Research has shown that investing in IPOs has been a bad deal – you lose money compared to a comparable index fund. But a new paper shows that certain VC-backed IPOs deliver alpha for investors.
Many investors think that initial public offerings (IPOs) are both exciting and rewarding – especially when familiar brands become broadly available to investors for the first time (such as Uber, Lyft, and Beyond Meat). And classical economic theory suggests that because they are riskier, IPO investors should expect higher returns as compensation. However, defying both investor expectations and economic theory, there is a large body of evidence from around the globe (as detailed in my Nov. 14, 2022, Advisor Perspectives article) demonstrating that unless you are sufficiently well connected (to a broker-dealer who is part of the issuing syndicate) to receive an allocation at the IPO price, IPOs have generally underperformed appropriate risk-adjusted benchmarks, and by wide margins.
Dimensional studied the performance of IPOs over the period 1992-2018 and found IPOs generated an annualized compound return of 6.93%, 13.63%, and 3.74% over the full, initial nine-year, and final 18-year sample periods, respectively, as compared to 9.13%, 15.70%, and 5.98% for the Russell 3000 index over the same time horizons. In comparison to the Russell 2000 Index, the hypothetical portfolio of IPOs underperformed in the overall period (6.93% vs. 9.02%) and the 2001–2018 (3.74% vs. 7.29%) subperiod and outperformed (13.63% vs. 12.56%) over the period from 1992 to 2000. The evidence is why Dimensional generally excludes IPOs from their funds.
Two explanations have been offered for this anomaly – the lottery effect (investors prefer positive skewness in returns and are willing to accept a high probability of a below-average return for the small chance of earning an outsized return) and the winner’s curse (in an auction, like an IPO, where we assume the average bid, reflecting the collective wisdom of the crowd, is accurate, the winner, making the highest estimate, is likely to have overpaid).
New evidence
Anup Basnet, Magnus Blomkvist, and Douglas Cumming contribute to the IPO literature with their April 2023 study, “Long-Run IPO Performance and the Role of Venture Capital,” in which they examined both the performance of IPOs when venture capital (VC) firms were present and after VCs exit post-IPO. They studied:
- The role of VC reputation to capture the quality of monitoring – calculating VC reputation at the IPO date as the ratio of all IPO involvements by the lead VC (the VC with the highest amount invested) during the last five years, scaled by the number of all VC-backed IPOs during the same period.
- The role of syndicate size (the number of VCs invested before the IPO). Larger syndicates can create both short- and long-term value.
- The role of a holding period before the IPO – the difference in years between the lead VC’s first investment date in the portfolio company (PC) and the PC’s IPO date.
- The role of financial details such as research and development (R&D) and capital expenditures of portfolios of companies among high- and low-reputation VCs pre- and post-VC exit.
They began by noting that when VCs take a company public, they refrain from selling all shares at the IPO – selling a large fraction of the holdings sends a negative signal concerning the company’s valuation. In addition, they cited research demonstrating that 15% of the VCs actually increase their holdings post-IPO – VCs have substantial holdings after the IPO, which offers multiple exit strategies.
- As VCs search for exit routes, they simultaneously continue to create long-term value in the PC through costly monitoring to maximize their return on investment.
- As VCs often sell a fraction of their shares at the IPO, it reduces the incentives to engage in costly monitoring and instead shifts their focus toward divesting their remaining holdings and diverts their attention to their other PCs.
- VCs potentially retain their investments longer than optimal to capture management fees at the expense of their limited partners (LPs).
- The limited fund life incentivizes the VCs to act myopically by substituting long-term value creation for increased short-term earnings.
Basnet, Blomkvist, and Cumming explained: “Among the exit strategies, the first represents the optimal outcome for VCs, LPs, and PCs, while the latter three infer increased utility of the VCs at the expense of the other parties.”
To examine the pre- and post-exit value creation in VC-backed companies, they hand-collected lead VC ownership and exit times for 448 U.S. VC-backed companies that went public during the time period 2004-2014 and tracked their exiting behavior in the subsequent years to 2018. Their sample included 526 non-VC-backed IPO companies. To study the valuation effects of lead VC presence, they used Tobin’s Q (the ratio of market value of assets to book value of assets). They included standard accounting controls: size (market capitalization), leverage (long-term plus short-term debt scaled by total assets), and return on equity (ROE; the ratio of net income to total equity). They measured cash holdings as cash scaled by total assets. Following is a summary of their findings:
- Lead VCs exited 2.90 (median = 2.5) years after the IPO date. The average exit time varied from 1.83 years in 2008 to 3.49 years in 2007.
