Take a chance? Implications of auditor going concern opinions for IPO investors

Transcription

1 Take a chance? Implications of auditor going concern opinions for IPO investors Abstract In a marked shift, it has recently become relatively common for ordinary IPOs to contain going concern (GC) opinions in their offering documents. We examine the implications of such opinions for IPO investors in a sample of ordinary IPOs from We find that GC IPOs (relative to non-gc IPOs) are more likely to withdraw their IPO plans, but conditional on going forward with the offer, they are more likely to delist, have poorer long-run stock and operating performance, but are similarly underpriced. Despite the worse performance, GC IPOs have similar institutional ownership, analyst forecast errors and recommendation levels, but are less likely to be sued post-ipo. Overall, our findings indicate that auditor GC opinions contain important information that market participants do not fully value. Keywords: Going concern opinions; IPOs; Delisting; Institutional investors; Litigation; Withdrawn offerings JEL Classification: G14; G22; G23; K22

2 1. Introduction A going-concern (GC) opinion issued in a company s initial public offering (IPO) registration statement indicates that the auditor has substantial doubts about the company s profitability and long-term viability. A decade ago such opinions were virtually nonexistent in IPO filings for ordinary firms (as opposed to highly speculative penny stock or microcap offerings). In more recent years, they have become relatively commonplace, but there has been no research comparing outcomes for GC versus non-gc ordinary IPOs. Thus, in this paper, we seek to better understand the implications of GC opinions for IPO investors. To illustrate the language in a GC opinion for an IPO firm, we take an excerpt from the February 1, 2001 prospectus of Briazz s IPO filing, which can be found under the section, Report of Independent Accountants. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the financial statements, the Company has reported operating losses since inception and needs to raise additional capital to fund future operating losses and planned growth. These are conditions that raise substantial doubt about its ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 2. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. There is an established literature focused on GC opinions of seasoned companies (e.g., Li (2009), Goh, Krishnan and Li (2012), Carcello, Vanstraelen, and Willenborg (2009), and Chen, Martin, and Wang (2013)). However, to our knowledge, only a handful of papers examine GC opinions in an IPO setting. During 1993 to 1994, Willenborg and McKeown (2001) examine the impact of GC opinions on underpricing and the probability of subsequent delisting for a sample of microcap IPOs, defined as IPOs that raise $10 million or less. They find that GC microcap IPOs are associated with less underpricing, but higher delisting probabilities. Again using a sample of microcap IPOs, Weber and Willenborg (2003) document that the pre-ipo opinions of large auditors are more predictive of post-ipo stock delisting, implying a certification effect for more prestigious 1

3 auditors. However, based on auditor s GC opinions of stressed Internet companies filing to go public on Nasdaq, Leone, Rice, Weber and Willenborg (2013) find that big 5 auditors are less likely to issue GC opinions during the bubble period from 1999 to They argue that these auditing firms did a poor job in recognizing the IPO bubble. We extend the literature in this area by examining the implications of GC opinions in a much larger sample of ordinary IPOs from 2001 to We examine a variety of questions, but we focus primarily on whether GC opinions are informative about IPO firm prospects, meaning that auditors are able to meaningfully discriminate among IPO firms. We also examine whether IPO offer prices accurately reflect the information in GC opinions. Our results show that auditors are able to predict subsequent firm performance to a significant degree. First, IPO firms are more likely to withdraw their IPO plans if they receive a GC opinion. However, conditional on going public, IPOs with GC opinions are much more likely to delist for performance-related reasons shortly after going public, and they have much worse operating performance post-ipo compared to non-gc IPOs. Given this, it is surprising that we find IPO offer prices do not fully reflect the information in GC opinions. We document that GC IPOs have much worse stock price performance post-ipo, implying that IPO offer prices for these firms were too high. Further, underpricing is often thought to be compensation to investors for riskiness, but there is no meaningful difference between underpricing for GC and non-gc IPOs once we control for other important offer characteristics. Our results and paper contributes to the stream of literature that suggests that the market reaction to GC opinions present an anomaly investors tend to underreact to their opinions (e.g., Taffler, Lu and Kausar (2004), Kausar, Taffler, and Tan (2009), Kausar, Kumar, and Taffler (2013)). We also explore whether investors sue GC IPOs more than non-gc IPOs. Presumably, GC IPOs are riskier, and indeed we document higher failure rates, poorer stock market performance, 2

