Venture capital investment and the performance of entrepreneurial firms: Evidence from China

We examine the contributions of venture capital investment to entrepreneurial firms in China. Based on a panel dataset of Chinese manufacturing firms, we investigate the performance and R&D activities of venture capital-backed (VC-backed) and non-VC-backed firms during the period 1998 to 2007. We explore whether VC-backed firms in China generally outperform their non-VC-backed counterparts, and if so, whether this outperformance is mainly attributed to the ex-ante screening or ex-post monitoring efforts of venture capitalists (VCs). We then determine whether the different types of VCs and investment approaches affect the ex-post monitoring efforts of VCs, and consequently, the performance and R&D activities of the VC-backed firms. Our analysis shows that VC-backed firms outperform non-VC-backed firms in terms of profitability, labor productivity, sales growth, and R&D investment. First, VCs select firms with higher profitability, labor productivity, and sales growth, as well as firms that invest more in R&D activities. Moreover, the differences in profitability and labor productivity are significantly magnified after VC entry. After receiving investment from VCs, firms on average achieve magnified higher ROS, ROE, and labor productivity compared to non-VC-backed firms. However, no evidence demonstrates the magnified improvement in sales growth or R&D investment of the VC-backed firms after the venture investment is made. We distinguish the screening and value added effects by using propensity score matching. We also use instrumental variables to determine whether the post-investment performance improvements of the firms are driven by the venture capital investment. Finally, we find different types of VCs and investment approaches affect the performance of the firms after the investment is made. Foreign VCs add more value to the firms they invest in compared to domestic VCs. Firms backed by syndicated investment perform better and invest more in R&D after the investment is made compared to those backed by non-syndicated investment and non-VC-backed firms.     

The reputation effect of venture capital

The main purpose of this paper to examine how the reputation effect of venture capital (VC) is associated with the initial return and ex-post performance of its invested IPO firms. In this paper, we use 267 Taiwanese IPO firms in 1994–2007 periods and find that VC-backed firms outperform non-VC-backed firms in terms of ex-post equity market-to-book ratio, ROA and R&D expenditure ratio. For those VC-backed IPOs, reputable VC-backed firms outperform mediocre VC-backed ones. Moreover, among the four proxies of VC reputation, the market share with respect to total IPO proceeds is most promising in explaining IPO firms’ ex-post performance. The overall result confirms the reputation effect associated with VC.     

Earnings management in IPOs: Post-engagement third-party mitigation or issuer signaling?

Initial public offering (IPO) firms typically hire auditors, underwriters, and attorneys to assist in the IPO process. Many firms that take the IPO route are also backed by venture capitalists. In the extant literature, these four specialists (auditors, underwriters, attorneys, and venture capitalists) are termed third-party certifiers. In this study, we examine 3900 IPOs from 1985 to 2005 and document a significant negative and robust correlation between IPO firm earnings management and the presence of prestigious third-party certifiers. Next, we test if this correlation is driven by (1) IPO firms attempting to signal firm quality or (2) third-party certifiers mitigating earnings management in the issuing firm. Using a two-stage multivariate model, we find empirical support for the signaling hypothesis — IPO firms self-select prestigious certifiers for IPOs. We do not find support for post-engagement mitigation hypothesis — after engagement, third-party certifiers do not significantly impact earnings management in IPOs.     

Underwriter reputation,earnings management and the long‐run performance of initial public offerings

This study contributes to the extant literature on the nature of earnings management surrounding initial public offerings (IPOs) by investigating the role of underwriter reputation. We argue that prestigious underwriters will protect their reputation by carefully monitoring and certifying financial information on IPO firms, thereby limiting any potential earnings manipulation. As a result, those IPO firms that are associated with more prestigious underwriters are likely to exhibit substantially less‐aggressive earnings management. Conversely, we find the existence of a negative relationship between earnings management and the post‐offer performance of an IPO firm’s stocks only for those firms associated with less‐prestigious underwriters.     

