The Going Public Decision and the Product Market

1. The Going Public Decision and the Product Market Thomas J. Chemmanur Shan He and Debarshi K. Nandy Third RICAFE Conference Entrepreneurship, Risk Capital, and the Financing of Innovative Firms

2. MOTIVATION • The decision to “go public” is one of the most important events in the life of a firm. • An IPO is the first public offering of equity, and typically the first public offering of any security undertaken by the firm. • It not only satisfies the immediate capital requirements of the firm, but also paves the way for the firm to make subsequent public offerings of equity and other corporate securities. • Since going public allows the firm access to the public capital markets for the first time in its life, it has important implications for a firm’s product market performance as well. • The going public decision has generated considerable theoretical research in recent years: e.g., Chemmanur and Fulghieri (1999), Maksimovic and Pichler (2001), and Clementi (2002).

3. MOTIVATION • Empirically however it is one of the least studied issues in corporate finance. Existing studies are either in non-U.S. markets: Pagano, Panetta, and Zingales (1998), or in special U.S. samples: Helwege and Packer (2003). • This is the first large sample study of the going public decision in the U.S. using the Longitudinal Research Database (LRD) of the U.S. Bureau of Census, which covers the entire universe of private and public manufacturing firms in the U.S. • In particular, this is the first paper focusing on the relationship between the product market characteristics of a firm and its decision to go public.

4. THIS PAPER • The objective of this paper is to bridge the above gap in the literature by addressing two related questions: • What is the relationship between the ex ante product market characteristics of a firm and its going public decision? • How does going public affect a firm’s subsequent product market performance? • We first study the relationship between the ex ante product market characteristics of a firm immediately before going public and its likelihood of going public. • We then study the dynamics of a firm’s product market performance in the years before its IPO, and in the years after its IPO.

5. THIS PAPER • We conduct the latter analysis using different methodologies: • Using both firms that went public during our study period and those that remained private throughout: • By comparing the dynamic changes in the performance of firms going public to that of firms remaining private. • Using only firms that eventually went public, comparing their performance in the years before and after the IPO to their own performance in the IPO year.

6. THIS PAPER • A secondary objective of this paper is to shed new light on the reasons underlying operating underperformance of firms subsequent to IPOs. • A number of papers (Jain and Kini, 1994, and Mikkelson, Partch, and Shah, 1997) have documented post-IPO operating underperformance. The reasons for this underperformance, are, however, controversial. • Several alternative explanations have been proposed for this underperformance, including earnings management or “creative accounting” by firms going public. • Our analysis is able to provide new insights on the relative merits of these theories for two reasons.

7. THIS PAPER • First, we examine the operating performance of firms going public for a number of (five) years before the IPO. • Existing studies focus only on operating performance in the two years (at most) before the IPO and the years subsequent to the IPO • Second, while earlier studies use accounting numbers, we use economic performance measures such as total factor productivity (TFP), derived from a variety of economic variables which are less subject to manipulation compared to accounting numbers.

8. RELATED EMPIRICAL LITERATURE • There has been little empirical research on the going public decision, since in general private firms do not need to report their financial results, so the data is not readily available. • Pagano, Panetta, and Zingales (1998): Investigate a sample of Italian firms using a data set provided by a consortium of Italian banks. • Fischer (2000): Investigate a sample of privately held German firms, some of which went public on the Neuer Markt. • It is difficult to generalize these Italian and German results to the U.S.

9. RELATED EMPIRICAL LITERATURE • Helwege and Packer (2003): Only direct empirical evidence regarding the going public decisions of U.S. firms. Use a sample of 178 firms that issued corporate bonds prior to IPO. • Hard to generalize since private firms which issue public bonds before their IPO tend to be large and highly leveraged. Only about 35 of sample firms attempted to go public. • This is the first paper which studies the going public decisions of U.S. firms using a large and representative sample: We use the Longitudinal Research Database (LRD) of the U.S. Bureau of Census, which covers the entire universe of private and public manufacturing firms in the U.S.

10. THEORY AND HYPOTHESES Relationship between Product Market Characteristics and the Going Public Decision • Chemmanur and Fulghieri (1999): Model a firm’s going public decision under asymmetric information about firm value; outsiders can produce information about firm value at a cost. • If a firm raises capital by going public, it faces some duplication in outsiders’ information production costs. • If it raises capital privately (e.g. from a venture capitalist), the provider of private financing (taking an undiversified position in the firm) will charge a risk premium over cost of funds. • The decision to go public emerges from the trade-off between this risk-premium and the duplication of outsiders’ information production costs.

