Important Factors that Influence the Performance of Initial Public Offerings - Term Paper Example

INITIAL PUBLIC OFFERING PERFORMANCE Student name: October, 2015. ABSTRACT Initial Public offerings had been in the spot light of many researches during last decades considering two major facts that are related to it. On a one side it is a mean that privately owned companies collect the necessary funding for further business growth, and secondly there is ever lasting interest from investors side related to high returns on such investments. One of the major questions in this process is performance of privately owned companies after gone public. In order to investigate the topic of important factors that influence performance of IPO companies, there are several variables that had been analyzed for this purpose within course of this work, including : rate of return three years after IPO, age of the company, total assets of the company, ownership concentration, average return on capital employed and CEO-founder relation. It has been concluded that companies where founder stays on CEO position after IPO are performing significantly better that companies where this is not the case. Secondly, larger size companies have larger possibility to output better performance results than smaller size companies, but here, still the question remains whether small sized companies had been overpriced during the IPO process. . Keywords : IPO, performance, Table of contents: 1. Introduction ………………………………………………………….…….. page 3 2. Literature review ……………………... ….………………...………….……. page 3 3. Description of variables and analysis method ..……. …………………….. page 6 3.1. Multivariate analysis of data …………….…………………………… page 9 3.2. Effects of ownership structure on company performance ……………. page 11 4. Conclusion ………………………………………………………………… page 12 List of Reference 1. Introduction Initial Public Offering (IPO) represents a mean that is at disposal to the management of one company to collect additional funds for the increase of the business or any planned changes that would lead to future growth of the business. Its major consequences for the current state of the company is the change in the shareholder structure, but in majority of the cases, also drives changes in the management structure. On the other side, the IPO companies had always been in the spot light of investors due higher expectations of returns on investments. One of the crucial issues in this process is the performance of the companies after initial public offer is conducted and major drivers of future performance after the IPO. This topic had been in the spot light of many academic researches. There are several factors pointed in literature as significant drivers of future performance, like size of a company (Nelson, 2003), company key-person (Tamm, 2014), number of Board members (Sahoo,2014), and others. Specific requirements of this assignment call for simple roll playing, in which a junior consultant is required to provide a specific advice to a client – a large investment management firm, regarding the question of historical factors influencing future performance of new IPO companies. For this purpose, a set of historical data, which consists of 300 observations, is already provided and includes following variables: rate of return three years after IPO, age of the company, total assets of the company, ownership concentration, average return on capital employed and CEO-founder relation. In order to achieve target, data had been analyzed through univariate and bivariate statistical analysis, and discussion of the major findings is provided. In addition, a comprehensive literature review is conducted in order to attain information has been of importance for deriving conclusions and / or support the findings of the research. Concluding part of this assignment incorporates major conclusions derived through findings followed with presentation of the requested data to the client. 2. Literature review One of the most significant topics that had been in the spot line of many academic researches is performance of the companies after initial public offer is conducted. From the investors point of view, there could be noted extremely high interest for companies who are entering the market for the first time, due to expected extremely high returns on investment derived through abnormal market price increase. Ecker (2014) had concluded in his research that the luck of adequate historical data and estimation of available data with “considerable error”, within the period of approximately 18 months from the date of IPO, is the reason for such market behavior. Rock (1986) also points to “market asymmetry” in the initial period of the IPO`s. Sahoo (2014) conducted research on a topic of a relation between pricing performance of IPO and company structure of the Board through examination of Boards “size, maturity, diversity, reputation and leadership“ (Sahoo, 2014) and found out that Boards with relatively large number of members are to influence underpricing of the company more than Boards with smaller number of members. There are also many other researches on this topic that could be found in the literature, providing the same conclusion that well selected Managing Board could bring quite positive performance of the company (Sahoo, 2014). His research is also significant taking into consideration found positive correlation between size of the firm and market underpricing (Sahoo, 2014). Recently, the most famous IPO of the large IT company “Facebook“, had been also in the spot of many researchers and provided some useful conclusions. Tamm(2014) had noted that the company had already reached its peak on the users side, and that some other factors influenced significant increase in the IPO price, like “road-show” Tamm(2014) conducted, although there had been concerns expressed toward future business slow down. However, the investors perceived as a positive side that company’s key-person will still hold the majority stake in the company (Tamm, 