4 and poorer operating performance. Nonetheless, GC IPO companies are much less likely to be sued post-ipo. We conjecture that the GC opinion provides some immunization from accusations of inadequate or deceptive disclosure. In additional analyses, we explore whether institutional investor ownership and analyst recommendations are associated with GC status. Despite the worse performance of GC IPOs, we find that institutional investors and sell-side analysts, who are often presumed to be more sophisticated than retail investors, do not discriminate between GC and non-gc IPOs. Overall, our results indicate that auditor GC opinions provide valuable information to market participants that is not fully incorporated into stock prices. Our baseline results employ either ordinary least squares or logistical regression methods. Thus, a potential concern with our analysis is that we do not properly control for selection bias. To mitigate this concern and help establish causality, we employ a propensity score matching technique and rerun our main results with this method. We find this method has a very small impact on our results and overall conclusions. The remainder of the paper proceeds as follows. Section 2 reviews relevant literature and develops a set of hypotheses to be empirically tested. Section 3 introduces data selection, main variables, and descriptive statistics. Section 4 and 5 present multivariate tests and results. Section 6 examines firms that withdrawal their IPO plans, and section 7 concludes the paper. 2. Related literature and hypotheses development On the role of auditors in IPOs, there is a small body of literature that examines the demand for auditors during the IPO process, the role of auditor quality and reputation on predicting IPO long-run performance, and the effect of auditor opinions on IPO delisting rate and underpricing. Willenborg (1999) tests and confirms that auditors serve the dual role of both enhancing resource 3

5 allocation (an informational role) and providing investors with a claim on the auditor in the event of an audit failure (an insurance role). He demonstrates the importance of IPO proceeds in explaining both the impact of auditor choice on IPO underpricing and the auditor's compensation. Willenborg and McKeown (2001) find that microcap GC IPOs are more likely to be delisted within 3 years after IPO, and these IPOs also suffer less underpricing due to reduced uncertainty surrounding the IPOs. Weber, and Willenborg (2003) document that for those microcap IPOs, the pre-ipo opinions of large auditors are more predictive of post-ipo negative stock delisting. Based on the auditor s GC opinions of stressed Internet companies filing to go public on Nasdaq, Leone, Rice, Weber and Willenborg (2013) find that the big 5 auditors are less likely to issue GC opinions during the bubble period from 1999 to They suggest that the big 5 auditor firms did not do their job well in preventing the Internet IPO bubble from inflating. No research to date, however, has examined the effect of GC opinions for larger size, ordinary IPOs over a relatively long time span covering different market environments. It is well documented that IPOs in general underperform over the long run (Ritter, 1991; Loughran and Ritter, 1995). However, certain firm and offering characteristics, such as non-venture capital backing (Brav and Gompers, 1997) and less prestigious investment banks as underwriters (Carter, Dark, and Singh, 1998) are associated with more severe IPO long-run underperformance. Research also identified other reasons, such as investor sentiment, that might explain the long-run underperformance of IPOs. There is limited research on identifying internal reasons that could possibly explain the underperformance. GC opinions for IPOs rendered by auditors indicate that a private firm has substantial financial constraints such that its continual operation and future viability might be an issue of concern. Therefore, the evidence in this paper on GC IPOs provides another piece of the story for IPO long-run performance. 4

6 Perhaps the most puzzling and researched question in the IPO literature is the issue of first day return (underpricing), which has stimulated a variety of theoretical predictions and empirical assessments. The most plausible explanations that stand the test of time are those based on information asymmetry. Ritter (1984) and Rock (1986) suggest that underpricing is mainly a compensation mechanism for the cost that uninformed investors bear to become informed. Everything else being equal, there should exist a positive relationship between pre-ipo uncertainty and IPO first day return. High risk offerings, such as high tech companies, small firms, and Internet firms, should have higher first day return to compensate uninformed investors. For GC IPOs, things become unclear. On the one hand, GC IPOs presumably should be classified as a high risk IPOs since they are diagnosed by their auditors as financially constrained. On the other hand, as an important accounting disclosure, GC opinions in IPO filings are public information and should reduce the uncertainty involved in an offering. Therefore, the relationship between GC opinions and underpricing for ordinary IPOs is an empirical question that we will address. A relatively large body of literature has demonstrated that institutional investors are more sophisticated and more important players in the financial markets (Sias, Starks, and Titman, 2006). In the IPO arena, Field and Lowry (2009) document that firms with the lowest levels of institutional investment significantly underperform, suggesting that institutional investors are able to avoid worst-performing firms. Their paper raises another, deeper question: How are institutions able to identify and avoid the worst-performing firms? Using a large sample of transaction-level institutional trading data, Chemmanur, Hu, and Huang (2010) provide evidence that institutional investors possess significant private information, and they realize considerable above-average returns in the first few months after IPOs. Our paper on GC opinions in IPOs provides a promising setting for 5

