Initial Public Offerings and The Czech Republic:The Need for New Equity

Abstract:

     This paper analyzes the factors that hinder the development of an effective Initial Public Offering (IPO) market within the Czech Republic. The conditions of the stock market, the legal and political framework that surrounds it, and an incomplete transition process greatly hinder the current growth possibilities of an IPO market. With structural and political reforms, the development of a viable and liquid equity market, supported by a functioning IPO market, will benefit individual companies and investors, while leading to economic growth within the Czech Republic.

Key Words: initial public offering, economic transition, privatization, emerging marketsJEL Classification: E22, E61, G32, G38, K22, O16, P27

I would like to thank Evzen Kocenda for his helpful comments and patience. The usual disclaimer applies.

Correspondence to: Bronwen Smith, Duke University, Box 93467, Durham, North Carolina, tel. (1 212) 794 5091, fax (1 212) 794 5095, e-mail: bgs3@duke.edu

I. Introduction: Benefits of an Effective Initial Public Offering Market
     Throughout the past decade, the Czech Republic has made important steps in its transformation from a planned economy to a market based system. Through various rounds and methods of privatization, the establishment of the Prague Stock Exchange, and the evolution and transformation of political and social ideas, the country has made progress towards creating an entirely new system. However, there is still much room for improvement and integration into the world economy. Without a liquid and effective financial market, economic growth will be relatively stagnant in comparison to more developed transition economies. There is a considerable need for initial public offerings (IPOs) to be invited onto the equity market in order for the economy to grow and for the market to establish itself on a more developed level. A strong and effective IPO market will bring about many improvements to the system that will benefit the overall development of a competitive economy.
     An IPO occurs when formerly privately held stock is issued onto the market for the first time, in order to raise capital. The stock is then traded regularly on the market, with hopes that its price will increase with time, improving the stock’s value to current and potential shareholders.

(i) Benefits to the Company
     The benefits of bringing a company public are numerous for all those associated with the company. A publicly traded stock has more exposure to potential investors as well as greater access to liquidity. The increased public image brings about greater recognition for those interested in merger and acquisition opportunities with the company, and also may improve the customer’s perception of the company. Another key advantage is the opportunity to give employees a valued stake in the company, by offering them shares of the newly public stock. Not only does this serve to potentially increase employee output and productivity, but also it may increase employee satisfaction with their firm due to the fact that they would have a formal, although perhaps minimal, stake in the company. With the potential for an increased stock price, employees have greater incentive to maximize effort, potentially increasing company output and performance (Demirguc-Kunt and Levine, 1996). However, one must return to the more general financial benefits that a company may sustain through the public offering process. On the onset of an IPO the company may raise large amounts of capital that would not have been found through other mechanisms, while also having the possibility of seeing its stock increase in price in the future, adding more capital value to the company.

(ii) Benefits for Capital Markets and Economic Growth
     IPOs may also benefit capital market activity and stock market performance. The increased capital that is brought to the marketplace through equity offerings can boost a stagnant stock market. When more IPOs occur, the liquidity of the market increases and more information becomes available to the public, attracting more investors to the marketplace. The increased liquidity of the market may lead to risk diversification, improved corporate control mechanisms, resources allocation, savings mobility, and greater information availability (Levine and Zervos, 1996). Foreign investors, who provide capital as well as innovation, are more attracted to an active, liquid market. In addition, as argued by Lieberman and Fergusson (1998), efficient equity markets boosted by successful IPOs can serve as a political mechanism by allowing invested citizens to have a direct financial position in the potential growth of the economy.

II. Failures of The Czech Economy
     With all the potential benefits that IPOs may add to the economy, one must question why the Czech Republic has had only one IPO since the fall of communism, and why it has not been more active in pursuing a healthy and robust equity market. In 1997, the company “Software602” placed a two million dollar issue onto the Czech Republic’s lesser-known equity market, the RM-System. However, the Prague Stock Exchange (PSE), the more formerly recognized exchange, has yet to see its first IPO. There are several reasons behind the Czech Republic’s merely non-existent IPO market including the conditions of the stock market, the legal and political framework that surrounds it, and an incomplete transition process, which inevitably results in an uninviting atmosphere to foreign and national investors.

