2.1 Under-pricing and Underperformance
This paper presents what can be considered as the most appropriate IPO certification factors determining under-pricing and underperformance, which are the reputation of the issuers’ underwriters and its sponsors. This view is backed by several studies on quality signalling, underwriters’ and sponsors’ reputation. Brau and Fawcett’s survey of over 300 CFOs, agree the most efficient way of signalling value, excluding strong accounting results, is to have underwriters with a well-known reputation. Moreover, research on ameliorating the information asymmetry by Megginson & Weiss (1991), Hadryd et al. (2010) and Cao (2011) found that it has positive effects on the issuers under-pricing and underperformance.
An IPO (initial public offering) is the primary issuance of shares by a private firm to the public. The main motive of this process is to create liquidity for the company to be invested in future projects or other business operations. The private firm (issuer of shares) will seek assistance from a financial institution also known as the underwriter to act as an intermediary between the issuer and the market. The underwriter will perform a due diligence on the issuer and value the company. Following that it will set the number of shares offered to the market with the price range and the initial offering price. In the process of valuation, there might occur discrepancies between the underwriter’s valuation and the market’s due to asymmetric information. This leads to a different perception of the stock price during the initial public offering, which results in higher first day closing prices. This phenonomenon is known as the under-pricing theory on first day stock returns. If the closing price is higher (positive first day returns) than the initial offering price, the issuer will lose out on the amount of potential extra capital to the advantage of the investors. Most research undertaken on this phenomenon is based on the United States of America market, however over the last decades, it has been stated that it is in fact an international occurrence. Jenkinson and Ljungqvist (2001) determined that the under-pricing of IPOs in developed countries is between 15 and 18 percent, on the other hand in less developed countries it is significantly higher.
Once the company is traded publicly, the information asymmetries between the investor and the issuer are reduced as the performance of the companies will be published to the market and its forces will adjust the true value of the firm. This occurs according to economic laws of market-demand and supply which will adjust the traded share prices. Some studies looked into the abnormal returns of IPOs and found that the newly issued companies perform less well in comparison to their benchmarks. Ritter (1991) looked at a sample of 1526 initial public offerings and matched them according to their industry and company size. Ritter looked at the abnormal returns over a three year time span and found that the newly issued companies had only a return of 35.47%, whereas the given benchmark has had a return of 61.86% from 1975 till 1984. Other scholars including Loughran and Ritter (1995), Baker and Wurgler (2000) and lastly Hirshleifer (2001) agreed with the findings of Ritter (1991) which were also consistent with Millers (1977) mispricing view of IPOs. A reason for the mispricing is the irrational behaviour of investors that deviates from optimal decision making. However, this explanation contradicts the traditional view of self regulating market like Schultz (2001) suggested.
However, there is also existing research that indicates that the phenomenon of underperformance is an irregularity caused by the methodological approach.
Research by Brav et al. (2000) depicts that IPO returns are similar to non-issuing firms’ returns if compared to size and similar book-to-market relations. Furthermore, misspecifications can influence models measuring the long term returns of firms and result in underperformance.
Over a long time horizon there have been attempts on explaining the phenomenon of under-pricing and underperformance. However scholars investigating this subject have not come to a consensus yet.
Concepts such as signalling, underwriter’s liability and hot and cold markets have been proposed as explanations. In the research conducted by Draho (2001), it is stated that the negative returns occur due to market mispricing and bad mismanagement of new information.
Over the next segments, the paper will discuss the theories of under-pricing and underperformance regarding information asymmetry and other factors in more detail.
