Value creation by private equity-backed IPOs. Underpricing and long-term performance in Germany

Table of contents

List of tables

List of figures

List of abbreviations

1 Introduction
1.1 Growing importance of private equity
1.2 Problem statement and objectives
1.3 Delimitations
1.4 Structure

2 Private equity business model
2.1 Definition of terms
2.2 Value chain of a private equity process
2.3 IPO as an exit strategy
2.4 Private equity landscape in Germany

3 Theoretical background of IPO phenomena
3.1 Underpricing
3.1.1 Empirical findings on underpricing
3.1.2 Explanatory approaches for underpricing
3.2 Long-term aftermarket performance
3.2.1 Empirical findings on aftermarket performance
3.2.2 Explanatory approaches for negative aftermarket performance

4 Empirical strategy
4.1 Data overview
4.1.1 Data collection
4.1.2 Sample selection
4.1.3 Sample characteristics
4.2 Methodology
4.2.1 Underpricing methodology
4.2.2 Long-term performance methodology
4.3 Results and analysis
4.3.1 Underpricing results
4.3.2 Long-term performance results

5 Conclusion

Bibliography

Appendices
A. Descriptive statistics for underpricing sample
B. Descriptive statistics for long-term aftermarket sample
C. Descriptive statistics for underpricing performance
D. Descriptive statistics for buy-and-hold abnormal returns
E. Descriptive statistics for cumulative abnormal returns
F. List of Private Equity-backed IPOs
G. List of Non-sponsor-backed IPOs

List of tables

Table 1: Comparison of investment strategies of venture capital and private equity

Table 2: Categorization of explanatory approaches for underpricing phenomenon

Table 3: International evidence of IPO long-term performance

Table 4: Overview of collected data

Table 5: Sample selection process

Table 6: Issue proceeds [in million €] by industry (2002-2018)

Table 7: Overview of independent variables of the regression model

Table 8: Descriptive statistics of market-unadjusted initial returns

Table 9: Results of regression analyses on underpricing

Table 10: Results of Mann-Whitney U-test for buy-and-hold abnormal returns

Table 11: Results of Mann-Whitney U-test for cumulative abnormal returns

Table 12: Summary and results of tested null hypotheses

Table 13: Number of IPOs and issue proceeds [in million €] by year

Table 14: Number of IPOs and issue proceeds [in billion €] by issue volume (2002-2018)

Table 15: Issue proceeds [in million €] by industry (2002–06/2016)

Table 16: Descriptive statistics of market-adjusted initial returns

Table 17: Descriptive statistic for buy-and-hold abnormal returns of all IPOs

Table 18: Descriptive statistic for buy-and-hold abnormal returns of NS-backed IPOs

Table 19: Descriptive statistic for buy-and-hold abnormal returns of PE-backed IPOs

Table 20: Descriptive statistic for cumulative abnormal returns of all IPOs

Table 21: Descriptive statistic for cumulative abnormal returns of NS-backed IPOs

Table 22: Descriptive statistic for cumulative abnormal returns of PE-backed IPOs

List of figures

Figure 1: Value chain of a private equity financing process

Figure 2: Divestment volume in Germany by exit channels [in million €]

Figure 3: Private equity investments in Germany from 2007 to 2018 [in million €]

Figure 4: Average first-day returns on worldwide IPOs

Figure 5: Number of IPOs and issue proceeds [in billion €] by year

Figure 6: Number of IPOs and issue proceeds [in billion €] by issue volume (2002-2018)

Figure 7: 36-month equally-weighted buy-and-hold abnormal return development

Figure 8: 36-month value-weighted buy-and-hold abnormal return development

Figure 9: 36-month equally-weighted cumulative abnormal return development

Figure 10: 36-month value-weighted cumulative abnormal return development

Figure 11: Number of IPOs and issue proceeds [in billion €] by issue volume (2002-06/2016)

List of abbreviations

BHAR Buy-and-hold abnormal return

Bn Billion

BVK Bundesverband Deutscher Kapitalbeteiligungsgesellschaften e.V.

CAR Cumulative abnormal return

DACH Germany, Austria and Switzerland

DBAG Deutsche Börse AG

E.g. For example

EW Equally-weighted

FIRE Finance, insurance, and real estate

IR Initial return

ISIN International Securities Identification Number

IPO Initial public offering

FWB Frankfurt Stock Exchange

LN Natural logarithm

M Million

M&A Mergers & acquisitions

NS Non-sponsor

P P-value

PE Private equity

PwC PricewaterhouseCoopers

SEO Seasoned equity offering

SPAC Special purpose acquisition company

SSE Sum of squared residuals

SSR Sum of squared errors

VC Venture capital

VW Value-weighted

1 Introduction

“We must help companies acting in the interest of their future and the future of their employees against irresponsible locust swarms, who measure success in quarterly intervals, suck off substance and let companies die once they have eaten them bare.”¹ – Franz Müntefering (January 2005)

1.1 Growing importance of private equity

Ever since the biblical comparison of locust swarms with private equity (PE) by the German politician Franz Müntefering, which has sparked a national debate that continues to this day, PE must deal with a bad reputation in Germany. The locust debate has dominated the public opinion on PE in the past, and their business model is still widely discussed. They are criticized as short-term investors, neither able nor willing to create long-term value in their companies. Since these PE firms are mostly pure financial investors, their success often depends only on the proceeds from the sale of the corresponding portfolio companies. The sustainable development of the company in question is of secondary importance. They are therefore excoriated for taking unpopular measures such as breaking up of companies or mass redundancies to achieve the sales and profit targets set.² Accordingly, investor and business magnate Warren Buffet criticized that businesses under PE control become “a piece of merchandise”³.