7 testing whether institutional investors also employ publicly available information to avoid worst-performing IPOs. There has been enormous debate regarding the informative role of security analysts in the financial markets. McNichols and O Brien (1997) suggest the self-selection hypothesis, which states that analysts selectively cover firms with more favorable prospects. In a similar vein, Das, Guo, and Zhang (2006) provide evidence that IPOs with higher level of coverage significantly outperform those firms with low levels of coverage. This paper examines analyst coverage for GC IPOs and attempts to address the following questions: Do analysts self-select and shy away from GC IPOs? Are analysts less optimistic about the prospects of GC IPOs? The answers to these questions should be useful for understanding the informative role of analyst research in the IPO setting. The existing literature has not reached a definite conclusion regarding the complex relationship between disclosure and subsequent litigation risk following IPOs. Field and Shu (2005) document that disclosure deters some types of litigation after the enactment of Private Securities Litigation Reform Act of 1995 (PSLRA). Using word content analysis on the time-series of IPO prospectuses, Hanley and Hoberg (2012) find evidence that strong disclosure serves as a substitute for underpricing and provides an effective hedge for all types of lawsuits. On the other hand, Rogers and VanBuskirk (2009) provide evidence that firms decrease the precision and magnitude of disclosure after being sued and suggest that managers of sued firms perceive that disclosure might trigger lawsuits. Similarly, the causation between initial return and lawsuits has also been a subject of debate. Some authors suggest that initial return could serve as an insurance device for investors and reduce the litigation risk for IPOs in the following years (Lowry and Shu, 2002), whereas others demonstrate that underpricing is not an effective hedge for all types of lawsuits. As one of the most important sources of accounting disclosure, auditor s GC opinions in IPOs and the subsequent 6

8 probability of lawsuits offer us an opportunity for testing an unsettled relationship and contributing to the ongoing debate. As probably the most important event in the life of a corporation, going public is not an easy transition for most companies, and some companies withdraw their plans due to various reasons. A few papers have examined the causes and consequences of this special group of companies who filed initial registration(s) with SEC, but discontinue their effort to go public (Busaba, Benveniste, and Guo, 2001; Dunban and Ferster, 2008; Cooney, Moeller, and Stegemoller, 2009; Hao, 2011). Among other factors, GC opinions from independent auditors could possibly be the determinant for a company to withdraw their IPO plans. Based on the above discussion, we develop the following null hypotheses to be examined empirically: Hypothesis 1: Compared to non-gc IPOs, GC IPOs are no more likely to underperform and be delisted in the 3 years after public offerings. Hypothesis 2: Compared to non-gc IPOs, GC IPOs are no more or less underpriced during public offerings. Hypothesis 3: Compared to non-gc IPOs, GC IPOs attract the same level of institutional investment. Hypothesis 4: Compared to non-gc IPOs, GC IPOs receive the same earnings forecasts from analysts and same analyst recommendations after public offerings. Hypothesis 5: Compared to non-gc IPOs, GC IPOs are no less likely to be sued in class action lawsuits after initial public offerings. Hypothesis 6: Compared to non-gc companies, GC companies are no more likely to withdraw their plans for public offerings. 7

9 3. Data and methods 3.1. Data and main variables Our primary IPO sample spans the decade of 2001 to We end in 2010 because of our need to examine post-ipo long-run returns and delisting frequencies. We identify IPOs using Thomson Financial s Securities Data Company (SDC) database. After eliminating closed end funds, spin-offs, unit issues, real estate investment trusts, limited partnerships, financials (SIC ), IPOs with offer prices less than $5, and IPOs with critical missing information from their SEC filings or CRSP, we arrive at a total of 793 IPOs. After further deleting IPOs that are not listed on CRSP within 6 months of issuing following Liu and Ritter (2011), our final sample consists of 776 IPOs, of which 708 are non-gc IPOs and 68 are GC IPOs. We also collect a sample of 591 withdrawn IPOs from SDC using the same criteria during the same time period. SDC is the source for a variety of additional IPO characteristics such as lead underwriters, proceeds, offer price, VC backing, share overhang, auditors, and high tech industry classification. We obtain accounting data from Compustat, analyst recommendations and earnings forecasts from the Institutional Brokers Estimate System (I/B/E/S), and 13f institutional holdings data from the Thomson Reuters Ownership Database. For each company in our sample, we gather information on class action lawsuits for three years after the IPO date from Stanford Law School s Securities Class Action Clearinghouse. Stock price data needed to compute underpricing, long-run stock performance, and delisting frequencies are from CRSP. Finally, we hand-collect GC opinions from IPO firm filings downloaded from EDGAR. We examine both Form S-1 (the initial filing) and Form 424B3 (the final prospectus). ***Table 1 about here*** Panel A of Table 1 presents the distribution of our sample by year. There are more than 100 IPOs per year in our sample from , but significantly fewer in the 3 years before and 3 8

