Being a phenomenon that has attracted both attention and criticism within various media following its advent in the form of leveraged buyouts back in the 1980’s, private equity is a pertinent subject within the purview of finance. Referring to an investment method in which investment is made on un-publicly-traded companies within the stock exchange market, private equity firms, as studies reveal, demonstrate a positive return on investment. Keeping within this argument is Crifo and Forget (2013, p. 22) who contend that private equity has indeed shown an ability to cultivate sustainable growth in especially unlisted companies potentially. This, therefore, underscores the reason why they have managed to carve out an important niche in investment firms within the world financial markets. To this end, it, therefore, becomes particularly critical to underline that the central argument in this paper is that private equity-backed IPOs can contribute positively to the growth of their portfolio companies’ in the long run.
On the other hand, IPO refers to a critical step in the life of a company in which shares of a company are availed for sale for the initial time making it possible for a private firm to transform into a public company. This could either be an offer in which companies raise new capital or an offer in which company shares are sold. According to Sieradzki and Zasepa (2016, p. 261), while the stock exchange market avails access to capital whose utility could be on investments such as entity acquisition as well as settling company debts, the main goals of IPOs include among others, to raise funds and enable a current market valuation and making the company illustrious among investors and clients alike. To this extent, it is apparent that IPOs have almost always been private companies whose owners decide to discontinue their business or established companies wishing to spin off part of their operation or else, public companies that get delisted after the transaction.
Having explained what private equity (PE) and IPO mean within the purview of corporate financial management, howbeit briefly, it is also crucial to present here that this paper will first attempt to trace the evolution and growth of private equity within its industrial setting through its UK industry will be the primary reference point. Furthermore, the paper will look into the phenomenon of underpricing where vested interest is in assessing the impact of PE on this phenomenon. Ending with an assessment of the operational progress of private equity IPOs as juxtaposed to regular IPOs, the paper will also evaluate the short-term and as the long-run progression of private equity IPOs.
In a bid to comprehend the driving force pulling investors the private equity way, it becomes apparent that potential benefits accruing from such investment portfolios are in some way a critical factor. This vantage point is given flesh by Bernstein, Sorensen, and Stromberg (2016, p.1920) who underscore their market value by arguing that such investments usually demonstrate the tendency of growing exponentially on both the employment and total production sides with this exemplary growth getting anchored on a relatively lesser susceptibility to aggregate shocks. However, it remains worth noting that various types of private equity with particularly buyouts and venture capital investments are becoming key here. To this extent, while buyouts which get financed via debt instruments involve investment in already-existing companies, it follows that venture capital funds refer to entrepreneurial investment in start-ups and infant companies. Venture capital investment could also be an equity investment in an early-development-stage unlisted company which could either be start-up or seed but operates within an innovative surrounding with high return potential.
However, since venture capital involves start-ups and growing companies, its urgency for value-based industrial knowledge and networking is more pressing. This is particularly so due to its much-needed effort to survive yet as Howel and Jason (as cited in Kaplan and Stromberg 2009, p.124) postulate; survival is the actual test of a firm’s success. To this extent, therefore, it is incumbent upon private equity investors to inject market-based information into their portfolio companies. It should be noted that this is critical to elevating company performance beyond the real goal of achieving survival for the said start-ups. Nevertheless, buyouts are no exclusion in this regard as this has to be made a norm in all private equity-backed IPOs for purposes of ensuring superb output.
The Evolution of Private Equity
The private equity industry is a rapidly evolving industry that has undergone radical changes in response to the phenomenon of globalization. Firstly, it is worthy to note that the private equity industry began as what was termed ‘leveraged buyout firms.’ According to Kaplan and Stromberg (2009, p. 122), leveraged buyout firms today form what is called private equity companies and in a buyout on leverage basis, a specialized investment firm employs a lesser portion of equity augmented with relatively more significant debt financing from an external source
Investigating their evolutionary development, it becomes clear that private-equity-acquired leveraged buyouts returning to public status perform better in comparison with other floated firms. Such is the speed at which private equity kicked off at its early developing stage. Bernstein, Sorensen, and Stromberg (2016, p. 1199) also highlight the spectacular initial performance of private equity in their postulation that industries, where PE funds invest, are likely to grow faster on the cumulative production and employment basis while simultaneously appearing less susceptible to cumulative shocks.
