access to equity markets. The question whether legal
standards such as investor protection rights are a prerequisite to the development of
vibrant equity markets or if alternatives such as increased disclosure can also foster such
a development is important in understanding how financial markets evolve, yet there is
little empirical evidence on the choice between these alternatives. The lack of research in
this area is particularly noticeable because a large number of countries is currently in the
process of trying to give capital markets a larger role. This paper attempts to show that
for these countries, the choice of information disclosure regime is an important policy
decision.
The creation of new equity markets in several European countries offers a unique
opportunity to study the effects of a change in disclosure rules while leaving the legal
framework constant. Starting in 1996 with the Nouveau Marché in Paris and quickly
followed by the Nieuwe Markt in Amsterdam, the Neuer Markt in Frankfurt and
Euro.NM in Brussels, these newly created stock exchanges use the approach of strict
disclosure rules based on private contracts between the exchanges and firms willing to
list as a method of attracting a new type of companies to the equity market, specifically
small, young growth firms. This process took place largely without government
involvement; namely, the creation of New Markets was not accompanied by any major
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legal changes to promote IPO activity, such as the improvement of investor rights.
Therefore, the creation of New Markets offers an interesting natural experiment to study
the effects of a change in disclosure rules while leaving the legal framework constant.
Increased disclosure can be a way of overcoming the problems of asymmetric
information faced by small growth firms when they attempt to raise equity capital.
As a consequence, the creation of a New Market should lead to an increase in the total
number of firms going public. The ability to precommit to an open disclosure policy by
listing on the New Market creates an avenue for IPOs of firms that are able to make such
a commitment and that did not have the possibility to credibly implement such a policy
before the creation of the new stock exchange. On the other hand, the type of mature
firms that went public on the standard markets before the existence of the New Market
still have the opportunity to do so; the IPO of an established firm in a mature industry on
the traditional exchange will not be perceived as a negative signal about the firm’s
quality.
The requirement of a credible precommitment to revealing information crucial to investor
decision-making constitutes a signaling mechanism which gives high-quality firms an
opportunity to separate themselves from low-quality rivals, thereby increasing investors’
confidence in the New Market. In this sense, increased disclosure can be seen as a
possible substitute for weak investor rights in the context of La Porta et. al. (1998).
The New Market’s signaling mechanism based on disclosure should benefit the firms
with the largest amount of information asymmetries most strongly, namely young growth
firms characterized by the lack of a track record, complex technologies and uncertain
cash flows. Therefore, the characteristics of IPO firms should change after the creation of
the New Market.
This paper tests the two predictions on the quantity and characteristics of IPO firms
and finds evidence in favor of the above arguments. In a panel of 42 countries studied
from 1985 until 1999, the creation of New Markets with strict disclosure standards leads
to a statistically and economically significant increase in the number of IPOs controlling
for the level of stock market indices. This result is subject to the caveat of possible
endogeneity, as it is unclear if the creation of the New Market caused the increase in
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IPOs, or if a large number of firms willing to go public exerted pressure to create the new
exchange. As an attempt to address this issue of reverse causality, I show that in
countries which introduced a New Market with low disclosure requirements we observe
no significant effect on IPO activity.
My empirical analysis using a unique database on privately held German firms lends
support to the prediction on the change in the characteristics of IPO firms. I show that the
introduction of the New Market leads to a change in the composition of IPO firms in
favor of younger, smaller, technology-oriented firms with large growth potential.
Variables that proxy for growth opportunities tend to induce firms to choose the stricter
disclosure requirements of the New Market, whereas large, old firms select the
established exchanges for their IPOs. These effects have strong economic magnitudes; an
increase in the industry market-to-book ratio of a firm by one standard deviation
increases the probability going public on the New Market from 70% to 88%, whereas the
same increase in age decreases this probability to 44%.
The remainder of this paper is organized as follows. Section II discusses the related
literature and theories. Section III provides information on the structure of the New
Market. Section IV describes the data used, and section V presents the empirical results.
