Determinants of corporate tone in an initial public offering: Powerful CEOs versus well-functioning boards

doi:10.1016/j.ribaf.2021.101481

Research in International Business and Finance

Volume 58, December 2021, 101481

https://doi.org/10.1016/j.ribaf.2021.101481 Get rights and content

Abstract

Recent literature on initial public offerings (IPOs) suggests a significant effect of tone in IPO underpricing but ignores its determinants. This study concentrates on the factors that shape the tone of the information disclosed in IPOs. Sampling 211 Latin American IPOs during the period 2000–2019, we find empirical evidence that a powerful CEO can influence tone, avoiding unfavorable tone and fostering the use of positive words in the information disclosed to the market. We also show that more independent boards tend to use more unfavorable tones. Additionally, we find a non-monotonic relationship between board size and the tone in the prospectus, which suggests that an optimal board size mitigates the excessive use of positive tone and leads to more unfavorable tones in the IPO prospectus. Overall, well-functioning boards counterbalance powerful CEOs and generate more realistic disclosure to the market. Finally, we find that market-dominant auditors, age of the issuing firm, proposed use of proceeds, and the number of risk factors significantly affect the tone in the information disclosed.

Graphical abstract

Introduction

Agency problems become greater once an entrepreneur decides to sell some part of their firm to outsiders (Jensen and Meckling, 1976). Specifically, when a firm decides to go public via a primary share offering, adverse selection and moral hazard problems may arise. An initial public offering (IPO) is a critical moment as it results in the separation of ownership and control of a firm. This separation can affect the way investors value the IPO (over or undervaluation) and the firm’s future performance. The problems are associated with information asymmetries between insiders and outside investors and the alignment of interest among managers and shareholders.

These problems are a major concern in Latin America when considering the role that capital markets play in economic growth (Levine, 2005). The region has lagged behind others regarding the regulatory environment and shows limited development of its capital markets compared to others. This fact might force firms to develop signaling mechanisms to attract capital from investors (Chong and Lopez-de-Silanes, 2007). Corporate governance, specifically information disclosure, can be used by firms to reduce information asymmetry and obtain better asset valuation, thus compensating for a weak institutional environment and poor investor protection (La Porta et al., 2006; González et al., 2020).

Additionally, recent research has shown that the level of information disclosure and the tone used in corporate communications matter for a firms’ valuation. For example, Loughran and McDonald (2013) and Brau et al. (2016), for the U.S., and González et al. (2019), for Latin America, found a direct relationship between tone in the IPO prospectus and underpricing. Specifically, González et al. (2019) showed that tone matters after including firms’ governance, financial, industry, and other control variables. In addition, González et al. (2021) found that tone in annual reports impacts a firms’ value. Nevertheless, despite the relevance of tone, little is known about its determinants.

Given the importance of tone (González et al., 2019, 2021), this paper goes further by considering its determinants in corporate communications, specifically through IPO prospectus in Latin America. We speculate that the tone used in the IPO prospectus, being the firm’s first contact with the stock market, is crucial for the issuance’s success. Sampling 211 Latin American IPOs during 2000–2019, we first followed an empirical approach to obtain a descriptive analysis of the language in the prospectus via the identification of patterns in texts. We are interested in the demonstration of language in its written form as a proxy for meaning. Furthermore, in a multivariate analysis setting, we studied the determinants of tone in IPO prospectuses.

Performing the descriptive analysis of the language in an IPO prospectus, we first choose the most relevant sections in terms of qualitative information; these are the summary and risk factors sections. Other elements of the IPO prospectus, such as the financial sector and other firms’ specific data, industry overview, ownership structure, and glossary, convey more factual and quantitative information and are less heterogeneous and informative for tone.

As expected, an unfavorable tone is more prevalent in the risk factor section than in the summary section; and the reverse is true for positiveness. Hence, our analysis shows that these two sections differ in terms of tone within the same prospectus. Additionally, an analysis of the risk factors section across different prospectuses did not reveal significant differences in tone, suggesting that firms convey this type of information in standard ways. Therefore, consistent with previous literature (González et al., 2019; Ferris et al., 2013; Hanley and Hoberg, 2010), we can conclude that the prospectus’s most informative part is the summary section.