11. THEORY AND HYPOTHESES Relationship between Product Market Characteristics and the Going Public Decision H1: Larger and older firms are more likely to go public. H2: Firms operating in industries characterized by less information asymmetry and more stock market liquidity of already listed firms are more likely to go public. H3: Firms operating in industries where it is easier for outside investors to evaluate the firm’s projects are more likely to go public. H4: Firms operating in more capital intensive industries and in those characterized by greater riskiness of cash flows are more likely to go public.

12. THEORY AND HYPOTHESES Relationship between Product Market Characteristics and the Going Public Decision • Bhattacharya and Ritter (1983) andMaksimovic and Pichler (2001): Develop models of the going public decision driven by product market competition between innovative private firms in an industry. Their trade-off: • Raising capital by going public allows a firm which is an industry leader to raise cheaper capital, allowing it to implement its project at its optimal scale. • However, going public has the disadvantage of releasing confidential information to competing firms. H5: Firms with greater market share in their product market are more likely to go public. H6: Firms operating in more concentrated industries are more likely to go public. H7: Firms operating in industries where the value of confidentiality is greater (e.g., high tech firms) are less likely to go public.

13. THEORY AND HYPOTHESES Relationship between Product Market Characteristics and the Going Public Decision • Clementi (2002): Assumes decreasing returns to scale in the firm’s industry. • Going public is costly, and prior to going public, a borrowing constraint keeps the firm operating at a suboptimal scale. • The decision to go public is triggered by a sudden and persistent increase in the firm’s total factor productivity (resulting in a new set of positive NPV projects becoming viable to the firm). • The productivity shock widens the gap between efficient and actual scale, so that the marginal benefit of expanding operations by going public outweighs the marginal cost of doing so. H8: Firms with higher total factor productivity (TFP) are more likely to go public. H9: Firms with higher levels of output growth and higher levels of capital expenditures are more likely to go public.

14. SUMMARY OF RESULTS Relationship between Product Market Characteristics and the Going Public Decision • Older firms, larger firms, and firms which have higher sales growth are more likely to go public. • We are the first to document the following: • Firms with greater productivity (TFP), greater market share, more capital intensive, and with projects cheaper for outsiders to evaluate are more likely to go public. • Firms operating in less competitive industries, and characterized by riskier cash flows are more likely to go public. • Firms in industries characterized by less information asymmetry and greater average liquidity of already listed equity are more likely to go public.

15. SUMMARY OF RESULTS Relationship between Product Market Characteristics and the Going Public Decision • Consistent with the implications of three of the theories of going public: • The information production theory of Chemmanur and Fulghieri, (1999); • The confidential information release theory of Bhattacharya and Ritter, (1983) and Maksimovic and Pichler, (2001); • The productivity shock theory of Clementi, (2002).

16. THEORY AND HYPOTHESES The Dynamics of Firm Characteristics Before and After the IPO • Clementi (2002): Has implications for the dynamics of firm characteristics before and after the IPO: • Before going public, performance measures like TFP increase, peaking in the year of IPO; after going public, productivity will decline due to decreasing returns to scale, giving an inverted U-shape pattern of TFP around the IPO year. • Since the firm experiences a (series of) positive productivity shock(s) prior to the IPO and increases its scale of operations, capital expenditures, output, employment and all costs will increase in the years before and after IPO.

17. THEORY AND HYPOTHESES The Dynamics of Firm Characteristics Before and After the IPO • Teoh, Welch, and Wong (1998): Immediately prior to the IPO, firms have the incentive to show superior earnings by increasing current accruals, to obtain a better IPO price: • While reported operating performance will increase immediately before the IPO, it will decrease post-IPO. • Bhattacharya & Ritter (1983), Maksimovic & Pichler (2001): • The market share may decrease or increase after the IPO, depending on the costs vs. benefits of information release.

18. SUMMARY OF RESULTS The Dynamics of Firm Characteristics Before and After the IPO • Total factor productivity (TFP) and sales growth increase steadily in the five years prior to the IPO, reaches a peak in the IPO year, and decline steadily in the years subsequent to the IPO (i.e., exhibit an inverted-U shape). • The dynamic pattern we find in various firm performance variables before and after the IPO (and especially the inverted-U shaped pattern of productivity changes) is broadly consistent with the firm increasing its scale of operations around the IPO, supporting the dynamic implications of Clementi (2002). • Sales, capital expenditures, employment, total labor costs, materials costs, and rental and administrative expenses exhibit a consistently increasing pattern in the years before and after the IPO. • Market share neither increases nor decreases in the years before or after the IPO.