(i) Complications of the Market Structure
     The Czech securities market is divided between two organized markets (the PSE and the RM-System), and an inefficient off-market trading system. In 1998, the off-market trading unit performed up to twenty percent of activity with little to no effective price disclosure (IMF, 2000). Studies by the European Commission (2000) on the Czech Republic’s progress towards accession and the IMF (2000) have shown that the weak organization of this market structure leads to divergent prices and distortion between the markets, as three separate prices may be quoted for the same stock. Such a system is completely inadequate for a nation that looks to its financial system as a source for economic growth.

(ii) Regulatory Failures
     The Czech stock market has created many barriers to entry due to the problems of regulation and corruption that have plagued it throughout the years. While the stock exchange was established in 1993, it was not until 1998 that the Czech Republic began to have a functioning Securities and Exchange Commission (SEC). This provided the country and the economy with at least five years that were plagued by unethical cases of fraud and corruption that severely hampered the investing climate. The SEC arguably still lacks the commitment and regulation, which is represented by its western counterparts, but is beginning to protect against the corruption and other illegal activities that were abundantly present in the 1990s. However, it is necessary for the SEC to be a solely independent authority, without any interference from government intermediaries and regulatory agents. This type of regulation is essential to the growth of a functioning stock market, based on the fact that companies and investors will only take part in a market that is safe and provides a viable investment climate.

(iii) Inefficient Bankruptcy Laws
     Ritter (1998) suggests that the comparatively large volumes that are seen on the United States markets, are in part due to the investor protection offered by the American legal system, something that the Czech Republic greatly lacks. The legal and regulatory framework that must develop will need to consist of concrete bankruptcy laws. In 1999, four thousand bankruptcy proposals were made, while two thousand judgments were finalized (European Commission, 2000). Such activity shows the necessity for dedicated bankruptcy regulation. Investors, as creditors to the company, currently receive an astonishingly low seven percent of what they are owed in the case of bankruptcy (Johnson, 2000). This type of environment in no way protects these individuals. The World Bank (2000) has illustrated that it is essential for standardized court procedures to be put into place with the establishment of a complete regulatory framework and effective reorganization procedures, in order to strengthen creditors rights. Without established laws and effective bankruptcy standards, investors, nationally or internationally, will be reluctant to put money into a company through stock or direct investment, if they do not feel that there is some sort of safeguard in place if the company fails to perform. Investors need to feel like they are being treated fairly and that they are involved in a viable economy.

(iv) Lack of Disclosure and Transparency
     It was not until recently that full disclosure of a public company’s financial situation has been required by the authorities, therefore allowing much room for questionable activities, and uncertainty as to a company’s true position. It is necessary for all parts of the market, including, off-market trading, to be regulated by complete disclosure requirements in order to prevent fraud and corruption. Past failures of the system have lead to a lack of transparency that resulted in the process of “tunneling” or asset stripping (IMF, 2000 and Lizal and Kocenda, 2000). The Czech economy, and the IPO market, cannot be competitive with global markets and will not grow without a regulated and transparent marketplace.

(v) Social and Political Mindsets
     Besides for the economic and political hindrances to the development of an IPO market, one must also take into account the social and historical limitations. When a company makes a decision to go public, it must be prepared to pay the legal and financial fees that are associated with the process, work with accountants to determine valid financial statements which will be disclosed to the public (including competitors), and owners must be prepared to give up some percentage of their control and financial stake in the company. Many owners and entrepreneurs are not prepared, or willing to make such sacrifices. Some hints of leftover communist mentality, as well as a general fear of the unknown, remain in the minds and hearts of many who are looking to find additional sources of capital for their firms.