Section VI concludes.
II Theoretical Basis and Related Literature
The observation that forms the basis for the theoretical predictions in this paper is that
the New Markets discussed above combine an absence of traditional listing requirements
such as age, size and profitability records with strict disclosure rules. For example, the
New Market in Frankfurt sets itself apart from the established exchange by requiring
financial reporting according to international standards instead of the more opaque
German commercial code as well as by increasing the frequency with which firms are
required to report financial information. It also imposes stricter lock-in rules on existing
shareholders than the established exchange (a detailed discussion of institutional facts can
be found in section III).
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These rules can be seen as an attempt to alleviate information asymmetry problems
for investors who have incomplete information about the quality of IPO firms. Given the
stricter disclosure and lock-up requirements, a listing on the New Market can be
interpreted as a signaling device for high firm quality. A precommitment to the New
Market’s strict information rules is very costly to an insider subject to lock-up rules who
has negative information about the future prospects of his firm, as the revelation of this
information becomes more likely. A separating equilibrium where low-quality firms are
discouraged from going public and in which the firms that do go public voluntarily
disclose large amounts of information in turn should attract demand from investors that
rely on such information. It is interesting to observe that demand on the New Market is
driven by small individual investors, who according to newspaper reports hold 50-70% of
the shares traded, compared to 18% on the established markets (Deutsches Aktieninstitut
(1998)). The fact that the New Market seems to disproportionately attract the investors
that rely most heavily on publicly available information gives some support to the
argument above.
Since the signaling device of a listing on the New Market did not exist prior to 1997, a
potential effect of the stricter listing requirements could be to provide a precommitment
mechanism that allows high-quality firms to overcome the effects of asymmetric
information which tend to discourage raising equity capital in the model of Myers and
Majluf (1984). An important element of this process is that violation of the required
information disclosure rules must be costly in order to make the precommitment to
inform credible: simply announcing an open disclosure policy, as was obviously possible
before the New Market was created, has no value if violations of this announcement are
not punished. The New Market commits to strictly enforcing its information
requirements, and has recently forced two firms (Lösch Umweltschutz and Sero) to
change listings to the standard exchange for providing faulty financial information.
Since the effects of asymmetric information are likely to be highest for firms without
established track records and with complex products yielding uncertain cash flows far in
the future, young, high-quality technology firms should benefit most from the availability
of a market segment that allows them to separate themselves from lower-quality
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competitors and thereby achieve a higher valuation of their equity, in turn increasing their
propensity to go public.
This paper is related to different strands of the empirical and theoretical literature. On
the empirical side, La Porta, Lopez-de-Silanes, Shleifer and Vishny (1997) document a
significantly lower number of IPOs and publicly traded firms relative to total population
in countries of French or German as compared to English legal origin. They argue that
the lack of investor protection rights in civil law countries is important in explaining the
small role that equity markets play in these countries. It will therefore be interesting to
see the effects of attempting to increase the role of equity markets in Germany, which
ranks in the lowest quartile of countries with respect to investor rights in their paper. This
is particularly true because no substantial effort was made in Germany to improve
investor rights concurrently with the introduction of the New Market. Specifically, none
of the six key investor rights identified by La Porta et. al. (1997) was changed in
Germany in the time period studied here.
As to characteristics of firms going public, Rydqvist and Högholm (1995) find that
European IPO firms tend to be established firms from mature industries, an observation
confirmed by Pagano, Panetta and Zingales (1998) for the case of Italy. Corwin and
Harris (1998) and Gompers (1996) show that IPO firms in the US are at the opposite side
of the maturity spectrum, with an average age of around 6 years.