2014). There are also researches on the subject of the company size and its performance in the IPO process. The relationship between IPO performance and company’s management has been investigated by Nelson (2003). She concluded that market participants are perceiving better companies where there is founder-led governance, simply due to the reason that they know the best “structure and strategy” (Nelson,2003). Certo (2003) had found evidence, through conducted research, that management “prestige” is having significant influence on investors perception within decision making process through IPOs. The explanation for such behavior Certo (2003) finds in a general fact that companies that had been privately owned are unknown to the investors and one of the major components that could influence investors decision is a prestige of management or owner of such company. The research conducted by Certo (2003) on a management prestige factor within IPOs was argued by Lester and others, noting that prestige is not necessarily crucial factor for investors in “different environmental conditions” ( Lester, et al, 2006). Additional question that is imposed among academics is impact of IPO to a different size companies. One such research conducted by Ganasamoorthy and Shankar (2013) on the performance of the 219 Indian companies during and after period of IPO`s had shown that large-size companies are performing better from the other companies of lesser size, but also that small-sized companies are in most cases overpriced during IPO process. Levis (1993) conducted research of the IPOs performance in the UK and US market and found that important role of company’s size to its long-run performance. He found evidence that larger size companies are outperforming lower size companies on both markets (Levis,1993). In this sense, it could be generally concluded that size of the company and IPO is one of the important determinants of company performance both on emerging and developed markets. On the other side, Ritter (1991) had found that on a long-run, taking three years period of time from initial public offering, those companies are underperforming in relation to other companies that did not passed through IPO process. As a reasons for such performance Ritter (1991) is mentioning wrong measurement of risk and “fads and over optimism” (Ritter,1991). It is also worth mentioning the work of Loughran, Ritter and Rydqvist (1994) who had found evidence that companies are perfectly timing going public, during periods when “valuations are high”, and in this sense transferring risk to the investors. Due to this reason, investors are getting lower returns (Loughran, et al, 1994). There are also other researches that support such view, noting it as a general behavior of market participants on all world markets ( Aggarwal, et al, 1993). Zarafat and Vejzagic (2014) investigated long-term returns of companies that went through IPOs in Malaysian stock exchange and found that book to market value ratio, among others, has significant impact on a three-year performance of the stock. Another topic that is widely discussed in respect to IPOs is principal / agent topic. Namely, current management of the company might be in conflict of interest in the process of IPO, which could lead to under pricing of the company. Researching this topic, Arthurs et al (2008) had found out that that under pricing of the company during IPO is increased in cases where there are existing ties between venture capitalists and underwriters. However, Bruton et al. (2010), based on researched data in 112 countries, concluded that “concentrated ownership” expressed through retain of share ownership significantly improves performance of the IPOs. On the other side, Tinic (1988) is arguing that initial public offerings shares are by default underpriced. He is noting that such behavior is coming from the intention of agents to insure against their legal liability in the process of IPO. Based on this idea, he established “implicit insurance hypothesis” ( Tinic, 1988). This is also in line with other research conducted by Benveniste et al (1998), who was investigating the way that offer price is determined by investment bankers, and found that new IPOs will be underpriced, and stressing existence of the conflict between the agents and issuing company ( Benvieniste et al, 1998). It is relatively well known the fact of influence of media on a company’s business, however, there had been researchers who investigated further this topic through examination of media influence on IPO process and valuation of an company. Pollock and Rindova ( 2003) conducted one such research in whitch they wanted to examine the influence of media on investors perception of accompany and its further interest in new initial public offering companies. The result of their research based on 225 companies that went through process of initial public offering, outputted result that the volume of information provided through media has significant impact on the positive side for the company, diminishing market information asymmetry and bringing better valuation of the company and higher interest of investors, as it reflects “ IPO`s legitimacy” (Pollock and Rindova, 2003). Rajan and Servaes ( 1997) had researched the topic of initial public offer “anomalies” which is the common name for “under pricing, hot issue markets, and long-run underperformance”. They have noted that there could be found significant level of over-optimism in the market and among analysts during the initial stages of initial public offerings. The “anomalies” that they are referring to are actually coming from wrong analyst perceptions on the future company growth and earning potential in this sense (Rajan and Servaes, 1997). However, it is not clear if those anomalies are coming from “market inefficiency” or there are some other factors that influence such market behavior. 