Local underwriter oligopolies and IPO underpricing

We develop a theory of initial public offering (IPO) underpricing based on differentiated underwriting services and localized competition. Even though a large number of investment banks compete for IPOs, if issuers care about non-price dimensions of underwriting, then the industry structure is best characterized as a series of local oligopolies. We test our model implications on all-star analyst coverage, industry expertise, and other non-price dimensions. Furthermore, we posit that venture capitalists (VCs) are especially focused on all-star analyst coverage, and develop the analyst lust theory of the underpricing of VC-backed IPOs. Consistent with this theory, we find that VC-backed IPOs are much more underpriced when they have coverage from an all-star analyst.     

Public policy and venture capital: Pursuing the disclosure goal

Using a sample of US firms that went public between 2000 and 2011, we conduct a textual analysis of 10-K filings to jointly evaluate the impact of the Sarbanes-Oxley Act and venture capital (VC) on the disclosure practices of both VC- and non-VC-backed IPOs. We find that the annual reports of VC-backed IPOs are much more readable than the annual reports of their peers. This finding suggests that VCs introduce more clarity into financial reporting to improve the reaction in the firm market price to create value and feed their own reputation. On the contrary, we find that the Sarbanes-Oxley Act forces firms to produce longer 10-Ks consistent with the aim of the reform (Title IV) to enhance financial disclosures. In turn, this ends up to negatively impact on the readability.     

Politician as venture capitalist: Politically-connected VCs and IPO activity in China

This study examines the impact of venture capitalists' (VC) political connections on their portfolio companies. Specifically, we use a manually-collected dataset of VCs' political connection to investigate the potential benefits and costs that politically-connected VCs bring to their portfolio companies. On the benefit side, we find that companies backed by politically-connected VCs are more likely to obtain IPO approval from the Chinese Securities Regulatory Commission (CSRC, China's counterpart to the SEC in the US). On the other hand, these VCs are more likely to acquire equity in the company at a significant discount and to invest shortly before the IPO application. In addition, we find that politically-connected VC-backed companies do not experience greater improvements in financial performance, corporate governance, or innovation output subsequent to receiving venture financing. Our results further show that companies backed by VCs with political connections are less mature and experience more underpricing at their IPO than non-politically-connected VC-backed companies. Finally, we find that, compared to non-politically-connected VCs, politically-connected VCs exit earlier after a company's IPO and that their portfolio companies experience greater post-IPO underperformance and performance volatility.     

Venture capital reputation and investment performance

I propose a new measure of venture capital (VC) firm reputation and analyze its performance implications on private companies. Controlling for portfolio company quality and other VC-specific factors including experience, connectedness, syndication, industry competition, exit conditions, and investment environment, I find companies backed by more reputable VCs by initial public offering (IPO) capitalization share (based on cumulative market capitalization of IPOs backed by the VC), are more likely to exit successfully, access public markets faster, and have higher asset productivity at IPOs. Further tests suggest VCs’ IPO Capitalization share effectively captures both VC screening and monitoring expertise. My findings have financial implications for limited partners and entrepreneurs regarding their VC-sorting activities.     

Venture capital and underpricing: capacity constraints and early sales

I present a model of the venture capital (VC) and public markets in which VCs suffer from capacity constraints, due to the shortage of skilled VC managers. Consequently, VC firms can only handle a limited number of new projects at once, having to divest from ongoing projects in order to take advantage of new opportunities. This framework is able to match key features presented by the VC and initial public offer (IPO) empirical literatures: (1) VC-backed firms are younger, smaller, and less profitable at the IPO than their non-VC backed counterparts; (2) VC-backed IPOs are more underpriced than non-VC backed ones, (3) there is a positive relationship between underpricing and VC fundraising; (4) small and young VC firms usually take portfolio firms public earlier than their large and mature counterparts; (5) in hot IPO markets, VCs are more likely to take public both very young and small firms as well as mature and large firms, compared to cold markets. Differently, non-VC backed firms are usually smaller and younger in hot markets than in cold ones.     

