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Journal of Accounting and Economics

Journal of Accounting and Economics 56 (2013) 216–223

0165-41http://d

☆ Thecomme

n Tel.:E-m

journal homepage: www.elsevier.com/locate/jae

The London Stock Exchange's AIM experiment: Regulatory ormarket failure? A discussion of Gerakos, Lang and Maffett$

Joseph D. Piotroski n

Stanford University, Graduate School of Business, 655 Knight Way, Stanford, CA 94305, United States

a r t i c l e i n f o

Available online 6 November 2013

JEL classification:G14G18G38K22M48

Keywords:RegulationAlternative Investment MarketPost-IPO performanceGrowth enterprise markets

01/$ - see front matter & 2013 Elsevier B.V. Ax.doi.org/10.1016/j.jacceco.2013.10.004

author would like to thank Michelle Hanlonnts and suggestions. The author would like tþ1 650 498 6988.ail address: jpiotros@stanford.edu

a b s t r a c t

The conference paper by Gerakos, Lang and Maffett (2013) provides reliable, descriptiveevidence on the post-IPO performance of firms listing on the London Stock Exchange'sAlternative Investment Market (AIM). Their findings are consistent with both a failure ofprivate sector regulation and incorrect market expectations about AIM's investor protec-tions. In this discussion of Gerakos et al. (2013), I highlight the strengths and limitationsof their conference paper, summarize how various regulatory and market factors couldproduce the observed systematic under-performance of AIM offerings, and outline pathsfor future research on the topic.

& 2013 Elsevier B.V. All rights reserved.

1. Introduction

“It doesn't matter if the cat is black or white – if it catches mice, it is a good cat.”

Deng Xiaoping

An important role of securities regulation is to protect investors when firms raise capital through public debt and equitymarkets; however, the optimal form and structure of these protections is subject to considerable debate. As part of thedevelopment of modern stock exchanges, the primary oversight of listed firms was transferred from the realm of courts and privatecontracting to formal regulatory agencies, such the Securities and Exchange Commission (US) and Financial Services Authority (UK),who serve as both the monitors and enforcers of local securities law compliance. Prior research documents that robust investorprotections and securities laws produce significant capital market benefits (e.g., LaPorta et al., 1997, 1998, 2002). However, thebenefits arising from public sector regulation and enforcement activities are not unambiguously positive. Public regulators tend toadopt costly, one-size-fits-all regulation. Such a regulatory approach is capable of both screening out low quality firms from theregulated exchange (e.g., Sarbanes Oxley) and minimizing regulatory discretion and ambiguity (e.g., Coates, 2007), yet can createsignificant inefficiencies by imposing potentially burdensome costs upon (or conferring limited benefits to) many affected firms(e.g., Zingales, 2007). Additionally, whereas regulation promoting transparency and facilitating private enforcement activities (e.g.,loss recovery standards) is beneficial, LaPorta et al. (2006) find limited evidence that the public enforcement of securities lawscontributes to capital market development. Public enforcement effectiveness can be adversely impacted by numerous factors,

ll rights reserved.

(Editor) and the participants at the 2013 Journal of Accounting and Economics conference for usefulo thank Zach Wang for research assistance.

J.D. Piotroski / Journal of Accounting and Economics 56 (2013) 216–223 217

including resource constraints (e.g., talent, funding) and countervailing incentives of the central regulator (e.g., political factors, rent-seeking tendencies, bureaucracy).

A private sector approach towards regulation and enforcement has the potential to mitigate the frictions andinefficiencies associated with public regulators. In this alternative regulatory regime, private entities, such as listingsponsors and nominated advisers, serve as both exchange gatekeepers (by attesting to the viability of candidate firms) andmonitors of compliance with exchange rules and relevant regulation. The incentives of these private entities are shaped bythe expected reputation benefits and costs arising frommarket successes and failures, respectively. By transferring oversightto the private sector, candidate firms and their sponsors can negotiate the details of the listing firm's regulatory obligationsand subsequent compliance requirements, resulting in regulation and monitoring that is tailored to each listing firm'ssituation. If these regulatory choices are disclosed to investors, adhered to by the firm, and enforced by the sponsor, theresult is a transparent, flexible system that minimizes the costs and maximizes the benefits of an exchange listing for theaffected firms while retaining the necessary investor protections.