A reflection into the development cycle of private equity suggests steady and sustainable patterns. Highlighting this position, Froud and Williams (2007, p. 407), concur that the global growth of the PE industry has been spectacular such that in the period starting 1985 to 2005, private equities underwent a yearly growth of 18.5 percent with this growth getting sustained after that. Taking Poland as an example of a PE market representing Central and Eastern Europe, it is manifest that the PE industry therein progressed in distinct steps of buyout, stagnation, expansion, and development. Elucidating the Poland situation is Klonowski (2011, p. 298) who argues that the Polish PE industry evolved through revamping of institution infrastructure, vehement entrepreneurship, vibrant growth of the economy and effective establishment of exit markets. Within the US, PE funds raised the US $401 billion in 2006 which exceeded 311 billion USD raised in 2005 (Froud and Williams 2007, p.406). These statistical reveals demonstrate the impressive growth of the PE industry following its inception.
Nowhere has the PE industry performed the best than in the UK. As Caselli and Negri (2018, p. 5) posit, the global PE industry includes an agglomeration of substantial British funds such as the Permira and Apax with some of these large firms being public companies with several smaller enlisted PE houses. Elsewhere in a study by Wilson et al. (2012, p. 193), it becomes manifest that within the current global slump, revenue and employment growth for private equity firms in the UK was steady with results implying positive-trend differentials of 5-15 percent in productivity and almost 3-5 percent in profits for firms on buyout relative to regular firms. The evolution and rise of the PE industry from the 1970s in the UK have been so exponential due to what Crifo and Forget (2013, p. 23) refer to as its ability to enhance long-term practices in especially companies that have not undergone listing. The UK PE industry equally demonstrates impressive growth patterns over its development cycle.
Private Equity backed IPOs: Underpricing and periodical Operational Performance
On average, IPOs are known for apparently demonstrating positive initial returns. It is this phenomenon of displayed initial positive returns that is termed underpricing within the context of IPOs. Gompers (as cited in Sieradzki and Zasepa 2016, p. 270) contend that underpricing is natural aftermath that issues from the greater risk perceived by the market whenever especially venture capital private equity funds decide to take their company portfolios public due to their high-risk tendency emanating from their young life cycle phase. To this extent, it follows, therefore, that the underpricing phenomenon is not entirely new in the global financial market. In fact, as espoused in several works on private equity-backed IPOs, this phenomenon may as well be considered to be the difference between the issue price and share closing price within the first day of training-a phenomenon that is commonplace in almost all global equity markets.
It is, nevertheless, critical to first assess the importance of reputation as a factor influencing the operational progress of a private equity initial public offering within the underpricing purview. In this respect, Lee and Wahl (as cited in Wilson et al.2012, p. 194) underpin the importance of a firm’s reputation as a significant factor explaining the thriving of venture capital equity-backed firms as compared to other IPOs. These authors contend that this emanates from the fact that funding of venture capital equity firms is dependent on the former progression of their investment portfolios always weighed by the number of investment exits via IPOs.
Enhanced efficiency in operations is another critical factor leading to an impressive performance by private equity firms. Because venture capitalists have to close down business operations whenever their funds exhaust, the actual lifetime of partnerships within venture capital funds tends to lead toward recapitalization (Bessler and Seim 2011, p. 13). This concerted efforting by venture capitalists to ensure the survival of their seed and start-up companies partly explains why venture capital private equity performs better as compared to other IPOs.
On a similar base, the management and governance structures in private equity firms prove to be comparatively better about that of regular IPOs. Furthermore, this enhanced corporate management also contributes to the efficacy of private equity operations. In tandem with better management comes the contribution of private equity investment sponsors to the initial offer. While their grip on company activities dwindles after the time of the offer, Meles, Monferra, and Verdoliva (2014, p.216) concur that equity sponsors continue to influence the running of the firm even in the post-offer period. It is the involvement of these sponsors which augmented with appropriate closer scrutiny minimizes the potentiality for future conflicts thus keeping the firm’s performance on a steady upward ascendance. Regular IPO, on the other hand, lack the appropriate structures to match such a performance.
