Hot IPOs Can Damage your Long-Run Wealth! Essay Example for Free

Hot IPOs Can Damage your Long-Run Wealth! Essay This paper investigates the links between hot markets, long run underperformance and venture capital in the UK using a unique sample of 593 IPOs for the 1985-2003 period. It finds no evidence for long run underperformance for the full sample but does find robust support for significant underperformance during hot markets. The significant hot market return differential relative to the first day trading is consistent with investor sentiment and market timing. The differential relative to the offer price is also statistically significant thereby confirming Ljungqvist et al. ’s (2006) first prediction and providing further support for long run underperformance by hot market IPOs. The evidence does not support certification hypotheses. Hot-market, venture-backed IPOs underperform very significantly while their non-venture counterparts suffer substantial negative returns for only three years post-IPO. Similarly, the significantly negative relationship between underpricing and long-term returns for venture-backed IPOs during hot markets furnishes evidence of market timing. Industry analysis reveals that the return differential is significant for the high-technology sector both for the full sample and separately for venture-backed and non-venture IPOs. Indeed a majority of high-technology firms in the sample went public during hot markets. Cross-sectional regressions provide additional support for significant underperformance by high-technology firms in hot markets for the whole sample and non-venture IPOs. Finally, IPOs in general and venture-backed IPOs in particular with strong pre-IPO earnings growth generated significantly superior performance in all periods. The impact was most marked during hot markets, suggesting a role for robust pre-IPO operating results in determining the likelihood of long-term performance. 1. Introduction Loughran and Ritter (1995) find for a sample of almost 5000 US IPOs 1970-1990 that investors receive annual returns of just 7% on average in the five post-issue years. To place this underperformance in context, investors would have had to invest a staggering 44% more in issuers than in similar-sized non-issuers to achieve the same terminal wealth. Their graphic conclusion is that â€Å"Investing in firms issuing stock is hazardous for your wealth† (Ibid. p. 46). Long run underperformance has puzzled researchers in financial economics ever since and is identified by Ritter and Welch (2002) as possibly the most controversial area of IPO research. This paper has three objectives. The first is empirically to test hypotheses related to hot markets and especially some of those proposed by Ljungqvist, Nanda and Singh (2006). To our knowledge the latter has not been done to date. Ljungqvist et al. argue that investor sentiment is the underlying cause of the IPO underperformance anomaly. They propose that a test of underperformance in hot markets relative to the offer price rather than the first day trading price provides a tougher hurdle. We adduce empirical support for significant underperformance in hot markets relative to both the first day trading price and to the offer price. These are in line with those of Ritter (1991), Cook, Jarrell and Kieschnick (2003) and Helwege and Liang (2004) and Derrien (2005) who link investor sentiment to hot markets. Our results are in agreement with recent findings for IPO markets in other countries. Helwege and Liang (2004) compare US firms going public in hot and cold markets during 1975-2000 and examine their performance over the following five years. Both hot and cold market IPOs are found in the same narrow set of industries and hot markets occur at the same time for many industries. Their results suggest that hot markets reflect greater investor optimism rather than other factors. Cook et al. (2003) also find that US IPOs during hot markets have lower long-term returns than IPOs during cold markets due to sentiment investors driving prices beyond their fair value. Derrien (2005) is one of the few hot market studies to focus on a non-US market. His findings support the view that IPOs occurring during bullish market conditions in France are overpriced. The second objective is to explore the links between long run underperformance and hot markets for a sample of UK IPOs. In this context it is the first attempt to investigate such links in the UK which boasts one of the largest and most developed capital markets outside the United States. Ibbotson and Jaffe (1975) and Ritter (1984) pioneered the hot markets concept. They documented the existence of hot periods of high IPO volume (underpricing) where subsequent underperformance tends to be more dramatic. The implication is that market timing is uppermost in issuers’ minds when taking advantage of market sentiment in such periods. Our UK sample comprises of a set of 593 venture-backed and non-venture IPOs on the Official List of the London Stock Exchange over the period from 1985 up to 2003. The advantages of this sample are twofold. On one hand, it is a relatively large sample according to the definition of Ritter (2003) who points out that Japan and the UK are the only countries other than the US that can muster IPO samples in excess of 500. On the other hand and more importantly, our UK IPO sample differs in one fundamental aspect from US samples. The latter contain a large proportion of high-technology firms while our UK sample is more evenly distributed by industry. Thus our data should provide a basis for robust hypothesis testing of aspects of long run underperformance. The third objective of the paper is to explore the conjecture first postulated by Brav and Gompers (1997) that venture capitalists play an important role in explaining the underperformance puzzle. They show that US venture-backed IPOs outperform non-venture IPOs five years after the offer date and conclude that underperformance primarily resides in small non-venture IPOs which are the most likely to be influenced by investor sentiment. However, our sample shows no significant difference in returns between venture-backed and non-venture IPOs in contrast to the Brav and Gompers (1997) findings. The return differential between hot and normal markets is highly significant for venture-backed IPOs although it is only marginally significant for non-venture firms. Industry analysis reveals that this return differential is significant for the high-technology sector for both the full sample and separately for venture-backed and non-venture IPOs. We find some evidence of venture capitalists exploiting investor sentiment during hot markets which is confirmed by a significantly negative relationship between underpricing and long-term returns for venture-backed IPOs during hot markets. This latter finding contrasts with that of Helwege and Liang (2004) who find no significant role for venture capital presence during either hot or cold markets in the US. The remainder of this paper is organised as follows. In section 2 the literature on long run IPO performance, venture capital involvement and investor sentiment is reviewed. Section 3 describes the data and methodology related to performance measurement. Section 4 discusses the empirical results of univariate sorts and cross-sectional regressions. A final section concludes. 