Product diversification strategy, business group affiliation, and IPO underpricing: A study of Chinese firms

• Author: Daphne W. Yiu,William P. Wan,Xiaodan A. Wang
• Published date: 01 June 2019
• DOI: http://doi.org/10.1002/sej.1297
• Date: 01 June 2019

RESEARCH ARTICLE

Product diversification strategy, business group

affiliation, and IPO underpricing: A study of

Chinese firms

Xiaodan A. Wang

1

| William P. Wan

2

| Daphne W. Yiu

2

1

Department of Management, Haworth

College of Business, Western Michigan

University, Kalamazoo, Michigan

2

Department of Management, CUHK Business

School, The Chinese University of Hong Kong,

Shatin, Hong Kong

Correspondence

Xiaodan A. Wang, Department of

Management, Haworth College of Business,

Western Michigan University, 1903

W. Michigan Avenue, Kalamazoo, MI 49008.

Email: xiaodan.wang@wmich.edu

Research Summary: Extant research has largely ignored if and how

product diversification strategy influences IPO performance. We

intend to fill this gap in the literature, especially in relation to tran-

sition economies where the role of diversification is institutionally

bound. Specifically, drawing on the strategic actions and political

connections arguments, we contend that the level of a firm's prod-

uct diversification has a positive relationship with IPO underpricing.

Given the prominent role of business groups in shaping firms’

diversification strategies in transition economy, we further examine

whether business groups’nonmarket capital—political, relational,

and reputational capital—moderates the relationship between prod-

uct diversification strategy and IPO underpricing.

Managerial Summary: Due to the lack of transparency, investors in

transition economies face higher ex ante uncertainties and have to

bear more investment risks. As such, IPO firms have to “leave more

money on the table”to compensate investors. This study aims to

answer the question of whether and how an IPO firm's corporate

strategy and business group affiliation affect investors' perceived

uncertainties and, thus, the need to leave a large amount of money

on the table to compensate investors. Using a sample of IPO firms

in China, this study finds that the nonmarket capital that stems

from business group affiliation helps mitigate the uncertainties

investors perceive with higher levels of diversification, thus reduc-

ing the need for IPO firms to discount their offerings too much so

that they can retain more wealth for business development.

KEYWORDS

business group, institutional embeddedness, IPO underpricing,

political connections, product diversification, transition

economies

Received: 21 January 2016 Revised: 26 May 2018 Accepted: 28 May 2018 Published on: 19 July 2018

DOI: 10.1002/sej.1297

Strategic Entrepreneurship Journal. 2019;13:179–198. wileyonlinelibrary.com/journal/sej Copyright © 2018 Strategic Management Society 179

1|INTRODUCTION

Research on IPOs has captured a lot of attention in recent years (e.g., Arthurs, Hoskisson, Busenitz, & Johnson, 2008;

Bell, Filatotchev, & Aguilera, 2014; Leitterstorf & Rau, 2014; Park & Patel, 2015). However, despite the significant

growth of studies on IPOs, the determinants of IPO performance are still not fully understood (Ljungqvist, 2007).

With the almost “fanatical”growth of many IPO markets in transition economies in recent years, understanding the

determinants of IPO performance in those economies becomes even more relevant and important. Research has well

documented the underdeveloped institutional environments in transition economies (Peng, 2003; Peng, Lee, &

Wang, 2005). To better understand IPO performance in transition economies, we need to examine the unique insti-

tutional features as well as how investors valuate IPO firms.

In this study, we focus on China and examine how its two institutional features influence IPO performance. First,

the composition of IPO firms in China differs from their counterparts in developed economies. For entrepreneurial

ventures in developed economies, IPO represents a popular vehicle for firms to raise additional capital for continued

growth. For state-owned enterprises in transition economies, IPO is a key process toward realizing privatization of

state assets. Many IPO firms in China are mature and highly diversified. Given the importance of product diversifica-

tion strategy in determining firm performance (Hoskisson & Hitt, 1990), such strategy is likely an important factor in

affecting IPO performance. This is especially the case in transition economies where diversification is often viewed

as a market substitution strategy and firms diversify to gain access to critical resources not via market means but by

political connections (Wan & Hoskisson, 2003). We view an IPO firm's product diversification strategy as important

information for investors to estimate its intrinsic value from (a) a strategic actions perspective focusing on a firm's pri-

mary value proposition and quality of underlying strategic resources and (b) a political connections perspective

emphasizing political resources in facilitating corporate diversification. Particularly, political connections is a salient

success factor in China (Fan, Wong, & Zhang, 2007; Li & Zhang, 2007), warranting its value in investors’evaluations

of firms' diversification strategies. By examining how product diversification influences IPO performance, we respond

to the call made by Certo, Holcomb, and Holmes (2009) on the need to study whether or not IPO performance would

be affected by the product diversification strategy of an IPO firm and, consequently, fill the gap in the literature.

Second, product diversification strategy in China is closely related to the unique organizational form of business

groups (Khanna & Palepu, 2000; Khanna & Rivkin, 2001; Kock & Guillen, 2001). A business group is a unique institu-

tional arrangement historically embedded in many transition economies (Khanna & Rivkin, 2001; Peng & Delios,

2007). It is a collection of legally independent firms that are tied by multiple types of relations through which they

coordinate to pursue collective objectives (Yiu, Lu, Bruton, & Hoskisson, 2007). Firms selected to join business

groups are typically elites from a variety of industries or leading enterprises in related industries from different

administrative regions. Business groups differ in various ways, such as relationships with government, within-group

interactions, and visibility and influence in the market. Given the prominence of business groups and its inseparable

linkage with diversification strategies in transition economies, we explore the impact of business group affiliation

and, more specifically, if and how business groups' political capital, relational capital, and reputational capital moder-

ate the relationship between product diversification strategy and IPO performance.

Following most studies on IPO, we focus on IPO underpricing as a reflection of IPO performance. As a widely

used measure of IPO performance, IPO underpricing reflects the value of issuing firms' stock determined by the mar-

ket but not captured by the issuing firms when the stock was first offered for sale, which is “money left on the table”

(Daily, Certo, Dalton, & Roengpitya, 2003; Ljungqvist, 2007). IPOs are often underpriced due to investor uncertainty

about the value of the IPO firm (e.g., Ritter & Welch, 2002; Sanders & Boivie, 2004). The more uncertain firm valua-

tion is from the perspective of the investors, the more underpriced the IPO firm will have to offer in order to com-

pensate investors for the risk they are taking. To the extent that investors are uncertain of the true value of an IPO

firm, the amount of IPO underpricing will increase. Because underpricing represents value not captured by the firm,

IPO firms want to minimize underpricing (Ljungqvist, 2007). In other words, higher levels of underpricing are

180 WANG ET AL.