The relevance of the topic becomes even more apparent when one considers the latest trend within the PE industry. After a slowdown of the PE business following the financial crisis in 2008 and 2009, it has reached a new record in global deal volume of $1.4 trillion with more than 9,000 transactions in 2018.⁴ PE firm Apollo Global Management raised gigantic $24.6 billion of capital in 2017 for the largest fund in PE history.⁵ European PE firms, however, are in no way inferior with new mega funds in the pipeline as CVC Capital Partners targets to raise Europe’s largest PE fund at more than €18 billion for next year.⁶ Under these circumstances and new evolving discussions, it is essential to deal with the PE business model and take a look into potential short- and long-term value creation of PE firms in their portfolio companies.

1.2 Problem statement and objectives

Against this background, this thesis aims to provide evidence on the discussion whether PE creates value for the companies which they acquire, finance and support during the investment period, and then exit at the highest possible profit. As the investment most often takes place in private companies, for which financial data is hardly available, the following thesis deals with companies backed by PE firms going public.

An initial public offering (IPO) is one of the potential exit routes for PE and experiences in general, two phenomena: Underpricing and negative long-term abnormal returns. Underpriced IPOs are characterized by high first-day closing prices compared to issue prices, leaving a significant amount of money left on the table, as the issuer could have set an even higher issue price for its shares. Negative long-term abnormal returns, in turn, mean that IPOs are outperformed by their benchmarks, e.g. country or industry indices, on a significant basis.

The resultant research question of this thesis is: How do German PE-backed IPOs differ from non-sponsor (NS) backed IPOs, and how do German IPOs perform in general? If PE-backed IPOs are less underpriced and outperform their NS-backed counterparts in the long-run, it will imply that PE firms can create more value for their portfolio companies than firms without a financial sponsor can create. Moreover, the purpose of this thesis is to identify whether the IPO phenomena described above are true for IPOs in Germany.

This paper shall give detailed insights on a mostly US-based research topic, as only two known studies are conducted on the German market dealing with both underpricing and long-term performance of PE-backed IPOs. One study analyzed 39 German IPOs backed by PE firms from 2004 to 2007,⁷ while the other investigated 46 sponsor-backed IPOs from 2000 to 2013.⁸ The presented paper differs from these studies in terms of a broader time horizon and extensive calculation methodology. 134 German IPOs from 2002 to 2018, of which 49 were identified as PE-backed are analyzed, contributing empirical evidence on the PE value creation discussion.

1.3 Delimitations

The presented paper is limited to the analysis of PE- and NS-backed IPOs. Companies backed by venture capital (VC) firms are thus excluded from the investigation. Moreover, the operational performance of the companies is not subject of this thesis, as only share price performance is considered for value creation. Hence, the purpose of this paper is not to identify the reasons for any potential out- or underperformance, e.g. better operational performance, resulting from PE sponsors, but if the sole existence of PE backers results in any differences.

As mentioned above, the thesis is geographically limited to German IPOs, as the empirical evidence is relatively low, even though Germany is one of the countries in which PE is most controversially discussed. Moreover, Germany is seen as the most attractive country for PE investments within the European Union.⁹

1.4 Structure

The structure of the investigation is outlined with the described objectives above. Chapter 2 will first provide a detailed overview of the PE business model, including its delimitation to VC, and its value chain of financing. Furthermore, different exit strategies from portfolio companies are outlined, and a short overview of the PE landscape in Germany is given. Chapter 3 presents the two IPO phenomena in more detail, shows empirical evidence of their existence and describes the theoretical explanation approaches. Chapter 4 combines the academic background of the previous chapters providing the methodology of the empirical investigation. First, the empirical strategy for underpricing and long-term performance is outlined, including calculation metrics and hypotheses development. Subsequently, an in-depth description of the procedures regarding sample selection and data collection is provided, followed by an illustration of the sample characteristics. The last subchapter shows the results of the empirical investigation, along with a thorough analysis. Finally, chapter 5 summarizes the main findings of the study and an outlook points to the necessity of further research studies on this topic.

2 Private equity business model

2.1 Definition of terms

The three terms equity financing, PE and VC are regularly used in connection with the financing of unlisted companies. As the understanding of these terms varies, it is necessary to define them at the beginning of this thesis.

Equity financing is commonly used as the generic term to describe the asset class of equity investments in unlisted companies. In the practice of equity financing, a distinction is made between PE and VC. While PE describes equity investments in later-stage financing phases, the term VC is used for equity financing in high-tech and early-stage sectors.¹⁰

A detailed distinction between both financial sponsors is shown in Table 1. However, the overall strategy of these two types of financial sponsors is the same: Provision of capital, after a process of negotiation with a target company, aiming at developing the business and creating value, before exiting the investment with a high return.¹¹

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Table 1: Comparison of investment strategies of venture capital and private equity

Source: Adapted from Deloitte (2017), pp. 16-18

2.2 Value chain of a private equity process

After having defined the term PE, the value chain of PE financing will be clarified in the following. The value chain is usually similar for each PE company and characterized by a typical structure, which is displayed in Figure 1 and described in more detail below.

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Figure 1: Value chain of a private equity financing process

Source: Adapted from Hockmann, H. J./Thießen, F. (2012), p. 283

The first step in the value chain describes the generation of investment proposals, which is defined as deal flow. In general, deal flow can be achieved through three different sources:¹²

1. Direct demand: Private equity firms receive capital requests from companies which require further financial resources and cannot cover these capital requirements through internal financing. The success of this source is mainly based on a private equity firm’s reputation as it adopts an observant and passive attitude.
2. Network: Private equity firms build a network of individuals and organizations through which companies are recommended to them.
3. Acquisition: Potential target companies are identified by screening the market on their own initiative.