3. Description of the variables and analysis method For the purposes of reaching defined goal of defining major factors that influence future performance of new IPO companies, set of historical data had been already provided. Data are collected for several industries which are marked in the analysis with numbers as follows: (1) computer hardware / electronics; (2) pharmaceuticals; (3) other manufacturing; (4) software development; (5) other services. Total 300 observations from period of three years, include following information: a) Variable “iporeturn” is given in percentage and represents rate of return three years after IPO, as Pt / Pt-0,Iporeturn, where Pt-0 is IPO price while Pt the trading price three years subsequently , b) Variable “age” represents the age of the company expressed in years, c) Variable “size” represents total assets of the company expressed in million British pounds, d) Variable “con” represents ownership concentration and is presented as a percentage of shares of pre-IPO owners post floatation e) Variable “founder” outputs if CEO of the company is also founder of that company. The information is provided through numerical number as follows: (1) if yes or (0) if not, f) Variable “ROCE” represents average return on capital employed over the year prior to IPO and is given in percentage. For the purposes of statistical data analysis the EVIEWS7 program had been used. Separate data are initially analyzed through descriptive statistics, including basic statistical information on mean, median, maximum, minimum, and standard deviation. Additionally, information includes skewness, kurtosis and Jarque-Berra. All data are graphically presented through histogram as a representation of probability distribution of data series. The initial analysis outputted following results : Table 1: Univariate statistical analysis for variable IPORETURN The rate of return for all companies during observed period had been in a range from 16.44 to 160.5, with average at 60.24, and deviation from average of 27.9. Table 2: Univariate statistical analysis for variable AGE The total number of years that companies had been operating during observed period had been in a range from 7 to 22 years, with average at 14,6, and deviation from average of 2,8. Table 3: Univariate statistical analysis for variable SIZE The total assets of companies expressed in billions of British pounds had been in a range from 130 to 41.977, with average at 18.355,28, and deviation from average of 9.600. Table 4: Univariate statistical analysis for variable ROCE The return on capital employed over the year prior to IPO had been in range from minus 22 to plus 101, with average 35,48 and standard deviation of 24,6. Table 5: Univariate statistical analysis for variable CON The ownership concentration of pre-IPO owners in relation to post flotation had been in range from 5% to 92%, with average 28.85% and standard deviation of 17.08 Data for CEO variable have not been statistically examined considering that they represent description of actual state : with number one are marked companies where current CEO is also founder of that company, while with number 0 are marked companies where CEO is not at the same time the founder of that company. 3.1. Multivariate analysis of data Further, it has been investigated relations between variables conducted through correlation analysis as it quantifies the amount of variation or dispersion of a two sets of data. Such analysis is useful in order swiftly to check if there are interrelations between variables and potential influences between them. Generally, if two variables are moving into same direction, there is a significant positive correlation between them, while with negative correlation, they are moving in opposite directions. Table 1. Correlation matrix Through correlation matrix it could be seen significant positive correlation between IPORETURN and variable FOUNDER of +0.41, which signifies on relationship between rate of return of company in relation wheter the CEO is also a founder of a business or not. On the other side, it could be also noted positive relation between IPORETURN and ROCE of +0.63, implying that if return of capital is increasing, the IPO rate of return will follow the trend. In addition, there is also relatively significant negative correlation between ownership concentration and age of the company of -0.31, Above mentioned correlations could be clearly seen on below graphs. Graph 1. IPORATE v.s. ROCE Graph 2. CON v.s. AGE Relatively smaller but still significant for the research purposes there are correlations between variables IPORETURN and SIZE of +0.12, and also between variables CON and IPORETURN of 0.13. , which requires further investigation in order to define concrete relationship of variables. All other variables are expressing relatively low level of correlation, due they shall be neglected in the future course of work. 3.2. Effects of ownership structure on company performance Following literature review the ownership structure and management of the company play extremely important role within an IPO process and post performance, hence, this topic deserve special attention within analysis of factors influencing company’s performance. Some of the crucial factors influencing performance of the IPOs, literature is pointing to number of Board members (Sahoo, 201), key-person (Tamm, 2014), company size ( Nelson, 2003), management prestige ( Cerrto, 2003), retained share ownership ( Bruton, et al, 2010), management conflict of interest (Arthurs, et al, 2008). Due to lack of relevant data, all factors found in literature cannot be examined, but however, following multivariate statistical analysis from previous chapter, there are expressed certain dependences between several variables, whitch are in line with found factors, that requires further analysis in order to be better understood in order to derive adequate conclusions. As previously noted, there is certain level of correlation between variables IPORETURN and FOUNDER. Going further into analysis the data had been separated into two groups : one in which CEO of company is at the same