2.1.1 Information Asymmetry
Hayek initially cited the issue of information asymmetry in 1945. It looks at the importance of owning information to make rational economic decisions whereas dispersed information is a widespread hindrance to decision making. Hayek recognizes that economic market inefficiencies are not only resulted by the misallocation of resources but in addition the only way to utilize “the knowledge not given to anyone in its totality is to rely on the price system”. (Hayek, 1945) In addition he described the random economic order as a marvel that cannot be beaten in efficiency “The marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; that is, they move in the right direction.” (Hayek, 1945)
The theory discussed by Hayek in “The Use of Knowledge in Society” has influenced and motivated economists to further work on the economics of information. One of the more notable economists was George Akerflof with the Article “The Market of Lemons: Quality Uncertainty and the Market Mechanism” (1970) in which he tried to elaborate the issue of information asymmetry through the quality and uncertainty of the automotive industry. The equal pricing of “peaches” (good quality cars) and “lemons” (of lesser quality cars) makes it virtually impossible for the consumer to distinguish between the two products. Akerlof’s research concludes that the prices determine the quality of the market. Low prices will drive out “peaches”, which in conclusion will only leave “lemons” behind and cause the quality deterioration of the market.
Additional research in asymmetric information economy was undertaken in the financial sector by Sanford J. Grossman (1975). Grossman developed a dual model illustrating how current prices are influenced by traders that have access to related information and those who do not. Within Grossman’s research, he indicated the likelihood of information-efficient markets that give access to all information to investors, which will result in no return for informed traders that have invested in obtaining information. This model has a dual role for prices in the economy, firstly as constraints that affect present costs and benefits and additionally it conveys information about the future to investors.
Continuative to his previous work Grossman developed in his paper “On the Efficiency of Competitive Stock Markets where Trades have Diverse Information” (Grossman, 1976) a variance model to research how prices are reflected by aggregated information. “The result that price perfectly aggregates information is not robust”. (Grossman, 1976) This can be depicted when “noise” factors, such as the total stock of risky assets, are added into the model. Grossman’s finding stated that there is a dichotomy between investing in information and when the price system aggregates information efficiently, as it will be a negative incentive for data collection. (Grossman, 1976)
Bridging the issue of asymmetric information has been an ongoing economic issue. One theory applied to overcome this problem is certification, which has taken many forms. To bridge the information gap and convey quality Klein and Leffler introduced the idea of increased market prices. (Klein and Leffler, 1981) The concept comprises to two levels of assurance; firstly, from the buyer’s viewpoint that exerts a capital commitment and secondly, under-pricing will signal the buyer a better quality, when the quality of the offer is not known due to information asymmetry. Reissuance behaviour drives price signalling as the first offering at under-price is seen as an unsalvageable capital. This “loss” can only be recovered by “good” or high-quality companies, by signalling the future earnings prospects. (Denning, 1992) Certification theory plays an essential role in the economic environment and in this case in the IPO market regarding unsalvageable capital. Booth and Smith (1986) displayed that “bonding investments are made to certify new issue price” which could potentially increase the value of the company.
Booth and Smith presented an additional model to increase the confidence of the IPO through the reputation of the underwriter. Looking at the effect of information asymmetry Booth and Smith believe that the underwriter has positive effects on the certification of the IPO, thereby decreasing the gap between the investor and issuer. It can be argued that it is in the best interest of having a good reputation, as the manipulation of information would result in a large onetime gain but would lose out on future perspective earnings. The research indicates that having a reputable underwriter may increase the valuation of the company. However, to what degree the valuation will change, will be determined by the extent of involvement of the underwriter in the IPO.
“The effects of underwriter reputation on pre-IPO earnings management and post-IPO operating performance.” by Sun, Lee, Li and Jin (2010) states that managers manage earning disclosures by applying accounting procedures well within the legal framework, in order to influence outcomes in certain events. This leads to the first hypothesis, in which some companies manipulate accounting to increase share prices to gain more capital. Thus Sun et al. expect a negative relationship between the underwriters’ reputation and the earnings management of the issuer before an IPO. The second hypothesis looks at the positive relationship between the post IPO operating performance and the underwriters’ reputation. In both cases, the study was able to prove the stated hypothesis by analysing the benefits of the underwriter before and after the issuance of the shares. Sun et al. (2010) stated: “If high levels of abnormal accruals reflect deceptive accounting, we expect the related IPOs to be shunned by investment bankers that have significant reputation capital at stake.” Therefore, we can deduct that the reputation of underwriters is essential for future client acquisition and therefore it is in their interest to fairly represent the companies’ financial situation prior the IPO and continue monitoring the performance of the company for future share issuance.
