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Competitive Effects of IPOs

By Harvard Law School Program on Corporate Governance

(Editor?s Note: This post comes to us from Hung-Chia Hsu of the University of Wisconsin Milwaukee, Adam V. Reed of the University of North Carolina at Chapel Hill, and Jörg Rocholl of the ESMT European School of Management and Technology.)

In our paper The New Game in Town: Competitive Effects of IPOs, which was recently accepted for publication in the Journal of Finance, we investigate the returns and operating performance of publicly traded firms around the time of large IPOs in their industry with two goals in mind.

First, we seek to measure the performance of publicly traded firms around IPOs in their industries. If IPO firms can successfully compete against publicly traded firms, then we would expect these competitors to perform worse after the IPO. We indeed show that industry competitors experience negative stock price reactions around IPOs and a significant deterioration in their operating performance after these IPOs. As further evidence that IPOs are responsible for this underperformance, we show that withdrawn IPOs have the opposite effect: publicly traded firms respond positively to the withdrawal of an IPO in their industry.

Second, we seek to explain the underperformance of publicly traded firms by examining the relation of cross sectional differences in performance and survival to firm competitiveness. We identify three determinants of the competitive advantage of IPOs over industry peers. First, as a direct consequence of the IPO, the offering recapitalizes the issuing firm in a way that generally results in a low debt-to-equity ratio. Low leverage may give issuing firms an advantage over their more highly leveraged competitors by allowing them more flexibility in their investments. This effect has been documented empirically in papers outside the IPO literature. Second, issuing firms have the advantage of being recently certified by investment banks. To the extent that the certification effect is stronger for new issues, the certification role of investment banks affects investors? willingness to purchase new issues as opposed to shares of other firms in the same industry. Third, new entrants may have some nonfinancial advantage over their industry competitors; a non-financial advantage may make issuing firms more attractive to investors.

We find that performance and survival of publicly traded competitors are each related to all three of these determinants. Controlling for a number of factors such as market timing and the hotness of the IPO environment, we document that competing companies show relatively better operating performance after large IPOs in their industry if they have less leverage, if their IPO has been underwritten by a highly ranked investment bank, and if they spend more on research and development. In addition, we find empirical evidence that these factors also affect a competitor?s probability of survival for the three year period after the IPO.

The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on August 21, 2009 (boomark / email).