Fundraising for especially venture capitals firms operating at the seed or start-up level is also dependent upon the reputation that the particular firm wields in the market. Analyzing company reputation as a critical factor in determining company performance in the financial markets, it is particularly important to underscore that for private equity firms, a vehement reputation vivid in a high return on investment is pertinent about raising funds in such enterprises. Corroborating this view is an argument by Gompers (as cited in Sieradzki and Zasepa 2016, p. 270-271) which opines that young private equity funds tend, in a relatively short investment period avail companies to the market. Such means that such funds at such an early life cycle phase usually grandstand due to the much- needed urgency required to cement a spectacular reputation capable of availing to them access to new prospective funds. The reality that reputation is key to funding thus makes equity fund managers to work extra hard with regard to promoting company reputation.
Underpricing of private equity is another element that goes hand in hand with the operational performance of private equity. Reflecting on this phenomenon which manifests differences in the offering price on first trade day and the closing price of a stock, it becomes manifest that there are two prominent arguments that provide a premise on which the phenomenon of underpricing can be explained within the framework of private equity-backed IPOs. However, in doing so, a confluence emerges connecting, albeit comparatively, underpricing of private equity-backed IPOs with other regular IPOs. This nexus, therefore, ends up juxtaposing the operational performance of private equity-backed IPOs with that of regular IPOs. To this extent, regular IPOs provide a yardstick for comparing IPO performance within the short-term as well as the long run.
To begin with, one strand of literature on underpricing argues that private equity-backed IPOs are less underpriced than other IPOs. As a result, the private equity-backed IPOs have lower initial returns. As argued out by Brav and Gompers (1997, p. 1797), the lower underpricing of private equity-backed IPOs issues from the lowering of information asymmetry pitting private companies and their respective investors. Barry, Muscarella, Peavy, and Vetsuypens (as cited in Sieradzki and Zasepa 2016, 269) suggest that private equity funds monitor companies in which they hold an equity stake and after that reduce irregular information exchange between related investors and managers of private companies. In ensuring this, private equity firms become relatively less underpriced as compared to regular IPOs.
In understanding the taproot from which underpricing issues, it reveals that monitoring of company portfolios plays a somewhat prominent role. Underpricing of private equity-backed IPOs is almost always attributed to higher oversight which is believed to be capable of leading to underpricing with the effect being greater especially for venture capital-backed IPOs. Backing this argument is output from research conducted by Lin and Smith (as cited in Sieradzki and Zasepa 2016, p. 265) which shows that private equity-backed IPOs with a high reputation in the market are bound to experience low underpricing when selling a majority of their shares. The above-discussed argument is further elucidated by Gandolfi et al. (2018, p. 3) who contend that venture capitalists are perceived company insiders hence the sale of stocks during the IPOs could be construed to be a market-emergent negative signal. From this argument, it follows. Therefore, that venture capital private equity firms have to bear a trade-off between the firm’s reputation which is a significant pull-factor to attracting future funds and postponing the exit time which could potentially instigate funds loss by the affected firm. Low underpricing in equity firms is thus related to the monitoring role as well as the firm’s reputation within financial markets.
Though there is a lack of consensus on whether private equity leads to lesser or higher underpricing, it is observable that the underpricing high school garners greater support as compared to the other strand. The arguments here are even bolstered with a host of theories from Gompers and Ritter. While the grandstanding theory by Gompers and the spinning hypothesis by Ritter majorly elucidate this high underpricing phenomenon, Popov, Alexander and Roosenboom (2009, p. 16) contend that it is the presence of the private equity fund among shareholders of a company executing an initial public offering that actually elevates the level of underpricing in such firms. However, time is an essential component in this respect as observed from certain studies.
Gompers (as cited in Gandolfi et al.,2018, p.3) explains that because most of IPOs by private equity firms are conducted during hot issue periods, it can be assumed that private equity-backed IPOs are highly underpriced. Findings in another research study by Bessler and Seim (2011, p.8) also support this view though, in this purview, preponderance is placed on the period in which the IPO is made. In their study, it was made manifest that the level of underpricing for private equity-backed IPOs is higher during the hot issues period epitomized by the dotcom bubble anchored on the pre-financial period as compared to other periods. Following this argument, it becomes evident that the phenomenon of underpricing due to private equity-backed IPOs was relatively higher in the years between 1998 and 2000 as compared to the period between 2003 and 2007. The year 2000 which platformed the dotcom bubble is in fact widely believed to have registered some of the highest degree underpricing ever witnessed in history.