After selecting potential target companies which seem worth to be financed in the first place, due diligence, the most important step in the entire investment process, takes place. Due diligence is divided into a rough and detailed analysis. In the rough analysis phase, also known as short-screening, target companies are examined promptly concerning their worthiness of being financed. The selection criteria that determine the PE firm's investment strategy and policy play a decisive role in the decision process. For example, fundamental characteristics of the target company such as industry, region, company phase, type of investment or targeted deal volume must accord to the investment strategy. The main objective is to select investment opportunities that promise to maximize the expected return until disinvestment at a given risk.¹³

If the target company was classified as worthy of being financed in the rough analysis, the detailed analysis begins. As this is the actual start of the due diligence, it is essential to note that the due diligence is individually adapted to the situation of the target company and is thus not a standardized process.¹⁴

The purpose of the detailed analysis is to obtain a precise insight into the company regarding its strengths and weaknesses, to be able to grasp the opportunities and risks of an investment more precisely. The detailed analysis serves PE companies as an instrument for efficient decision-making, for negotiating optimal investment conditions and as a basis for the successful development of the company after the investment, which is crucial for a successful exit. The due diligence process, which is primarily conducted by external parties, comprises at least of a financial, legal, market and tax due diligence. Moreover, in contrast to the usual M&A transactions, exit due diligence plays an essential role in the PE investment process due to the limited holding period of the target company. Its goal is to determine all information relevant for a successful exit. At the end of the analysis, the possible exit channels should be determined, and the associated conditions should be identified.¹⁵

Concluding, the due diligence of a target company is essential for PE firms, as their subsequent exit capital gains depend to a large extent on the quality of its investment portfolio. They are therefore required to carry out the due diligence as precisely as possible to avoid later problems due to information that has subsequently emerged.¹⁶

If the target company has passed the due diligence, the PE company enters into real negotiations with the company and a participation agreement is drafted. This process step is called deal structuring. The aim hereby is to negotiate a contract that is based on mutual acceptance and thus overcomes any conflicts of interest that may arise.¹⁷ As the target company has a high incentive to maximize its purchase price, the PE company bears the risk that not all weaknesses were identified during the due diligence. To overcome the superior information of the entrepreneur, the PE company tries to implement contractual regulations to avoid potential disadvantages. The following measures, among others, are possible: Milestone financing, financial commitment of management as well as monitoring and influencing the business development.¹⁸

After successful negotiation and structuring of the contract, the PE firm invests in the company, which then becomes a portfolio company of the PE firm. From this point on, portfolio companies usually remain in the portfolio for several years. During this time, PE companies provide active support and control in the portfolio company. This means that their area of responsibility goes far beyond a pure financing function.¹⁹ The aim of this monitoring is to minimize risk by reducing the asymmetrical distribution of information and increasing the value of the company. The monitoring process is of decisive importance for PE companies, as it represents the most important possibility for an ongoing active influence of the investment success after the selection procedure of the portfolio company.²⁰

Each PE firm pursues a different policy regarding the management of portfolio companies. The intensity of the support depends on the problems and support needs of the portfolio company and can be distinguished into three approaches:²¹

- Hands-on: PE firm supports the management with advisory and knowledge transfer in the fields of financing, distribution, marketing or strategical planning
- Hands-off: no management support
- Semi-active support: medium management support, often only in single chosen company functions

The monitoring phase is not only the longest in the context of PE value creation but also represents a unique challenge. In addition to financial questions, strategic and operational support must be provided. The successful implementation of such support requires specialist knowledge and a high degree of experience on the part of the private equity managers. As a result, they only manage a minimal number of portfolio companies and specialize in sectors or technologies.²²

Jensen was one of the first to discuss the value creation of PE-backed companies during the monitoring phase. He argues that a high debt ratio, concentration of ownership, PE management expertise and efficient monitoring of the company’s management has a positive impact on the operational and financial performance of the portfolio company.²³ His theory was shortly after empirically supported as it was found that operating performance of companies, such as operating income to sales or cash flow to sales, significantly improved during PE ownership.²⁴ Moreover, the profitability of PE-backed companies increased as they achieved lower costs by reducing their relative capital expenditures.²⁵ In more recent studies, it has been confirmed that PE firms are able to add value to their portfolio companies by tighter monitoring, involvement in strategic planning and decision-making, higher leverage levels as well as by skilled portfolio managers.²⁶ Moreover, a study examined a total of 2,000 PE transactions over the last 30 years worldwide, concluding that the average value created by the participation of a private equity company is 3.4 times the invested capital over the term of the investment. 48% of this effect can be explained by the influence of the investors on the operational and strategic management of the company.²⁷

The exit represents the end of the value chain of PE financing and pursues the goal of successively realizing the added value of the portfolio company. In principle, five different exit routes exist:²⁸

- Going public: Placement of the portfolio company on the stock exchange.
- Trade sale: Sale of the investment to an industrial or strategic investor who either operates in the same industry or explicitly wants to buy into it.
- Buy back: Sale of the shares in the portfolio company to the co-shareholders, in general to the main shareholder.
- Secondary purchase: Sale of the investment to a financial investor or another PE company.
- Liquidation: Complete settlement of the portfolio company as worst-case scenario, resulting in a write-off of the investment.

As shown in Figure 2, trade sale accounted for 37% of the divestment volume in the last eight years and thus has been the exit route with the highest sale proceeds for German PE-backed companies in this time horizon. Furthermore, secondary purchases play an increasingly important role, representing 43% of the total divestment volume in 2018. Buy backs, on the other hand, are by far the least used route, accounting for only 3% of the exit volume since 2010. One possible explanation for this could be that buy backs in general bring, apart from liquidation, the least profit as the co-shareholders might only have scarce financial resources. Otherwise, they would not have needed the financial support of the PE companies in the first place. IPO as an exit route played a more significant role between 2012 and 2015 but has tremendously decreased since 2016.²⁹

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Figure 2: Divestment volume in Germany by exit channels [in million €]

Source: Adapted from BVK (2018), pp. 25 f.