The Pricing of Initial Public Offers of Corporate Straight Debt

This study examines the initial-day and aftermarket price performance of corporate straight debt IPOs. We find that IPOs of speculative grade debt are underpriced like equity IPOs, while those rated investment grade are overpriced. IPOs of investment grade debt are typically issued by firms listed on the major exchanges and underwritten by prestigious underwriters. In contrast, junk bond IPOs are more likely to be handled by less prestigious underwriters and are typically issued by OTC firms. Our analysis also reveals that bond rating, market listing of the firm, and investment banker quality are significant determinants of bond IPO returns.     

Underwriter Reputation, Initial Returns, and the Long-Run Performance of IPO Stocks

We find that the underperformance of IPO stocks relative to the market over a three-year holding period is less severe for IPOs handled by more prestigious underwriters. Consistent with prior studies, we also find that IPOs managed by more reputable underwriters are associated with less short-run underpricing. Among the various existing proxies for underwriter reputation, the Carter–Manaster measure is the most significant in the context of initial returns and also in the context of the three-year performance of IPOs. The study also provides an updated list of the Carter–Manaster measure for various underwriters.     

AN ANALYSIS OF THE UNDERWRITER SELECTION PROCESS FOR INITIAL PUBLIC OFFERINGS

This study extends previous research that shows prestigious underwriters avoided underwriting smaller, more speculative initial public offerings (IPOs) during a post-SEC period, 1966–77. Estimating a logit model with a sample of 1,192 IPOs from 1977 to 1988, we evaluate the effect of offering characteristics and prevailing market conditions on the probability a prestigious investment banker will underwrite an IPO. Similar to previous studies, we find that prestigious underwriters avoid smaller, riskier issues. However, we also find stock market volatility, interest rate volatility, and the strength and profitability of the recent market for seasoned new issues to be important determinants of a prestigious underwriter's decision to underwrite an IPO.     

UNDERWRITER REPUTATION AND REPETITIVE PUBLIC OFFERINGS

A recent examination of underwriter reputation and initial public offerings (IPOs) suggests that one of the reasons prestigious underwriters market low-risk IPOs is to increase the expected present value of subsequent offerings. There is a greater likelihood that a firm issuing low-risk IPOs will be a viable future operation with the potential for subsequent offerings than a firm issuing high-risk IPOs. I examine the hypothesis that the likelihood of subsequent offerings is negatively related to IPO risk. In addition to finding support for this hypothesis, I show that the likelihood of subsequent offerings is positively related to the IPO underwriter's reputation and negatively related to the IPO gross spread. Finally, I find that the likelihood of firms switching IPO underwriters for subsequent offerings decreases with increasing IPO underwriter reputation.     

合资承销商影响新股破发率的实证研究

新股破发是目前中国股市目前面临的一个重要现象。本文基于2004年至2010年上市的A股IPO,研究合资承销商对新股破发率的影响。研究发现,合资承销商所承销的新股破发率显著低于本土承销商。合资承销商的低破发率主要归功于更加有效且符合市场预期的一级市场发行定价能力,其表现为合资承销商发行的股票的短期市场价格相对发行价的偏离程度显著低于本土承销商发行的股票。另外,我们还发现合资承销商采取了一定的托市行为,该行为也减小了短期内新股跌破发行价的概率。本文的发现从新股发行的角度提供了开放金融市场对我国资本市场影响的新现象。     

The Diversification Effects of Initial Public Offerings

Abstract:  A firm's stock becomes publicly tradable through an initial public offering (IPO). This study suggests a portfolio diversification perspective to explore IPOs. We examine whether investors can gain diversification benefits by adding an IPO portfolio to a set of benchmark portfolios sorted by firm size and book-to-market ratio. Using US IPOs from 1980-2002, we find that adding a value-weighted IPO portfolio does lead to a statistically and economically significant enlargement of the investment opportunity set for investors relative to investing solely in a set of benchmark portfolios. Specifically, the Sharpe ratio of the tangency portfolio increases by 5.50% on average after including IPO stocks. Furthermore, IPOs associated with prestigious lead underwriters are the main source of this augmentation of the mean-variance investment opportunity set. Finally, our study implies that issuing IPO exchange traded funds or similar products can provide diversification gains to investors.     

