Information and Capital Markets

Paul HalpernTSE Chair in Capital MarketsRotman School of Management

University of Toronto

1. Introduction:

The purpose of this note is to highlight the importance of information in the functioning

of capital markets. Information is of two forms, that which is publicly available and is

used by investors to make investment decisions and that which is available to only one

party in any security transaction i.e. —asymmetric information. In this note I emphasize

the problems of information disparities and look at its impact on a number of factors in

capital markets: home bias, venture capital, organized exchanges and governance, initial

public offerings, and financial intermediation dynamics.

2. What is meant by ‘Capital (Financial) Markets’?

In a domestic capital market, funds are transferred from surplus to deficit units in the

economy. The term ‘capital markets’ encompasses not only stock and bond markets,

both organized and informal, but also credit markets, venture capital and private equity.

Transactions in these markets can be formalized as in securities exchanges or in

institutions such as a bank or insurance company or can be more informal and include

venture capital and angel financing.

The term ‘capital markets’ is used to refer to both primary and secondary markets. In the

former, transactions involve surplus units and the ultimate user of the funds, frequently

mediated by a financial intermediary such as a financial institution or investment

(securities) dealer. Financial intermediation reduces search costs and in the case of

financial institutions that purchase securities from the user of the funds, places

monitoring responsibilities on the party that is most effective in the activity. There has

been a movement to bypass financial intermediaries and transact directly; examples

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include private equity, private debt, and the issuance of financial instruments over the

internet and certain types of short term financial instruments.

In the secondary market, issued financial securities are traded between parties. These

transactions can be facilitated by a formal securities exchange or informally between

participants in the market. Formal exchanges include those structures that not only list

securities of companies from their involvement in the primary market but also facilitate

trading in the issued securities. Trading organizations that engage exclusively in trading,

called ATS’s and ECN’s, are competitive structures to the standard securities exchange in

the trading function.

The functioning of these two elements in the capital markets is related. Clearly a

secondary market that has depth, market integrity, liquidity and low transactions costs

will provide listing companies a lower cost of capital and assist investors in their desire to

build portfolios and diversify their holdings to achieve a required risk profile.

Recently with the rise of global companies and increased interest in foreign capital

markets, there has been a large international element added to the capital markets.

Companies that met certain standards were always able to issue debt securities in foreign

markets. We now observe companies listing the equity securities on foreign exchanges

and trading by domestic and foreign investors on their exchange of choice.

3. Functions of a Capital Market

The two over-arching functions of a capital market are to allocate resources efficiently

and to provide a governance function for the operations of firms. I consider each in turn.

(i) Allocation of Capital

Capital markets assist in the discovery of prices (or yields) for the securities issued by

entities in the capital market. These prices and yields reflect the risk of the entity and

identify the entity’s cost of capital. Capital markets take these prices as given and capital

is funneled to those entities and projects that can best use it. When capital markets do

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their job properly, investment will go to growing industries; for declining industries,

investment will be reduced. In fact, in the latter situation, sales of assets and a net

reduction of investment can be observed.

In addition capital markets permit risk sharing by piecing out claims to project cash flows

among a number of claimants. As a result of this diversification, companies can

undertake larger investments since risk is not concentrated in one entity. Investors can

structure portfolios that match their risk preferences, through their ability to trade

financial securities in capital markets.

(ii) Governance

Market participants continually evaluate firms that have financial securities trading

capital markets. While this evaluation is more intense at specific times in the company’s

life—financial reporting, new issue of securities, analysts reports—the continual review

by market participants results in security prices (yields) that reflect the underlying value

of the company. In undertaking this function, the market is monitoring the effectiveness

of the users of capital and through the market price, provides a barometer of this success.

A low price can be a signal that the management is not performing well and a precursor

for a takeover bid. Thus the market is an important adjunct to the internal governance that

is provided by the board of directors of the firm.

4. Information in Capital Markets

We consider two types of information: (i) general economy wide information and (ii)

firm specific information. The former is widely available and is interpreted by market

participants in order to evaluate the future performance of financial securities. The latter,

however presents a serious potential problem for capital markets.