Several theoretical papers model the effects of listing requirements established for the
New Market such as increased disclosure and stricter lock-up requirements for existing
owners. In Leland and Pyle (1977), the willingness of individuals with inside information
to commit to an investment in their firm serves as a signal to outsiders about the true
quality of the firm. Diamond and Verecchia (1991) study the general implications of
information disclosure policy and argue that a policy of information disclosure is
beneficial to shareholders since it increases liquidity by attracting the demand of large
investors. Similarly, Diamond (1985) shows that the value of public releases of
information is that they homogenize information and reduce the use of investor resources
to produce information, thereby increasing demand. To the contrast, Yosha (1995) argues
that disclosing information is a disadvantage to firms, since it provides valuable insights
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for competitors and thereby puts the disclosing firm at a disadvantage. He predicts that
high-quality, innovative firms prefer bilateral financing arrangements in order to avoid
disclosure of private information. Cheung and Lee (1995) counter this argument by
showing that given exchanges with different disclosure requirements, listing in the
market with the more rigorous rules might serve as a signal of firm quality. The value of
the signal to a high-quality firm might be sufficiently high to offset the costs resulting
from its disclosure of important private information, which might benefit its rivals.
III New Markets
Several Continental European countries, in an effort to alleviate the paucity of equity
capital for young, small growth firms, have created new equity markets in the past two to
three years. The common characteristic of these new markets is that they combine
leniency with respect to traditional listing requirements such as size, age or profitability
record with rigid reglementation of the information and disclosure rules that firms must
follow before and after the IPO. Specifically, five newly formed European exchanges1
have joined to create EURO.NM, a loose association in the legal form of a European
Economic Interest Group. Interestingly, all five new markets were created by the
traditional exchanges, thus setting a contrast to the fiercely competitive environment in
which NASDAQ squares off with its rival exchange NYSE. In competition with
EASDAQ, an exchange based in Brussels founded in 1996 by venture capitalists,
investment bankers, securities dealers and investment institutions from Europe, Israel and
the US, these New Markets strive to attract firms to equity finance that were previously
either unwilling or unable to raise capital by issuing publicly traded shares.
Beyond giving some cross-sectional evidence using international data, this paper
focuses on the effects of one particular example of a recently founded stock market, the
New Market in Frankfurt. The German economy is often characterized as the prototype
of a bank-based system in which equity finance plays only a marginal role, firms are
financed predominantly through loans obtained from banks with whom they have long-

1 The Nieuwe Markt in Amsterdam, the EURO.NM Brussels, the Neuer Markt in Frankfurt, the Nouveau
Marche in Paris, and (recently) the Nuovo Mercato in Milan
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term relationships and who often hold substantial ownership stakes in the firms, and in
which shareholders in public companies enjoy minimal levels of investor protection. The
bank-based system of finance is prevalent in most countries of Continental Europe, and
contrasts sharply with the Anglo-Saxon system, in which arm’s length debt and equity
markets play major roles. Since the example of Germany is representative for the
financial system of several other European countries, the insights from this paper will be
valuable to understand the effects of a transformation of bank-based systems with low
levels of investor protection towards giving equity markets a larger role.
The Frankfurt New Market was created in March 1997 as an attempt to improve the
flow of equity capital to the small, young technology firms with high growth potential
that very rarely went public in Germany or other Continental European countries. (see
Deutsche Börse AG (1999)). Similar to other European countries that introduced this type
of stock market, the Frankfurt New Market requires no minimum age, size or profitability
record of firms wishing to go public. For the case of Germany, this does not separate the
new from established markets, however: no size or profitability requirements existed and
firms of any age could go public on the second segment of the traditional exchange2 prior
to 1997. The New Market does, however, differ substantially from the established
markets by imposing stricter information and disclosure rules3. Specifically, firms that
wish to list on the New Market must first be admitted on the standard market’s second
segment, and then apply to be listed for trading on the New Market. Beside the disclosure
rules, listing on the New Market also requires firms to prove that they meet the desired
profile of New Market listings. This profile is not defined objectively, but Deutsche
Börse AG (1999) outlines that firms listed are typically expected to have “a strong future
and above-average sales and earnings prospects”. This explicitly does not mean to
exclude firms from traditional industries, which can qualify for listing if they offer new

2 listing requirements on the established first and second segment markets are very similar, so that these
segments will be treated together in the remainder of this paper.
