Private Equity and Venture Capital Investors' Involvement in Firms Post Initial Public Offering

Matanova, N. (2015). Private Equity and Venture Capital Investors' Involvement in Firms Post Initial Public Offering. (Unpublished Doctoral thesis, City University London)

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Abstract

The capital provided by private equity (PE) and venture capital (VC) investors represents an alternative type of financing available to firms in comparison to more traditional financial intermediaries such as banks, equity from owners or angel investors. These financial sponsors not only provide funding, but also complete intense restructuring, improve corporate governance, align interest of managers and shareholders, provide certification and improve performance (Jensen 1986, 1989; Baker and Wruck, 1989; Baker and Gompers, 2003; Hochberg, 2012; Acharya et al, 2009). These investors are likely to realize their highest returns by bringing their sponsored firms to the stock market in the form of initial public offerings (IPOs). However, in practice PE and VC investors do not always exit fully at the IPO date (Celikyurt et al, 2014; Krishnan et al, 2011; Cao, 2011). They tend to maintain a block ownership in some IPOs, which allows them to remain actively involved in shaping firms' corporate policies. It is of great importance to academics, practitioners and other market participants to understand why these investors carry on investing in firms they brought to the market and whether such holdings create or destroy value. These issues motivate my research agenda. I focus on investigating PE and VC investors' post-IPO presence in firms, their effect on corporate policies and impact on the long-run performance. In particular, the three chapters of my thesis pursue the following three distinct objectives: (i) to answer the fundamental question concerning the motivation of PE and VC investors to retain ownership in the post-IPO period and whether this retention affects the firm’s aftermarket performance (ii) to examine whether PE and VC investors remain active monitoring agents and exert significant influence on various corporate policies (iii) to investigate the effect of PE and VC ownership retention on firms' cash reserves, which, as documented in previous studies, can lead to significant agency conflicts. Hence, the main objective of my thesis is to explore the extent, type and channels of private equity and venture capital investors' involvement in firms post-flotation, and its impact on the long-run performance. To answer these research questions, I use a large sample of US and UK IPOs over the 1997 and 2010 period. In this dissertation, I differentiate and analyse separately firms backed by PE and VC investors because these investors are different in many respects, particularly since they provide capital to distinctive type of companies, as VCs invest mainly in young, growing, high-tech firms, while PE investors are likely to back high cash flow mature firms in stable industries. I provide a comparative analysis across these investors to assess whether, after controlling for these fundamental characteristics, their involvement, investment and strategies with their IPOs in the post flotation period are homogeneous. I also contrast the US and the UK markets which I found to be significantly different in terms of the composition of these two types of investors, but also the characteristics and annual distributions of IPOs. In the first empirical study, I focus on the motivations of PE and VC funds to retain voluntarily ownership, defined as holdings outside the lockup restrictions, in the post-IPO period. I test the monitoring and signalling hypotheses, which suggest that IPOs in which VC and PE firms retain their holdings in the post-IPO period are more likely to generate higher returns because of these funds’ certification and their ability to monitor companies in which they hold large stakes. I find that in contrast to UK, where both type of financing play an equally important role in bringing companies to the stock market, the relative importance of VC-backed IPOs in the US is time varying. Moreover, the VC-backed IPOs are equally distributed across various industries in the UK, whereas VC financing is more prominent in certain industries in the US such as high-tech, telecommunications and healthcare. I find a non-monotonic (convex) relationship between financial sponsors’ voluntary ownership and firm performance. Hence, in contrast to managers who become entrenched at higher levels of ownership, financial sponsors create value in companies they hold more concentrated equity stakes. More specifically, I document that financial sponsors’ ownership is positively related to firm value when PE and VC investors’ stake is above 1.83%. Therefore, continued involvement of financial sponsors in the post-flotation period is beneficial for the shareholders. Also, I present evidence that compulsory and voluntary financial sponsors’ equity retention is used to mitigate potential managerial expropriation of outside shareholders. I demonstrate that a different institutional framework in UK and US has a significant impact on financial sponsors’ divestment extent at the IPO date and in the post-flotation period. I find that investment banks impose significantly stricter lockup restrictions (in terms of how much shares to retain) on financial sponsors involved in US backed IPOs than in UK ones. This is driven by more dispersed ownership in US companies, whose market is defined by a lower prevalence of institutional investors and the largest group of shareholders in the US being individual investors. In addition, I find that PE/VC house and underwriter reputations are only considered to be alternative commitment devices in the UK. I also highlight a number of other factors which affect voluntary ownership of PE and VC investors in the post-IPO period. In particular, I show that PE and VC fund characteristics (syndicate size, PE/VC fund’s bank-affiliation and low proximity to IPO firm headquarters) partially explain compulsory and voluntary holdings of financial sponsors post-flotation. This paper extends the literature on IPOs' performance by demonstrating that financial sponsors divest fully from stronger firms at the IPO date, while commit their resources to underperforming ones in which they create value in the