The success of this system, however, depends upon the incentive of the private entities to effectively regulate theirsponsored client firms. Low quality firms screened from and/or penalized by traditionally regulated exchanges will have anincentive to exploit the flexibility imbedded in this regulatory environment and raise capital through this alternativechannel. If the expected penalties and reputation costs of market failure are too small, sponsoring entities (e.g., nomads)may allow low quality firms to enter the market in order to capture fees and listing-related benefits. The result would be a“race to the bottom” with low cost exchanges and their affiliated sponsors competing for global listings. Such an outcomewould cast considerable doubt on the effectiveness and long-run viability of this alternative regulatory arrangement. Theoutstanding empirical question is whether this form of private sector regulation can screen out low quality firms and protectinvestors as effectively as public sector regulation?

The conference paper by Gerakos, Lang and Maffett (2013) (hereafter GLM) sheds first light on the effectiveness of privatesector regulation and enforcement mechanisms by examining the post IPO performance of firms listing on London StockExchange's Alternative Investment Market (AIM). To the extent that post-IPO performance reflects the degree of ex anteinvestor protections and enforcement, an analysis of post-IPO performance of AIM firms against alternative benchmarkfirms will provide information about the relative quality of the AIM exchange. With that working assumption, the authorscautiously conclude that private regulation in the AIM setting appears to be ineffective. This conclusion is based on theevidence that AIM listed firms (1) experience greater post-IPO underperformance than samples of matched firms listing ontraditionally regulated exchanges and (2) experience performance that is indistinguishable from firms on non-regulated USexchanges (OTC Pink Sheets). More importantly, this underperformance varies by firm, nomad and inter-temporalcharacteristics that reinforce this interpretation of the evidence. Together, the mosaic of evidence is consistent with theAIM jointly functioning as a listing platform for low quality, high-risk firms and providing minimal protections to itsinvestors.

In my opinion, the research objectives of this conference paper are both timely and relevant given the global trend ofsmall growth companies raising equity capital on low cost markets. The paper provides reliable, descriptive evidence on thepost-IPO experience of AIM-listed firms and the quality of firms that choose to list on the AIM. More importantly, thepaper serves as a useful starting point for future research on the effectiveness of private sector regulation and the efficiencyof growth enterprise markets. The remainder of this discussion will provide a structured interpretation of GLM's primaryresults, highlight key limitations to the current study, and outline important questions and opportunities for future research.

2. Background and implications for study's objectives

The AIM was created by the London Stock Exchange as a platform for small, growth companies to access global capitaland to create share liquidity without incurring the costs associated with a listing on traditionally-regulated exchange. Asnoted on the AIM's website, “AIM offers smaller growing companies the benefits of a world-class public market within aregulatory environment designed specifically to meet their needs”. To that end, AIM's regulatory structure is independent ofthe EU investment services directive and directly regulated by its parent organization, the London Stock Exchange. The AIMfeatures customized regulation administered through the private sector. This flexibility includes listing, regulatory anddisclosure requirements that are limited relative to other major markets and selectively chosen by the listing firm (i.e.,comply or disclose requirements). Primary oversight is entrusted to nominated advisors (hereafter referred to as “nomads”),who are chosen and hired by the listing firm. Nomads help the firm decide which rules to comply with and the manner ofcompliance (allowing for flexibility and customized rules tailored to the listing firm's circumstances) and act as the firm'ssponsor during the listing process. Moreover, the nomad is responsible for monitoring the firm's subsequent compliancewith the AIM's rules after listing on the exchange. Nomads – which tend to be law, audit, investment banking, andconsulting firms – are registered through the LSE, and face potential disciplinary action and loss of reputational capital ifthey do not fulfill their responsibilities. Thus, in this private regulation framework, nomads serve as both gatekeepers to theexchange and monitors of the firm's compliance with AIM Rules and Regulations. And, as noted by both the authors and theexchange, the overall objective of this framework is not less oversight or weaker regulation, but less costly, customized,“light touch” regulation overseen by the private sector. As such, the AIM represents a natural setting to examine theeffectiveness of two different aspects of private regulation: “light touch” regulation and private sector oversight.