The problems relating to firm specific information are its availability to investors and the

possibility of information asymmetries (disparities) between parties in the capital market.

The first issue iswhat information should be provided to investors and in what manner.

The second issue reflects differential information availability about the company’s future

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performance –one party has better information than the other on the true quality of the

company. The asymmetry can be between insiders of the firm and

investors—insiders/managers have better information on the company’s prospects, or

between the investment dealer and the investor—investment dealer has better information

perhaps through contacts with the firm. This asymmetry does not include situations

where superior ability to analyse publicly available data provides an advantage to a

market participant.

If information is not available, stocks will generally have lower valuations and it will be

in the best interests of the company to make information available so as to maximize their

value, even if the information is expected to be harmful to the company. If information

disparities are serious, they will negatively affect participant’s perception of the integrity

of the capital market. As a result there is the possibility of the market having insufficient

transactions to provide liquidity or effective price discovery. Information disparity is a

crucial issue in capital markets and participants in the market attempt to find ways to

eliminate it or at least to price it.

The influence and extent of information disparities will be affected by the rules and

regulations under which parties operate. Formal exchanges, securities commissions and

corporate law introduce these rules and regulations. However, information provision has

a cost and the appropriate amount of information provision and the method of ensuring

information disparities do not impact the market involves a trade-off of benefits to

investors and costs to information providers. A recent study of world capital markets

investigated the importance of various factors in the allocation function provided by

capital markets. The study found the allocative function was positively related to the

amount of firm specific information reflected in stock prices and larger markets had more

informative prices.1

With the growth of the internet and the associated ability of investors, both retail and

institutional, to access firm specific data, will information disparities continue? While

1 Jeffrey Wurgler (2000) “Financial markets and the allocation of capital”, Journal of Financial Economics, 187-214.

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the internet makes information more accessible, it does not necessarily improve its

quality or the quality of the analysis of the data. With lower cost access to information,

quality in interpreting information will become an important factor in capital markets.

Human capital will become as, if not more, important than physical capital. However this

does nothing to reduce the true information disparities where one party by virtue of its

position has more information than another.

5. How do we know information disparities are important?

While the answer seems obvious, there are some interesting observations that

demonstrate the importance of informational disparities and their impact on capital

markets.

First, if information disparities are important, they should have an impact on the

existence of financial securities for certain types of companies and on the types of

securities issued by the company. Note that the security type includes monitoring activity

undertaken by the security holder. In Figure 1 below, I have identified firm types based

on the expectation of information disparities and the security typically found for the firm

type. Information disparities will be at a minimum for large companies that have a

significant analyst following and largest for small companies with little following and

young growth companies where the future of the company is often under the control of

the owner/manager. As can be observed in this figure, as information disparities are

reduced the security types used rely on less direct investor monitoring and generally have

greater liquidity since they are found on public markets.

Second, if information disparities are important, both retail and institutional investors

should prefer acquiring securities where information disparities can be minimized, such

as large firms or firms that have well-known products. For firms that have a high

potential for information asymmetries, investors would want to have first-hand

knowledge of the company. Investing in companies with head offices located near the

investor facilitates the acquisition of this knowledge. When investing in small

companies, companies with high levels of leverage, and hence high risk, and companies

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that produce local goods, investors prefer that the investee company’s head office is

physically close. Investors can improve their information on local companies by talking

to employees, managers, other financial claimants and suppliers to the firm. Additional

information is obtained through local media and personal ties to the executives of the

firms; the latter could result in the selective provision of information! This investor

preference effect is related to location and its impact on the availability of information

and its verification.

Using a sample of U.S. mutual fund investment portfolios and information on the

geographic location of the fund manager and investee companies’ headquarters, Coval

and Moskowitz observed a strong geographic preference for investments in firms that

displayed the characteristics noted above.2 Distance between investors and potential

investments is a key determinant in U.S. mutual fund investment portfolios. Given this

influence in the case of institutional investors, its impact will be more extreme for retail

investors. Regional preferences also extend to investors use of investment managers.