Thus, it seems that going public is not the favorite exit strategy of PE firms despite being described as “golden harvest”³⁰ in literature. In the following section, an evaluation of going public from PE-backed companies will be discussed in more detail.

2.3 IPO as an exit strategy

Before discussing the advantages and disadvantages of taking a firm public, general terms in this context are defined. The capital market can basically be divided into a primary market, which is also known as the issuing market, and a secondary market. In the former, the first sale of newly issued securities takes place, while in the latter already issued securities are traded.³¹

IPO, also known as going public or primary offering, is described as the first sale of a company's shares to the public. In contrast, a secondary offering, also known as seasoned equity offering (SEO) or capital increase, describes a new issue of shares by an already publicly traded company.³² If the shares are not publicly sold, but only to a selected group of investors, the issue of shares is called a private placement.³³

An IPO is a highly sophisticated process, the planning of which can take several months. Nevertheless, it is described as the ideal and most attractive exit route, as it offers the most advantages for a PE company. First and foremost, an IPO is expected to generate higher proceeds than any other exit channel. For example, it has been empirically proven that an IPO can generate around five times higher profits than the next best exit route, a trade sale. Furthermore, there is a comprehensive market for the shares, the issue price can be determined comprehensibly, even small participation shares can be sold, and the shares are also highly fungible.³⁴

Besides the advantages mentioned above, an IPO also entails considerable disadvantages for a PE company, as the process is very time-consuming and cost-intensive. The selection of advisors, restructuring process, preparation of the prospectus and the roadshows can take several months and have an impact on daily business. Based on a survey conducted by PwC, the most significant cost pool in an IPO process is the underwriting fees equal to 4 to 7% of the gross proceeds. On average, depending on the issue size, a company additionally incurs $4.2 million in offering costs directly attributable to the IPO, such as legal and accounting fees or roadshow expenses. However, not only the going public costs must be taken into consideration, but also the costs of being public. One-time costs for converting into a public company of $1 million and annually recurring incremental costs in the same amount incur on average for publicly traded companies.³⁵

Additionally, an IPO represents only a partial divestment from a portfolio company as PE firms cannot sell all their shares due to a so-called lock-up period. This period typically lasts for six to twelve months after the IPO, in which the previous owners cannot sell their remaining shares. Lock-up agreements are often imposed by underwriters to secure a successful and stable IPO and to signal to investors that pre-IPO shareholders assess the company’s prospects of success positively.³⁶ However, lock-up periods contain risks for PE companies as they cannot adequately estimate the future development of the share price, and thus, their profit realization remains uncertain.³⁷

In summary, an IPO is a promising exit route with high-profit potential, but it can only be considered for a few portfolio companies. Thus, this exit route is rarely used compared to trade sales or secondary purchases since only the best-performing companies can successfully be placed on the stock exchange.

2.4 Private equity landscape in Germany

Since the locust metaphor by Müntefering, private equity has been subject to controversial discussions and many critics in Germany. The following chapter gives an insight into the development and current situation of the private equity industry in Germany.

In 2018, more than 300 PE firms were active in Germany, financing more than 1,100 companies annually. Overall, 5,000 German companies are financed by PE firms. The entire PE invested a total of 9.6 billion euros in German companies in 2018, which represents an important capital flow within the local economy.³⁸ The development of PE investments is illustrated in Figure 3 below.

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Figure 3: Private equity investments in Germany from 2007 to 2018 [in million €]

Source: Adapted from BVK (2018), p. 12

After a noticeable decline caused by the financial crisis in 2008, PE investments reached a new peak in 2017, further clarifying the relevance of the research topic. However, PE investments measured by gross investment volume represented for 0.34% of the GDP in Germany in 2018, ranked only 12th in Europe. Denmark leads the statistic with 1.04%, followed by the Netherlands with 0.77%.³⁹ In a survey conducted by PwC, the German PE market is believed to become more attractive for PE investments in the next five years by nine in ten respondents. In contrast, the United Kingdom only reached 29% as a potential consequence of the Brexit.⁴⁰ Moreover, Germany was listed as the 8th most attractive country worldwide for PE and VC investments. Attractiveness criteria were economic activity, depth of capital market, taxation, investor protection and corporate governance, human and social environment as well as entrepreneurial culture and deal opportunities.⁴¹

PE investments in the DACH region accounted for 18% of the European PE deal value in 2018.⁴² In the same year, Germany was ranked 8th in the value of private equity deals by target country, representing around 3% of the global deal volume. The statistic is headed by the US with almost 44%, followed by China with 14.5%.⁴³

In conclusion, it can be said that the German PE market is relatively small on an international level. Nevertheless, Germany is ranked in the top ten for various statistics, like global deal volume or country attractiveness. Besides, investments in German companies reached a new high in 2017 and will continue to grow according to PE companies, while the UK is expected to see less growth due to the forthcoming Brexit. This development could lead to a more critical role of Germany in the European PE segment.

At the end of chapter 2, it can be concluded that PE firms are highly selective regarding their investments. Each portfolio company needs to undergo intensive due diligence before being financed and supported by the PE firm. In addition, only the best portfolio companies are selected for an IPO as a listing is very costly, and only the companies with the highest profit potential are worth bearing these costs.

3 Theoretical background of IPO phenomena

After the basics of the private equity industry have been explained, the following chapter deals with the two phenomena associated with IPOs: Underpricing and long-term performance. For this reason, the empirical findings, as well as explanatory approaches, are systematically reviewed and discussed in the following chapter.

