CONFLICTS OF INTEREST AND THE PERFORMANCE OF VENTURE- CAPITAL-BACKED IPOs: A PRELIMINARY LOOK AT THE UK

Transcription

1 CONFLICTS OF INTEREST AND THE PERFORMANCE OF VENTURE- CAPITAL-BACKED IPOs: A PRELIMINARY LOOK AT THE UK by Susanne Espenlaub Ian Garrett Wei Peng Mun First draft: August 1998 This version: 18 March 1999 Submitted to Venture Capital: An International Journal of Entrepreneurial Finance 1

2 ABSTRACT We document the incidence of initial public offerings (IPOs) issued by UK companies with existing venture capital investors and sponsored (and underwritten) by issuing houses that are parents or affiliates of the venture capital backers. The effects on the performance of the stock offering of the resulting conflicts of interest between the venture capitalist-affiliated sponsors and the investors taking up the stock is examined. Contrary to the conflicts-of-interest hypothesis, IPOs underwritten by VC affiliates perform better in the long-term than other IPOs. We also examine the role of the reputation of the financial firms involved in the IPO. The long-term performance of UK IPOs is found to be positively related to the reputation of the venture capital backers. In the short-term, IPO returns appear to be related to the prestige of the sponsor rather than the venture capitalist in that top 15 underwriters are associated with lower short-term returns. Although there is evidence of higher initial returns in IPOs where the sponsor and venture capitalist are affiliated, this is offset by an approximately equal reduction in initial returns if the venture capitalist is associated with an issuing house which may or may not act as the actual IPO sponsor. Thus, the net effect is that backing by venture capitalists with links to issuing houses reduces initial returns but only if those affiliates are in fact not employed as the actual sponsors to the offerings. Keywords: venture capital, initial public offering (IPO), flotation, underwriting. 2

3 AUTHORS BIONOTE The authors are from the Manchester School of Accounting & Finance, Manchester University, Oxford Road, Manchester M13 9PL, UK. Their research interests cover a wide range of areas in corporate finance and asset pricing including varoius aspects of initial public offerings. Address correspondence to Susanne Espenlaub (tel: (44) (0) , s.espenlaub@man.ac.uk). 3

4 INTRODUCTION There are two widely observed stylised facts on the performance of stocks issued by companies at the time of going public, so-called initial public offerings (IPOs). First, IPOs on average earn significant positive abnormal returns in the immediate aftermarket. To demonstrate, over the period , IPOs issued by UK companies on the London Stock Exchange earned an average return of 12% over the first six trading days (Espenlaub and Tonks, 1998) while over the period July 1992 to December 1995 UK IPOs earned a return of 9.5% on average over the first trading week (see Table 1). Moreover, this phenomenon does not seem to be confined to one or two markets but instead is observed worldwide (Loughran et al, 1994). The second more recently noted stylised fact is the poor longer term performance of IPOs (see, for example, Loughran and Ritter, 1995.) Several possibilities have been advanced to explain such abnormal returns, focusing on agency costs, information asymmetries and signalling as explanations for abnormal returns in the IPO market (Baron, 1982, Rock,1986 and Allen and Faulhaber, 1989, for example). A number of studies (Barry et al, 1990, Megginson and Weiss, 1991, and Brav and Gompers, 1997, for example) have examined the performance of IPOs of companies backed by venture capital funds at the time of the flotation in relation to offerings of other, non venture-capital-backed companies. The evidence on short-term IPO performance is somewhat mixed, with some studies finding venture capital backing associated with lower initial returns (Megginson and Weiss, 1991), others with higher initial returns (Hamao et al, 1998), and yet others finding no difference (Barry et al, 1990). In the longer term, Brav and Gompers (1997) find that venture capital backing results in better IPO performance especially in the case of smaller companies. Although the evidence on the performance of venturecapital-backed IPOs is mixed, venture-capital-backed IPOs are interesting because of the potentially adverse effects of conflicts of interest, particularly in the situation where the IPO is underwritten by 4

5 a financial firm that is affiliated with one of the venture capital funds holding shares in the issuing company. In this paper we document the incidence of IPOs issued by UK companies with existing venture capital investors and sponsored (i.e. underwritten) by issuing houses that are parents or affiliates of the venture capital backers. We investigate the effects on the performance of the stock offering of the resulting conflict of interest between the venture capitalist-affiliated sponsors and the investors taking up the stock. We also investigate the role of the reputation of the financial firms involved in the IPO to see whether reputation has an impact on IPO performance and whether it counters the potentially adverse effect of the conflict of interest. To anticipate the results, we find that, contrary to the conflicts-of-interest hypothesis, IPOs underwritten by affiliates of venture capital backers perform substantially better in the long-term than other IPOs. We also find the long-term performance of UK IPOs to be positively related to the reputation of the venture capital backers. One possible explanation for this is that reputable venture capitalists effectively screen the companies they back and certify the quality of their IPOs. There seems to be evidence of extra strong certification of IPOs underwritten by affiliates of the venture capital backers. In the shortterm, the initial returns to investors purchasing shares at the offer price and holding them for a few days appear to be related to the prestige of the sponsor rather than the venture capitalist in that offerings sponsored by investment or merchant banks ranking among the top 15 are associated with lower initial returns. This suggests there may be less underpricing of IPOs with prestigious underwriters. Although there is evidence of higher initial returns in IPOs where the sponsor and venture capitalist are affiliated, this is offset by an approximately equal reduction in initial returns if the venture capital backers are associated with an issuing house regardless of whether this affiliate actually acted as the IPO sponsor or not. Thus, the net effect is that backing by venture capitalists with links to issuing houses reduces initial returns but only if those affiliates are in fact not 5