Clients tend to invest with managers who are approximately 30% closer than the average

manager.3

Geography also plays an important role in international portfolio investment. Appearing

to ignore the benefits from international diversification, investors do not hold well-

diversified international portfolios. This ‘home bias’ is greatest in Switzerland and

lowest in Japan. The prevalent explanation for the bias is informational disparities when

investing in foreign markets; this potential is related to the investor’s distance from the

investment and differences in culture and language. Home bias is also explained by costs

to foreign investments and restrictions on foreign investments through government

regulation; these factors, however, do not explain the extent of the home bias.4 .

International equity flows for portfolio investment are based on differences in

informational endowments between foreign and domestic investors. Since domestic 2 J. Coval and T. Moskowitz (1999), “Home Bias at Home: Local Equity Preference in Domestic Portfolios” Journal of Finance, December, 2045-733 see citation in Coval and Moskowitz4 With the pervasiveness of the home bias, one wonders why the foreign property rule was even necessary.

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investors are better informed about payoffs on domestic market than are foreign

investors, you would expect investments by the latter to be in companies that are large

and well known internationally. In Japan foreign investment is concentrated in the

largest firms.

As an example of the importance of information disparities and the impact of distance,

consider the Mexican stock market where domestic firms issue class A shares, held by

citizens, and class B shares held by foreigners. It was observed that company events that

should impact share prices and share volumes did so first for class A shares and then for

class B shares.5 The share price and volume reactions for A shares occurred before the

events and with a lag for the B shares. After considering and eliminating a number of

other possible explanations, the authors of the study investigating this issue concluded

that the lack of enforcement on insider trading rules and the importance of physical

proximity and domestic knowledge resulted in markets that lacked integrity—a major

concern for international investors.

5 U. Bhattacharya, H. Daouk, B. Jorgenson, D-H Kehr (2000) “When and event is not an event: the curious case of an emerging market”, Journal of Financial Economics, 69-101

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6. Implications for Capital Markets

(i): Venture Capital

Venture capital is rife with information disparities and other high risk elements. To

address these risks, there is a ‘home bias’ in the sense that venture capital organizations

and investment bankers dealing with venture capital generally are located close to each

other and close to the physical operations of the investee companies. This location

preference permits direct discussions with the investee companies to obtain current

information, to be involved in the local venture capital network in which information is

often obtained on an informal basis and to be in place to react to fast paced events.

Distance is important in the determination of the board composition of investee

companies; venture capital organizations that are physically close to the investee

companies are more likely to provide board members than venture capital organizations

more remote. With the necessity for close monitoring, ongoing international Venture

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Capital investments on a large scale are unlikely to occur. When they are observed, it is

usually a result either of the use of informational agents (local entities) who do the

monitoring and information gathering for the international, remote investor or as a result

of an excess supply of funds and the need to do deals where the monitoring function is

downplayed.

With the influence of home bias it is surprising that investments in venture capital has

been proportionally less in Canada than in the United States. While this could have been

a result of the supply of projects, this does not appear to be the case currently. Domestic

funds for venture capital have increased dramatically in Canada but these increases have

not kept place with those in the U.S. To maximize the potential for domestic financing

changes need to be made to improve this market or the Canadian economy will have too

little investment in this area. There are a number of areas that could improve this market.

Improved income tax laws that will make investments in venture capital more

profitable.

Improved exit options through a reduction in the cost –direct and regulatory

induced—of going public.

Improving the functioning of labour sponsored venture capital funds.

(ii): Organized Exchanges

Circumstances facing organized exchanges have changed dramatically over the past few

years. Members of organized exchanges have recognized that they must operate as a

business in a competitive environment. Competition has increased both domestically and

internationally. As organized exchanges reorganize, demutualize and in some situations

issue equity and become publicly listed companies, they face the same challenges as

companies in other industries facing major change. In the exchange situation, the change

is fueled by technology, both on the trading side and on information availability. Stock

exchanges have two businesses, obtaining listings of both domestic and foreign

companies and trading securities of listed firms. There is competition in both elements.