10 years following this period. This lack of IPO deal flow is not surprising since 2001 follows the bursting of the Internet bubble of , and corresponds to the recent financial crisis. The percentage of IPOs that receive a GC opinion from their auditors shows considerable variation with no apparent time series trends. For instance, in 2009, none of the 34 IPOs received a GC opinion whereas, in 2003, close to 20% of IPOs received one. Overall, 8.4 percent of our sample firms have GC opinions, which is a huge increase for ordinary IPOs (i.e., IPOs that are not microcaps or penny stocks). In previous decades, such opinions were almost nonexistent for these IPOs. We examine both the original S-1 filing and the final 424B3 for evidence of GC opinions. Based on the S-1s, 8.40% of our sample IPOs have a GC opinion; however, in 4 cases the GC opinion is expunged in the final prospectus. We include these 4 cases in our GC sample, but we rerun our analyses with them in the non-gc sample, and our results are not materially impacted. Panel B reports descriptive statistics for non-gc versus GC IPOs. Several differences are immediately apparent. First, GC IPOs are smaller and have lower offer prices. The average non-gc IPO raises an average of $184 million with an offer price of $14, and the average company has a market capitalization of $706 million. In contrast, the average GC IPO raises $77 million and has an offer price of $10 and a market capitalization of $362 million. Both mean and median differences are economically and statistically significant. GC IPOs are less likely to use higher quality agents (investment banks and auditors). Non-GC IPOs have a Carter-Manaster underwriter rank of 8.2 on a 9-point scale compared to 6.6 for GC IPOs. 88% of non-gc IPOs use a big 5 auditor compared to 75% for GC IPOs. Institutional ownership is approximately 1/3 higher for non-gc IPOs, and these companies receive significantly more recommendations and earnings forecasts from analysts. Finally, 43% of non-gc 9

11 IPOs are high-tech compared to 25% of GC IPOs. However, there are no significant differences between the proportion of VC-backed IPOs or Internet-related IPOs for the two groups. Panel C provides an industry breakdown of our sample. The majority of GC opinions are in the manufacturing sectors. About 60% of GC opinions have a 1-digit SIC code that begins with a 2 or 3. Approximately 10% of firms are in the services (SIC code 7) and the transportation, communications, electric, etc., industries (SIC code 8). The remaining industries are sparsely populated. Explaining why GC opinions have become relatively common in ordinary IPOs is not the primary purpose of our study. Nonetheless, in Panel D, we briefly examine the question indirectly by comparing IPOs from the 1990s to our sample. A potential reason for the sharp increase in GC opinions is that IPOs became riskier in our sample relative to previous periods. However, the evidence in Panel D (and in more detailed studies such as Gao, Ritter, and Zhu (2012)) suggests that, if anything, the opposite is true. IPOs in our sample are substantially larger (in terms of both proceeds and post-ipo market cap), much more likely to have a big 5 auditor, and significantly older. Not surprisingly, underpricing is much smaller. These characteristics are associated with less risky deals. The offer prices are about the same, and the only potentially negative factor is the percentage of companies with positive EPS at the time of the offer is 7 percent smaller in our sample, 26% versus 33%. Overall, it does not appear that the rise in GC opinions is due to a sharp increase in the riskiness of firms going public. Whether regulatory changes such as Sarbanes-Oxley and Regulation FD or events such as the Global Settlement of 2003 are an explanation is an open question for future research. For the remainder of our paper, we focus on the implications of a GC opinion for IPO companies and their investors. 10