6 employed as the actual sponsors to the offerings. The rest of the paper is organised as follows. In the next section, we review the literature on the short- and long-term share price performance of IPOs and possible explantions for underpricing and poor longer-term performance. This provides the background and sets the scene for the hypotheses we test. We then turn our attention to the literature on venture-capital-backed IPOs and the potential conflicts of interest that can arise when the venture capital backer(s) and the sponsor/underwriter to an issue are affiliated. The third section develops the testable hypotheses, gives details of the data sources and sample selection, and presents the empirical analysis. The final section offers some concluding comments. BACKGROUND Short- and Long-term IPO Performance As mentioned in the introduction, one stylised fact that has emerged with regard to IPOs is that the initial abnormal returns on IPOs are on average significantly positive (see Loughran et al, 1984, for international evidence, and Espenlaub and Tonks, 1998, for evidence relating to the UK). This finding has been rationalised in a number of ways. One school of thought argues that it is the result of intentional underpricing of shares by issuers. Explanations for why issuers are prepared to sell shares at a discounted offer price include asymmetric information theories with moral hazard or adverse selection. For instance, Baron (1982) suggests that underpricing arises due to asymmetric information and conflicts of interest between issuers and the investment bankers acting as agents on behalf of issuing firms. Baron & Holmström (1980) and Baron (1982) hypothesise that investment bankers take advantage of their superior knowledge of market conditions to underprice offerings. In doing so, they expend less marketing effort and ingratiate themselves with buy-side clients. 6

7 However, contrary to this theory, Muscarella and Vetsuypens (1989) find that investment banks underprice self-marketed issues of their own stock by as much as other IPOs of similar size. Rock (1986) focuses on informational asymmetries between different types of investors and relates IPO pricing to the 'winner's curse' faced by less informed investors. Since shares are usually sold at a fixed price, rationing will occur if the issue is oversubscribed due to strong demand. Issuing firms (and their advisers) are assumed to have less information than some potential investors, and cannot forecast the market price with certainty. However, issuers can form an expectation of the value of their shares. Informed investors who know the true market value will only subscribe to issues that are priced below their true value. By contrast, uninformed investors are assumed to subscribe indiscriminantly to all issues. Due to informed demand their applications for underpriced issues will be rationed, yet they are allocated all of the undesirable overpriced issues shunned by informed investors. Consequently, uninformed investors bear the winner's curse and the presence of informed investors results in adverse selection in issue quality. The model assumes that because informed demand is insufficient to take up all of a given issue, issuers need to attract demand from uninformed investors. Hence, shares must be priced below their expected value to ensure that uninformed investors expect to earn a non-negative (abnormal) return despite the winner's curse. Levis (1990) provides evidence of the significance of the winner's curse for the pricing of UK IPOs. Beatty and Ritter (1986) extend the winner's curse model, emphasising the role of reputable underwriters in overcoming time-inconsistencies in the model. Underwriters are long-term players in the new issue market and are able to establish reputations with both investors and issuing companies. It is the underwriter's reputation which lends credibility to the issuer's commitment towards uninformed investors to underprice the IPO. The model predicts that uninformed investors will be reluctant to subscribe to issues marketed by underwriters who are believed to underprice too 7

8 little, and issuers will not resort to underwriters who underprice too much. This prediction is supported by Beatty and Ritter's (1986) empirical analysis of changes in underwriters' market shares over time. Signalling theories of IPO underpricing propose that informed issuers communicate favourable private information to less informed investors by selling the IPO at a discount (Allen and Faulhaber, 1989; Welch, 1989; Grinblatt and Hwang, 1989). In a signalling equilibrium, the initial owners of high-quality firms separate themselves from their lower-quality counterparts by retaining more shares and pricing the IPO below its true value, which can be inferred by uninformed investors from the IPO signal. As the information contained in the signal is impounded in the aftermarket share price, high-quality issuers are able to recoup the costs of IPO underpricing by selling the shares they retained at the IPO at a higher price than without signalling. Other signalling theories suggest that the employment of a prestigious auditor or other financial advisors to the issuing company may be interpreted by investors as a positive signal of issue value (Titman and Trueman, 1986). In the UK, companies conducting an IPO employ an issuing house, typically an investment or merchant bank, to sponsor the offering and effectively act as the lead underwriter. Using data on IPOs issued in the UK during , Holland and Horton (1993) examine the relation between the reputations of the professional advisers involved in the IPO (specifically the sponsor, the reporting accountant and the auditor) and the short-term performance of the offering. Although they find that more reputable auditors are associated with lower initial returns, which is interpreted as lower underpricing, there is no evidence of a significant relation between initial returns and sponsor reputation. 8