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As documented in Table 1 of GLM, the AIM has been very successful at attracting new domestic and foreign listings, andthe market is now emblematic of a new approach towards raising capital and regulating firms globally.1 This success can beprimarily attributed to two factors: (1) a shift in the relative composition of firms seeking public equity capital globally, witha trend towards smaller, early stage growth-oriented firms (e.g., Doidge et al., 2009; Piotroski and Srinivasan, 2008), and (2)the absolute level and increased cost of a traditional listing, including initial listing fees, compliance costs, and, most notably,costs associated with Sarbanes Oxley in the US. As a result of these two factors, the success of AIM corresponds to thebroader global development of markets with similar regulatory characteristics and client firm orientation (i.e., exchangeregulated markets; growth enterprise markets).2 These global trends increase the relevance of GLM's study, yet alsohighlight that the fact that the post-IPO performance of AIM listed firms will likely reflect a multitude of factors thatdifferentiate low cost markets from traditionally regulated exchanges. To conclusively attribute the post-IPO performance ofAIM firms to the effectiveness of private sector regulation, the chosen research design must either control for thesecorrelated differences and/or exploit exchange-level variation in attributes to provide cleaner insights into the source andnature of AIM performance.

From a research design perspective, the differences between the AIM exchange and traditionally regulated exchangesare not solely limited to the realm of public versus private sector oversight. Instead, there exist a bundle of attributes thatdifferentiate these markets, including:

1.

Entcon

Level of regulation being applied to the firm (light touch regulation versus mandatory regulation)

2. Type of oversight (nomads versus central regulator) 3. Type of firm being intentionally targeted by and unintentionally drawn to the market (AIM tends to attract GEM firms

and/or low quality lemons)

4. Type of investor (retail versus institutional investors) 5. Taxation (preferential tax benefits for long-horizon retail investors in AIM securities)

These institutional differences limit GLM's ability attribute the post-IPO experience of AIM firms strictly to ineffectiveprivate sector regulation and weak investor protections. As a result, conference participants expressed numerous concernsabout how to interpret the authors' results. For example, if return underperformance is the result of weak investorprotections, can one separate out the effect of weak rules (i.e., flexible regulation) from the effect of weak oversight (i.e.,ineffective nomads/sponsors)? What if the results reflect the bundle of endogenous attributes (i.e., rules, enforcement, firms,and investors) that characterize growth enterprise markets, and how does one grapple with the notion that weaker, youngerand/or riskier firms are self-selecting onto these exchanges? Why do these negative returns persist (i.e., no apparent priceprotection as the exchange matures)? Do the authors have the right benchmark (i.e., post-IPO returns) to assess whether theAIM is failing to screen out and/or successfully attracting low quality firms? The following section explores these questionsin detail, discusses the plausibility of various interpretations of GLM's results, summarizes the main conclusions of thepaper, highlights open empirical questions, and provides suggestions for future research on the topic.

3. Primary observations, interpretation of results, and suggestions for future research

To examine the effectiveness of private sector regulation, GLM examine the post-IPO experience of AIM listed firms(a) relative to performance of firms on traditionally regulated and unregulated exchanges and (b) conditional upon theattributes of the listing firm, the type of nomad chosen, type of investor, etc. The authors find that AIM firms underperformmatched firms listed on traditional exchanges by approximately 13% (30%) over the one year (two year) period subsequentto their IPO. This main result is robust to numerous controls for differences in profitability, growth, and investmentopportunities, and to alternative estimation techniques, matching heuristics, benchmark samples, and measures of post-IPOreturns. Moreover, GLM find that AIM firms are more likely to fail, less likely to generate positive return outcomes, andpossess lower quality earnings than firms listed on traditional regulated exchanges. These relations suggest that thedifference in ex post return performance is driven by ex ante differences in the quality and/or risk profile of AIM listed firms.Finally, GLM document that the post-IPO performance of AIM firms is economically and statistically similar to the post-IPOperformance of firms listing on the unregulated OTC Pink Sheets.