25. SUMMARY OF RESULTS The Dynamics of Firm Characteristics Before and After the IPO • The dynamic pattern in firm performance around the IPO is inconsistent with operating post-IPO underperformance being generated solely by earnings management by the firm prior to the IPO. • It is unlikely that the consistent growth in firm productivity that we document in the five years (and more) before the IPO is created purely by the manipulation of performance numbers, since the performance effects of such manipulation are unlikely to persist for so many years before the IPO: they are likely to be confined to the years immediately prior to the IPO. • Further, unlike earlier studies which use accounting numbers, we use performance measures such as the total factor productivity (TFP) derived from a variety of economic variables which are less subject to manipulation compared to accounting numbers.

26. SUMMARY OF RESULTS The Dynamics of Firm Characteristics Before and After the IPO • Our post-IPO performance results indicating declines in productivity post-IPO, and the pattern of sales and capital expenditures are consistent with prior empirical literature (e.g., Jain and Kini, 1994, and Mikkelson, Partch, and Shah, 1997).

27. DATA AND SAMPLE SELECTION • The primary data source that we use in this study is the Longitudinal Research Database (LRD) • Crucial advantage: LRD covers the universe of public and private U.S. manufacturing firms. IPO firms: • Our sample of IPOs is from Security Data Corporation's (SDC) Platinum New Issues Database. • We remove all Equity Carve-outs, ADRs, ADSs, Global depository receipts, Global deposit shares, Units, Trust receipts, and Trust units. • Also require that the primary industry of the firm going public is within manufacturing (SIC 2000 to 3999); and the firm is present on Compustat for the fiscal year of the IPO. • Our sample of IPOs from SDC comprises of 2578 firms during the years 1972 to 2000.

28. DATA AND SAMPLE SELECTION • We match this sample of IPO firms to the LRD using the LRD-COMPUSTAT bridge file. Out of the 2578 firms, we matched 1315 firms to the LRD. Private Firms: • The sample of private firms is identified by removing all the public firms from the LRD using the LRD-COMPUSTAT bridge file. Other Data Sources: • In addition to product market measures from the LRD, we use CRSP and I/B/E/S for constructing industry level measures related to stock market liquidity and information asymmetry measures respectively.

29. SUMMARY STATISTICS • The firms that eventually go public in our sample period are on average about 6 times larger, and on average older than their private peers. • Firms that have an IPO, on average invest about 17% more than private firms. • The average sales growth for IPO firms is 13.3%, which is about 250% higher than the sales growth of firms remaining private. • The TFP of IPO firms is on average 3.6% higher than their industry average, while that of private firms is about 1.4% below than that of their industry average.

30. EMPIRICAL TESTS AND RESULTS Relationship between Product Market Characteristics and the Going Public Decision Estimated using the following Probit regression on panel data covering both public and private firms: Pr (IPOijt = 1) = F (1SIZEi,t-1 + 2SGTH i,t-1 +3MSHR i,t-1 + 4TFPi,t-1 + 5CAPINTi,t-1 + 6AGEi,t-1 + 7CAPR i,t-1 + 8INDRSKj,t-1 + 9HIj,t-1 + 10TOVj,t-1 + 11HTEK i,t-1 + 12LISTj,t-1 + 13STDEV j,t-1 + 14FORERR j,t-1 + 15NUMA j,t-1 + 16SP500t-1)

31. EMPIRICAL TESTS AND RESULTS Relationship between Product Market Characteristics and the Going Public Decision Firm specific product market variables: SIZE: the natural logarithm of assets (capital stock). (+) Sales Growth (SGTH): the average growth in sales in the past three years. (+) Market Share (MSHR): the firm’s market share in terms of sales at the 3 digit SIC level. (+) Total factor productivity (TFP): measure of overall efficiency. (+) Capital Intensity(CAPINT): capital stock over total employment.(+) AGE: the natural logarithm of age. (+) Capital Expenditure Ratio(CAPR): capital expenditure over assets (capital stock). (+)

32. EMPIRICAL TESTS AND RESULTS Relationship between Product Market Characteristics and the Going Public Decision Industry specific characteristics: Industry Risk(INDRSK): the industry median of the five years coefficient of variation of firm sales at the 3 digit SIC level. (+) Industry Herfindahl index (HI): (+) Liquidity (TOV): the mean of the share turnover across the equity of already listed public firms in the same 3 digit SIC industry. (+) HTEK: high tech dummy. (-)