9 In relation to to long-term returns the initial overperformance of IPOs tends not to persist in the longer term. Rather, it has been widely observed that IPOs perform significantly worse than other, seasoned stocks in the long-term. Similarly, the stocks of firms issuing equity through seasoned equity offerings have been found to underperform in the long-term (Loughran and Ritter, 1995). The long-term performance of UK IPOs issued during is examined in detail in Espenlaub et al (1999). Depending on the benchmark used, they report three-year abnormal returns of between -8% and -28%. This puzzling pattern of initial over- and long-term underperformance has been interpreted as evidence that the hypothesis of informationally efficient financial markets, and even that of investor rationality, is systematically violated in practice. However, there is still some debate over the robustness of the long-term underperformance result with regard to sample selection and the methods used to measure abnormal returns (Fama, 1998). Carter et al. (1998) have examined the effect of underwriter reputation on the performance of IPOs for the US. They found that over a three-year holding period underperformance is less severe for IPOs handled by more prestigious underwriters. Similarly, Michaely and Shaw (1995) have shown that the involvement of more reputable auditors attesting the quality of information disclosed in the IPO prospectus is associated with better long-term performance. For UK IPOs, by contrast, there appears to be little evidence of a significant relation between underwriter (or auditor) reputation and long-term performance (Iqbal, 1998). Venture-capital-backed IPOs At the time of flotation, venture capital funds usually hold substantial equity positions in the companies they back. Consequently, they are in a position to exercise significant influence on management and they have a clear incentive to become involved in the decision-making, especially 9

10 at the time of going public. It is therefore reasonable to expect differences in performance between the IPOs of companies with investment by venture capitalists prior to flotation and other nonventure-backed IPOs. The evidence on the short-term performance of venture-capital-backed IPOs is, however, mixed. Using a sample of US IPOs issued during , Barry et al (1990) find no significant difference between the average initial returns of the venture-backed subsample and of other IPOs. However, in a multiple regression controlling for issue size, underwriter quality and the standard deviation of aftermarket returns, which acts as a proxy for ex ante uncertainty surrounding the offering, they find that initial returns are negatively related to proxies for the venture capitalist's skills in monitoring and guiding their portfolio companies. These include the number of venture capitalists involved in the issuing company, the lead venture capitalist's age, the size of the venture capitalists' equity stakes in the issuing companies and the length of the venture capitalists' tenure on the company boards. In contrast, however, Megginson and Weiss (1991) find that, in a sample of 320 venture-backed and 320 other offerings matched both by offer size and by industry over the period , venture-backed IPOs raise larger amounts at higher prices with venture-backing reducing intial returns from 12% to 7%. Megginson and Weiss attribute their finding to the fact that Barry et al (1990) failed to correct for the difference in the industrial composition of the venturebacked sample and the unbacked control sample (like Barry et al, they note the concentration of venture-backed IPOs in certain high-tech industries and in business services). Megginson and Weiss also report that venture-backed firms tend to go public at a significantly younger age. Overall, Megginson and Weiss interpret their findings as evidence that venture backing certifies the quality of offerings and facilitates flotation at an earlier stage in a company's life-cycle by reducing the information asymmetries specifically associated with younger firms. In stark contrast to these results, Hamao et al. (1998) find that venture-capital-backed offerings are associated with higher initial returns not only for a sample of Japanese IPOs but also for a sample of US IPOs issued more recently ( ). 10

11 The longer-term performance of US venture-capital-backed IPOs issued during is examined by Brav and Gompers (1997) using a variety of alternative techniques to quantify abnormal returns. They find that venture-capital-backed offerings outperform other IPOs although these differences are significantly reduced when returns are value-weighted. In fact, based on a Fama-French (1993) three-factor regression they find no significant underperformance for venturecapital-backed offerings, and among unbacked IPOs only the smallest underperform. Certification, Monitoring and Conflicts of Interest Various aspects of the role played by venture capitalists in companies going public have been identified by previous studies. Earlier studies have emphasised the value-enhancing effect of venture capital backing through the reduction of information asymmetries and the venture capitalists' monitoring and screening of companies. Megginson and Weiss (1991), for example, focus on the certification hypothesis formally developed by Booth and Smith (1986). This holds that reputable venture capitalists certify the value of the issuing companies they back and the quality of the information disclosed by the company at flotation. In this context, venture capitalists can play a similar role as underwriters and auditors in overcoming information asymmetries between insiders and uninformed, outside investors. As repeated players in the IPO market, venture capitalists are able to credibly commit themselves to the accuracy and completeness of disclosed information since false certification would lead to the loss of any valuable reputation built up over time. The incentive for truthful certification thus relies on the potential losses from cheating outweighing the gains from cheating. Venture capitalists are also able to screen potential portfolio companies by offering them contracts that only companies of a given quality will accept. Further, as long-term players in the new-issue market, venture capitalists are able to form lasting relationships 11