- VCs rarely sold all their shares at the IPO and held, on average, 15.4% of the outstanding shares.
- Post-IPO VC-backed companies had higher Tobin’s Q, R&D expenditure, and held more cash, but had lower leverage and ROE.
- Consistent with prior research, using a Fama-French three-factor (beta, size, and value) model with a 60-month tracking period they did not find that VC-backed IPOs outperformed benchmarks.
- However, when the lead VC was present, the average monthly alpha was 0.88%. Following the exit, the outperformance diminished.
- Relaxing the holding period to include companies until the VC exited increased the three-factor alpha to 1.11% when the lead VC was present.
- Using the Fama-French five-factor model (adding investment and profitability) increased the monthly alpha to 1.79% while the lead VC was present. Following the lead VC’s exit, some outperformance persisted, but the monthly alphas were reduced to 0.65%.
- VC-backed IPOs had a smaller offer size, offer price per share, and age at the IPO, as well as greater underpricing.
- VC-backed IPOs exhibited higher pre-exit valuations, and valuations were higher when the lead VC was present.
- VC-backed companies continued to be unprofitable with high investment rates after the VCs exit.
- Alphas were higher among portfolios of firms with high R&D and low capital expenditures – considering the role of intangibles is important.
- Portfolios of high-reputation, VC-backed companies did not exhibit positive alphas after VCs exited unless both syndicate size and pre-IPO holding periods were above median levels – having a large syndicate or being highly reputable alone did not entail superior performance. When all three conditions were met the alpha was 1.42% and significant at the 1% level. If any of these three conditions were not met, alphas were insignificantly different from zero.
- High-reputation VC portfolios after exit generated positive and significant alphas as long as R&D expenditures were high (alpha = 1.79 and significant at the 10% level) and capital expenditures were low (alpha = 1.26 and significant at the 5% level).
- Portfolios of low-reputation, VC-backed companies did not exhibit positive alphas after VCs exited, regardless of syndicate size, pre-IPO holding periods, and capital and R&D expenditures.
- The alphas were positive and significant when low-reputation VCs were present only if there were high R&D expenditures and low capital expenditures. In contrast, when high-reputation VCs were present, alphas were significantly positive, regardless of capital and R&D expenditures.
- Alphas were much higher at higher R&D levels when high-reputation VCs were present – when high-reputation VCs were present, the monthly alpha was 1.16% (significant at the 5% level) for low levels of R&D expenditures and 2.67% (significant at the 1% level) for high R&D expenditures.
- The results were robust to value-weighted portfolios (to ensure results were not driven by very small firms) and other robustness tests (including minimum number of companies in portfolios).
Their findings led Basnet, Blomkvist, and Cumming to conclude: “Contrary to prior work, we identify lead VC exit times that enable us to fully capture lead VCs’ roles in post-IPO value creation. By taking into account exit times, we show that VC presence is linked to higher returns…. Our findings imply that the stock market fails to fully incorporate all the value added provided by venture capitalists.” They added: “We show that monitoring is linked to value creation. Adding to the literature, we find that this effect diminishes after the exit.”
Investor takeaways
Prior to the publication of the paper by Basnet, Blomkvist, and Cumming, there was a large body of evidence on the poor risk-adjusted performance of IPOs, particularly those of smaller companies and those with negative earnings. Their study demonstrated that there has been a subset of IPOs that has delivered statistically significant alpha – companies backed by high-reputation venture capital firms where the lead VC firm is still present. Post-exit by the lead high-reputation VC, companies continued to generate alpha when R&D expenditures remained high and capital expenditures remained low. The takeaway for investors is that if you are considering investing in an IPO, you should favor companies with those characteristics. Of course, that advantage may be arbitraged away as the findings of this research become known to investors.
Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners.
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Research has shown that investing in IPOs has been a bad deal – you lose money compared to a comparable index fund. But a new paper shows that certain VC-backed IPOs deliver alpha for investors.