III. The Troubles of Privatization and Company Development
(i) Incomplete Privatization
     The privatization process that began after the fall of communism allowed for the initial developments of much of today’s financial sector and economy. Through restitution, small-scale privatization, and large-scale privatization much of the formerly-government controlled property and assets were put in the hands of the people. However, as Bokros (2000) and the World Bank (2000) suggest, early macrostabilization and development of an export market have lead to a drastic slow-down of privatization efforts. The National Property Fund (NPF), a state run shareholder, currently holds a stake in more than three hundred and fifty companies (European Commission, 2000). Table 1 shows selected companies that could potentially put forth IPOs if held as private entities, independent from state control. There however is no possibility of taking these companies public if they are under NPF ownership. The companies in which the NPF holds fifty percent or more of the stock have a total relative book value of forty-one percent of the total book value of the NPF’s portfolio, meaning that the state, through the NPF, still controls a large portion of the market capitalization (Kocenda, 1999). With such a large amount of the country’s capital still controlled by the government, it will be nearly impossible to see an effective IPO market develop. The first step towards this process, and furthermore a growing economy, must be for the government to remove themselves from any sort of financial or authoritative role in Czech firms. Individuals need to act with the best interests of the company and for themselves instead of political incentive or government position. When these individuals feel that they, themselves, are truly controlling the success and failures of a company they will be prepared to take steps towards improving the productivity and increasing the value of the company.

(ii) Underdeveloped Companies
     Many companies themselves are not prepared to make the step towards an initial public offering. If these companies did attempt to move to the public market, the current state and development of many of these firms, would provide for little to no investor interest in their stock. Investors, national or foreign, will not be interested in a company that does not have respectable profitability potential. The company needs to show sign of product, financial, and image growth in order to be attractive to the investor’s eye.

(iii) Attraction to Foreign Markets
     Those companies that are prepared for a public offering have found themselves more attracted to the international marketplace, placing stock on some of the larger, more recognizable exchanges through Global Depository Receipts (GDRs) and American Depository Receipts (ADRs). Table 2 shows selected companies that have obtained capital, through these instruments, in international markets. This represents the amount of capital that could have been placed through Czech IPOs if a viable market existed. The above instruments provide companies with the opportunity to offer stock to the public on an international stock market – in the case of GDRs, this usually occurs on the London or Frankfurt exchanges, while ADRs occur on one of the American exchanges. Both forms of depository receipts offer benefits to companies that are not easily found through the Prague Stock Exchange. Foreign investors obviously become more accessible through these methods, and in general provide more capital than national investors. More importantly however, is that international stock offerings give companies, such as Ceska Sporitelna, Ceske Radiokomunikace, and Cesky Telecom, a much greater exposure to investors and the general public than can be found within the Czech Republic. Another key incentive for Czech companies is that in most cases, these depository receipts do not allow for international shareholders to have voting rights, ensuring that the decisions remain in domestic hands.

IV. Conclusion
     It is important to recognize that regardless of the structural changes that might occur within the political and economic systems, and the progress towards an effective market economy that may occur, IPO markets in even the most established global economies remain volatile and inconsistent. These markets depend on general conditions of all global stock markets, current exchange rates, unemployment levels, industry sectors, the state of the political system on a day-by-day basis, and many other factors that are outside the control of structural reforms.
     One must also take into consideration the size of the country itself, and the information and knowledge that global investors lack regarding the Czech Republic. For example, Russia, in a comparatively similar state of emergence from the days of the planned economy, is significantly closer to the forefront of the global mind. Its size, location, and international activity, provide more accessibility and interest from the international markets.
     An effective and established IPO market will be of great benefit to the Czech Republic, and other emerging economies. The infusion of capital to the marketplace will not only help to build strong, recognizable, and innovative firms but will also help to build the overall economy, and encourage further growth. However, it is not an overnight process, and much attention must be paid to the inherent problems of the current state of the Czech Republic. The country must take the time to establish an inviting equity market through the structural and political reforms that have been outlined above. With time, great steps will be made towards integration in the world economy and a nation’s stronger financial system.

Table 1.
Incomplete Privatization: FNP's Involvement in Czech Equity Market
(end of 3rd quarter 2000)

Table 2.
Global Depository Receipts Issued by Czech Companies

REFERENCES

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