12 with other financial firms. Consequently, they may be able to attract higher quality underwriters and auditors at a lower cost. Consistent with this, Megginson and Weiss (1991) find that venture capitalists frequently use the same underwriter for more than one issue and that venure-backed IPOs are indeed associated with more reputable underwriters and auditors. Megginson & Weiss (1991) also find that venture capital backing significantly lowers both underpricing (or, more precisely, initial returns) and underwriter compensation as a proportion of IPO proceeds even after controlling for underwriter quality and issue size. This is consistent with the hypothesis that the venture capitalists' certification and long-term relationships with underwriters lowers the expected costs of 'due diligence' or legal liability as well as the information costs to underwriters. Thus, both the direct and indirect underpricing costs of an IPO can be reduced by venture capital backing while at the same time venture backing may also be able to attract more interest in the offering from large institutional shareholders. Indeed, Megginson & Weiss find that institutional investors on average hold more than 42% of the equity of venture-backed companies at the end of the first quarter after the IPO (with, on average, ten such investors per firm) compared with only 22% for other IPOs (with typically five institutional investors per firm). Barry et al (1990) compare venture capitalists to other active investors such as leveraged-buyout (LBO) specialists that hold concentrated equity stakes, are active in financing and monitoring their portfolio of companies and significantly contribute to improvements in company performance. They argue that monitoring and guidance by experienced and reputable venture capitalists increase the market value of portfolio companies. In support of this hypothesis, they provide evidence that venture capitalists take concentrated equity positions and that, contrary to the view that the IPO serves as an (immediate) exit route for the venture capitalists, they maintain significant investments for some time after the IPO. This is particularly true for the lead venture capitalist which Barry et al identify as the venture capitalist with the largest equity stake and a board seat. They find that there 12

13 are typically three venture capitalists involved in a single firm, accounting for a total equity stake of more than a third prior to the IPO. Just after the IPO, the average venture capital stake falls to about a quarter and even one year on venture capitalists still hold nearly 18%. Furthermore, in more than half the cases venture capitalists sell no shares at the IPO. Venture capitalists also typically hold either two seats on the board or one third of the total. The presence of the lead venture capitalist on the company board typically lasts for more than half the company life prior to the IPO and in almost 90% of cases extends beyond one year after the IPO. Barry et al (1990) also find that the venturecapital-backed IPOs in their sample are usually sold using more reputable underwriters. They present a comparison of two subsamples of venture-capital-backed IPOs: 87 offerings backed by a venture capitalist who is an affiliate of an investment bank, and a subset of these comprising 19 offerings where the investment bank affiliated with the venture capitalist acted as the lead underwriter to the IPO. In neither of these subsamples is there evidence of reduced underpricing. However, Barry et al do not relate this evidence to potential conflicts of interests between selfinterested underwriters and IPO investors. Rather, they interpret it as a rejection of Baron's (1982) agency theory that investment bankers take advantage of their superior knowledge of market conditions, a finding that is in line with Muscarella and Vetsuypens' (1989) findings that the selfmarketed stock offerings of investment banks appear to be just as underpriced as other issues. In venture-backed IPOs there is clearly great scope for a variety of conflicts of interest between the players involved, specifically the managers and pre-ipo shareholders of the issuing company, the (investors and managers of the) venture capital fund backing the offering, the underwriters and other agents employed by the issuer, and the various types of investors taking up the offering. Gompers (1996) focuses on conflicts between venture capitalists and the issuing companies they back. He provides evidence that young venture capital firms 'grandstand' i.e. they take companies public earlier than more established firms in order to raise their profile in the market and attract 13

14 capital for new venture capital funds. He also finds that this is costly both to the young venture capitalists and to other initial owners of the issuing companies because the greater uncertainty and information asymmetries associated with younger firms mean that IPOs backed by inexperienced venture capitalists are more underpriced. Gompers and Lerner (1997) and Hamao et al (1998) examine the effects of the conflict of interest between underwriters and outside investors in IPOs where the venture capital firm backing the offering is a capitve subsidiary of, or otherwise affiliated with, the underwriting investment bank. In such cases, the underwriter is likely to have access to private information about the issuing company and an incentive to exploit this information at the expense of IPO investors. Specifically, underwriters may set offer prices too high and time share offerings so as to coincide with the market's overvaluation of the issuing firm's equity. The studies investigate whether the existence of such conflicts of interest is reflected in differences in the short- and long-term performance between offerings underwritten by venture capitalist affiliates and other IPOs. In terms of long-term performance, both Gompers & Lerner (1997) and Hamao et al (1998) predict that the presence of conflicts of interest will result in worse long-term performance of offerings underwritten by venture capitalist affiliates if the market fails to recognise the adverse effects of the underwriters' self-interests on IPO timing and pricing. If the effects of this incentive problem are fully anticipated and incorporated in the immedate post-ipo share price, however, such offerings should not exhibit abnormal long-term performance (at least not any more than other IPOs). They also predict that the conflicts of interest affect the short-term performance of the offerings. They argue that if investors anticipate the adverse effects of the conflict of interest, such as the underwriter's incentive to set the offer price too high, then investors will rationally demand a 'lemons discount' to compensate them, both for the greater information asymmetry between the 14