12 3.2 Univariate results To begin our analyses, we examine univariate differences between key variables in our GC and non-gc IPO samples. 1 Table 2 presents the results. Underpricing for non-gc IPOs averages 11.8% compared to 4.6% for GC IPOs, and the difference is highly significant. Thus, despite the presumed higher risk of GC IPOs, they are significantly less underpriced, at least on a univariate level. Subsequent analyses will explore whether this difference is due to factors other than GC status. ***Insert Table 2 about here*** We explore several measures of aftermarket performance. First, we examine delisting rates within 3 years of the IPO. To identify delistings due to performance reasons, we rely on CRSP delisting codes and We find that 31% of GC IPOs delist within 3 years of the IPO compared to 7% of non-gc IPOs. This difference is economically and statistically significant, and it indicates that auditor GC opinions meaningfully predict eventual delisting. In the next two rows of Table 2, we compare the frequencies of lawsuits between GC and non-gc IPOs. We find that 13% of non-gc IPOs are sued within 3 years of the IPO compared to 11.8% of GC IPOs. While economically meaningful, this difference is not statistically significant. Further, if we focus on Section 11 lawsuits, which are for damages specific to IPO purchases brought under Section 11 or 12 of the Securities Act of 1933, the difference is much smaller (6.5% versus 7.4%). We next examine various measures of stock price and accounting performance. We first calculate 3-year buy-and-hold returns (BHARs) and cumulative abnormal returns (CARs), which are matched on size and book-to-market portfolios. In both cases, we use equal- and value-weighted returns. In all four cases, GC IPOs underperform, and the differences are economically large and 1 The appendix provides detailed information on each variables used in this paper. 11

13 statistically significant in three of four cases. We also examine accounting performance using EBITDA/TA and CFO/TA in year 1 and year 3. In every case, GC IPOs significantly underperform. Summarizing our univariate findings, we find that despite much worse long-run performance and a sharply higher performance-related delist rate, GC IPOs are significantly less underpriced than their non-gc IPO counterparts. However, there are no differences between the two types of IPOs in terms of their being involved in a lawsuit following the IPO. However, because we have shown that GC IPOs are different along many dimensions in Table 1, we next consider a series of multivariate analyses. 4. Multivariate results We begin by first modeling underpricing as a function of IPO, firm, and market characteristics. Our main independent variable of interest is GC, which is a dummy variable that equals one if the IPO has a GC opinion, zero otherwise. In model 1, we only include this variable. The coefficient is and is significant at the 1 percent level, which replicates our univariate result. ***Insert Table 3 about here*** In model 2, we include the natural log of firm proceeds, the partial adjustment term (percentage difference between the offer price and the midpoint of the initial file range), and share overhang (pre-ipo shares scaled by shares offered). The latter two terms have been shown to be significant predictors of IPO underpricing (e.g., Hanley (1993), Bradley and Jordan (2002), Loughran and Ritter (2004)). We also include an indicator for multiclass IPOs (Smart and Zutter (2003)) and the cumulative market return one month prior to the offering. With these controls in the model, GC becomes insignificant with a coefficient of Partial and Overhang are positive and highly significant, consistent with the literature. The natural log of market capitalization is also positive and 12

14 significant. The other controls are not significant. Note that the adjusted R 2 jumps from 1% to over 24% with the inclusion of these variables. Model 3 includes High Tech and VC, which are both dummy variables that equal one if an IPO is classified as high-tech and venture capital (VC) backed, respectively. High-tech is not significant, but consistent with Lee and Wahal (2004) and others, VC is positive and significant. A dummy variable indicating Internet companies is not significant. Model 4 adds variables for third party certifiers of value. Top Tier and Big 5 are dummy variables indicating whether an IPO retains a top tier underwriter (a Carter-Manaster ranking of 8 or higher) or a Big 5 auditing firm, respectively. As shown, Top Tier is negative and significant indicating that hiring a top tier underwriter is associated with 5% less underpricing. Taken together, the models in Table 3 show that GC IPOs are less underpriced, but after the addition of various controls known to influence IPO underpricing, the effect of a GC opinion on underpricing is not reliably distinguishable from zero. However, Table 2 also showed that from a univariate perspective, GC IPOs significantly underperform non-gc IPOs in the post-ipo period. We examine this underperformance more thoroughly in the next several tables. In Table 4, the dependent variable is a dummy variable identifying delisting within three years of the IPO, where delisting is performance-related (CRSP delist codes and ), so we use a logit model. As in Table 3, we begin with a parsimonious specification and add variables to explore the incremental impact of each set. To ease economic interpretation, we report marginal effects (measured at the mean). IPO delisting frequencies have not been studied as extensively as IPO underpricing, so the determinants are less well understood empirically, and we restrict our analyses in Table 4 to the controls considered in Table 3. ***Insert Table 4 about here*** 13