2.1.2 Under-pricing
2.1.2.1 Signalling Effect
As mentioned before signalling effect plays a crucial role in the performance of the IPO of companies. There has been empirical evidence supporting the thought that under-pricing the shares conveys a signal to the market of the company’s future earning prospects and its quality.
Allen and Faulhaber designed a model in “Signalling by Under-pricing in the IPO Market” (1989) that tries to elaborate the situation, which would be favourable for the issuing firm. The paper classifies the sample collected, depending on the expected dividend stream, into good and bad firms. The expected dividends are dependent on two factors of innovation namely, planning and execution. This creates information asymmetry between the investor and issuer, as the investors do not posses enough information about the quality and the future endeavours. The perception of whether the firm is good or bad will only vary after the first dividend pay-out, ameliorating the information asymmetry. The analysis of Allen and Faulhaber differentiates between a separating equilibrium, in which good companies signal quality with a low offer price, and a pooling equilibrium, where investors cannot distinguish between good and bad firms, as no under- pricing occurs. It concludes that pooling is more profitable for good firms, if they remain as a good company in the eyes of the investor, whereas signalling is more profitable if the future perspective of the firm changes negatively.
2.1.2.2 Liabilities of the Underwriter
In 1988 Tunic published “Anatomy of Initial Public Offerings of Common Stock”. Part of the study was to analyse to what extent under-pricing was operating as an insurance mechanism towards liabilities if they occur post the IPO process. The paper argues under-pricing is used as a quid pro quo between the issuer and the investor, as the investor gains a reward due to increased aftermarket value of the shares, this reward would reduce the risk of being sued by the investor post IPO. The hypothesis tested in the paper specifies that firms with higher exposure to legal risk are more likely to discount the potential cost from the initial offer price, whereas companies with lower risk do not account this factor in the pricing of the issuance of initial shares. To assess whether the hypothesis is correct or not he looked at IPOs taking place before and after the 1933 Securities Act. It concludes that the introduction of the legislation in 1933 had an impact on the pricing of initial offerings, which in turn influenced the investors’ return. The liabilities related to underwriters were the main factor to the results found by Tunic (1988). Overall the results are interlinked with concurrent research on information asymmetry. However Tunic argues that the under-pricing phenomenon cannot be explained through a single hypothesis.
2.1.2.3 Winner’s Curse
The winner’s curse is a phenomenon suggesting that the winner of the auction bidding tends to overpay due to either emotional aspects or information asymmetry. There are two possible outcomes of the winner’s curse; firstly, the winner/ investor bid exceeding the value of the issued share resulting in a loss or secondly, the offer price will be less than anticipated by the winner in which case the bidder will be worse of than expected. This motivates bidders to create pressure on the offer price. In addition, a model established by Rock (1986) suggests that information asymmetries in the bidding market can create an adverse impetus towards uninformed investors to partake in the auction. For instance, bad investors would win the auction if it involves bad issuances, as informed investors would not participate. On the other hand, the uninformed bidders would lose most of the time if the auction is comprised of high valued shares.
However, under the revenue equivalence theory researched by Vickrey (1961), it is suggested that the winner’s curse does not occur, as the bidders consider their own bias in the strategy.