15 underwriter and themselves and the higher likelihood of adverse selection. Under this scenario, IPOs will need to be more underpriced, that is, the offer price will be lower (relative to fundamentals) than it would be without the conflict of interest. Gompers and Lerner contend that this greater underpricing will give rise to higher initial returns. By contrast, if the conflict is unanticipated, investors will be exploited as underwriters will set a higher offer price the greater their self-interest. Hamao et al argue that in this case, initial returns will be lower than without the conflict of interest as investors will still bid up the share price in the aftermarket but not by as much. In the longer term, investors will realise their initial mistake and adjust their valuation downward over time. Both studies, however, recognise that the adverse effects of the conflicts of interest may be ameliorated or reversed if underwriters value their reputation and reputable underwriters are able to certifiy and screen issues. If underwriter certification is recognised by the market, both the offer and the post-ipo market price will be higher and the difference between the two (the initial return), will be lower. In terms of the relationship between IPO perfomance and reputation Gompers and Lerner report that in a sample of 885 venture-backed US IPOs issued during , long-term IPO performance is positively related to both venture capitalist and underwriter reputation, findings that are consistent with the certification hypothesis. Short-term performance, by contrast, is affected only by underwriter reputation, with more prestigious underwriters being associated with lower initial returns. Contrary to the conflict of interest hypothesis, Gompers and Lerner find no evidence of either worse long-term performance or higher initial returns in IPOs backed by venture capital affiliates of the underwriters. In stark contrast to these results, Hamao et al (1998), who examine a sample of IPOs issued on the Japanese OTC market between April 1989 and December 1995, find significantly worse long-term performance for venture-backed IPOs where the lead venture capitalist was affiliated with a securities company. They also report much higher average initial 15

16 returns for IPOs backed by venture capitalists whose parent is the lead underwriter, while all other forms of venture capital are associated with lower initial returns. Further, they find that contrary to Brav and Gompers' (1997) US results, the long-term performance of Japanese venture-backed offerings is no better than that of other IPOs. Empirical Analysis Hypotheses Based on the discussion above it is possible to formulate a number of predictions about the likely effects of reputation, certification and conflicts of interest on the performance of IPOs. The focus of the empirical analysis below is on the effects of potential conflicts of interest in venture-backed IPOs where one (or more) of the venture capital firm(s) backing the issue are affiliates of the firm sponsoring (and underwriting) the offering. In this situation, the sponsor may have incentives to exploit IPO investors, e.g. by marketing the issue very aggressively, setting the offer price too high and timing the issue so as to coincide with the temporary overvaluation of the stock by investors. If these adverse incentives are insufficiently controlled the resulting dysfunctional decisions on IPO timing and pricing will be reflected in the performance of the stock. Consequently, a comparison of the performance of IPOs that may be affected by the conflict of interest with that of other offerings should shed light on the empirical significance of the problem. In particular, if the problem is not anticipated by investors, then venture-backed IPOs sponsored by an affiliate of (one of) the issuing firm's venture capital backers will have lower long-term performance than venture-backed offerings sponsored by an issuing house without such links. 16

17 In terms of initial returns, one possible hypothesis proposed by Gompers and Lerner (1997) and Hamao et al. (1998) is that higher initial returns in the conflict of interest subsample is an indication of greater underpricing to compensate investors for the adverse effects of any conflicts of interest. However, while this interpretation of underpricing is appealing, it could be argued that even if the issuer chooses to underprice more relative to the first-best value of the firm (the value of the firm in the absence of information asymmetries and conflicts of interest), the underpricing need not necessarily translate into higher initial returns in the immediate aftermarket. If investors believe that the detrimental effects of the conflict of interest are an ongoing problem, for example, then the stock will continue to trade at a discount relative to its first-best value. Conversely, high initial returns may be the result not of underpricing but of faddish overbidding by investors in the aftermarket, possibly spurred on by aggressive marketing of the issue. However, issues of interpretation aside, the relation between short-term performance and links between the venture capitalist and the sponsor is an interesting one and will be explored in the empirical analysis. While the expected direction of any relationship is questionable a priori, evidence of either unusually high or low initial returns and/or of exceptionally bad long-term performance of IPOs subject to the conflict of interest might be consistent with the conflict-of-interest hypothesis. We also investigate the link between IPO performance and the characteristics of the venture capital backers. If Gompers (1996) grandstanding problem is true then it is to be expected that offerings backed by more experienced, established venture capitalists will perform better in the long-term than IPOs of firms with younger venture capital backers. If the market recognises the certification effect of involving reputable underwriters and/or venture capitalists, then IPOs underwritten by well-known, prestigious sponsors and/or backed by more larger, established venture capitalists should show evidence of lower underpricing (as reflected in lower initial returns) and better longterm performance than other offerings. Furthermore, issuing companies with reputable venture 17

