Over the recent years, ESG practices have gained momentum and garnered the interest of investors and stakeholders.
Several private companies have responded to the demand for ESG transparency by constructing proprietary ESG ratings.
The exposure of firms’ ESG-related risk management activity through rating and the visibility of the companies to stakeholders and potential investors prior to going public oblige firms to remain, if theywere, ESG responsible or to reevaluate their practices and comply if they did not in order to obtain the social license to operate.
Our empirical findings robustly support the hypothesis that firms’ ESG rating by specialized agents prior to their IPO leads to higher underpricing of the issue (Ha). The mechanism at work is the positive market response, which reveals the materiality of the ESG rating. Such a reaction is validated, first, by higher abnormal returns for a period after the IPO; second, by the use of IPOs proceeds, which are channeled by ESG-rated issuers to real investment and debt redemption and are not stockpiled as cash for opportunistic purposes; and third, by the better long-term financial performance of ESG-rated issuers compared to non-ESG-rated issuers. Further, before going public, ESG-rated firms are found to suffer less from agency costs than ESG-unrated firms. They also attract investors who are financially sophisticated and characterized by a long-term orientation. Altogether, our results support in a consistent way that investors’ response to ESG-rated equity issuers does not suffer from any affection bias. Instead, they invest in ESGrated firms based on firms’ potential rather than on sentiment.
This table reports estimates of Equation (1) excluding years 2007, 2008, and 2009 from the sample. Panel A presents results of OLS in column (1), Heckman in columns (2) and (3), and IV in columns (4) and (5) regressions modeling the determinants of the IPO returns. The dependent variable is the log(Underpricing + 1), defined as difference of closing minus offer price to offer price. All regressions include year and industry (one-digit SIC code) fixed effects. Reported intercepts represent the average value of the fixed effects. For the first stage of the IV estimation (column 4), the Wald (the weak instruments’) test is 14.22 and the corresponding p-value is 0.010. Panel B presents the estimates of Equation (1) in matched samples based on three matching methodologies (nearest neighbor, kernel, and stratification). The Appendix provides detailed definitions of all variables. Heteroscedasticity-robust standard errors are reported in parentheses. *, **, and *** indicate significance at 10%, 5%, and 1%.
We, therefore, do not espouse the viewpoint of Dutordoir et al. (2018), who despite documenting a positive association between CSR performance and stock price reaction to SEOs find that (high) CSR scores mislead shareholders into attributing value-increasing motives to seasoned equity issues.We suspect that our results differ from those of
Dutordoir et al. (2018), mainly because of the period of investigation and the type of eventwe examine. As the authors mentioned, the peak of the offerings in their sample took place in 2009. In contrast, only 5.3% (Table 1, Panel A) of our sample IPOs took place during the years 2008 and 2009—the “heart” of the global financial crisis. What is noteworthy, however, is that for a quarter of the issuers there was ESG-related information available, indicating that such firms were able to raise equity in difficult financial circumstances, pointing to the trustworthiness of ESG-oriented management.
The credit crunch during a financial crisis may have spurred more firms to seek equity through SEOs instead of debt financing, and this is usually the case in SEO studies (Dutordoir et al., 2018; Feng et al., 2018). During crisis periods, only financially sound companies (either high- or low-CSR) are able to raise equity financing, and such firms may hold cash for precautionary rather than opportunisticmotives, slowing down real investment due to uncertainty.
Perhaps, the exclusion of the unusual situation in 2008 and 2009 could be more revealing about the true motives of managers concerning firms’ CSR.
Our finding of the higher underpricing of ESG issuers is seemingly in contrast to Feng et al.’s (2018), who support that firm-level CRS activities associate with lower underpricing at the SEOs. The authors find that highly CSRconscious issuers have significantly higher announcement returns than issuers with poor CSR ratings, and they argue that ethical issuers have an incentive to provide extensive and informative disclosures, which mitigate the degree of information asymmetry, thereby decreasing SEO underpricing.
We argue that our results and those of Feng et al. (2018) are not very different in essence. At the IPO, the offer price is set prior to the market feedback effect, which takes place at the closing of the first day of trading; therefore, the offer price is not affected by the market response (Eckbo et al., 2007). A noteworthy aspect of IPOs is the substantial information disparities between IPO participants. When it comes to public firms, investors are often familiar with seasoned equity issuers due, in part, to required periodic disclosures. In contrast, private firms do not have the same disclosure history and, therefore, suffer from greater information disparities. In this respect, ESG information available prior to a firm going public acts as a trust-enhancing mechanism, which is crucial in uncertain environments and, therefore, makes the market willing to pay a premium (Lins et al., 2017) for ESG-rated firms—even during a severe crisis of confidence; this drives the closing price up, creating potentially higher underpricing. In contrast, at SEOs, market feedback takes place at the announcement date of the SEO, which is prior to the setting of the offer price. If quality CSR issuers receive positive market feedback at the SEO announcement date, as the positive returns documented in the studies of Feng et al. (2018) and Dutordoir et al. (2018) indicate, then quality CSR firms have an incentive to raise the offer price and, therefore, reduce the underpricing of the issue. Consequently, the seemingly divergent results between Feng et al. (2018) and our study are attributed to the different nature of the IPO and SEO events. Despite the different workings of the IPO and SEO mechanisms, in both events the market reacts positively to quality ESG (or CSR) issuers by higher underpricing at the IPO and lower underpricing at the SEO. Both reactions converge to a common conclusion: a responsible firm attitude is a value-creating attribute that the market recognizes and rewards in both events. Our findings corroborate with those of Feng et al. (2018) when we further consider the SEO performance of firms in our sample and document a lower underpricing of the SEO issue for the ESG-rated issuers compared to the ESG-unrated ones.
A recent study that is closer to ours, as it is the only study in the literature thus far to examine the role of ESG on IPO underpricing, is that of Baker et al. (2021). The authors examine the effect of government ESG ratings on IPO underpricing for a panel of 36 countries based on the supposition that ESG government rating is a good proxy for firmlevel ESG policies; they find that underpricing tends to be lower in countries with stronger risk management practices.
Aggregate cross-country evidence, however, applies to the “average” firm and may mask important variation across firms’ ESG activities within the same country. Especially in countries where legislations about ESG firms’ practices are not mandatory, the heterogeneity of firms’ responses to conform with the government’s ESG paradigm may vary considerably.
For example, two countries with the same ESG government score may have very different firm-specific ESG distributions, and consequently, IPO underpricing. Also quite different may be the distributions of rated and unrated (though equally good) firm-level ESG performances. This is exactly what our study purports to add to the literature: a finer, when it comes to the level of analysis, look at the subject matter by specifically focusing not only on the quality of ESG practices but also on their visibility in firms’ pursuance of external finance.
Finally, our results are in line with those of Deng et al. (2013), who document that investors correctly use quality CSR as an indicator of merger quality in their reaction to M&As and that high-CSR bidders effectively have better operating performance following their deals. Our findings also align with Ferrell et al. (2016), who find a positive relation between CSR and value and that qualityCSR attenuates the negative relation between managerial entrenchment, with Hartzmark and Sussman (2019), who show that sustainability is viewed as something positive that predicts future performance, and finally, with Starks et al. (2017) on the preferences of long-term investors toward firms’ high-ESG performance.