3.1. Primary source of AIM post-IPO underperformance: regulatory failure

3.1.1. Evidence in favor of weak investor protections interpretationThe most compelling explanation for the paper's results – and the explanation offered by the authors – is that the flexible

regulatory structure offered by the AIM, as currently implemented and enforced by nomads, is ineffective. If the AIMstructure jointly attracts and fails to screen out low quality firms and the investors incorrectly perceive the AIM as offering

1 Moreover, the spirit of AIM's private sector regulation and focus on retail investors is embodied in the CROWDSOURCE provision of the US Jobs Act.2 These other exchanges capture many aspects aspect of the AIM, including flexible private sector regulation (e.g., AIM Italia, Tokyo AIM and theerprise Security Market (Irish Stock Exchange)) and/or a focus on providing small, growth oriented firms lower cost access to public equity capital in thetext of public regulators (e.g., Hong Kong GEM exchange; Shenzhen GEM exchange).

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adequate investor protections, then these low quality firms will subsequently underperform peer firms on traditionallyregulated exchanges as the relative low quality of AIM listed firms is revealed. Moreover, if investors systematically assignstrong investor protections to all firms listing on exchanges domiciled in strong legal/institutional environments regardlessof the relative strength of the particular exchange's regulatory oversight, the performance of AIM firms would mirror thepost-IPO performance of low quality peer firms listed on unregulated markets (e.g., US Pink Sheets), with subsequentunderperformance reflecting the revelation of low quality listings on both exchanges.3 The documented pattern of post-IPOreturns in GLM is consistent with these weak regulation/weak enforcement predictions.

More importantly, GLM provide useful supplemental evidence that corroborates this interpretation. First, AIM firms havelower earnings quality than peers firms on traditionally regulated exchanges (see GLM, Table 9). These differences areconsistent with prior work linking the strength of regulation and investor protections to corporate reporting behavior (e.g.,Leuz et al., 2003; Bushman et al., 2004). Second, AIM firms experience lower survival rates than their peer firms (see GLM,Table 6). Given that ex post failure rates are a reasonable, alternative means of assessing ex ante IPO listing quality (e.g.,Demers and Joos, 2007), the evidence reinforces the argument that differences in ex ante firm quality (as proxied byexchange choice) are driving differences in ex post returns. Third, the underperformance is stronger for firms that seek toraise capital on the exchange (see GLM, Table 8). The concentration of the results among capital raising firms is consistentwith the adverse selection story underlying GLM's ineffective private regulation arguments. Fourth, GLM document animprovement in the relative performance of AIM firms following the tightening of the AIM's rules with respect to cash shellsand all firms in 2005 and 2007, respectively (see GLM, Table 7, panel B). This inter-temporal variation in underperformancehighlights a potential causal link between the relative strength of AIM's regulatory environment and post-IPO performance.Lastly, the post-IPO underperformance of AIM firms is attenuated through the listing firm's choice of a high quality nomad(see GLM, Table 10). Essentially, high (low) quality firms credibly reveal their type through the self-selection strong (weak)nomads, with the resultant ex post performance a function of their choice of regulatory oversight.4

3.1.2. Limitations to weak investor protection interpretation and suggestions for future researchOverall, the post-IPO return evidence is consistent with regulatory failure on AIM. However, to truly assess the

effectiveness of private regulation, are ex post returns the best outcome variables? Returns-based tests critically dependupon (a) an efficient market, of which there is considerable evidence may not exist in the context of growth firms andaround IPO events (e.g., Lakonishok et al., 1994; Loughran and Ritter, 1995) and (b) market participants who attribute astrong enforcement regime to the AIM and systematically misprice the underlying security at the time of the IPO. Theauthors earnings quality test (using discretionary accruals and accruals reversals) is a reasonable attempt to provide analternative outcome benchmark for assign firm quality; however, there is a considerable literature documenting thatdiscretionary accruals estimates are poor and are confounded by growth (e.g., Zhang, 2007). This is a significant concernbecause many of the firms seeking financing on the AIM firms are growth companies. Similarly, post-IPO survivability is agood idea, but could also capture unobserved differences in the firm fundamentals (i.e., risk-payoff attributes).