The spinning hypothesis is another analytical framework supporting the postulation that private equity is capable of leading to higher underpricing as compared to regular IPOs. In keeping in line with such argument, Sieradzki and Zasepa (2016, p.270) contend that the spinning hypothesis underlines that decision-makers who comprise private equity fund managers in an initial public offering demonstrate a tendency to strike a deal with underwriters. In most cases, they intend to deliberately underprice the offer with a vested interest of receiving an allocation of shares during hot IPOs period in the future. On the other hand, augmenting arguments in his grandstanding theory, Gompers (as cited in Sieradzki and Zasepa, p.270) opines that underpricing directly emanates from relatively more significant market-perceived risks whenever a private equity fund takes a young capital public since such a young company at the infant stage of its life cycle is a very risky investment. Greater risk within venture capital funds thus serves to elevate the level of underpricing in such firms.
To this end, it is lucid that private equity-backed IPOs have a substantial effect on the phenomenon of underpricing. Furthermore, though divergent views exist on whether private equity-backed IPOs lead to higher or lower underpricing, there seems to be coherence and a consensus among scholars on factors driving to either case. This is manifest through the output from various studies conducted in varying time frames as discussed above.
The Short-term and Long-term progression of Private Equity IPOs in a Comparative Perspective
Most private equity IPOs demonstrate positive performance in the short term. Meles, Monferra, and Verdoliva (2014, p. 211) augment this view by arguing that most of the undertaken empirical studies’ results exhibit positive short-term returns for IPOs. Other studies, nevertheless, demonstrate that the short-term performance of IPOs is substantially variable across markets worldwide. This view is given credence by results of a study on average initial positive returns between 1990 and 2003 conducted in 2005 by Echo for 19 European countries, 16 Latin American countries as well as the Asia Pacific. Study findings revealed that in Europe, Poland (over 60 percent) led the charts of the highest average initial returns followed by Greece, Germany and Ireland all of which approximated to 40 percent whereas Luxemburg (5 percent) and Denmark (less than 10 percent) demonstrated the lowest average initial returns (Sieradzki and Zasepa 2016, p. 271). Whereas Latin American countries such as Uruguay, Brazil, and Chile (less than 5 percent) exhibited the lowest initial returns, the study findings revealed that the highest-recorded initial IPO returns were recorded in Malaysia (around 90 percent) with Thailand and Singapore following at over 30 percent(Sieradzki and Zasepa 2016,p. 271).
In a similar set of the long-run IPO progression of private equity IPOs and other regular IPOs, it becomes lucid that private equity-backed IPOs seemingly outperform their regular IPO counterparts. In this respect, Brav and Gompers (1997, p. 198) argue that compared by the equitable average weighted returns; private equity IPOs progress relatively better in the long run as compared to regular IPOs. This complements the higher underpricing of private equities as compared to regular IPOs as is observed in several markets including the UK market, especially during the “dotcom bubble” era.
The comparative study of the long run performance between private equity funds and other regular IPOs, therefore, reveals that private equity-backed IPOs exhibit a more positive trend than the latter. Seha (1998, p.793) on the other hand augments that whereas evidence from most studies suggests a consistent performance of private equity-backed IPOs across varying dimensions of operational characteristics, the underperformance of non-private equity-backed IPOs is, to some level, their smaller size at their flotation time. With the short-term performance of private equity IPOs demonstrating positive short-term performance as per most studies, their long-run performance is equally strongly positive.
This paper establishes that the rise of the PE-backed IPOs industry has been exponential since its real take off with statistical evidence proving this. About the operational progress of private equity IPOs in comparison to other IPOs, the paper established that PE-backed IPOs outperform their counterparts. To this end, it is also arguably reasonable to infer that the long-run stock progression of private equity IPOs is positive in comparison to regular initial public offerings. However, the paper acknowledges the importance of sponsor-ties, effective corporate management and the validity of company reputation as being key to achieving impressive operational performance for PE-backed IPOs as compared to regular public offerings.