Regarding the determinants of tone and using its measures in the summary section, we found that powerful CEOs (those who are also chairman of the board) avoid unfavorable tone and use positive language. Although it could be argued that any CEO will use positive words to promote their firms, from the agency perspective, CEO duality is a proxy of CEO entrenchment. Entrenched, powerful CEOs have more private benefits to lose if investors significantly underprice the IPO, leading to a potential CEO turnover. Hence, powerful CEOs are understandably more prone to use a positive tone with less uncertainty in the IPO prospectus.

Concerning corporate governance structure, we show that more independent boards lead to the use of a more unfavorable tone in the information released to investors but have no effect on the positivism of this information. Moreover, we found a non-monotonic relationship between board size and the prospectus tone, which suggests an optimal board size that allows the firm to avoid an excessively positive tone in the IPO prospectus and to use a more unfavorable (realistic) tone in the process of disclosing information. Overall, well-functioning boards counterbalance powerful CEOs in the preparation of IPO prospectuses more accurately and conservatively. We also report that market-dominant auditors, age of the issuing firm, proposed use of proceeds, and the number of risk factors significantly affect tone.

This paper contributes to the growing literature regarding tone in corporate communications in the field of financial economics (Loughran and McDonald, 2013; Ferris et al., 2013; Brau et al., 2016; de Souza et al., 2019d; González et al., 2019, 2021; Wang et al., 2021; Reid et al., 2021; Duan et al., 2021). As far as we know, this paper is the first to analyze the determinants of tone in corporate communications by specifically using the IPO prospectuses. Our results show the relevance of corporate governance mechanisms in shaping the way firms communicate with their stakeholders.

Additionally, we show the tension between the boards and powerful entrenched CEOs through the information disclosed in the IPO prospectus. On the one hand, entrenched CEOs foster the market attention to the IPO and, therefore, their reputation. It is also true that an unsuccessful IPO will increase the probability of their dismissal and loss of control. On the other hand, we show that independent directors influence misleading information by CEOs and offer a more realistic IPO assessment to the market. Overall, we highlight the relevance of a proper balance of power in corporate governance at the firm level to guarantee more accurate information for outside investors, especially in terms of board size and independence.

The rest of this paper is organized as follows. We first review the literature and develop our main hypotheses. Next, we describe the data used and perform a linguistic analysis. We then analyze the determinants of tone in Latin American IPO prospectuses. Finally, we conclude.

Section snippets

Corporate governance at firm level and tone in IPOs prospectuses

Transparency practices and, hence, corporate communications are a key component of corporate governance (Morey et al., 2009; OECD, 2015; Patel et al., 2002). Therefore, the quantity and quality of information that firms reveal to the market and the tone used could be affected by corporate governance arrangements at the firm level. Further, there is a natural tension between the board of directors and CEO, attributable to the board’s supervising role (Fama and Jensen, 1983; Weisbach, 1988).

Analysis of tone in Latin American IPOs

Our data is described in Table 1. The full sample is based on information collected across 1990–2019 and is composed of 521 prospectuses. Analyzing preliminary data, we observed a huge concentration of IPOs during 2000–2019, with 459 prospectuses compared with 62 during 1990–1999. We decided to work with IPOs across 2000–2019 because (a) these are representative of the full sample, (b) the more homogeneous structure of the prospectuses facilitates further analysis, and (c) access to the

Determinants of tone

This section considers the determinants of tone in the Latin American IPO prospectuses. We ran an Ordinary Least Square regression model with the following structure: $Y_{i} = α + β_{k}^{'} {GV}_{i} + δ_{k}^{'} {CV}_{i} + φ_{k}^{'} {CC}_{i} + ε_{i}$ where $Y_{i}$ is the tone measure in the summary section (positive or unfavorable); ${GV}_{i}$ is the vector of governance-related variables: CEO duality (CEO Director), the number of directors (Board Size), and Board Independence $. {CV}_{i}$ is the vector of control variables, including the financial and the firm’s

Conclusion

This paper studied the prospectus issued during an IPO and its role in reducing information asymmetry between buyers and sellers of new assets. We focused on the qualitative information disclosed by the prospectus, specifically in the sections labeled “risk factors” and “summary.” Using a statistical approach to natural language processing, we found empirical evidence of dissimilarity between the two sections. This dissimilarity can be found in the tone used to describe the nature of the

Author statement

All authors contributed equally to this work.