3.1 Underpricing

In general, underpricing is defined as a significantly higher stock price on the first trading day compared with the issue price . If the offer price is lower than the first day’s closing price, a stock is hence considered to be underpriced. On the other hand, if the closing price is below the issue price, a stock is considered to be overpriced.⁴⁴ Investors initially assess this difference between the first market price and the issue price positively, as they can achieve an initial return on the first trading day through underpricing.⁴⁵ For the issuers, on the other hand, underpricing means a waiver of assets, as they cannot achieve the maximum possible proceeds from the issue. This waiver of assets is, in turn, referred to as money left on the table.⁴⁶

3.1.1 Empirical findings on underpricing

The underpricing phenomenon had firstly been observed in the US in 1969.⁴⁷ Since then, many empirical studies on underpricing have been conducted. Figure 4 summarizes one of the most comprehensive country-based underpricing studies, containing data over decades of various capital markets. The returns are equally-weighted averages. The extent of the average initial returns that can be achieved is subject to a wide variation from 3.3% in Russia to 51.0% in Malaysia. Even higher underpricing levels have been investigated in India and China amounting to 85.5% and 113.5% respective. Due to presentation reasons, however, they have been excluded from Figure 4. Between 1987 and 2014, 779 IPOs in Germany showed an average underpricing level of 23%. Hence, German IPOs experience a higher level of underpricing compared to most of the other European countries. However, it should be mentioned that the analyzed time periods vary from country to country in the below figure. For this reason, conclusions from direct comparisons between the individual capital markets must be drawn with reservations.⁴⁸

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Figure 4: Average first-day returns on worldwide IPOs

Source: Adapted from Loughran, T./Ritter, J. R./Rydqvist, K. (2019), pp. 2 f.

According to Figure 4, there is an empirical agreement that underpricing is a worldwide phenomenon that can be observed on all international capital markets. The reasons for this anomaly are still the subject of intense discussion and are often referred to as “underpricing mystery”⁴⁹. Various explanatory models try to justify why issuers are willing to forego such high issue proceeds. These controversially discussed approaches are described in detail below.

3.1.2 Explanatory approaches for underpricing

Different systematization approaches of underpricing theories can be found in the respective literature. The categorization of the explanatory models used in this thesis distinguishes between equilibrium-based and ad-hoc hypotheses. While equilibrium-based hypotheses are based on the asymmetric distribution of information, ad hoc explanatory hypotheses attempt to explain underpricing based on underlying market imperfection, based on institutional framework conditions or the behavior of investors.⁵⁰ In the following sections, the hypotheses of Table 2 are presented and discussed in more detail.

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Table 2: Categorization of explanatory approaches for underpricing phenomenon

Source: Hofmaier, M./Wiedemann, F./Winterhalter, T. (2019), p. 38

Equilibrium-based hypotheses

Traditional theories such as the neoclassical capital market theory are not able to determine the existence of a systematic positive initial return. According to Fama's theory of information-efficient markets, all market participants have the same level of information.⁵¹ In its strong form, the efficient-market hypothesis states that even insider information is immediately and completely reflected in the stock price.⁵² Hence, a systematic deviation of the secondary market price from the issue price would not be possible because the issue price must equal to the secondary market price based on the same information available to all market participants. However, it has to be noted that the strong-form of the efficient-market hypothesis is mostly refuted in research and is more of a theoretical approach.⁵³ If the central assumption of an information-efficient capital market is abolished, the underpricing phenomenon indicates inefficiency in at least one of the markets involved, primary or secondary market.⁵⁴ Assumptions beyond the neoclassical model world are consequentially needed to explain the information asymmetries and the associated added value of an information advantage for the IPO market.⁵⁵

Consequential, equilibrium-based hypotheses explain underpricing by the unequal distribution of information among market participants. Some market participants have a more precise understanding of the true value of the share price than other market participants. Hence, underpricing is considered as a necessity to restore the market equilibrium. Concerning underpricing, the unequal distribution of information can exist among investors, between investors and issuer or between the issuer and issuing bank.⁵⁶ In the following, the most relevant equilibrium-based hypotheses are described in more detail.

Adverse-selection models

The adverse-selection models by Rock and Beatty/Ritter differentiate between informed and uninformed investors. Underpricing is a requirement for returning to market equilibrium in their models. Otherwise, the issue market would collapse due to the adverse selection problem as uninformed investors will no longer subscribe for newly issued shares.

Winner’s curse: Adverse-selection model

The adverse-selection model developed by Rock assumes an asymmetric information distribution between investors. The informed investors have complete information about the fair value of a newly issued company. On the contrary, the uninformed investors are not able to distinguish between undervalued and overvalued IPOs.⁵⁷ The rationally acting informed investors will only subscribe to new shares, which are undervalued. The uninformed investors, on the other hand, subscribe to both undervalued and overvalued stocks due to a lack of information. This results in a lower probability of receiving an undervalued stock than an overvalued one for the uninformed investor.⁵⁸ Thus, the initial return is expected to be below average for uninformed investors, which is described as “winner’s curse”⁵⁹ in subsequent literature.

The fact that both informed and uninformed investors wish to subscribe for undervalued shares leads to a corresponding oversubscription of the shares.⁶⁰ The uniformed investors, therefore, must share the positive returns of the undervalued IPOs with the informed investors, while they alone bear the negative returns of the overvalued shares. Consequently, there is a crowding-out of uninformed investors as they cannot expect positive initial returns. When uninformed investors withdraw from the IPO market, overvalued IPOs are no longer placed while undervalued issues are not fully placed. To prevent this, the issuer must offer its shares below the actual expected equilibrium price to compensate uninformed investors for taking the risk in trading against informed ones.⁶¹ Thus, underpricing is a necessary condition to return to market equilibrium in Rock’s model as otherwise, the adverse-selection problem would result in a collapse of the issue market. Moreover, it can be concluded that the higher the information asymmetry between investors, the higher is the expected underpricing and thus compensation for uninformed investors.