post-flotation period. The second empirical study focuses on examining whether PE and VC investors create value by actively shaping IPO firms’ corporate policies in the post-flotation period. In this paper I focus on three corporate policies, namely the corporate governance, as reflected in the structure of the board of directors, the investments’ spending patterns, and the payout policy. These decisions are identified in prior literature to have a direct impact on firm value. I demonstrate that PE and VC investors with retained ownership continue to extensively monitor their backed IPOs. However, the two types of investors implement different monitoring approaches, which are driven by fundamentally different characteristics of the firms they finance: PE investors’ ownership has a significant positive effect on the board’s size, while VC investors primarily focus on the proportion of independent directors on the board of directors. Moreover, I find that the ownership structure of financial sponsors has a material impact on monitoring of portfolio firms, as IPOs backed by bank-affiliated PE funds have significantly larger boards. In terms of investment decisions, VC investors minimize expenditures in all retained IPO firms. PE sponsors’ only reduce expenditures in IPOs with low proximity, so when PE investors’ monitoring abilities are significantly constrained by distance and hence costs of monitoring are higher. In contrast to non-backed IPOs, I find that financially sponsored companies are more likely to initiate a payout via dividends. Since backed IPOs and matched samples are at a similar maturity stage, my results imply that financial sponsors are very effective monitors because they intentionally commit firms to disgorge cash to their shareholders in the form of cash dividends in future years, as opposed to a more flexible distribution method such as share repurchase. Hence, financially sponsored IPOs represent a distinctive type of companies which initiate payouts via dividends, in contrast to non-backed IPOs which prefer share repurchases (Jain et al, 2009). In addition, I find that changes on the board’s level indicate that in the near future other corporate policies are likely to undergo significant alterations. For example, I present evidence that firms which change the initial proportion of independent directors are significantly more likely to initiate a payout in the post-flotation period. Moreover, I show that VC investors are able to create value in the post-flotation period by shaping certain corporate policies such as corporate governance (board size and proportion of independent directors) and capital expenditures. However, there are some dangers of continued ownership. For example, I find that in exited PE-backed IPOs capital expenditures positively affect IPO firm’s value, however in retained peers this relationship is statistically negative. Moreover, I find that the firm value of retained VC IPOs which do not initiate a payout is lower than of exited peers. This finding implies that VCs withhold initiating a payout to shareholders for some private motive, which deteriorates firm value. In sum, I demonstrate that continued involvement of VC investors in the post-flotation period can be beneficial for shareholders. The third empirical study examines the impact of PE and VC ownership retention on financially sponsored IPOs' cash reserves. I assess whether monitoring of cash holdings leads to higher long-run stock returns of backed IPOs. The paper is motivated by the rapidly increasing corporate cash reserves and the existing void in extant literature on the effect of PE and VC investors on this phenomenon. I argue that financial sponsors are incentivized to monitor cash holdings because a substantial part of their returns is not realized at the IPO date, and by retaining shares in the post-flotation period they reduce the agency costs associated with large cash holdings. I demonstrate that the proportion of assets held in cash in VC-backed IPOs is significantly larger than in PE-backed companies; this relationship holds in all industries. I find that backed IPOs with higher VC (PE) ownership concentration maintain significantly higher (lower) cash ratios post-flotation. This different effect of financial sponsors’ post-IPO involvement on cash reserves is explained by fundamentally different growth opportunities of these firms. VC IPOs need sufficient internal funding to finance their growth, whereas mature PE-backed companies with higher free cash flows are more prone to agency conflicts and PE investors minimize cash reserves in these firms. I find that within retained VC sample, IPOs with higher high reserves outperform peers with low cash reserves, which implies that in order to outperform in the long-run VC firms need high cash reserves. I demonstrate that post-IPO ownership retention by PE and VC investors mitigates the agency problems, which allows financially constrained firms to hoard cash. PE and VC syndicate characteristics have a significant impact on cash reserves. In particular, an existing relationship with an investment bank through PE funding reduces the firm’s cash reserves, while more risky firms proxied by syndicate size tend to hold higher cash holdings. Moreover, I find that monitoring of cash reserves conducted by PE investors in the post-flotation period leads to positive long-run returns. Hence, the market values cash more in companies with higher post-IPO PE investors’ equity ownership. I do not find a similar effect in the VC sample, which confirms that PE-backed IPOs are more prone to agency conflict and its mitigation by PE investors’ monitoring is valued by the market. Overall, these results suggest that continued involvement of financial sponsors in the post-flotation period is value creating. The three empirical studies demonstrate the channels through which financial sponsors continue to exert influence in retained firms. Overall, this dissertation presents evidence that PE and VC investors can be effective post-IPO monitors who are intensively involved in shaping firms' corporate policies, which has a positive effect on the long-run stock performance.

Item Type: Thesis (Doctoral)
Subjects: H Social Sciences > HG Finance
Divisions: Cass Business School > Faculty of Finance
URI: http://openaccess.city.ac.uk/id/eprint/11893

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