15 Looking at Table 4, it appears that GC IPOs are substantially more like to delist. The marginal effect declines from an initial.24 in model 1 to.17 in model 6, but the effect remains statistically significant. Focusing on model 6, the strongest impact comes from prior market returns with higher levels associated with a significantly higher likelihood of delisting. High-tech firms are more likely to delist whereas having a big 5 auditor leads to a decreased likelihood. *** Insert Table 5 about here *** In Table 5, we consider post-ipo returns in a calendar time setting. Specifically, each month over our sample period, we form portfolios containing all GC and non-gc IPOs, respectively, from the most recent 36 months. We consider both equal and value weighting. We require at least five IPOs in a portfolio for a month to be included. We also calculate the returns on a hedge portfolio that is long GC IPOs and short non-gc IPOs. We regress the time-series of portfolio returns on the three Fama-French (1993) factors and the Carhart (1997) momentum factor, focusing on the intercept or alpha. Looking at the results for equal weighting first, we see that the non-gc IPOs have a positive alpha of about 24 basis points per month, but the estimate is not statistically different from zero. In contrast, the GC IPOs have an alpha of -164 basis points per month, which is economically large and statistically significant (p =.039). The hedge return has an alpha of 188 basis points, which again is highly significant, both economically and statistically. The hedge portfolio also shows that the factor exposures for the two portfolios are not substantially different. Turning to the value-weighted returns, the story is similar economically, but statistical significance drops. In particular, the non-gc portfolio has an alpha of essentially zero, whereas the GC portfolio has an alpha of -128 basis points per month, which is economically large, but not reliably distinguishable from zero (p =.141). The hedge portfolio has an alpha of 127 basis points, but, again, the point estimate is not statistically significant. Unlike the equal weighted results, there is 14

16 a noticeable difference in factor exposures in the value weighted portfolios. In particular, the non-gc IPOs have a much smaller market beta, 1.125, compared to for the GC portfolio. The difference of.40 is economically and statistically significant (p =.057). Overall, Table 5 shows that the GC IPOs significantly underperform. When comparing the equal versus value-weight results, it is useful to keep in mind that the value-weighted portfolios are often dominated by a few IPOs. Further, value weighting means that as an IPO underperforms, it receives a smaller weight going forward. In other words, value-weighting means that, all else the same, greater weight is being given to more successful deals as time passes. With equal weighting, the reverse is true. The implicit rebalancing means that winners are sold off and losers are purchased. Equal weighting therefore tells us about the average IPO, whereas value weighting tells us about the average dollar invested in IPOs. *** Insert Table 6 about here *** In Table 6, we turn to operating performance. We first look at EBITDA at the time of the IPO. We then examine EBITDA in the subsequent three years, scaled by assets at the time of the IPO. Our inferences are quite consistent; namely, GC IPOs have much poorer operating performance. The underperformance is economically large and significant statistically. We also examine the change in EBITDA over the first three years (relative to assets at the beginning of the first year) and find much greater improvement in performance for the non-gc group. The GC IPOs in fact suffer degraded operating performance whereas the non-gc companies improve. In the second part of the table, we look at CFO instead of EBITDA. The results are essentially the same: The GC companies have much poorer operating performance overall. Taken together, the results in this section paint a relatively clear picture. A GC opinion in an IPO is not strongly associated with underpricing. However, such an opinion is a relatively reliable predictor of poor post-ipo stock market performance. A GC opinion is associated with an 15

17 increased likelihood of delisting due to poor performance, and GC IPOs have much poorer post-ipo operating performance. Overall, when issuing GC opinions on IPOs, auditors are able to very meaningfully distinguish between those companies likely to survive and those that are not. Thus, the information is of significant value to IPO investors. 5. Additional analyses 5.1 Institutional investors We have previously shown that, on a univariate basis, institutional investors were less likely to purchase GC IPOs. We explore this issue in greater depth in Table 7, where we model institutional ownership as a function of a number of variables. As before, we start with a univariate model containing only the GC IPO dummy and then add additional independent variables. *** Insert Table 7 about here *** Examining the various models in Table 7, we see that institutional ownership is consistently lower in GC IPOs, though the difference is only significant at the 10% level in models 4-5. Institutional ownership is consistently higher in multiple share class, which is consistent with Smart and Zutter (2003), and high-tech IPOs. Having a top tier underwriter and big 5 auditor also is associated with greater institutional ownership. In evaluating the results in Table 7, we have to be careful about inferring causality. Taken at face value, it appears that institutional ownership is influenced by GC opinions. However, it could be the case that institutional investors simply tend to avoid the types of IPOs that receive GC opinions. To the extent that we are missing important determinants of institutional ownership in our models, the correlation we document may just be association rather than causation. To deal more thoroughly with this self-selection problem, we employ propensity score matching in section