Ex-ante uncertainty: Adverse-selection model

In an expansion of Rock’s model, Beatty & Ritter argue the greater the uncertainty about the fair value of an IPO is, the more important it is to obtain information. This implies that the fewer information issuers disclose on their own initiative, the higher the information gathering costs for the investors.⁶² Therefore, informed investors will demand issues with lower ex-ante uncertainty more than those with higher uncertainty. This increased demand, in turn, leads again to a crowding out of uninformed investors as the chance of allocation of shares with low uncertainty is reduced. Hence, uninformed investors will demand higher underpricing for IPOs with high ex-ante uncertainty. Accordingly, issuers must price their shares the lower, the higher the uncertainty about their IPOs is to prevent the uninformed investors from withdrawing from the IPO market. The ex-ante uncertainty model thereby explains the differentiated level of underpricing and presents a correlation between the amount of underpricing and ex-ante uncertainty: The higher the ex-ante uncertainty about shares’ fair value, the higher is the expected underpricing.⁶³

The practical problem with ex-ante uncertainty arises from the fact that the explanatory variable of uncertainty is not directly measurable and needs to be replaced by proxies such as issue price, proceeds or company-specific variables such as revenue or equity.

Signaling models

Signaling models, in contrast to adverse selection models, assume that issuers have superior information over investors. On this account, issuers try to signalize the high quality of their company by intentional underpricing to attract the attention of investors: “High-quality firms demonstrate that they are high quality by throwing money away”⁶⁴. Issuers are willing to send those signals as they expect an increase in secondary market prices due to their high quality. Hence, potential SEOs can be carried out at higher prices, which would compensate the issuers for lower IPO prices. As one signaling model, the one developed by Grinblatt & Hwang is explained in more detail in the following:

To solve the asymmetric information problem between issuer and investor, issuers signal true value by offering its shares below fair value and retaining a certain proportion of its shares. As the issuer has superior information about the firm’s future cash flows and the issuer is willing to retain those shares, a higher portion of retained shares serves as a signal for higher expected future cash flows.⁶⁵ However, signaling is costly, because the issuer must sell part of the shares at a price discount and retain the other portion. Only high-quality companies will be able to bear these additional signaling costs.⁶⁶ The model thus describes a positive correlation between the proportion of shares held by existing shareholders and underpricing.⁶⁷ In conclusion, signaling models assume that issuers overcome information asymmetry problems by intentionally underpricing their shares as a signal of corporate quality to “leave a good taste in investors’ mouths”⁶⁸.

Venture capital certification thesis

The certification theory by Megginson and Weiss is regarded as the first fundamental presentation and empirical examination that VC-backed IPOs are a sign of high quality and low risk. The theoretical basis for the VC certification hypothesis is the asymmetric distribution of information between corporate insiders and outside investors. In the sense of this theory, corporate insiders include all individuals who are involved in the IPO of the company and possess useful information for its valuation. Outside investors are interested in buying the firm’s shares but do not have the relevant company information. Corporate insiders have an interest in hiding certain information from investors or delaying their disclosure. The reason for this is the company's IPO valuation. The concealment of company relevant, possibly negative facts could lead to a higher valuation and thus to an increase in issue proceeds. The investors though are aware of this intention and anticipate the existence of such information. Accordingly, they bid a lower amount when making offers to purchase shares. The spread between this amount and the amount initially envisaged is seen as a risk discount that investors receive when buying stocks.⁶⁹

Outside investors will therefore only be convinced that correct disclosure of information has taken place if a third party, with reputational capital at risk, has certified this. According to Megginson and Weiss, the following three conditions must be met by a third party, also known as the agent, to be able to fulfil this certification function:⁷⁰

1. The agent must have a certain level of reputational capital at stake, which would be lost if an actual overvalued issue is certified as fairly priced.
2. The value of the agent’s reputational capital must be higher than the maximal potential profit that could be gained by certifying falsely.
3. The service offered by the certifying agent must be costly for the issuer to obtain.

VC companies can fulfil the required criteria for a certification agent, as they only invest in capital seeking companies and take them public if they are convinced of the future success of the business model. This has advantages for the issuing company itself, but also for outside investors. The issuing company benefits from low information disclosure costs due to the reduced asymmetry of information and thus a lower underpricing. Investors, in turn, can view the investment of financial sponsors as a positive signal for the quality of the business model and the probability of its successful implementation.⁷¹ In conclusion, the certification hypothesis presented can be seen as a central explanatory model for on average lower initial returns of VC-backed IPOs.

Ad-hoc hypotheses

In contrast to the explanatory approaches above, which are based on an asymmetric distribution of information, the hypotheses presented below do not assume an equilibrium price.⁷² The ad-hoc hypotheses are not primarily based on the assumption of information-efficient markets but on the existence of certain factors or circumstances that make IPO markets imperfect. These hypotheses can be subdivided into institutional, behavioristic and other ad-hoc explanations as illustrated in Table 2. The institutional explanations, however, are not described in more detail as it will exceed the scope of this thesis.