Overall, behaviourally and empirically it is proven that the winner’s curse is a common occurrence in the auction place. (Thaler, 1988)
2.1.2.4 Cost Theory
In “How investment bankers determine the offer price and allocation of new issues” by Beneviste and Spindt (1989) it is proposed that the cost relates to the underwriter to act as a facilitator to ameliorate information asymmetry. The underwriter being normally a financial institution is trying to sell equity of the issuer to the market, however, as there is little knowledge prior to the initial public offering investors might be weary of the shares. Thus, the underwriter needs to develop a strategy to attract potential investors by either reducing the risk or increase potential return. Hence, Beneviste and Spindt state that under-pricing is the natural result to attract investors, as it acts as a risk premium. In addition, the under-pricing can be reduced by the underwriter’s ability to increase efficiency through leveraging expected future cash flows.
Furthermore, the paper argues that “under-pricing should be larger for companies with high benefit-to-cost ratios for monitoring activities, such as high-tech firms.” (Beneviste and Spindt, 1998) However, looking at companies that have a track record of operation over a long-time horizon, hence display less scope for monitoring, should be closer to the fair value.
2.1.2.5 Herding Behaviour
Devenow and Welch recognise two different herding behaviours in the paper “Rational Herding in Financial Economics” (1996), Firstly, the irrational herder is an investor that follows the larger groups investment behaviour without doing any research or rational analysis. Shiller (2000) stated that wasting time is part of peoples’ nature. Hence, investors follow the judgement of others. Secondly, the rational herder is characterised by optimal decision making that does not follow the masses. However, the rational decision making is hindered by noise and information asymmetry.
A widespread and recognised elucidation of the deficient decision-making behaviour is the reputation of the agent. The agent can increase their reputation with one of the two approaches. Firstly, “hide in the herd” which follows the decision making of the majority, hence the agent is less evaluable because everyone has the same results. Secondly, the agent distinguishes its strategy from the majority based on its personal information, which is known as “riding the herd”, signalling quality. However, empirically the models suggest that agents ignore most of the time the individual research undertaken and “hide in the herd” when the market moves inefficiently.
2.1.2.6 “Hot and Cold” Issue Markets
The IPO market undergoes cycles of variations, also known as hot and cold markets. (Ritter, 1984) The hot markets are characterized by a high quantity of offerings, a strong concentration of issuances in single industries and higher than usual under-pricing. On the other hand, cold markets have a lower volume of offerings and are more closely priced at market value.
Lerner (1994) suggests that in hot market periods the is an opportunity to gain higher returns than usual for smaller size and riskier firms, as a bullish trend characterizes the market. The bullish trend is most likely the result of a larger quantity of well performing firm issuing shares in the same industry thus giving the opportunity to less reputable firms.
2.1.3 Underperformance
2.1.3.1 Signalling Effect
The research undertaken by Jenkinson and Ljungqvist (2001) suggests positive post IPO market returns indicate “quality signalling”. However, companies that try to signal the quality need to outperform the benchmarks and give investors positive market returns. However, Ritter (1991) conducted a study on IPOs in the US market and concluded that the issuing companies are considerably underperforming its non-issuing counterparts. Brav and Gompers (1997) dispute the fact that IPOs are always underperforming in comparison to the non-issuing benchmark. In their research, it is proven that the IPOs are not underperforming the benchmarks if they are matched by size, book-to-market ratios and furthermore if the abnormal returns are value weighted. The scholars argue that it is hard to conclude whether underperformance is desirable as the definition of a good company depends on the subjects’ perspective.
2.1.3.2 Agency cost
One of the first influential papers introducing the principle of agency cost theory has been written by Jensen and Meckling (1976). It elaborates on how the conflict of interest between the principal and the agent can cause poor operative performance results. Applying this phenomenon to the IPO market, it can be seen that the management shares will be diluted if the firm decides to issue additional shares. This will result in conflict as their personal gain is under threat and therefore the goals of the principal (issuing firm) and the agent (management) are not correlating. Further studies have identified a positive correlation between operation performance at the ownership structure of the company. (Mikkelson et al., 1997) Moreover, Burghof and Kraus (2003) identified that the agency cost phenomenon was the main factor for the underperformance of IPOs in their research.