18 5.2 Analysts In Tables 8 and 9, we evaluate the relation between analyst forecast errors and recommendations and GC opinions for our IPO sample. In Table 8, the dependent variable is analyst earnings forecast errors post-ipo. Forecast errors are defined as the difference between the first quarter s actual EPS and consensus EPS forecast scaled by the stock price. Forecast errors are consistently between 9-11% lower for GC IPOs across all models. Thus, this result indicates analysts are, on average, systematically overestimating EPS forecasts for GC IPO firms. Forecast errors are positively related to market capitalization and the initial return. *** Insert Tables 8 and 9 about here *** Table 9 repeats Table 8, now with average analyst recommendation level as the dependent variable. Here, the GC dummy is insignificant in all models. In the most extensive model (column 4) we consider, firm size, multiple class shares, and having a top tier underwriter are associated with lower recommendations (again, recall that a higher recommendation takes a lower value numerically). Overall, we find mixed evidence that the presence of a GC opinion in IPOs plays a role with analysts. We find GC opinions are related to analysts forecast errors, but not recommendation levels. Again, because analysts choose which firms to cover there may be a self-selection issue that we have not properly addressed. Thus, we reexamine the role of GC opinions and analyst behavior in section 5.4 using propensity score matching. 5.3 Lawsuits In Table 10, we present logistic regression results on the relation between GC opinions and the probability of an IPO firm being sued post-ipo. We consider lawsuits in the first three years, 17

19 and Section 11 lawsuits within 3 years of the IPO. 2 Again, to ease interpretation, we present marginal effects (measured at the means) as well as coefficient estimates. Also, to save space, we present only the full models. *** Insert Table 10 about here *** Examining the results in Table 10, it is immediately apparent that a GC opinion significantly lowers the likelihood of a firm being sued. Thus, all else the same, the increased disclosure from the GC opinion appears to immunize firms to a significant degree. However, there is an important caveat. This immunization only applies to firms that do not have big 5 auditors. The marginal effects we report make it appear that having a GC opinion and a big 5 auditor (the interaction term) greatly increases the likelihood of being sued, but an examination of the logistic coefficients indicates that the sum of the GC dummy and the GC/big 5 interaction is indistinguishable from zero. In other words, firms with GC opinions and big 5 auditors are no more or less likely to get sued. Looking at the other variables in the models, there is a positive relation between IPO offer price revisions and lawsuits. It may be that IPO firms that aggressively raise their offering prices increase the likelihood of eventual losses to investors. No other variables are consistently significant, including the two certifier variables. Thus, the probability of a lawsuit is unaffected by underwriter prestige and the presence of a big 5 auditor outside of the interaction effect Propensity score matching We conduct additional analysis to alleviate concerns regarding endogeneity issues because GC opinions are not randomly assigned by auditors. Econometric techniques, such as propensity score matching (PSM), have been developed to help make causal interpretation of observable data 2 Section 11 lawsuits (Section11) are the lawsuits that are brought under Sections 11 and 12 of the Securities Act of 1933, where damages for direct purchasers in the IPO are based on the difference between the offer price and either the sale price or the security s price at the time of the lawsuit, depending on whether or not the share was sold (Lowry and Su, 2002). 18

20 more plausible by adjusting for other factors that may responsible for differences between groups (Dehejia and Wahba, 1999, 2002). We implement PSM methods in three steps to detect possible issues due to these observables in the sense of Tucker (2010). In the first step, we run logistic regression models with the GC dummy variable as the dependent variable, as in Table 11. These results are shown in Panel A, column 1. Among the independent variables that are known at the time of the IPO, the prior market return, high-tech status, and the offer price are consistently negatively associated with GC opinions. The other control variables are not significantly related to IPO firms GC opinions once joint effects are considered. *** Insert Table 11 about here *** In the second step, we estimate each IPO s propensity score based on the probability that a going public firm with the above characteristics will get a GC opinion. Next, we match the GC and non-gc IPOs using one-to-one nearest neighborhood matching (Caliendo and Kopeinig, 2008). The matching process generates a sample of 67 GC IPOs and 67 non-gc IPOs (we lose one GC IPO because of data availability for the independent variables). We then use this matched sample and rerun the logistic regression. These results are shown in Panel A, column 2, which is the post-match regression. Now we find no significant differences between the control and treatment groups, so our matching procedure was effective in eliminating differences between the two samples. In the third step, we run either OLS or logistic regressions with specifications that are similar throughout the paper. The dependent variables are delisting status, initial returns, institutional ownership, analyst forecast errors, analyst recommendation levels, and class action lawsuits, respectively. The results are shown in Panel B. 19