To reinforce the authors investor protections interpretation of AIM post-IPO underperformance, future research shouldexamine ex post outcomes that directly capture ex ante firm quality and/or listing incentives. For example, are AIM firms aremore likely to engage in accounting fraud, to experience financial misreporting outcomes (e.g., restatements), to besanctioned by nomads or the exchange, to face allegations of fraud, to engage in illegal behavior, to engage in expropriationrelated activity, or to receive qualified audit opinions? Additionally, the current set of analyses cannot identify the source ofregulatory failure. Is the breakdown due to insufficient rules or the firms' failure to adhere to agreed upon rules? Arenomads failing to establish sufficient rules or monitor ex post compliance? Is there collusion between the listing firm andnomad? Does the listing prospectus identify the scope of rules the listing firm agrees to? If so, can we measure each firm'slevel of compliance with their own self-selected rules after the IPO? Although beyond the scope of this study, additionaldetailed evidence about post-IPO behavior and outcomes will help disentangle the source and nature of the long-run,ex post outcomes documented in GLM.

More critically, not all of the evidence presented in GLM is unambiguously consistent with regulatory failure. Forexample, why do foreign firms perform marginally better than domestic listings (see GLM, Table 4, panel A)? Is the relativeperformance of foreign firms inconsistent with arguments that the AIM attracts low quality foreign firms screened from USmarkets? Or does the relative strength of foreign firms reflect the compliance costs of US regulation diverting marginallyhigher quality foreign firms to the AIM relative to domestic companies choosing to list on the AIM.5 In either case, what doesthe documented relation tell us about the strength of AIM regulatory oversight? To better understand the nature of thisresult, does foreign firm performance improve or deteriorate after the enactment of Sarbanes-Oxley in 2002? It would alsobe interesting to document other aspects of post-IPO performance along the foreign-domestic dimension (e.g., accruals

3 Prior research documents that investors appears to price protect themselves based upon the inherent degree of investor protections offered bycountry level legal institutions. However, it remains unclear whether investors systematically distinguish between the relative degree of protection offeredby different exchanges/markets within a given country and price-protect accordingly.

4 This result highlights a direction of potential prescriptive actions for the AIM, namely, the need to credibly hold the nomads accountable for bad firmsgetting on the market.

5 For example, one of the stated objectives of the AIM was to actively attract small, high quality foreign firms seeking to avoid the compliance costs ofSarbanes-Oxley (Oxera Consulting, 2006).

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quality, IPO survivability, etc.). GLM's main results suggest that the AIM has, in general, become a listing destination for lowquality firms. If this interpretation is correct, and low quality foreign firms shift their listing preferences toward AIM to avoidthe heightened level of regulatory scrutiny and penalties associated with Sarbanes-Oxley, then relative performance offoreign firms (vis-à-vis domestic firms) is expected to deteriorate after enactment of Sarbanes Oxley.

There are also opportunities to examine post-IPO performance conditional upon inter-temporal variation the regulatoryenvironment (and the corresponding shift in incentives of listing firms and their nomads) to strengthen the causal linkbetween the effectiveness of private sector oversight, listing firm quality and post-IPO performance. For example, GLMexamine the tightening of rules on the listing on “cash shells” in 2005 and a general increase in regulation in 2007; both ofthese analyses reinforce GLM's investor protection interpretation of AIM underperformance. However, other regulatorychanges occurred that affect the incentives of listing firms; do these events yield similar inferences? For example, Sarbanes-Oxley increased the cost of listing on US exchanges; do we see more bad firms listing on AIM post-Sarbanes-Oxley? In 2006,the London Stock Exchange increased the mandatory requirements for all AIM listed firms. One such requirement was thatfirms maintain a functioning webpage with investor relations data; did such an improvement in disclosure increase theaverage quality of listing firms? Such a shift in firm quality would be expected under the author's prevailing interpretationof regulatory failure if the new rules are credible and expected to be enforced. Did the new rules alter IPO pricing structure,and/or change expectations about the level of investor protections afforded by the AIM? If so, what does that say aboutinvestors' ability to assess the degree of investors protections afforded on the AIM? Alternatively, can the transparency-related incentives of AIM firms prior to 2006 be classified based upon availability of financial webpages at the time of theirlisting? Did the firms with limited disclosure perform worse?

