The Post-Issue Operating Performance of IPO Firms
Overview of the article As there were still few attempts to measure operating performance of IPO firms at that time, Jain and Kini (1994) wrote this article in a bid to focus on this particular issue by study on the IPO firms during 1976-1988. They investigate the change in operating performance of firms after going public through IPOs which they find that IPO firms show a decline in post-issue operating performance. The main reasons that explain the decline in the post-issue operating performance of IPO firms are the existence of information asymmetry and/or a conflict of interest between the existing entrepreneurs and the new shareholders. The authors separate the reasons into 3 points: (1) the agency cost increases when a private firm transfers to public and the reduction in ownership stake consequently leads to the agency problem, (2) the window-dressing made by managers causes overstate pre-IPO performance and understate post-IPO performance, (3) the timing that issue stock in periods of unusually good performance levels while they know that the good performance is not sustainable. This article is divided into four parts; Part 1 presents the sources of collected information on IPO firms and the criteria used for selecting them. So, their finally sample consists of 682 firms. The authors also stated that all significant tests are based on the two-tailed Wilcoxon signed rank tests, assuming that the observations are independent. They concerned about the skewness of the data from operating performance. So, they used the median as a measure of central tendency throughout the literature. Part 2 demonstrates evidences on post-issue operating performance changes. They measured it by using two proxies: (1.) the operating return on assets, (2.) the operating cash flows deflated by assets. These measures were calculated both before and after industry-adjusted. They also investigate deeply in factors (i.e. sales, asset turnover and CAPEX) that influence the two proxies above. Moreover, based on the agency theory hypothesis and the signaling hypothesis, they mentioned that the IPO firms where entrepreneurs retain higher ownership normally show superior performance relative to other issuing firms both before and after adjustment for industry effects. The authors are interested in this issue. So, they examine the relation between management ownership and operating performance. In addition, they investigate whether IPO underpricing and post-IPO operating performance have the relations as suggested by the signaling models which predicts that IPO firm that is underpriced should demonstrate greater operating performance in comparison to those that is not. Part 3 explains the results of market expectations and earnings performance decline significantly after post-issue, showing in M/B and P/E ratios. Finally, part 4 is the conclusion of this article.

Summary of the important findings of the article Jain and Kini observed that the operating performance as measured by the operating return on assets and operating cash flows scaled by assets of IPO firms decline relative to their pre-IPO levels, both before and after adjustment for industry effects. They tried to figure out for the reasons behind this situation and came up with some prospects. What if the IPO firms cannot generate income at the pre-IPO levels, managers reduce the required level of capital expenditures or positive NPV projects may have negative earnings and huge investments in the early periods. They studied the growth in sales, asset turnover and CAPEX for IPO firms to examine these possibilities. They found evidence that the IPO firms have high sales growth, declines in asset turnover and high CAPEX relative to their industry counterparts in the post-IPO period. So, the declining operating performance cannot be assumed due to a lack of sales growth opportunities or reduction in post-IPO CAPEX. They also find that IPO firms where entrepreneurs retain higher ownership normally exhibit superior operating performance compare to other similar firms both before and after industry adjustment. In addition, this is not because of cutbacks in CAPEX. Therefore, their result of relatively superior post- IPO operating performance of firms with high ownership retention by entrepreneurs are compatible with the inferences of agency theory, signaling and Ritter’s (1984) wealth effect hypotheses. Further, other explanations for the decline in operating performance are managers attempting to window-dress by overstating pre-IPO performance levels and/or they timing the offering to match with periods of extraordinarily good performance that they know cannot be maintained in the future. So, these firms start out with high M/B, P/E and EPS ratio, which decline significantly over post-issue periods. The authors also suggest that potential investors primarily have high expectations of future earnings growth, which are not subsequently satisfied. Next, they also examine the relation between IPO underpricing and post-IPO operating performance. Their study illustrates that the above- and below- median underpricing groups are the same prior to the IPO based on observable performance measures[1] and continue to be the same on these measures after the IPO. They thought that the signaling effect of managerial ownership may lead to those insignificant results obtained from testing the signaling impact of underpricing groups. To check this hypothesis, they estimated cross-sectional regressions[2] and concluded that “while managerial ownership retention is generally positively related to post-IPO operating performance, underpricing has insignificant explanatory power”. In other words, they find no relation between operating performance and underpricing. Finally, the authors pointed out that although the reverse-LBO firms substantially underperform similar firms in the post-IPO period, they have to examine the operating performance changes of these firms separately. This is because reverse-LBO firms are basically distinct from other IPO firms in terms of information asymmetry (less problem) and in their main motivation (debt reduction) for going public.