2.1.3.3 Legal Liability
The legal insurance model of Hughes and Thakor (1992) proposed that the liabilities of the underwriter partially explain under-pricing. However, underperformance can also be explained by this model as long the issuing company is co-liable. The underperformance might occur due to additional dividend pay-outs that hinder the investment prospect of the company. Another aspect to the legal liability of the issuer are the packages that are given to the investors, which bundle the issued shares with so known “litigation puts”. This enables the investors to recuperate a proportion of the losses incurred by the company if the issuer has been performing worse than expected. Hughes and Thakor conclude that the exclusion of litigation factors will lead to bias results of underperformance.
Nevertheless, some views disagree with the opinion of Hughes, such as Alexander (1993) stating that the effects of the dividend pay-outs can only be detected 3 to 5 years after the IPO and the underperformance is measured up to 3 years. In addition, Jenkinson and Ljungqvist (2001) contend with the importance of legal liability as internationally it has a much smaller impact than in the US. Hence, for the global analysis of IPOs, it makes the explanation of underperformance with the legal liability less likely.
2.2 Private Equity
2.2.1 Business Model of Private Equity
Figure 1
Private equity is the contrary to public equity, which is capital that is traded publicly on exchanges. It uses leverage buyouts (hence forth LBO), in which they use only a small fraction of capital and a larger proportion of debt financing to acquire private companies and therefore not listed. (Kaplan and Strömberg, 2009) In the figure below we can see an example of the structure of an LBO. The model bases on different processes post acquisition.
Figure 2
The fundraising phase and investment phase is explained in figure x. Through optimisation of the operations and structuring the PE fund will gain a return once it is introduced to the public market. PE funds search out companies that have stable expected future cash flow, low debt-equity ratios, are based in attractive industries, leave room for improvement in their operations and revenue expenditure and lastly, employ management teams with experience and expertise.
The participation of PE funds gives several benefits to the invested companies. In the management phase the invested company will have access to the wide knowledge of operation optimisation through management and industry expertise, knowledge in corporate financial structures and strategies to improve the valuation of the company. Furthermore, the broad network of the fund will give them further connections to knowledge-based sources and improve the reputation of the company itself. The managing phase itself will last up to 5 years before the private equity fund decides to divest from the firm and choose different exit routes to realise their returns namely, secondary buyouts, trade sales and IPOs. In this case, the thesis will focus on IPOs exclusively.
2.2.2 Dimensions of Value Creation
In 2004 Gottschalg and Berg developed a three-dimensional framework to identify the value generation created by Buyouts (henceforth BO). The first dimension is the different phases in the buyout process; the second, the causes of buyout value generation, in which primary states that the value creation is directly interlinked with the changes implemented by the PE fund; and lastly, the source of the value generation. In the figure below (figure x) we can see a complete overview of the levers and dimensions of value generation.
Figure 3
Over the next few sections, the thesis will look at the levers in more detail in order to comprehend the value generation mechanisms of BOs.
2.2.2.1 Financial Arbitrage
The primary lever of the value generation model is financial arbitrage. The basic thought behind it is to buy the target firm at a low price and sell it at the highest possible price. There are four underlying factors that impact the valuation of the target namely; key performance indicator ratios (KPI) of comparable firms in the same peer group, the financial information of the target given to the PE fund, the future growth expectations of the company and the market and lastly the agreement on the valuation between the target and buyer. (Berg and Gottschalg, 2004)
Changes in peer group valuation
The realised returns to the private equity fund between the acquisition and divestment heavily rely on the peer group ratios. The investors may benefit from the changes in the public market or even suffer from them. Thus it is important for the investor to get the timing right in both cases, acquisition and divestment.