References (57)

C.S. Armstrong et al.
Do independent directors cause improvements in firm transparency?
J. Financ. Econ.
(2014)
B. Black et al.
The effect of board structure on firm value: a multiple identification strategies approach using Korean data
J. Financ. Econ.
(2012)
A.L. Boone et al.
The determinants of corporate board size and composition: an empirical analysis
J. Financ. Econ.
(2007)
J. Céspedes et al.
Ownership and capital structure in Latin America
J. Bus. Res.
(2010)
S. Cheng
Board size and the variability of corporate performance
J. Financ. Econ.
(2008)
J.L. Coles et al.
Boards: does one size fit all?
J. Financ. Econ.
(2008)
J. Dahya et al.
Dominant shareholders, corporate boards, and corporate value: a cross-country analysis
J. Financ. Econ.
(2008)
J.A.S. de Souza et al.
The linguistic complexities of narrative accounting disclosure on financial statements: an analysis based on readability characteristics
Res. Int. Bus. Financ.
(2019)
Y. Duan et al.
COVID-19 sentiment and the chinese stock market: evidence from the official news media and Sina Weibo
Res. Int. Bus. Financ.
(2021)
T. Eisenberg et al.
Larger board size and decreasing firm value in small firms
J. Financ. Econ.
(1998)

U. Garay et al.

Internet-based corporate disclosure and market value: evidence from Latin America

Emerg. Mark. Rev.

(2013)

M. González et al.

What you say and how you say it: Information disclosure in Latin American firms

J. Bus. Res.

(2021)

A. Guzmán et al.

How institutional development news moves an emerging market

J. Bus. Res.

(2020)

M.C. Jensen et al.

Theory of the firm: managerial behavior, agency costs and ownership structure

J. Financ. Econ.

(1976)

H. Kim et al.

Business risk disclosure and firm risk: evidence from Japan

Res. Int. Bus. Financ.

(2018)

L. Klapper et al.

Corporate governance, investor protection, and performance in emerging markets

J. Corp. Financ.

(2004)

R. Levine

Finance and growth: theory and evidence

Handb. Econ. Growth

(2005)

T. Loughran et al.

IPO first-day returns, offer price revisions, volatility, and form S-1 language

J. Financ. Econ.

(2013)

C.P. Maquieira et al.

Theory and practice of corporate finance: evidence and distinctive features in Latin America

Emerg. Mark. Rev.

(2012)

M. Morey et al.

Does better corporate governance result in higher valuations in emerging markets? Another examination using a new data set

J. Bank. Financ.

(2009)

B.D. Nguyen et al.

The value of independent directors: evidence from sudden deaths

J. Financ. Econ.

(2010)

S. Patel et al.

Measuring transparency and disclosure at firmlevel in emerging markets

Emerg. Mark. Rev.

(2002)

M. Reid et al.

The role of financial journalists in the expectations channel of the monetary transmission mechanism

Res. Int. Bus. Financ.

(2021)

A. Shleifer et al.

Management entrenchment: the case of manager-specific investments

J. Financ. Econ.

(1989)

C. Wang et al.

Textual sentiment of comments and collapse of P2P platforms: evidence from China’s P2P market

Res. Int. Bus. Financ.

(2021)

M.S. Weisbach

Outside directors and CEO turnover

J. Financ. Econ.

(1988)

D. Yermack

Higher market valuation of companies with a small board of directors

J. Financ. Econ.

(1996)

F. Bertoni et al.

Board independence, ownership structure and the valuation of IPOs in continental Europe

Corp. Gov. Int. Rev.

(2014)

Cited by (8)