With the competitive environment, the unthinkable has occurred in the organized stock

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exchange area, consolidation either through hostile takeovers, mergers and acquisitions or

joint ventures and strategic alliances.

Exchanges are able to determine important attributes of their business and these can be

used as competitive advantages in attracting listings and trading. Examples include

listing requirements and conditions on securities transactions (the regulatory aspect of the

business), technology for trading and settlement and clearance, transactions costs and a

very important by- product, market liquidity and market depth. Liquidity is the lifeblood

of the exchange and it is affected by perceived market integrity i.e. the impact of the rules

in place to ensure that participants in the market are on an equal footing and their

enforcement. Without liquidity markets will not function and will wither—for example

the new European high tech stock markets are facing a problem with maintaining

liquidity in the markets. With the return of the retail investor in North American markets,

market integrity has become increasingly important.

With the home bias in domestic markets, investors will continue to invest in domestic

securities and domestic companies will continue to list and issue new securities.

However, transactions by foreign investors and firms on domestic exchanges will remain

small. Although domestic exchanges will continue to operate, will they be ‘regional’

catering to the local market or will they attract new listings and investors beyond

Canada?

For small firms, firms with high leverage, and firms producing ‘local’ products,

information asymmetry remains a problem and home bias will be a determining factor in

listing and trading decisions. A domestic exchange catering to these firms will be

successful since investors providing funds are more likely to know the players either

directly or through reputation intermediaries. However, to increase trading activity from

foreign investors, this exchange will need to identify ways to reduce information

disparities and build confidence in the functioning of the exchange.

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As the size of the firm increases and company products are sold around the world, home

bias is less important and investors need not be primarily local. However, these larger

firms may be able to list on foreign markets since they are known in those economies and

trading will take place off the domestic exchange. Therefore a domestic exchange will

have problems keeping sole listing for many of its larger companies. In order to attract

foreign listings and foreign investors, to maintain domestic firms’ listings and domestic

investors’ trading, and to provide a liquid market, the exchange will have to find

competitive niches. The exchange will compete on listing fees, quality of services, level

of regulation, integrity of the market and technology. With the existence of economies of

scale, especially in technology, an increase in size perhaps through alliances is essential.

What will be the impact on economic growth in Canada if capital markets do not change?

Will firms have trouble raising funds to finance needed growth? At the two extremes of

firm size, there is unlikely to be a problem. Firms with internationally recognized

products or operations and sufficient size to have a non-domestic analyst following will

be able to find capital in larger, more liquid foreign markets. The small firm for which

local information is important will also obtain funds on the domestic market. The

problematic area is the set of firm in the middle who may have to pay higher capital costs

to obtain capital on the domestic market.

Exchanges can establish criteria for listing firms and for trading in securities in an

attempt to identify a particular niche regarding market quality. While securities and

corporate law provide a set of standards, exchanges can set standards and thereby send a

signal to market participants, both domestic and foreign, of the commitment to certain

issues of market integrity. By choosing a set of standards, they will attract companies and

investors for whom these standards are important. However, in choosing the standards,

the exchange may eliminate a part of the market that finds the standards restrictive. These

investors/firms may be able to list/trade in other venues or through other means.

One example where an exchange can establish a standard is the decision to list a

company that has a dual class share structure. Like most capital markets in the world,

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apart from U.S. and U.K., there is concentrated ownership in Canada—the widely held

company is the exception and not the rule. Concentration and its related control of the

corporation is observed either through the ownership of cash flow rights or through

concentration of voting rights which are in excess of the cash flow rights. In the former,

the major shareholder owns a significant proportion of the equity of the firm. In the

latter, control rights are concentrated but cash flow rights are not. This result is achieved

either through dual class shares or pyramid holdings. Concentrated holdings, through

either structure, can lead to issues of minority shareholder rights and concerns of

expropriation of shareholder value. However, dual class shares present potentially

greater problems than concentration of ownership of cash flow and voting rights. The

result can be a lower market value for firms with these structures.