Private Information
Only the management buyout (MBO) allows taking advantage of insider information to manipulate the acquisition price and benefit from the process. This method has been popular early on as managers were able to lower the future earning projections and decreas the value of the firm. With this current shareholders would incure losses whereas the management and the current investor would benefit from the misinformation. (DeAngelo, 1986) However, over the last decades the number of buyouts increased rapidly and therefore certain security measure were put in place and expertise on the industry grew. For instance, managers won’t evaluate the company themselves, rather independent third parties will be responsible to give unbiased evaluations under new disclosure requirements. (Magowan, 1989) In addition, the increased importance of knowledge in this area made it more problematic to withhold such information and deceive potential bidders. (Wright et al. 2001) The only way to benefit from such method is by strong information asymmetries during the acquisition and divestment phase.
Market Information
Private equity funds cannot only benefit from private information asymmetries but also can create value by assessing the target with extensive market knowledge. The market knowledge derives from the well interlinked networks that enables them to gather and interpret information that is more difficult to access by other parties. This gives them the advantage over other potential bidders in valuing the target firm accurately.
Negotiation
Value can be created by finding appropriate targets and limiting competition entering the negotiation process. Private equity funds conduct extensive research on the potential firm for acquisition and follow market/ industry trends. (Anders, 1992) Furthermore, the barrier to enter the negotiation process of the acquisition ensures that the price will not be pushed upwards in a bidding war by other investors. (Barney, 1988)
2.2.2.2 Financial Engineering
Buyout associations are well known to change the capital structure to increase the leverage of the acquired firm and decrease the cost-of-capital after tax.
The PE funds good connections into the industry of financial institutions enables them to negotiate better terms on loans than if the target would have been able to do by itself. (Magowan, 1989) The ability derives from long-lasting relationships and their reputation of not defaulting, which gives them better conditions. Overall this aids the firm to restructure their debt and equity to an optimal level. (Anders, 1992) In addition, debts are less risky in comparison to equity investment which results in a lower discount rate and consequently increasing the firm’s valuation.
By increasing the debt level of firms, the PE funds can lift the burden of corporate taxes. Under the theorem of Modigliani and Miller the increasing interest rate payments create a tax shield, which has a positive effect on cashflows. (Brealey et al., 2006) Nevertheless, Modigliani and Miller argued as well that the wealth of the shareholders are not influenced by the capital structure of the firm, due to increased risk of default. Rapport (1990) argues “borrowing per se creates no value other than tax benefits. Value comes from the operational efficiencies debt inspires.” This prompted the realisation that PE funds need to find other ways to create value and realise their desired return. This leads to the next lever operational effectiveness.
2.2.2.3 Increasing Operational effectiveness
A key characteristic of Private equity funds is the change they introduce to the firms. It is illustrated by the transformation of operations and management practices with the goal of cutting costs and improving KPI margins. (Wright et al., 2001)
After the entrance of the PE fund, it engages in restricting corporate spending and looks at company costs to be reduced. (Kaplan, 1989) By not only reducing costs can the profitability be improved but also the operational effectiveness of plants is increased by a series of changes, such as reducing the overall production costs. (Harris et al., 2002) There is contradicting views on how buyout associations influence the research and development (R&D) funding of the acquired firm. Hoskisson and Hitt (1994) indicated that the R&D is decreasing after the acquisition, whereas other research conducted was not able to support the hypothesis. (Bull, 1989; Lichtenberg and Siegel, 1990) In addition to plant productivity, PE funds will increase the organisational efficiency by cutting overhead costs. (Samdani et al., 2001)
The management of corporate assets to reduce capital requirements can increase efficiency in the firm. Samdani et al. (2001) looked at how the change in managing working capital can generate value for the firm. Moreover, the introduction of stricter inventory control and trade receivable accounts is responsible for smaller amounts of working capital compared to its peer group. (Singh, 1990; Easterwood et al., 1989) The capital expenditure strategies introduced aim to remove unneeded investments and assets that operate at full utilisation levels. (Berg and Gottschalg, 2004) These cutbacks will result in higher cashflows, which can be used to pay back outstanding debt. Private equity funds need to take into account that the strategies that implement major cutbacks in investment and current assets does not hinder the competitiveness in the market place.