Behavioral finance explanations

The behavioral finance approaches are the most modern explanation theories for the underpricing phenomenon. Necessarily, it is assumed that there will be a positive impact on demand for IPOs due to irrational behavior by market participants. Underpricing is as a result no conscious action.⁷³

Informational cascades

Welch’s model of informational cascades assumes that investors often make their investment decisions not only based on their knowledge but also on the behavior of other investors. This leads to a herd behavior: Even if an investor has only positive information about an IPO, he will not subscribe for shares because other investors have not subscribed either. To ensure the placement, the issuer is prepared to offer the shares at a discount to arouse the interest of investors. Accordingly, a positive cascade effect is triggered, and the issue can be fully placed.⁷⁴

Investor sentiment

This model attempts to explain underpricing through the presence of irrational, sentiment investors in the secondary market. Within their model, a distinction is made between rational, institutional investors and the above-mentioned sentiment investors who are occasionally irrationally exuberant about the prospects of IPOs. It is argued that issuers should initially allocate all shares to cooperative, institutional investors to maximize their profit. Despite high demand by sentiment investors, the institutional investors hold the shares in their portfolio and thus deliberately shorten the supply to increase the excess demand. As a result, the secondary market price rises, and the institutional investors can realize a profit from selling their shares to the sentiment investors. For institutional investors, this strategy entails considerable risks, because sentiment demand may disappear prematurely, and a price collapse can occur very quickly while carrying these stocks in their portfolios. In return for taking this risk, they receive undervalued equities, which ultimately leads to underpricing.⁷⁵

Other ad-hoc explanations

Hot-issue markets

Ritter divides the IPO market into hot-issue and cold-issue periods, which are characterized by a particularly large number of firms going public and a high IPO volume or a correspondingly small number and respectively a low IPO volume. Accordingly, in hot-issue phases, the secondary market risk of an individual IPO is on average higher than in cold-issue phases, as firms are more likely to accept the increased costs of stock listing when other companies are going public as well which reduces the quality of listed companies resulting in above-average high first-day returns.⁷⁶

Market reputation thesis

According to Hunger, the individual stock exchanges and market segments have a different reputation in the market, which correlates positively with, for example, the admission and publicity requirements, the post-admission obligations, as well as market liquidity and media presence. The lower the reputation of a market segment, the higher the underpricing to compensate investors for the higher risk and, e.g. lack of market liquidity.⁷⁷ According to the market reputation hypothesis, an issuer could maximize its issue proceeds by selecting the segment with the highest reputation. However, if an issuer is unable to meet its expectations associated with the respective segment in which it is listed, the issuer runs the risk of being exposed, which can lead to price losses that overcompensate for the maximum issue proceeds. Therefore, it appears more rational to choose a segment with a lower reputation and offer the shares at a corresponding discount. From an investor's point of view, underpricing thus can be interpreted as a risk premium related to lower market liquidity and higher information procurement costs of the respective segment.⁷⁸

In summary, the review of the relevant literature has shown that the underpricing phenomenon can be observed on all international capital markets. Nevertheless, there are significant differences between individual countries. Furthermore, none of the theories presented can fully explain the existence of underpricing. It is argued that the asymmetric distribution of information is the main reason for underpricing and behavioral finance, on the contrary, can explain variations in the underpricing level over the years.⁷⁹ It may also be possible that the reasons for or relevance of the explanatory approaches change over time.⁸⁰

[...]

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¹ SPD, Programmheft I. Tradition und Fortschritt., 2015, p. 18.

² Cf. Bayaz, D., ,Heuschrecken' zwischen Rendite, Reportage und Regulierung, 2014, p. 78.

³ Berkshire Hathaway Inc., 2014 Annual Report, 2015, p. 32.

⁴ Cf. McKinsey & Company, Private markets come of age, 2019, pp. 20 f.

⁵ Cf. Afanasieva, D., Apollo raises $24.6 billion for largest private equity fund ever, 2017.

⁶ Cf. Espinoza, J., Private equity groups prepare to raise mega funds, 2019.

⁷ Cf. Meier, M./Möhlmann-Malau, T., Underpricing and Performance of Private Equity-Backed IPOs in Germany - an Empirical Study, 2010, p. 4.

⁸ Cf. Jung, M./Jyoti, G., Market Performance of Sponsor-Backed Initial Public Offerings: An Empirical Analysis of the German Market, 2017, p. 31.

⁹ Cf. PwC, Private Equity Trend Report 2019, 2019, p. 66.

¹⁰ Cf. Ernst, D./Häcker, J., Applied International Corporate Finance, 2011, p. 70.

¹¹ Cf. European Private Equity and Venture Capital Association, Guide on Private Equity and Venture Capital for Entrepreneurs, 2007, p. 8.

¹² Cf. Sonndorfer, T., Private Equity in Deutschland, 2007, pp. 51 f.

¹³ Cf. Ernst, D./Häcker, J. 2011, pp. 122 f.

¹⁴ Cf. Sonndorfer, T. 2007, p. 54.

¹⁵ Cf. Sonndorfer, T. 2007, pp. 54 f.

¹⁶ Cf. Hockmann, H. J./Thießen, F., Investment Banking, 2012, pp. 282 f.

¹⁷ Cf. Sonndorfer, T. 2007, p. 56.

¹⁸ Cf. Ernst, D./Häcker, J. 2011, p. 124.

¹⁹ Cf. von Daniels, H., Private Equity Secondary Transactions, 2004, p. 42.

²⁰ Cf. Sonndorfer, T. 2007, pp. 57 f.

²¹ Cf. Ernst, D./Häcker, J. 2011, p. 125.

²² Cf. von Daniels, H. 2004, p. 44.

²³ Cf. Jensen, M. C., Agency Cost Of Free Cash Flow, Corporate Finance, and Takeovers, 1986, p. 325.

²⁴ Cf. Kaplan, S., The effects of management buyouts on operating performance and value, 1989, p. 250.

²⁵ Cf. Muscarella, C. J./Vetsuypens, M. R., Efficiency and Organizational Structure: A Study of Reverse LBOs, 1990, pp. 1412 f.

²⁶ Cf. Acharya, V. V. et al., Corporate Governance and Value Creation: Evidence from Private Equity, 2013, p. 368.

²⁷ Cf. Achleitner, A.-K./Braun, R./Puche, B., International Evidence on Value Creation in Private Equity Transactions, 2015, p. 120.