3 In the words of the German Stock Exchange (Deutsche Börse AG (1999)), “Neuer Markt sets far higher
standards than the traditional first and second segment markets. ... A key feature of Neuer Markt is the
exceptional transparency companies show toward investors. Corporations listed in Neuer Markt have a
pro-active stance toward disclosing information to the capital market, favor shareholder value, and respond
actively to investors' information needs”.
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products or services or take an innovative approach to business processes. In practice4
firms wishing to list give a presentation to the listing committee explaining why they fit
the profile of the New Market. The listing committee, after communicating with the
applicant’s lead underwriter, then makes its admission decision. In the past, it rejected
roughly 20% of the applications; the results from this deliberation are highly confidential
and not accessible to researchers.
Specifics of the New Market’s listing requirements are in Deutsche Börse AG (1999).
Key requirements which separate the New Market from the traditional segments are that
IPO firms must publish a more detailed listing prospectus, precommit to publishing
quarterly reports, hold annual analyst meetings and publish their accounts according to
either International Accounting standards or the Generally Accepted Accounting
Standards of the US (US-GAAP). As discussed in section III, both of these accounting
standards, which are very similar to each other, are generally considered to give a more
accurate depiction of a firm’s financial status than the rules of the German Commercial
Code. Further listing requirements specific to the New Market are that only voting shares
can be issued in the IPO and that pre-IPO shareholders must hold their shares for at least
six months after their firm goes public; no such lock-up period exists on the established
market.
IV Data
A Data description
The data used in this paper comes from several sources. I obtain balance sheet data
from Hoppenstedt Publishers, listing prospectuses, Datastream and Global Vantage.
Information on characteristics of the firms going public such as age, venture capital
financing and main business field comes from listing prospectuses. IPOs are identified
using the Factbook of the Deutsche Börse AG, the IPO database of Börse-Online
magazine, back issues of GoingPublic magazine as well Deutsche Morgan Grenfell
(1998). Data on stock market valuations is from Datastream, Global Vantage and the

4 special thanks to Joseph Tobien (Head of Listing, Deutsche Börse AG) for valuable insights on this and
other matters
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German Stock Exchange. Information on IPOs in countries other than Germany comes
from the Federation Internationale de Bourses de Valeurs (FIBV) as well as individual
exchanges.
The database of Hoppenstedt publishers is to my knowledge the most comprehensive
database on German firms accessible to researchers. It covers approximately 6,500 firms,
with data ranging back until 1981. Hoppenstedt uses annual reports, data from the
Bundesanzeiger, where firms fulfilling certain size criteria are required to publish their
accounts, as well as data from the Commercial Registers, to which all limited liability
firms must submit their balance sheets and income statements. I have access to the full
database, but a major change in accounting laws rules out the use of data before 1987.
Also, the number of firms covered in the database increases substantially starting in 1993,
so that I use that year as the start of my sampling period. The data is complete until 1998.
Since the balance sheet information of a given year is used to predict the probability of
going public in the following year, and since I need one year of data to compute sales
growth, I study the IPOs from 1995 until 1999. Since I am only interested in the initial
listing decision, firms are dropped if they were already publicly traded at the start of the
sampling period, and firms are dropped after they go public. Financials and insurances
are also dropped since their balance sheet data is not comparable with the other firms’.
Where applicable, I use consolidated balance sheets. Also, I delete data that was
backfilled after a new firm is introduced into the database as described below. My final
sample covers 15,564 firm-years for 3,875 companies.
Although the database is to my knowledge the most reliable and comprehensive
collection of financial statements data available for Germany, it is not unproblematic for
my purposes.
A first obvious issue is selection bias. There is no question that the database is biased
towards including large firms. A first reason for this is that disclosure requirements vary
according to firm size in Germany. If and to what extent firms are required to disclose
balance sheet and income statement information5 is a function of their legal form of
incorporation, revenues, total assets and number of employees. Also, all publicly traded

5 German firms are not required to file statements of cash flows
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