New Knowledge Offered by the Findings, and Conflicting and Supporting Evidence There are many findings of later studies, both in developed and emerging markets alike, that agree with Jain and Kini’s finding of a decline in operating performance after IPO, for example, Mickelson et al.(1996), Wang (2003) which examines the IPO firms in China, and Kim et al.(2004) which investigates this topic in Thai IPO firms; however, these articles provide somewhat different explanations for this phenomenon as we shall explain after this. Since the article suggests that there is a decline in operating income on assets over time after the firms go public despite an ongoing increase in sales, the decline in operating performance is unlikely to be the result of the decline in sales. It shows further that the asset turnover also declines, which implies that the decrease in operating performance might be partially caused by the decrease in the efficiency of asset utilization, indicating that the management invests in non-productive assets or under-utilize the firm’s resources, which is the result of agency conflict. We can also say that, since this measure also takes selling (or operating), general and administration cost (SGA cost) into calculation, the manager might not try to manage this part of cost efficiently enough. Because SGA cost are expenses incurred to support sales activity, and to manage and organize other firm’s activities, which is directly the result of management’s decision, SGA cost can therefore reflect agency cost. With this deduction, it can be concluded that there are two possible proxies for agency cost: asset turnover and SGA cost. This is confirmed by some recent studies, for example, Firth et al. (2008), Singh and Davidson (2003), Ang et al. (2000), which use these two measures to study the agency cost. Furthermore, a continuing decline in operating returns on asset implies that the agency problem of IPO firms has the long-term impact on operating performance, in other words, the agency cost persists through time. This perhaps indicates that the management can exploit the resource of the firms for his/her own personal interest on the expense of firm’s operating performance even more conveniently as the time passes on. This seems to suggest that there is an increase in information asymmetry between the management and shareholders through time. This is supported by Kabir and Roosenboom (2002) which found statistical support for the asymmetric information hypothesis which suggests that corporate managers possess superior information about their firms than outside investors. The article further demonstrates that there is the positive relation between equity retention and post-IPO operating performance, which might suggest that more equity retention mitigate the agency problem of IPO firms. However, there are some studies that argue against this finding, especially Mikkelson, Partch, and Shah (1997) which argue that a decline in operating performance is not the result of a decline in pre-IPO ownership retention of IPO firms, because, according to their findings, the substantial holding ownership stakes continue to be high in the first year of public trading. In addition, during IPO, compensation linked to stock price substitutes for the incentive benefits of large ownership stakes of managers. Subsequently, they believe that the decline operating performance reflects insiders’ decision to sell shares following favorable performance, rather than the effect of changes in ownership. Instead, they find that the size and age of the firms are significantly related to the operating performance in the first few years after going public. They also pointed out that this conclusion of Jain and Kini (1994) is implausible because their misleading methodology; we will elaborate this later in the section of the article’s strengths and weaknesses.ไม่ใส่ว่าอะไรที่ทำให้ misleading methodology Also, there are some articles that even argue that equity retention can have many drawbacks Arbuquerque and Wang (2005) which provide the evidence that the controlling shareholders can expropriate the private benefits substitutes for the cost of outside minority investors by diverting resources away from the firm and distorting the corporate investment and payout policies. Assuming that signaling hypothesis, which says that firm uses underpricing to signal the firms’ quality, is valid, even though there should be the significant relation between the level of initial underpricing and post-issue operating performance (operating income on assets and operating cash flows on assets), which is used as the proxy for firms’ quality, Jain and Kini did not find so. This finding tells us that there might be other measures that better represent the firms’ quality. It signifies that for investors, perceived quality of the firms might be something else. Many recent studies seem to support this, for example, Zheng and Strangeland (2007), which focused on the signaling hypothesis as well, but instead used growth in sales and EBITDA as the proxy for firm’s quality, and found the positive relation between them. According to the article, as signified by high M/B of assets, M/B of equity, P/E and EPS ratio (which are profitability ratios), investors have overtly optimistic expectation towards IPO firms that the earnings growth will continue after IPO. The similar result is documented in Pástor, Taylor, and Veronesi (2006) which provide empirical evidence of a decline in profitability from a sample of 7,183 IPOs in the USA between 1975 and 2001. Pástor, Taylor, and Veronesi (2006) state that this bias is possibly the result of window-dressing and/or timing of issuance, which signifies the presence of information asymmetry in the time of IPO, but after IPO this bias is not corrected immediately, but gradually over time (as all measures gradually decline over 5 years). This infers that there exists the market inefficiency, because if the market is efficient, then investors should be aware of this bias immediately at the time of the issue. This finding also provides the evidence to the picture of capital market that, in general, the management tends to adopt myopic behavior of overstating their company potential and performance before IPO.