²⁸ Cf. Povaly, S., Private Equity Exits, 2007, pp. 118 f.

²⁹ Cf. BVK, Der deutsche Beteiligungskapitalmarkt 2018, 2019, pp. 25 f.

³⁰ Cf. von Daniels, H. 2004, p. 48.

³¹ Cf. Brealey, R. A./Myers, S. C./Allen, F., Principles of corporate finance, 2017, p. 366.

³² Cf. Brealey, R. A./Myers, S. C./Allen, F. 2017, p. 384.

³³ Cf. Ernst, D./Häcker, J. 2011, p. 77.

³⁴ Cf. Sonndorfer, T. 2007, pp. 69 f.

³⁵ Cf. PwC, Considering an IPO to fuel your company’s future?, 2017, p. 22.

³⁶ Cf. Bösl, K., Praxis des Börsengangs, 2004, pp. 72 f.

³⁷ Cf. von Daniels, H. 2004, p. 48.

³⁸ Cf. BVK 2019, p. 6.

³⁹ Cf. Invest Europe, 2018 European Private Equity Activity, 2019, p. 42.

⁴⁰ Cf. PwC, Private Equity Trend Report 2019, 2019, p. 63.

⁴¹ Cf. Biesinger, M. et al., The Venture Capital and Private Equity Country Attractiveness Index 2018, 2018, pp. 17 f.

⁴² Cf. Invest Europe 2019, p. 38.

⁴³ Cf. Bureau van Dijk, Global M&A Review 2018, 2019, p. 12.

⁴⁴ Cf. Hofmaier, M./Wiedemann, F./Winterhalter, T., Underpricing – Theorien zur Erklärung eines weltweiten Phänomens – Teil I, 2018, pp. 33 f.

⁴⁵ Cf. Weinberger, A., Going Publics in Deutschland - Underpricing, Fair Valuing oder Overpricing?, 1995, p. 4.

⁴⁶ Cf. Ruud, J. S., Underwriter price support and the IPO underpricing puzzle, 1993, pp. 135 f.

⁴⁷ Cf. Reilly, F. K./Hatfield, K., Investor Experience with New Stock Issues, 1969, p. 73.

⁴⁸ Cf. Loughran, T./Ritter, J. R./Rydqvist, K., Initial Public Offerings: International Insights, 2019, pp. 2 f.

⁴⁹ Ibbotson, R. G., Price performance of common stock new issues, 1975, p. 235.

⁵⁰ Cf. Kaserer, C./Kempf, V., Das Underpricing-Phänomen am deutschen Kapitalmarkt und seine Ursachen, 1995, p. 45.

⁵¹ Cf. Fama, E. F., Efficient Capital Markets: A Review of Theory and Empirical Work, 1970, p. 383.

⁵² Cf. Fama, E. F. 1970, pp. 409 f.

⁵³ Cf. Jensen, M. C., Some anomalous evidence regarding market efficiency, 1978, p. 99.

⁵⁴ Cf. Hunger, A., IPO-Underpricing und die Besonderheiten des Neuen Marktes, 2001, p. 29.

⁵⁵ Cf. Kaserer, C./Kempf, V. 1995, p. 47.

⁵⁶ Cf. Kaserer, C./Kempf, V. 1995, p. 47.

⁵⁷ Cf. Rock, K., Why new issues are underpriced, 1986, pp. 190 f.

⁵⁸ Cf. Rock, K. 1986, p. 192.

⁵⁹ Beatty, R. P./Ritter, J. R., Investment banking, reputation, and the underpricing of initial public offerings, 1986, p. 215.

⁶⁰ Cf. Rock, K. 1986, p. 195.

⁶¹ Cf. Rock, K. 1986, p. 206.

⁶² Cf. Beatty, R. P./Ritter, J. R. 1986, pp. 213 f.

⁶³ Cf. Beatty, R. P./Ritter, J. R. 1986, pp. 214–216.

⁶⁴ Ritter, J. R./Welch, I., A Review of IPO Activity, Pricing, and Allocations, 2002, p. 1803.

⁶⁵ Cf. Grinblatt, M./Hwang, C. Y., Signalling and the Pricing of New Issues, 1989, p. 394.

⁶⁶ Cf. Grinblatt, M./Hwang, C. Y. 1989, p. 400.

⁶⁷ Cf. Grinblatt, M./Hwang, C. Y. 1989, p. 415.

⁶⁸ Ibbotson, R. G. 1975, p. 246.

⁶⁹ Cf. Megginson, W. L./Weiss, K. A., Venture Capitalist Certification in Initial Public Offerings, 1991, pp. 880 f.

⁷⁰ Cf. Megginson, W. L./Weiss, K. A. 1991, p. 881.

⁷¹ Cf. Megginson, W. L./Weiss, K. A. 1991, p. 883.

⁷² Cf. Kaserer, C./Kempf, V. 1995, p. 49.

⁷³ Cf. Ljungqvist, A., IPO Underpricing, 2007, p. 412.

⁷⁴ Cf. Welch, I., Sequential Sales, Learning, and Cascades, 1992, pp. 723 f.

⁷⁵ Cf. Ljungqvist, A./Nanda, V./Singh, R., Hot Markets, Investor Sentiment, and IPO Pricing, 2006, pp. 1668 f.

⁷⁶ Cf. Ritter, J. R. 1984, pp. 283 f.

⁷⁷ Cf. Hunger, A., Market Segmentation and IPO-Underpricing: The German Experience, 2003, p. 29.

⁷⁸ Cf. Hunger, A. 2001, p. 209.

⁷⁹ Cf. Ljungqvist, A. 2007, pp. 417 f.

⁸⁰ Cf. Loughran, T./Ritter, J. R., Why Has IPO Underpricing Changed Over Time?, 2004, p. 32.