Lastly, PE funds will asses the managements teams in the acquired companies and will decide if their mismanagement causes the low valuation and poor performance. Hence, if that is the case, the management will be substituted by new managers that the funds deem fit.
2.2.2.4 Increasing Strategic Distinctiveness
Buyouts cannot just improve efficiency by improving operational functions within the firm but also by reshaping key strategic decisions. There are two approaches on how the PE funds achieve change within the firm namely, refocus of core activities and buy and build strategies. (Berg and Gottschalg, 2004)
The firm will have to discontinue business-subsidies and product lines that drain financial resources from business units that give the company a competitive advantage. Hence, the product line or subsidy will be sold to interests that benefit from owning it. The main reason behind the focus on its core business is the importance of strong growth under the ownership of the buyout association, that is essential for a successful exit. (Wright et al., 2001)
In other cases, private equity funds will use the high leverage to give access to high cashflows in order to grow a niche-market. It will look to increase the firm’s revenue through heavy investment and further acquisition of competitors that results in a leading market position.
2.2.2.5 Reducing Agency Costs
The reduction of agency cost does not contribute directly to the value generation as it is not ensuring the success of the business. However, it supports the previous factors in creating value. (Wright et al. 2001) Due to the increase in debt, the management is not able to waste cash on unsound investments and focuses on repaying debt obligations. It becomes essential that all sources be used wisely by the managers in order to avoid default. (Cotter and Peck, 2001) On the other hand, high leverage has also its disadvantages. Namely, firms lose sight of long term goals and focus only on short term earnings, market changes can result in near bankruptcy (increased interest rates, the rise of substitutes).
Incentives are implemented to satisfy the principal and agent (firm and management), which leads to an alignment of objectives. Management is motivated by being offered a fraction of the equity, which changes their role from just being a manager to a co-owner of the firm. This incentivises management to improve the company’s standings (earnings, strategy etc.) and generates value for all parties. The participation of PE funds introduces another party monitoring the operations. Hence, inefficiencies that could endanger the future value generation can be throttled by closer and more frequent monitoring processes. (Singh, 1990)
2.2.2.6 Parenting Effect
Research on conglomerates identified that businesses could benefit from a “parenting advantage”. (Goold et al., 1994) A similar effect can be achieved through PE funds as they assist most of the firms in their portfolio to generate value.
Being part of the portfolio can create an entrepreneurial mindset that reintroduces new innovative ideas and resources to business units which have been underinvested due to risk aversion. The new energy, which is known amongst researches as “LBO fever”, enables the management to make more decentralised decisions, subsequently the incentive to make the take-over a success is high.
2.2.3 Buyout transactions and its impact on IPO performance
In the following part, the paper will look at the findings of other scholars that identified the effect that sponsoring has on the aftermarket IPO performance.
3 Hypothesis
During the review of related literature, the paper identified that under-pricing and underperformance are influenced by information asymmetry and the levers introduced by Berg and Gottschalg. Scholars argue that the involvement of private equity funds can ameliorate agency cost and information asymmetry.
Furthermore, there has been a huge variation in the results of IPO performance when taken into account company sponsoring. In addition, most research is based on the US market. The following hypotheses will try to ameliorate the gap of this topic. Thus, the German market will be investigated on the IPO performance over a time horizon of 2004 till 2013.
3.1 Hypothesis I: IPOs in the German market are underperforming their corresponding Benchmarks in the long-run
It has been stated throughout most of the literature review that IPOs underperform their corresponding benchmarks, in this case, the German equity market DAX, MDAX and SDAX, also, their non-issuing peer group. There has been some evidence that in “hot market” time spans issuing companies can take advantage of overvaluation and gain a much higher first-day return through the under-pricing phenomenon. However, evidence suggests that this benefit is absorbed in the long-run and the performance returns to a lower mean.
3.2 Hypothesis II: IPOs in the German market are outperforming their corresponding Benchmarks in the short- and medium-run