There are situations where dual class shares are value maximizing. For example the

founder of a new company may need funds to expand and does not want to give up

control. Debt is unavailable sufficient amounts and issuing the lower voting class equity

will provide the funds without diluting control. In these situations the exchange can

require companies to have a sunset provision on the restricted voting share. In other

situations the dual class structure is formed to simultaneously reduce the investment by

the founder or family members, maintain control and lower the owner’s risk of a large

undiversified portfolio.

While the problems of dual class share structures have been discussed in detail, they stem

from the potential problem associated with abusing minority shareholder rights. These

problems are highlighted in a study in which it was observed that the allocative function

of capital markets was improved with the presence of minority rights and strong minority

investor rights appeared to curb overinvestment in declining industries.6

Concentrated ownership presents problems but finding solutions is difficult. Normal

responses such as the takeover market, capital markets, and internal governance are 6 Jeffrey Wurgler, op. cit. The study compared markets around the world, some of which were not well established and either had limited minority rights provisions or if they existed, were not enforced. Even though Canada does have minority shareholder rights, it is not obvious that firms that have dual class structures have no performance problems.

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ineffective. All that is left is the product market, which takes a long time to resolve the

problem. One solution to the dual class share problem is an internal one where firms

decide to eliminate the structure in order to increase share value. A number of companies

have taken this route. An external solution is to introduce a listing requirement that dual

share structure companies will be listed only if there is a sunset clause. This would be a

drastic and dramatic move that would affect a large number of companies that have no

desire to alter their structure. However, regulations in other countries have required the

removal of dual class share structures over a stated period time. This is a radical change

for the Canadian market. The problem, if it is severe enough, will be resolved through

attrition of the poorly performing dual class companies. However, this is a slow process

and during the interim period capital allocation, valuation of companies and the capital

market are affected.

Other governance related listing requirements could include an increased number of

independent board members who could monitor the company performance more

effectively and eliminate information disparities; these changes would lead to higher

share values. The companies affected by this change would cover the whole range of

ownership structures, not just closely held or dual class. The research literature on this

topic is primarily U.S. based and reflects impacts on the widely held company. The

empirical results are mixed showing an impact on behaviour of the company but not on

the share price. This result is similar to findings on the impact of activist shareholders.

The empirical evidence on the impact on Canadian company performance of independent

directors would be very interesting given the concentration of ownership and the

difficulty of independent directors in contradicting the majority owner.

(iii) Performance of Initial Public Offerings

An important element in venture capital financing is the exit option and one highly

publicized exit alternative is the initial public offering (IPO). There is a substantial body

of academic research on the short and long run performance of initial public offerings of

equity. Although the evidence is consistent with poor long run performance, there

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remains a debate in the literature whether what is being observed is a function of an

inappropriate benchmark or the result either of asymmetric information between investors

and firm management or the potential waste of new funds brought into the firm. To

address the latter issue, research on secondary offerings has been undertaken. The long

run performance observation of IPOs is consistent across stock markets in many

countries. Another strand of academic literature investigates firm performance by

looking at corporate governance issues, primarily the concentration of voting power.

An unanswered question is the extent to which the performance of IPOs is related to firm

specific characteristics such as concentration of voting power, share structures,

information disparities etc. The answer to this question will assist in making the IPO

market more efficient, providing more funds into the hands of the entrepreneurs and

perhaps finding new and more effective ways to undertake IPOs.

(iv) Financial Intermediation Dynamics

The traditional role of financial intermediation has been evolving for a number of years.

In the past, suppliers of funds, either as individuals or collectives (pension funds), would

purchase deposits or certificates from banks or securities issued through investment

dealers. Increasingly, there are direct linkages between suppliers and users of funds.

With the growth and effectiveness of technology, direct security issues of debt and equity

are becoming more common. These issues typically are cheaper to undertake but are

limited in scope at the moment. The ability to undertake these transactions and their

success will depend upon security regulation and information available on the company

undertaking the issue. At this point of time these issues usually are usually by companies

that are information rich or for securities that are not as information sensitive.

With the increase in information availability and the potential cost savings by the use of

this method, should regulation become more accommodating to these issues? Will the

applicability of this form of security issue be focused on those securities that have

characteristics that would minimize the home bias issues noted in previous sections?

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