2. Hot Markets and Long-run IPO Underperformance 2. 1 The underperformance anomaly While long run underperformance is well documented for the USA, results for other countries such as the UK are rather limited. Levis (1993) used a sample of 712 UK IPOs 1980-1988 to document significant long-term IPO underperformance 36 months after the first trading day. Espenlaub, Gregory and Tonks (2000) re-examine the evidence on the long-term returns of IPOs for a sample of 588 UK IPOs 1985-1992. Using an event-time framework, they find substantial negative abnormal returns after the first three years irrespective of the benchmark used. Although some researchers underline the role of hot IPO markets, only a few empirical studies have so far compared long-run performance in hot and cold (normal) markets. Helwege and Liang (2004) study a US sample of 3,698 IPOs between 1975 and 2000. Distinguishing between hot, cold and neutral markets they find both hot and neutral market IPOs tend to underperform while cold market IPOs tend to outperform a variety of benchmarks. After adjusting for economic conditions, they find little evidence for cross-sectional differences between the characteristics of hot and cold market IPOs and no significant difference between their post-issue operating performances. These findings lead the authors to conclude that hot markets are primarily driven by investor optimism. Similarly, Cook et al. (2003), using 6,080 US IPOs between 1980 and 2002, show that IPOs during hot markets tend to perform more poorly than IPOs during cold markets. They find that IPOs trade at higher valuations and their offer sizes are larger during hot markets and that these firms are less likely to survive. They conclude that investor sentiment is a more important feature of IPO markets then hitherto recognised. Non-US studies are rare but Derrien (2005) is a notable exception. He develops a model in which bullish noise trader sentiment during hot markets leads to overpriced IPO shares relative to their long-run intrinsic value. Using a sample of 62 IPOs on the French stock exchange for the hot period of 1999 till 2001, he empirically shows that the long-run stock price performance of IPO shares is negatively impacted by investor sentiment. Ljungqvist, Nanda and Singh (2006) build a theoretical model in which the presence of irrational investors leads to hot markets and the associated long-run underperformance. In their model, sentiment investors purchase stock from institutional investors at inflated prices. Underwriters allocate new issues to their institutional client base if there is insufficient sentiment demand, perhaps due to a hot IPO market and many issuers trying to tap the capital markets. These institutional investors then sell off their holdings at increased prices to exuberant investors post-IPO who are driven by market fads. The sentiment driven prices, on the other hand, deflate over time, leading to negative returns. Below we extend the existing hot market studies by empirically testing some of the hypotheses proposed by Ljungqvist et al. (2006). 2. 2 Venture capitalists and investor sentiment While much of this literature stresses asymmetric information and the certification role of venture capitalists, a part of it also ascribes a role to investor sentiment. Brav and Gompers (1997) were the first to test the long-run performance of a sample of new issues disaggregated into venture-backed and non-venture IPOs. They use a sample of 934 venture capital backed IPOs and 3,407 non-venture IPOs in the United States from 1972 through 1992 and show that venture-backed IPOs outperform non-venture IPOs over a five-year period. They conduct an asset pricing analysis and find that venture-backed IPOs do not underperform while non-venture IPOs indicate severe underperformance. Partitioning the non-venture IPOs on the basis of size shows that underperformance resides primarily in small non-venture IPOs. Brav and Gompers (1997) argue that bouts of investor sentiment are a possible explanation for the severe underperformance of small non-venture IPOs because the latter are more likely to be held by individuals. Along similar lines, Megginson and Weiss (1991) show that institutional ownership of IPOs is substantially higher for venture-backed than for non-venture IPOs. They report that institutions hold, on average, 42. 3% of the offer in venture-backed firms as compared to 22. 2% of the amount offered in non-venture backed firms. We employ the hot market concept to shed new light on the role and performance of venture versus non-venture backed firms 3. Data and Methodology 3. 1 Data A unique sample was selected from the IPOs listed on the London Stock Exchange for the period from January 1985 to December 2003. IPOs of investment trusts, financial companies, building societies, privatisation issues, foreign-incorporated companies, unit offerings and spin-offs are excluded. The filtering process also excludes share issues at the time of a relisting after a firm is temporarily suspended or transfers from lower tier markets such as the now defunct Unlisted Securities Market and the Alternative Investment Market. We exclude the latter IPO market established in 1995 since it has no minimum market capitalization and would likely lead to a small company bias. The final sample consists of 593 IPOs of ordinary shares by domestic operating companies on the Official List of the London Stock Exchange with listing methods comprising placements or offers for sale at a fixed price. This is the result of the filters applied to a total of 2,489 IPOs that listed on the Official List of the London Stock Exchange for the period 1985-2003. The sample include some 317 venture-backed and 276 non-venture IPOs. The data sources include Datastream, the London Stock Exchange Quality of Markets Quarterly Reviews, Primary Market Fact Sheets and Yearbooks, IPO prospectuses, Extel Financial microfiches and Thomson Financial Global Access Database.