Underpricing and long-run performance of Chinese IPOs: the role of underwriter reputation

This study examines the impact of underwriter reputation on IPO underpricing and long-run performance in the China stock market over the period 2001 to 2006. This sample period is notable for the implementation of a verification and approval system that occurred during it, which provided underwriters more freedom to price IPOs. We develop two alternative proxies to measure underwriter reputation based on either the ratio of the total gross proceeds raised or the number of IPOs managed by each underwriter. We find that underwriter reputation does not affect the level of underpricing, but that the level of long-run underperformance is significantly mitigated when IPOs are managed by more prestigious underwriters.     

Foreign VCs and venture success: Evidence from China

This paper analyzes the role of foreign VCs in driving venture success in emerging markets. We analyze a comprehensive data set of 4753 portfolio companies from China. We test whether the presence of a foreign VC increases the likelihood that a portfolio company is successfully exited. We find that the presence of a foreign VC does not per se significantly increase the likelihood of a successful exit. However, the likelihood of a successful exit increases if the foreign VC collaborates with a joint venture (JV) partner. Further, the impact of foreign VC backing depends on the nature of the VC, with foreign VCs tending to perform better when investing in late-stage companies and when they are diversified across industries. If a foreign VC successfully exits an investment, then, compared with a domestic-VC, it prefers to exit via a M&A or secondary-buyout than via an IPO, reflecting the significant lock-up periods associated with VC-backed IPOs in China, the difficulty of achieving a foreign listing, and the difficulty listing a start-up on Chinese markets.     

Underwriter reputation and underpricing: evidence from the Australian IPO market

Dimovski and Brooks (J Intern Financ Mark Inst Money 14:267–280, 2004b) examined 358 Australian industrial and mining company initial public offerings (IPOs) from 1994 to 1999 to report that more money was left on the table by IPOs that engaged underwriters than those that did not engage underwriters. Loughran and Ritter (Autumn 5–37, 2004) suggested that the negative relation between underwriter reputation and underpricing has reversed in the 1990s with U.S. IPOs. The main purpose of this paper is to study the relationship between underwriter reputation and underpricing in terms of Australian IPO data. In this paper, we use 380 Australian industrial company IPOs from 1994 to 2004 to perform the empirical study. Our results suggest that more prestigious underwriters are associated with a higher level of underpricing. Other variables that are found to be significant in explaining the level of IPO underpricing are market sentiment, share options, total capital raised and underwriter options.     

Universal Banking, Asset Management, and Stock Underwriting

This paper examines institutions that underwrite IPOs and have asset management divisions from 1993 through 1998. We provide evidence that these firms use asset management funds as vehicles to help them earn more equity underwriting business. We also show that asset managers affiliated with IPO underwriters use their superior information about their own institution's IPOs to earn annualised market adjusted returns 7.6% above asset managers of firms who did not underwrite the IPO. Superior future returns by asset managers who trade affiliated IPOs are dependent on the information environment for the IPO and the underwriter reputation rank.     

Do institutional investors play hide-and-sell in the IPO aftermarket?

We document a robust buy/sell asymmetry in the choice of the broker in the IPO aftermarket: institutions that sell IPO shares through non‑lead brokers tend to have bought them through the lead underwriters in the IPO aftermarket. This trading behavior is consistent with institutional investors hiding their sell trades and presumably breaking their laddering agreements with the lead underwriters. The asymmetry is the strongest in cold IPOs and is limited exclusively to the first month after the issue, when the incentives not to be detected are the strongest. We show that the intention to flip IPO allocations is not an important motive for hiding sell trades from the lead underwriters. We find that hiding sell trades is an effective strategy to circumvent underwriters' monitoring mechanisms: the more institutions hide their sell trades, the less they are penalized in subsequent IPO allocations.