Focusing on the incentives of nomads, it would be interesting to examine behavior before and after changes in theexpected penalties arising from weak monitoring activities. For example, in 2006, the LSE revised its code of conduct fornomads, and in 2008, the LSE fined a nomad for the first time. Both of these events (tighter rules and credible revelation ofsanctions) should increase the nomads' incentive to monitor effectively; hence, if underperformance is driven by weakprivate oversight, we should expected to see an improvement in AIM firm performance following these events. Moreimportantly, these types of events can be used to directly examine whether nomad behavior shifts – for example, do nomadswaive fewer regulatory requirements after these events (i.e., less flexibility with respect to compliance with the full set ofAIM rules)? As discussed earlier, nomads frequently serve a dual role for the listed firm: first as their AIM supervisor/sponsor and second as their auditor, lawyer, banker, and/or consultant (among other roles). Are nomads less likely to servesuch a dual role for the listing firm after the first sanction was levied (i.e., fewer conflicts of interest)? Together, such amosaic of contextual evidence has the potential to tighten the mapping of regulatory oversight and prevailing incentives todetermine where private sector regulation is failing.

3.2. Influence of non-regulatory factors on the relative strength of AIM post-IPO performance

Numerous conference participants raised variants the following question: why does AIM underperformance (i.e., post-IPO negative returns) persist over time? If the AIM offers weak investor protections and market participants are rational,then investors should “learn” that the AIM is a platform for low quality offerings and price AIM securities accordingly,especially after several years of bad outcomes. Such price protection should, conceptually, eliminate average negative long-run performance. Moreover, absent sufficient price protections, should not the market for AIM IPOs eventually shut down?

This line of reasoning is important, but potentially misguided if market participants are either not fully informed orsubject to behavioral biases. Underperformance following an IPO is not unique to the AIM; it is a long-standing, globalphenomenon (e.g., Ritter, 1991; Loughran and Ritter, 1995) that appears to be driven by both economic and behavioralfactors (e.g., Ritter, 1991; Pastor and Veronesi, 2005). The real question that needs to be addressed is why AIM-listed firmssystematically underperform relative to firms engaging in IPOs on traditional exchanges like the NYSE, NASDAQ and LSEMain exchange. GLM, unfortunately, do not provide direct evidence on whether AIM investors are actually price protectingthemselves to a lesser degree than investors on other exchanges, nor do GLM provide evidence on the aggregate trend inpost-IPO performance over time (other than the pre-post regulation/nomad inter-temporal analyses discussed in thepreceding section). The fact that this wedge in relative post IPO performance is persistent suggests that other correlatedfactors are having an impact on the observed relations. One explanation could be systematic differences in the level ofinvestor protections, but such an explanation requires market participant to not learn from past experience. Other potentialcandidates for the source of such persistent underperformance include role of individual investors in the market (and theirbehavioral biases), the types of firms participating in the market (i.e., the rational pricing of growth securities), and theinfluence of the preferential tax status of AIM investments. I explore each of these issues in detail below.

3.2.1. Market mispricing of AIM investor protectionsThe systematic underperformance of AIM securities could be driven by investors who possess incorrect expectations

about the level of protections afforded by the AIM and do not update these beliefs in response to new information. Becauseof the AIM's affiliation with the London Stock Exchange, investors could be mistakenly attributing the LSE's main board'sinvestor protections and regulatory oversight to AIM securities even though such protections are not available. Suchbehavior requires investors to anchor on labels or selective attributes instead of base rates. Essentially, the market couldsuffer from an attribution bias, where the LSE, FSA and UK labels are creating perceptions and expectations that are not

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warranted / justified by the AIM rules. To the extent that new investors with this bias enter the market (i.e., new generationsof traders) and/or the market is composed of primarily less sophisticated individual investors who do not engage inBayesian updating, such a behavioral pricing bias could persist through time. Such pricing behavior is internally consistentwith the authors' investor protections-based interpretation of their AIM post-IPO returns evidence, both relative totraditionally regulated markets and the OTC Pink Sheets.

