Does VC Hurt Chances of IPO Success?

Initial public offerings (IPOs), the darlings of the dot-com boom, would be put on the endangered species list if they were a plant or animal — based on how few have been seen in the past year. Investor sentiment toward IPOs has been almost as negative since the bubble burst as the IT hype was positive before. But is the aversion to IPOs warranted? Have IPOs really become more risky than they were in years past?

Stavros Peristiani of the Federal Reserve Bank of New York takes on the issue in his recent report, Evaluating the Riskiness of Initial Public Offerings: 1980-2000, and concludes yes, IPOs are more risky, but the blame cannot fully lie with the information and telecommunication technology explosion. Also, and perhaps more surprising for the tech-based economic development community, Peristani's models suggest "companies taken public by top-tier underwriters or funded by venture capital exhibit higher relative volatility and a lower likelihood of survival."

Peristani employs two approaches to investigate the post-issue riskiness of IPOs for the 1980-2000 period. First, he compares the stock price volatility for issuing and nonissuing firms. Second, he uses a qualitative model to estimate the likelihood that new issues will survive in the aftermarket. Both methodologies show the riskiness of IPO shares relative to the shares of a nonissuing peer group has increased roughly 30 percent in the 1990s.

Although the proliferation of Internet companies in this period helps account for the increased risk, Perisani's empirical analysis reveals a more gradual shift in risk that cannot be fully explained by the high-tech bubble. The study found Internet-related IPOs are five times more likely to be delisted than are non-Internet issuing firms and can account for a substantial portion of the increased risk found during the late 1990s. But not all of the increased overall risk can be attributed to the growth on these tech offerings, the report states, since a growth in risk was discernable in the early 1990s, before the Internet's impact was felt.

Some of the other possible explanations Peristani identifies for the increased riskiness of IPOs include: a deterioration in the make up of firms going public (such as, with the average age of four years, the relative youth of the firms compared to the average age of companies in earlier IPOs being seven years), agency conflicts and misaligned incentive structures in investment banking and for sell-side analysts; industrial deregulation; and, information asymmetries between the issuer and investor, particular with the advent of Internet-based trading for individual investors.

Regarding the decreased survivability of IPOs with venture capital backing, Peristani's model stands in sharp contrast to the widely cited work of researchers like Paul Gompers and Joshua Lerner (see Short-term America Revisited? Boom & Bust in the Venture Capital Industry and the Impact on Innovation). It is, Peristani points out, consistent with research done on the agency conflicts thesis, which argues strong incentives exist for underwriters to undervalue IPOs at the time of offering to dramatically increase the IPOs value quickly. Peristani also finds "the odds of delisting for venture-funded firms are around 1.47 higher than the odds of non-venture backed firms."

The full 56-page article is available at: http://www.newyorkfed.org/rmaghome/staff_rp/2003/sr167.html