18 capital backing will have easier access to, and hence be more likely to be sponsered by, high-quality issuing houses. Data & Sample Selection The IPO sample, including those that are venture-capital-backed, comprises 249 IPOs issued by UK companies between July 1992 and December 1995 on the London Stock Market. Since all of the venture-backed companies went public on the upper tier of the UK stock market, also known as the Official List or the Full Market, the non-backed control sample excludes (a small number of) offerings floated on the now defunct lower tier, the Unlisted Securities Market. Information on the offer price, the market capitalisation and the net assets of the company on flotation was obtained from the KPMG New Issues Statistics. Economic data, including the FT All Share and Retail Price Indices, and daily share prices from the issue day until the close of the sixth trading day, were obtained from Datastream. Monthly (total) stock returns were obtained from the London Share Price Database (LSPD). LSPD data was available until the end of 1997 which results in a minimum post-ipo aftermarket period of two years. Venture-capital-backed offerings were initially identified using a list of UK Venture Backed Flotations produced by the British Venture Capital Association (BVCA). These data are only available from July For the period from July 1992 to December 1995, the BVCA reports 147 IPOs issued by companies with venture capital backing. Venture capital organisations are defined as those included in the directory of member firms published by the BVCA (the BVCA Directory) and in the Venture Capital Report Guide To Venture Capital in the UK. The BVCA Directory records the venture capital organisations, the names of their funds and the amounts of the funds 18

19 managed/advised 1. Current and older editions of this directory and of the Venture Capital Report Guide were consulted to note any changes in the names or funds managed/advised of venture capital firms and the date the firms were established 2. For venture-capital-backed IPOs, the offering prospectus and subsequent annual reports were acquired on microfiche from Companies House in order to obtain detailed data on ownership, board membership and the identities of investors and financial advisers to the issue, including the issuing house sponsoring the offering. Rankings of issuing houses were obtained from the Annual Broker Survey conducted by Consensus Research International (Holland & Horton, 1993). Possible links between the sponsor and any of the venture capitalists backing the offering were identified by comparing the information given in the IPO prospectus and the data on the status and affiliations of venture capital firms from the Venture Economics: Guide to European Venture Capital Sources and the BVCA Directory. Of the original 147 venture-backed IPOs listed as UK Venture Backed Flotations by the BVCA, 36 companies were excluded because the microfiche and/or the IPO prospectus were not available from Companies House. Six IPOs were excluded because no venture capital organisations were identified as shareholders in the IPO prospectus even though the Venture Capital Report Guide or the BVCA's list classified the offering as venture-capital-backed 3. Three observations were excluded 11 Where data on the value of funds managed/advised were not available from the BVCA Directory, the Venture Capital Report Guide was consulted. 2 For venture capitalists not listed in The Venture Capital Report Guide, the establishment dates were obtained by contacting the firms in question directly. 3 In a few cases, discrepancies between the information in The Venture Capital Report Guide and the offering prospectuses were found. In most of these cases, venture capital backers listed in the Guide were not mentioned in the offering prospectus. This may be due to the Guide identifying investors who 1) own too small a percentage to be listed separately in the prospectus or 2) have liquidated their holdings before the IPO or 3) hold non-equity claims and are not explicitly mentioned in the `Substantial Shareholders section of the prospectus. In the remaining cases, 19

20 because they were not genuine IPOs but rather seasoned offerings by companies with pre-existing listings such as share offerings pursuant to transfers from the Unlisted Securities Market to the Official List or reverse takeovers. Of the remaining 102 observations, initial returns (based on share price data from Datastream) were available for 96 offerings, and monthly stock returns (from LSPD) for 100 issues. 4 More general information on IPO characteristics (from the KPMG New Issue Statistics) as well as long-term stock returns were available for a slightly larger sample of 135 venture-backed IPOs, and for 130 of these there was also data on initial returns. To assess the participation and ownership of venture capitalists, we examined the Board of Directors, Substantial Shareholders, Material Contracts and Placing/Offer Agreement sections in each IPO prospectus. Information on the presence, number and period of board tenure of any directors with links to venture capital firms was collected from the Board of Directors section which identifies the top executives and directors of the issuing company 5. Board representatives of venture capital firms usually act as non-executive directors. The Substantial Shareholders section gives details of the equity ownership immediately before and after the IPO for all officers, directors and any shareholdings (including venture-capitalist stakes) of at least 3%. To gauge the extent of share disposals by venture capitalists at the IPO we relied on the Substantial Shareholders section and the extracts of the Placing/Offer Agreement between the sponsor and the parties involved in the issue that are reproduced in the prospectus. venture capital investors who were listed in the IPO prospectus were not mentioned in the Guide. In all of these cases the ownership information in the prospectus is deemed to be accurate. 4 There are a few missing observations in some of the explanatory variables used in the regression analysis. For instance, the ranking of the sponsor to the issue is not available for three of these 100 offerings. 5 In a few cases a venture capitalist representative remained on the board of a former portfolio company even after s/he switches to another venture capital organisation. In these instances, the individual is coded as representing the venture capital firm with which s/he was affiliated when s/he 20