3.2.2. Market mispricing of IPO securitiesSystematic underperformance could also reflect behavioral pricing biases (independent of investor protections) that are

magnified on the AIM relatives to other exchanges. Such biases could be an artifact of the AIM's mix of retail investors andtype of listing firms (i.e., growth firms). Individual investors have been shown display overconfidence in their investmentdecisions, are more prone to experience portfolio losses, and are more likely to purchase highly visible stocks (e.g., Barberand Odean, 2000, 2008). To the extent that individual investors are more likely to purchase overpriced IPO's and thatthe marginal investor on the AIM (traditional exchange) is a retail (institutional) investor, we would expect the AIM tounderperform relative to other exchanges. Moreover, to the extent that individual retail investors are more likely tosuccumb to human cognitive biases than sophisticated institutional investors, mispricing should be most pronounced on theAIM (with its high preponderance of early stage growth securities) and will be directional in nature. Individuals tend tooverweight the probability to remote events; for growth firms, this amounts to overweighting the likelihood of extremepositive payoffs. Thus, even if investors are fully informed about the level of investor protections and fundamental risk-return attributes of the listed firms, AIM investors will overprice those fundamental growth attributes compared to moresophisticated investors on other exchanges, thereby producing the observed relative post-IPO underperformance of AIMsecurities.

Although such an explanation falls outside traditional pricing models that rely upon “rational expectations,” significantresearch in psychology and behavioral economics suggest such mistakes are prevalent in decision-making contexts. Whensuch cognitive biases translated into correlated valuation errors, as would be the case in markets dominated by retailinvestors, and arbitrage costs are high (which would be the case for smaller, less liquid AIM firms), persistent long-rununderperformance vis-à-vis other markets is possible. GLM provide a glimpse into the plausibility of these explanations bydocumenting that the AIM underperformance effect is strongest among firms with a high concentration of retail ownership(see GLM, Table 11). More importantly, such retail investor effects need not subsume an investor protections interpretationof the results. Instead, the evidence provides an additional, confounding channel by which these long-run negative returnsexist and persist, and highlights the complex, dynamic process that drives the valuation of AIM firms. More importantly,these argument suggest further evidence is need to understand the valuation of AIM securities, and understanding howthese factors interact in the AIM context.

3.2.3. Rational pricing of IPO securitiesPrior research in finance discusses various conditions by which average negative returns are expected following IPO

activity. One line of thought is the IPO wave literature, which provides a rational basis for negative average post-IPO returns(e.g., Pastor and Veronesi, 2005). Given the relative rapid growth experienced by the AIM vis-à-vis traditional exchanges, thearguments in this literature could provide insights into the relative performance of this market during periods of heightenedIPO activity. A second line of research considers expected returns to securities that have lottery-like characteristics. Forexample, Barberis and Huang (2008) argue that when one considers utility functions that are compatible with Kahnemanand Taversky's prospect theory, negative average returns are to be expected for these lottery-type investments.

These lines of research are important because they provide alternative frameworks for assessing the presence andmagnitude of post-IPO negative return performance across exchanges. To the extent that the composition of AIM is tiltedtowards these types of securities, relative underperformance is to be expected in this framework. Through their various“home run” analyses (see GLM, Table 5), GLM provide strong evidence that AIM does not experience a greater number oflarge positive return winners than traditional exchanges, casting doubt on this alternative explanation. However, given theshort relative history of the AIM, the lack of evidence could simply be reflective of “too few draws” from the underlyingdistribution.

As a means of augmenting GLM's analyses, I performed a preliminary comparison of the distribution of AIM returns tothe distribution of returns from the Hong Kong GEMmarket over the period 2007–2012. As a market specifically designed toprovide capital to young growth firms, the Hong Kong GEM market is a close analog to AIM in terms of firm and investorcomposition, but lacks the weak regulatory oversight of the AIM by retaining a role for the HK central regulator. If the AIM'sunderperformance is being solely driven by the presence of risky, high growth stocks, the underlying distribution of AIM andHK GEM should be similar. To the extent that weak investor protections are playing a role, the AIM return distributionshould be shift to the left versus the HK GEM's return distribution. This preliminary analysis suggested that the shape ofreturn distributions underlying these two markets is substantially different. Firms on the Hong Kong GEM experience higherpost-IPO mean returns driven by a few extreme winners offsetting many large losers. In contrast, firms on the AIM havelower mean post-IPO returns, a tighter distribution of returns, few large winners and many less extreme losers. Overall, theHK GEM return distribution seems like the lottery/high risk-high return distribution, while the AIM distribution seems toreflect the chronic overvaluation of a broad set of low quality firms.

