Is A Better than B? How Affect Influences the Marketing and Pricing of Financial Securities

Abstract

Culture and experience associate A with superior quality. In the marketing of dual-class IPOs, issuers are mindful of this preference. For years after IPO issuance, inferior voting rights shares labeled Class A enjoy higher market valuations and smaller voting premiums than do Class B shares.

A evokes a more positive feeling than B among many people. This phenomenon is the affect heuristic observed by psychologists. The affect for A is a result of both culture and experience. A is associated with superior quality—for example, Grade A eggs or honey, a grade of A in school, A rated bonds, or A journals. In our study, we asked whether participants in the financial market, such as issuers and underwriters, have exploited the affect for A over B in the marketing and pricing of financial securities. We conducted a natural experiment involving dual-class shares, which are otherwise similar shares issued by the same company but with different voting rights. A typical example is a class with 1 vote per share and another class with 10 votes per share, with both having equal cash flow rights. The former class comprises shares with inferior voting rights, whereas the shares in the latter class have superior voting rights. Companies that issue dual-class shares can choose to designate one class as Class A shares and the other as Class B shares. The issuers and their underwriters may strategically exploit investor affect for A by designating shares more frequently as A than as B, particularly when only the inferior shares are publicly issued and traded.

In our study, we asked the following questions: Is there evidence that issuers of dual-voting shares and their underwriters attempt to exploit the affect for A by designating the inferior voting rights (IVR) shares A? Do A-designated IVR shares manage to mimic A-designated superior voting rights (SVR) shares such that the initial market pricing of IVR A shares is more similar to that of SVR A shares than to that of IVR B shares? Could these companies realize significantly greater economic gains from less underpricing at IPOs, smaller voting premiums, and longer-term combined company valuations? Finally, could there be a rational explanation for this affect phenomenon?

We found evidence in support of affect’s marketing and pricing role in the issuance of dual-voting shares in IPOs. Our sample covered all dual-class companies with at least one share class traded on the three major exchanges from 1994 to 2008. When these dual-class shares went public, issuers and their underwriters offered more than 87 percent of IVR shares as Class A, as opposed to Class B. This finding is consistent with their perception that there is an affect for A over B. Investors, however, also confirm their affect for A by placing a higher valuation at IPOs. We found that IVR dual shares designated Class A experienced close to 70 percent (or 30 percentage points) less underpricing at issue than those designated Class B. During the first year after IPOs, A-designated shares enjoyed an economically and statistically significant price premium relative to that of B-designated shares. For a group of companies with both SVR and IVR shares, we found that when SVR shares were designated A and IVR shares were designated B or other (e.g., Common Stock), SVR shares traded at a premium of 9.82 percent relative to IVR shares. In contrast, this SVR share premium (voting premium) was only 3.78 percent when IVR shares were designated Class A. Moving from a system that designates superior shares Class A to one that designates inferior shares Class A significantly increases the market valuation (measured by market-to-book equity) of a typical dual-class company for at least five years after IPOs.

Our results support the hypothesis that affect plays a role in the pricing of financial assets. Designating a share class A rather than B is a strong explanatory variable of dual-class IPO underpricing even after controlling for a host of company characteristics or time period dummies known to influence IPO underpricing or to induce a potential sample selection bias. We also showed that our results do not support the alternative rational explanation—that companies choose an A designation for IVR shares to signal quality (i.e., better future performance) such that A is less underpriced than B. We found no difference in the share return performance of companies between these two groups up to five years after issuance; instead, companies with B-designated IVR shares delivered better-than-expected operating performance in the same period. This result echoes our findings on the voting premium that investor affect for A is persistent and not limited to the period around the IPOs.