21 These sections usually give some details of substantial sales or purchases of shares pursuant to the IPO by existing shareholders, including venture capitalists. However, in a significant number of cases not enough information was disclosed to evaluate what proportion of the venture capitalists pre-ipo shareholdings (if any) was sold through the offering. Frequently only the aggregate figure of shares sold by existing shareholders was given, and in many of these cases the identities of the selling shareholders were not disclosed. In these cases, we assume that the venture capitalists retained their entire pre-ipo shareholdings. This may result in a downward bias in the venture capitalist sales variable (vcsold). However, it is unlikely that this measurement error is systematically related to IPO performance. To trace the evolution of venture capitalist shareholdings after the IPO, ownership information was gathered from the Substantial Shareholders sections in the subsequent annual reports of the issuing companies. In a small number of IPOs, the venture capitalist(s) held more than one type of financial claim. In these cases, only investments in ordinary shares were considered. The variables used in the empirical analysis below are summarised in table A1 in the Appendix. The short-term performance of IPOs is assessed using the discrete return to an investor purchasing a share at the offering price and holding it until the close of the sixth trading day. We control for market-wide movements by subtracting the equivalent return on the FT All Share Index. Long-term abnormal returns are measured relative to the FT All Share Index benchmark. Again, we control for market-wide movements by subtracting the equivalent return on the FT All Share Index. joined the board. 21

22 Empirical Findings The total sample of IPOs used in this study comprises 135 venture-backed and 114 unbacked offerings, and there is an approximately equal number of venture-backed and unbacked IPOs in each year during the sample period (see table 1). [Insert table 1 about here.] Consistent with previous findings (e.g. Espenlaub and Tonks, 1998), table 1 shows that the sample of IPOs used in this study earned on average both statistically and economically significant initial returns over the first six days of trading in the stock market, although there is no statistically significant difference in the short-term performance of venture-backed and unbacked IPOs based on a comparison of the subsample averages. Table 1 also reports the longer-term performance of the subsamples. The averages of the abnormal (market-adjusted) returns over the periods 24 and 36 months after the IPO are reported by issue year while table 2 contrasts the cumulative average abnormal returns (CAARs) of the total sample and the venture-backed and unbacked subsamples for each post-ipo month. [Insert table 2 about here.] Both subsamples underperform the FT All Share benchmark over the entire 36-months post-ipo period. However, while the CAARs of the unbacked sample become negative after the sixth post- IPO month and continue to be negative in each month thereafter, the performance of the venturebacked sample is more variable, fluctuating above and below zero. The CAAR series move further apart after month 22 when the CAARs of unbacked IPOs start to dip, eventually falling as low as -12% in month

23 The comparison of the two subsamples suggests that venture backing is associated with better longterm performance. Over the first 24 months following flotation, the performance differential is still relatively small at about 3% but over 36 months it doubles to nearly 6%. However, it turns out that not only are the differences in the long-term returns between the venture-backed and unbacked subsamples not statistically significant, but there is no evidence of statistically significant long-term underperformance in either of the two samples. This can be seen from the large standard errors associated with the long-term returns in table 1. The same result emerges from an examination of the t-statistics of the CAARs in table 2 6. However, despite the lack of statistical significance, the differentials in long-term performance are clearly of an economically significant magnitude. [Insert table 3 about here.] Within the venture-backed sample, there appear to be systematic differences in the performance of IPOs associated with the reputation and experience of the venture capital backer(s). Table 3 illustrates the relation between both initial and long-term returns and venture capitalist characteristics, specifically the average age of the firms involved and the average amount of funds managed by those firms. There are no significant differences in the short-term performance of offerings backed by venture capitalists of above- or below-median age or fund size. However, there are dramatic differences in the longer term with older firms and/or larger funds being associated with substantially higher average three-year returns. These findings are consistent with both Gompers (1996) grandstanding scenario that less experienced venture capital firms tend to float 6 The statistical significance of the CAARs is assessed using t statistics based on Brown and Warner s (1980) Crude Dependence Adjustment in order to correct for cross-sectional dependence. None of these t statistics are significant at conventional levels. These results are available from the authors on request. 23