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3.2.4. Tax advantages of AIM securitiesLastly, what role does AIM's unique tax structure have on observed differences in realized returns? Under the exchange's

Enterprise Investment Scheme, tax benefits accrue to individual investors who subscribe to new ordinary shares in AIMcompanies. These benefits include an initial 30% income tax relief (akin to an investment tax credit), long-term capital gainstax reduction and/or exemption, capital gains tax deferral (if proceeds reinvested in new subscriptions), and loss relief(capital losses can be potentially offset against ordinary income). Given that the marginal investor on AIM is tax subsidized,they likely to accept lower pre-tax rates or return on their investments. The relevant question is: how do these taxpreferences translate into IPO pricing and post-IPO returns, especially if AIM investors subsequently sell to non-tax-subsidized, secondary market investors? Additionally, the UK government has started the Seed Enterprise InvestmentScheme, which provides tax relief for investing in start-up and early stage companies, including companies raising capitalon the AIM. This new scheme may allow future researchers to compare the post-IPO returns of AIM investors against similartax advantaged investors in early stage companies that are not raising capital through the AIM.

To address this issue, GLM re-estimated their results using estimates of pre-tax returns that incorporate the capital gainsbenefits associated with purchasing AIM securities at the time of the IPO (untabulated results). However, this adjustment isonly applied to firms that experience ex post capital gains. In contrast, the expected tax benefits would have influenced theex ante pricing of all IPO securities (i.e., tax advantaged investors would have been willing to pay a higher price, ceterisparibus, for each security); as such, observed ex post underperformance is likely to be magnified for both low and highquality securities (i.e., securities that both depreciate and appreciate in value after the IPO). Future research can examine IPOpricing across exchanges, conditional upon prevailing tax schemes, to assess the relative impact of AIM's tax scheme onobserved post-IPO underperformance.

3.2.5. SummaryTogether, these non-regulatory factors highlight the important unanswered question raised by GLM's analysis: what is

(are) the root source(s) of AIM's IPO pricing frictions and subsequent weak ex post performance. Poor investor protections inthe form of weak rules and limited oversight seem to be playing a role, but what market friction translates these deficienciesinto sustainable, systematic mispricing? Naïve individual investors also seem to play a key role, but are investors mispricinginvestor protections per se or the innate fundamentals of AIM firms and/or GEM markets? Future research should considerexploiting the institutional differences across a global set of exchange-regulated growth markets to better understandthe separable and joint impact of flexible regulation, private oversight, retail investors, tax rules and self-selection on theobserved performance of newly listed firms in these settings.

4. Conclusion

“All that glitters is not gold”Shakespeare (from The Merchant of Venice)

Based upon the growth in listings on the London Stock Exchange's Alternative Investment Market over the last twodecades, it is easy to characterize the AIM experiment as a success. This shine, however, is quickly tarnished once oneconsiders the returns earned by investors on the AIM compared to investors on other publicly regulated exchanges. GLMprovide some of the first evidence documenting the poor performance of AIM listed firms, and these results castconsiderable doubt about the effectiveness of private sector regulation as currently implemented. More importantly, thecurrent set of analyses raise fundamental questions about the pricing of AIM securities (especially as it relates to non-regulatory factors). The current results appear to reflect a tenuous equilibrium where low quality firm are attracted to a lowcost exchange with limited regulatory oversight, and yet seem to be capable of selling overpriced shares to unsophisticatedinvestors as a result of investors behavioral biases, tax attributes and/or specific risk-return preferences. Understanding howthis equilibrium is sustained, and how the AIM structure (and underlying incentives) can be altered to create effectiveregulation that screens on firm quality (without shutting out small growth firms) and creates a pricing mechanism that doesnot systematically produce investor losses represents an interesting path for future research.

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