21 We find that delisting status is negatively related to IPOs that receive GCs and remains highly significant. This confirms our baseline results and indicates that GC IPOs underperform. Also consistent with our previous results, we find no relationship between GC IPOs and underpricing, analyst recommendation levels, or lawsuit propensities. However, we do note two changes. First, the coefficient on institutional ownership is zero and is no longer significant. Second, while still negative, the coefficient on analyst forecast errors is no longer statistically significant. Of course, this finding may be the result of a power decrease due to the large reduction in the sample size, but we are nonetheless cautious in our interpretation of the impact of this variable. Overall, with the exception of institutional ownership and analyst forecast errors, our results are robust to controlling for potential self-selection using the PSM method. 6. GC opinions and the decision to go public In this section, we investigate the impact of a GC opinion on the firms themselves. While this question is not the main purpose of our paper, which is the impact of GCs on investors, it is nonetheless interesting to ask whether firms are deterred from going public by GC opinions. To explore this question, we expand our sample to include firms that filed Form S-1, but subsequently withdrew. We then run logistic regressions in which the dependent variable takes on a value of one for firms that withdrew from the going public process. Table 12 reports the results. As in our previous logistical regressions, we report marginal effects, measured at the means. *** Insert Table 12 about here *** Looking across the models in Panel A of Table 12, we consistently see that a GC opinion in the initial filing strongly increases the probability that a firm will withdraw. Somewhat surprisingly, the larger are the proposed maximum proceeds from the IPO (a measure of firm size, among other things), the more likely the firm is to withdraw, which is consistent with Dunbar and Foerster (2008). 20

22 Recent market performance has a relatively weak effect, but certifier quality enters strongly in the decision. Firms with top tier investment banks and big 5 auditors are much less likely to withdraw. Finally, the interaction between GC and big 5 auditors shows that GC firms with big 5 auditors are more likely to go public than GC firms using less prestigious auditors. Similar to the endogeneity concerns raised previously, withdrawing from the IPO market is a choice so we implement PSM techniques. In Panel B, column 1 we run a logistic regression with GC as the dependent variable. Firms backed by a top tier underwriter and big 5 auditor are less likely to receive a GC opinion. In column 2 we rerun the logistic regression after matching firms using the same approach in Table 11. Now firms are similar in terms of having a big 5 auditor, but we are unable to entirely remove the difference for top tier underwriters. However, note that the pseudo R 2 drops from 9% to 1%, so the differences between the two groups are minimal. In Panel C, we rerun the logistical regressions for withdrawal probabilities. Despite the significant drop in sample size and corresponding loss in power, similar to the results in panel A, we continue to find that having a GC opinion strongly influences the decision to withdrawal from the IPO market. In all 3 models shown, the GC dummy is statistically significant at the 1 percent level. Likewise, having a top tier underwriter and big 5 auditor are also important factors in the withdrawal decision. 6. Conclusion We examine the impact of auditor going concern (GC) opinions on IPO firms. It seems surprising that a company could go public if the auditor has substantial doubts about the viability of the firm; yet, in our sample of non-micro non-penny stock IPOs, almost 10% of firms have one. In the previous decade, these were virtually non-existent except for the smallest of IPOs that we do not consider in this study. 21

23 We find that a GC opinion is a credible signal about IPO firms prospects. We find GC IPOs (compared to non-gc IPOs) are more likely to withdraw from the IPO market, have worse long-run stock market and operating performance and are more likely to delist within 3 years of the IPO for performance-related reasons, but are similarly underpriced. Institutional investors and analysts do not differentiate between GC and non-gc IPOs. Despite the worse performance, GC IPOs are less likely to sued suggesting that these disclosures may hedge litigation risk. Overall, our findings show that GC opinions contain valuable information that is not fully incorporated by investors. 22

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