24 portfolio firms too early and with the certification hypothesis that venture capital firms with more reputation at stake are better able to screen and certify the quality of the companies they back. The figures in table 3 also show a positive relationship between long-term performance and the number of venture capitalists backing the IPO. Barry et al. (1990) suggest that a greater number of venture capital firms backing an issuing firm is associated with more intense monitoring, possibly because the (lead) venture capitalist has more incentive to monitor in order to protect its reputation vis-à-vis the other venture capital firms whose participation it solicited. There is also evidence of somewhat lower initial returns in offerings with an above-median number of venture capitalist backer, possibly indicating less need for IPO underpricing due to investors perception of better monitoring by the venture capital backers. Further, the figures in table 3 show the relationship between IPO performance and the reputation of the sponsoring issuing house. With reputation proxied by whether the house ranks among the top 5 or top 15 in the survey of investment and merchant banks conducted by Census Research International, there is evidence of slightly better long-term performance when issues are sponsored by more reputable issuing houses but this relation is not nearly as strong as it is for venture capitalist reputation. In terms of potential conflicts of interest, table 3 shows descriptive statistics for the 100 venturecapital-backed IPOs for which detailed data from the IPO prospectus were available. Of these, 65 offerings were backed by venture capital firms that were in some way affiliated with an issuing house, such as an investment bank. In only 10 of these cases did the affiliate actually act as the sponsor/underwriter to the offering. The remaining 55 offerings were sponsored by an issuing house with no links to any of the venture capitalists backing the issuing company. The incidence of venture capitalist-sponsor affiliation is so low that it seems to indicate that venture capital backers deliberately choose an unrelated sponsor in order to avoid any conflicts of interest. 24

25 [Insert table 4 about here.] Despite the potential for conflicts of interest the 10 IPOs marketed by a sponsor with links to (one of) the venture capitalist(s) have substantially better long-term performance compared to other offerings, as shown by the returns figures in tables 3 and 4. Comparing the performance of offerings backed by venture capitalists affiliated with issuing houses (irrespective of whether these affiliates actually acted sponsored the IPOs) and that of IPOs backed by independent venture capital firms (see table 4), it transpires that offerings backed by affiliated venture capitalists perform clearly better in the long-term than those backed by independent firms. This is consistent with the view that affiliated venture capital firms have more reputation capital at stake which makes them screen companies more carefully and/or ensure that the IPO is priced more conservatively. Such venture capital firms also seem to select more reputable sponsors, affiliates or others, to underwrite the issue. This is demonstrated by the figures in table 5 which show that while over 20% of offerings backed by venture capital firms with issuing house affiliates are underwritten by top 5 sponsors, this is the case in only 12% of other venture-backed IPOs. [Insert table 5 about here.] Comparing the short-term performance of offerings backed by independent venture capital firms and by issuing house affiliates in table 5, the former are found to have substantially higher average initial returns (although there is no such clear difference based on median returns). Like the evidence on long-term performance, this is also consistent with the more effective screening and certification of issue quality by affiliated venture capitalists resulting in less IPO underpricing. Table 5 also shows differences within the subsample of issues backed by venture capital firms affiliated with issuing houses. In particular, IPOs actually sponsored and underwritten by the 25

26 issuing-house affiliate of the venture capitalist have somewhat higher average (and significantly higher median) initial returns than offerings backed by affiliated venture capitalists but where the affiliated issuing house did not sponsor the IPO. This may be due to better marketing of such issues, more overbidding by faddish investors, or more underpricing possibly to compensate investors for the (perceived) adverse effects of the conflicts of interest as argued by Gompers and Lerner (1997) and Hamao et al. (1998). It may of course also be the result of a combination of these effects. [Insert table 6 about here.] These findings on short-term IPO performance are supported by the results of the multiple regression analysis reported in table 6. Using OLS, the initial returns on the venture-capital-backed IPOs are regressed on various potential determinants of underpricing including characteristics of the offering, the issuing firm and its backers. Besides industry dummies, the only marginally significant explanatory variables are dummies indicating whether the firm was sold by a top 15 sponsor (spontop15), whether the venture capital backers were affiliated with an issuing house (regardless of whether it sponsored the IPO or not) (invaffil), and whether the venture capital firm s affiliate actually sponsored the IPO (sponaffil). While sponaffil has a positive coefficient, the other two variables have a negative effect on initial returns. However, the hypothesis that the coefficients of the three variables are not significantly different from each other in absolute terms cannot be rejected. Thus, there is a negative net effect on underpricing if the venture capital backer has links with an issuing house but that affiliate is not actually employed to sponsor the offering. Further, this net effect is of the same sign and magnitude as the effect of employing a top 15 issuing house to sponsor the offering (spontop15). By contrast, the indicators of venture capitalist reputation have no significant effect, a finding that is consistent with the results in Gompers and Lerner (1997). 26