33. EMPIRICAL TESTS AND RESULTS Relationship between Product Market Characteristics and the Going Public Decision Information asymmetry proxies: Outsiders’ Evaluation Cost ( LIST): number of firms already listed in CRSP in the same 3 digit SIC industry. (+) STDEV: the industry average standard deviations in analysts’ forecast. (-) FORERR: the industry average analysts’ forecast error. (-) NUMA : the industry average number of analysts following. (+) Control variables: Year Dummies: used in most regressions. SP500: the annual return of Standard & Poor’s 500 Index. (+)

34. Summary of Results on the Relationship between Product Market Characteristics and the Going Public Decision • Larger, older, and more capital intensive firms are more likely to go public. • Firms with higher total factor productivity and higher growth in output (sales) are more likely to go public. • Firms with higher capital expenditure ratios and firms with higher market share are more likely to go public. • Firms operating in more concentrated industries and those with riskier cash flows, are more likely to go public. • Firms in industries where projects are cheaper for outsiders to evaluate, and in industries with higher average liquidity of the equity of already listed firms and firms in industries with less asymmetric information are more likely to go public.

35. Table 3: Determinants of the Going Public Decision

36. Table 3: Determinants of the Going Public Decision

37. Table 3: Determinants of the Going Public Decision

38. EMPIRICAL TESTS AND RESULTS The Dynamics of Firm Characteristics Before and After the IPO • Following Chemmanur and Nandy (2005), Bertrand and Mullainathan (1999) and Pagano, Panetta, and Zingales (1998), we adopt the following regression framework: • Yit is the variable of interest, e.g., TFP, Sales, Capital Expenditures, Employment and Labor Costs, Material Costs, Rental and Administrative Expenses, Sales Growth and Market Share. • Xitare firm size as a control – time varying. • i firm fixed effects.

39. Summary of Results on the Dynamics of TFP, Sales, and Capital Expenditure Before and After the IPO • Consistent with Clementi (2002), the TFP of firms going public exhibit an inverted U shape, which increases before the IPO, reaches its peak at the year of the IPO, and subsequently declines. • Sales and Capital Expenditures keep increasing throughout the years before and after the IPO. • The result implies that the IPO firms are growing in the above variables over the years around the IPO compared to their private peers. • While the TFP results continue to exhibit an inverted U-shape when the regression is restricted to the sample of the going public firms, the increasing pattern of sales and capital expenditures after IPO becomes weaker (after controlling for the growth in size of IPO firms). • This means that for a unit increase in size, the sales and capital expenditures of IPO firms grow faster than that of the private firms.

40. Table 4: Dynamic Characteristics of TFP, Sales, and Capital Expenditure around the IPO

41. Table 4: Dynamic Characteristics of TFP, Sales, and Capital Expenditure around the IPO

42. CONCLUSIONS • For the first time in the literature, we document that: • Firms with greater productivity (TFP), greater market share, more capital intensive, and with projects which are cheaper for outsiders to evaluate are more likely to go public. • Firms operating in less competitive industries, and those characterized by riskier cash flows are more likely to go public. • Firms in industries characterized by less information asymmetry between firm insiders and outsiders and greater average liquidity of already listed equity are more likely to go public.

43. CONCLUSIONS • With regard to the dynamic performance of various firm measures, we also document that: • Total factor productivity (TFP) and sales growth increase steadily in the five years prior to the IPO, reaches a peak in the IPO year, and decline steadily in the years subsequent to the IPO (i.e., exhibit an inverted-U shape). • Sales, capital expenditures, employment, total labor costs, materials costs, and rental and administrative expenses exhibit a consistently increasing pattern in the years before and after the IPO. • The dynamic pattern in firm performance around the IPO is inconsistent with the operating post-IPO underperformance being generated solely by earnings management by the firm prior to the IPO.

44. Table 1: Industry Distribution of the Going Public Sample

45. Table 2: Summary Statistics

46. Summary of Results on the Dynamics of Employment, Wages, and Costs Before and After the IPO • Total employment, total wages, material costs, and rental and administrative expenses all increase over the years around IPO. • The rates of growth of these costs in IPO firms are faster compared to the firms remaining private. • The increase in total employment, total wages, material cost, and rental and administrative expenses around the years before and after the IPO are mostly proportional to the going public firms’ growth in size.

47. Table 5: Dynamic Characteristics of Firm Employment, Labor and Other Costs around the IPO

48. Table 5: Dynamic Characteristics of Firm Employment, Labor and Other Costs around the IPO

49. Summary of Results on the Dynamics of Sales Growth and Market Share Before and After the IPO • Sales growth exhibits an inverted-U pattern, increasing in the years prior to the IPO, and declining in the years subsequent to the IPO, reaching its peak at the IPO year. • Market Share of the IPO firms is unchanged after controlling for firm size.

50. Figure 4: The dynamic pattern of Sales Growth around the IPO.