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Myth Or Reality? The Long -Run Underperformance of Initial Public Offerings: Evidence for Venture and Nonventure Capital-Backed Companies

Alon Brav and Paul Gompers

Journal of Finance December 1997

(Given the title of the paper, I would be remiss if I did not add that Gompers is an EXCELLENT RUNNER! 2:11 marathoner!)

Executive Summary

Some of the long-run underperformance found in previous papers is likely the result of mismeasurement. Using the Fama-French (1993) three factor asset pricing model, the authors show that the long-range underpricing is largely found in the "smallest nonventure-backed firms….Underperformance, however, is not an IPO effect. Similar size and market-to-book firms that have not issued equity perform as poorly. "IPO underperformance is not an issuing firm effect. It is a small, low-book-to-market effect."

Innumerable researchers have examined the difficulty in pricing IPOS. The general view has been that IPOs tend to outperform in the short run, but then underperform in the longer run. Among the authors that have exposed this finding that IPOs have historically underperformed the market are Ritter (1991) and Ritter and Loughran (1995). Other papers have found that this "underperformance extends to other countries.

Part of the difficulty in pricing IPOs is the information asymmetries and "potential capital constraints discussed in Fazzari, Hubbard, and Peterson (1988) and Hoshi, Kashyap, and Scharfstein (1991)." Gompers 1995 points out "that venture capital firms specialize in collecting and evaluating information on startup and growth companies" and thus may reduce the pricing difficulties. "Barry, Muscarella, Peavy, and Vetsuypens (1990) and Megginson and Weiss (1991) find evidence that markets react favorably to the presence of venture capital financing at the time of an IPO."

This paper looks at whether there are longer-term effects associated with the presence of venture capitalists. Reasons why venture capitalists may matter include:

1. "Venture capitalists stay on the board of directors long after the IPO and may continue to proved access to capital that nonventure-backed firms lack."
2. "The venture capitalist may pit management structures in place that help the firm perform better in the long run."
3. "Venture capitalists may affect who holds the firm's shares after an IPO. [They] may have contacts with top-tier national investment banks and may be able to entice more and higher quality analysts to follow their firms."
4. The venture capitalists "reputational concerns" make the venture capitalist "less willing to hype or overprice" a stock.

An alternative (Behavorialist view) of the underpricing issue is that investors are irrational and there are cycles of underpricing that can be "attributed to investor sentiment." This line of research has grown considerably and includes papers not only on reversals but also that value investing may be a profitable trading strategy. These views have been laid out in DeBondt and Thaler (1985, 1987), Lakonishok, Shliefer, and Vishny (1994), and La Porta (1996). If the Behavorialist school is correct, then the IPO/SEO long-run underperformance is another chink in the EFM armor. However, as Fama, Barber and Lyon (1996) and Kothari and Warner (1996) point out, long run tests are often model dependent and can be biased.

Like Ritter and Loughran (1995) and Ritter (1991) this paper looks at many measures of underperformance. For example, all three papers compare on size, as well as to standard benchmarks of the SP 500, Nasdaq value-weighted, NYSE/AMEX value and equal weighted indices. This paper extends previous work by matching on size, book-to-market, and using industry comparisons as well as the Fama-French (1993) three-factor model. It also eliminates IPOs and SEOs from the control groups.

When a size and book-to market benchmark is used, the authors demonstrate that the "venture capital sample shows little underperformance. The five-year wealth relative is .97." However, the "nonventure backed IPOs show substantial underperformance relative to their industry benchmarks, .79 for the five year wealth relative."

As the authors point out, Fama and French's (1993) three factors are:

1. RMRF-the excess return on a value weighted market index
2. SMB-the return on a zero investment portfolio constructed by shorting a portfolio of large firms and investing in a portfolio of small firms
3. HML-the return on a zero investment portfolio constructed by shorting low book to market stocks [high market to book] and buying low book to market stocks.[low market to book]. [numbers added by summarizer]

Using the three-factor time-series model is used the nonventure capital backed firms underperformed when an equally weighted portfolio was used, but not significantly so when a value weighted portfolio was used. "The results indicate that IPO underperformance is driven by nonventure capital backed firms in the smallest decile."

To "address the source of the underperformance [the authors] rerun the Fama-French three factor regressions including an index [to control for] the average discount on closed-end funds." This is done to control for investor sentiment--Lee, Shleifer, and Thaler (1991) hypothesize that the discount on closed-end funds is a good measure of investor sentiment, particularly small investor sentiment.

The closed-end fund discounts and IPO returns were negatively correlated which suggests that "investor sentiment might be an important source of underperformance." Moreover, many of these results are size-driven, leading to the conclusion that "IPO underperformance is not an issuing firm effect. It is a small, low-book-to-market effect."

Almost as interesting as this finding, is the degree to which how the testing is done matters. For example, if the market portfolio is equally weighted, then there is no statistical difference between venture-backed and nonventure-backed firms, but venture-backed firms do better when value weighted measures are used.

[Note: As a result of the importance of model specification and measurement, any results should be interpreted with caution.]

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