Discussion of strengths and weakness of the article There are many strengths of this article that worth mentioned. First, the article is systematically arranged; some important results and conclusions are first presented in the introductory section, helping the readers to form overall picture of the article and understand general ideas underlying the study. We think that this article is good for several reasons. The authors clearly explain about the decline in the post-issue operating performance and its relation between equity retention and underpricing at the IPO. In addition, it is quite easy to understand because the proofs are arranged systematically. For instance, they start up with the data description, then they show the tables values of the percent change in the median that is a middle value and is not influenced by outliers. They also illustrate some bar charts that represent IPO firms and the industry-matched firms to clarify vivid picture. Moreover, they cited several sources such as the journal of finance, the journal of accounting research and the journal of financial economics that make the results are reasonable and reliable. Turning to consider about the weakness of the article, however, the authors point out that their sample firms need to meet their all criteria consequently they choose only 682 firms from their initial firm commitment IPOs. Lacking of the supporting reason why the firms that match their all criteria are proper in their exploratory, it lead to unclear about their methodology. As a result, we cannot apply this process to other firms accurately. Besides, the mention that “IPO firms start out at higher levels of operating performance, they do not continue to outperform their industry counterpart”, in other word, IPO firms do not significantly outperform their industry counterparts in any year subsequent to Year -1 contradicts the bar chart of operating cash flows over total assets in figure 1. Apparently, the IPO firms’ bar chart is significantly higher than the bar chart of their industry counterparts in Year 0.

Our opinion of the article We agree with the use of median as a measure of central tendency throughout the article, because if there is skewness in observed data, using mean might result in the distorted picture of sample data. Since median is less sensitive to outliers than mean, the former measure is the better representative for the sample used. Secondly, we agree that this article uses the data from COMPUSTAT. The COMPUSTAT is a database of financial, statistical, and marketing information. It provides more than 300 annual and 100 quarterly Income Statement, Balance Sheet, Statement of Cash Flows, and supplemental data items on more than 7500 publicly held companies.[3]It is also one of the most complete and current databases of North American and Canadian companies. Thus, the data got from here is transparent and can be trusted. Moreover, we absolutely agree with the finding of the decline in post-issue operating performance of IPO firms, because when we seek additional information about this topic from other literature, as aforementioned in the previous section, we find little evidence against this phenomenon in recent studies. We also agree with the suggestion that, according to the absence of positive relation between post-operating performance and underpricing, there may be some other measures that better represent the perceived quality of the firms in investors’ perspective, as many later studies we mention in previous section show. However, we don’t agree with the documented positive relation between operating performance higher equity retention, because of the evidence shown in Mikkelson, Partch and Shah (1997) which strongly criticize this article on the methodology used for investigation, i.e. the separation of firms into only 2 groups of high- or low-equity-retention with the median alpha of 73%. Even though the median decline in operating performance of the low-equity-retentions is higher than the high-equity-retentions, the result can still be interpreted that the decline in operating performance of the 70%-equity-retentions may be higher than that of the 50%-equity-retention. It seems also that the authors mentioned only the merits of high ownership retention. We think they neglect its some disadvantages. For example, the firms that have high-ownership stockholders may have high costs because the large shareholder cannot invest by buying more stocks in other firms, consequently they cannot diversify their portfolio, given the capital constraints. Another drawback is the controlling shareholders can expropriate the private benefits substitutes for the cost of outside minority investors by diverting resources away from the firm and distorting the corporate investment and payout policies so, the firms have to attract the outside minority investors by offering the higher returns. There will be the result in the higher costs for that firms.

Conclusion of our critique In order to effectively evaluate the article, we first take a look at its overall picture and the findings it reaches; Jain and Kini’s The Post-Issue Operating Performance of IPO Firms is the study on the operating performance of firms after the IPO. They find a significant decline in operating performance subsequent to the IPO. Then, the potential explanations for the decline in post-issue operating performance of IPO firms are found which are the increase in agency costs when a private firm become a listed firm, managers try to distort accounting numbers which would make the potential investors have incorrect expectation about the opportunity growth of the IPO firms and entrepreneurs timing the offerings to occur simultaneously with periods of extraordinary good performance that they cannot be prolonged in the future. From their research, they find that IPO firms where initial shareholders retain maintain higher ownership commonly demonstrate greater performance relative to other issuing firms both before and after industry-adjusted effects. They do not find the relation between post-issue changes in operating performance and the initial underpricing. Their result also point that IPO firms cannot sustain their pre-issue performance levels because successful timing or window-dressing that results from the information asymmetry makes IPO firms priced at high P/E ratio. So, the potential investors have biased expectations of earning growth in the post-issue period, while in reality they decline over time.

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[1] Operating return on assets, operating cash flows deflated by assets, asset turnover and capital expenditure growth rates both before and after industry adjustment

[2] PERFit = B0 + B1DALPHAi + B2DUNDPRi + ei

[3] http://dataserv.libs.uga.edu/compustat/index.html