The effect of annual report narratives on the cost of capital in the Middle East and North Africa: A machine learning approach
2022, Research in International Business and Finance
Citation Excerpt :
First, more effort is needed to encourage bank managers in the MENA region to increase both the quality and quantity of their annual report narratives. This could be accomplished through regulators, who should find mechanisms to improve the quality of banks’ corporate governance systems in the MENA region, which could lead to an improvement in banks’ narrative reports (Grassa and Chakroun, 2016; Grassa, Moumen, and Hussainey, 2020; González et al., 2021). Second, our findings inform regulators about the benefits of improving the quantity and quality of banks’ narrative reports to investors and disclosing firms.
This paper contributes to accounting literature by reexamining the impact of the quantity and readability of annual report narratives on cost of capital. This study employs a machine learning technique, namely, the model-based (MOB) recursive partitioning, while the least absolute shrinkage and selection operator is used to select variables from a sample of 720 bank–year observations from eight Middle Eastern and North African countries between 2008 and 2019. The model-based (MOB) recursive partitioning works with local and global models to explore hidden information in the data that leads to better results in both linear and nonlinear relationships. Our analysis shows that, on one hand, the readability of annual report narratives has an insignificant impact on cost of capital. On the other hand, it shows that the greater the amount of narrative disclosure, the lower the cost of capital, a result that varies between countries and according to corporate profitability.
Do financial performance indicators predict 10-K text sentiments? An application of artificial intelligence
2022, Research in International Business and Finance
Citation Excerpt :
Firms’ financial performance boosts the managerial confidence/optimism that ultimately translates into managerial decisions and public communications, as managerial ability is positively related to the readability of narrative disclosure of 10-k reports (Hasan, 2020). González et al. (2021) suggest that powerful CEOs can influence the tone of information disclosure to the market by avoiding negative tones and disseminating positive words. In addition, powerful managers can also reduce the readability of financial reports by making them more complex.
In this study, we employ Natural Language Processing (NLP), a subdomain of artificial intelligence (AI), to predict the sentiments while analyzing 3729 annual 10-k financial reports of S&P 500 companies over the 2002–2019 time period. Our findings suggest that the firm’s financial performance indicators help reduce negativity in the textual part of 10-ks. In contrast, we do not observe any significant association between the firm’s financial performance indicators and 10-ks positivity. Our findings are robust to alternative econometric specifications and alternative measures of key variables. Our results contribute to the accounting and financial disclosure literature by indicating that corporate financial performance indicators can predict the tone of 10-k filings.
Do at home as Romans do? CEO overseas experience and financial misconduct risk of emerging market firms
2022, Research in International Business and Finance
Recent CEO scandals suggest that CEOs’ overseas experiences might relate to financial misconduct risks, but there is little evidence as to whether and how CEOs’ overseas experiences affect it. Given the increasing trend on hiring CEOs with overseas experiences in emerging markets, we fill in the gap in the literature by examining the financial misconduct risks of these particular CEOs based on Chinese firms. In sum, we find that firms hiring CEOs with overseas experiences have relatively low financial misconduct risks. Further, we find that firms hiring CEOs who worked or received education in host countries that show large differences from the home country, in terms of the economic or cultural environment, have lower financial misconduct risks. Cross-sectional tests show that the effects are more pronounced in firms hiring younger CEOs. These results indicate that CEOs’ overseas experiences will mitigate a firms’ financial misconduct risks by enhancing corporate governance efficiency.
The informational role of analysts’ textual statements
2022, Research in International Business and Finance
Citation Excerpt :
A detailed analysis of analysts’ textual opinions contributes not only to existing studies on the informational role of financial analysts but also to research regarding the value of textual information in financial markets. Recently, an increasing number of financial studies have performed textual analysis on a wide variety of texts, such as corporate disclosures (e.g., Henry, 2008; Li, 2010; Loughran and McDonald, 2011; Rogers et al., 2011; Price et al., 2012; Ferris et al., 2013; Jegadeesh and Wu, 2013; Arslan-Ayaydin et al., 2016; Maximiliano et al., 2021), media articles (e.g., Tetlock, 2007; Tetlock et al., 2008; Engelberg et al., 2012; Garcia, 2013), and internet posts (e.g., Antweiler and Frank, 2004; Das and Chen, 2007; Bollen et al., 2011; Curtis et al., 2016; Bartov et al., 2018; Chao et al., 2021). The empirical analysis of analysts’ textual statements is expected to provide further robust evidence regarding the value of qualitative (textual) information in financial markets for the following reasons.
This study explores the reasons why textual tones in analysts’ reports, a representative qualitative content of analysts’ reports, possess informational value. We predict that analysts use textual statements to disclose fundamental information that is not reflected in their quantitative outputs. Consistent with our prediction, we find that tones predict subsequent revisions in earnings and sales forecasts. Furthermore, the results show that the information contained in the tone differs among analysts with different incentives to utilize the textual statements, supporting the intentional disclosure story. In addition, the lead-lag relationship between textual and quantitative outputs induces a gradual price adjustment to the information contained in the textual statements.
Does the appointment of the three musketeers reduce IPO underpricing? global evidence
2023, Eurasian Business Review
Equivalent Sentiment Measures for Cross-Language Analysis of Corporate Communications
2023, SSRN

View all citing articles on Scopus

View full text