time and founder of a company and other group where it is not the case. It has been estimated that companies where CEO is also founder of the company, had 60 % better performance expressed through rate of return after three years compared with companies where CEO is not founder of the company. In the first case average rate of return was 67.72% compared with second case where companies performed with average 42.21%. On the other side, for the purposes of this analysis it has been also relevant to understand how those two groups performed before the IPO took place, which had been done through comparison of variable ROCE. Finding the average return on capital there could not be found any significant difference. This imply on conclusion that there had been an positive impact on the after-IPO company performance in cases where founder stays in the place of the CEO. It could be noted that such finding is also in line with comments made by Nelson (2003) in her research that company’s founders know the best the “structure and strategy” of their company. Following expressed negative correlation between ownership concentration and age of the company of -0.31, these two variables had been further examined. As a reference point for age of the company had been taken average number of years, where companies with higher number are treated as “old”, while companies below this number are treated as “young”. It had been concluded that “older” companies, above the average of the sample of 14 years, have lower average percentage of shares of pre-IPO owners post flotation than “younger” companies that exist less than 14 years ( average 24% v.s. 34% respectfully), implying on possibility that owners of companies for a longer period of time are much more inclined to sell their participations and leave the business, than shareholders of “younger” companies, probably hoping on a future benefits of business growth. Although variables CON and IPORATE did not express significant correlation of +0.13, still, it is relevant enough to be further examined. As a reference number had been used average concentration of old shareholders of 28.85%. The average rate of return of companies where old shareholders structure participated more than 1/3 in total shareholder structure had been 64.29, while in the case of companies where participation had been below 1/3 the performance was at level of 56.13. This imply on conclusion that retained higher level of old shareholders structure performed for at least 15% on average better in relation to companies that had old shareholder structure below 28%. Additionally, it had been concluded that companies above average size are outputting better after-IPO rate of return than smaller companies, below average size (63.22 v.s. 57.6 respectfully), while ROCE of both size companies are at relatively same level. This implies on a positive impact of the IPOs on larger companies in boosting business and profitability, which is also in line with research conducted by Levis (1993) and others, that larger size companies are outperforming lower size companies in the after IPO long run performance. However, following the work of Ganasamoorthy and Shankar (2013), it could not be concluded based on available data whether small sized companies had been overpriced during the process of IPO. 5. Conclusion Initial Public offerings had been in the spot light of many researches during last decades considering two major facts that are related to it. On a one side it is a mean that privately owned companies collect the necessary funding for further business growth, and secondly there is ever lasting interest from investors side related to high returns on such investments. One of the major questions in this process is performance of privately owned companies after gone public. It imposes changes in ownership structure and sometimes changes in the strategy of the company that imply the question of companies future performance in this sense. There are many academic researches that had been conducted on the topic of major factors that influence performance of IPO companies. There are several major conclusions that had been derived through literature like that companies are targeting to enter IPOs when there are high market valuations in order to transfer the risk to investors for their lower performance in the following years, due there are evidence that IPOs are performing lower than their non-IPO counterparts. The size of the company and “prestige” of the management had been pointed as crucial success factors. In order to investigate the topic of important factors that influence performance of IPO companies there are several variables that had been analyzed for this purpose, within course of this work, including : rate of return three years after IPO, age of the company, total assets of the company, ownership concentration, average return on capital employed and CEO-founder relation. The conclusion of the research and also the answer to the large investment managing firm on historical factors influencing future performance of new IPO companies are following: 1) CEO of a company that is also a founder of that company It is estimated that companies where CEO is also founder of that company, had performed 60% better speaking in terms of rate of return than companies whose CEO is not a founder at the same time. 2) Significant participation of old shareholders in current structure Companies that had more than 28% of old shareholders performed in average 15% better from companies where this stake is lower. 3) Long-term shareholders are more inclined to sell their stakes than shorter term shareholders It is estimated that companies older than 14 years have lower average percentage of shares of pre-IPO owners in relation to post flotation period. 4) Larger size companies are performing better in post IPO Companies above average size are outputting better after-IPO rate of return in relation to companies of relatively smaller size. 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