Institutional Investment in Newly Public Firms
Laura Casares Field
SmealCollege of Business
PennStateUniversity
University Park, PA 16802
E-mail:
Phone: (814) 865-1483
Michelle Lowry
SmealCollege of Business
PennStateUniversity
University Park, PA 16802
E-mail:
Phone: (814) 865-1483
September 30, 2005
We thank Harry DeAngelo, Linda DeAngelo, Amar Gande, Jean Helwege, Raghu Rau, Jay Ritter, Dennis Sheehan, John Wald and workshop participants at the 15thAnnual Finance and Accounting Conference, ArizonaStateUniversity, BinghamtonUniversity, PennStateUniversity, the University of Houston, and VanderbiltUniversity. We thank the Smeal Research Grants Program for generously providing funding to purchase the Spectrum/CDA 13F institutional data. This paper was previously circulated under the title, “How Is Institutional Investment in Initial Public Offerings Related to the Long-Run Performance of These Firms?”
Institutional Investment in Newly Public Firms
Abstract
This paper examines the relation between institutional investment in IPOs and the stock returns associated with these firms. Over both short and long horizons, IPOs with greater institutional shareholdings outperform those with smaller institutional shareholdings. In the short run, the superior returns stem from institutions’ ability to identify venture-backed firms that subsequently outperform. Over the long-run, however, the return difference reflects institutions’ ability to avoid firms that exhibit the worst performance. Institutions appear to rely heavily on readily available firm and offer characteristics when making their investment decisions. In contrast, individual investors are less likely to consider such characteristics and, as a result, they invest disproportionately in poorly performing firms. However, a simple strategy of investing in higher quality firms, for example firms with better accounting fundamentals, would enable individuals to avoid much of this underperformance.
I. Introduction
Initial public offerings (IPOs) are an extremely attractive investment opportunity when they first come to market, but less attractive over subsequent years. The average initial return from day 0 to day 1 is approximately 19%, while the average annual raw return over the following five years is only about 5% (Loughran and Ritter, 2004, 1995). In fact, IPOs have consistently earned lower returns than the S&P 500 over long horizons, and Brav and Gompers (1997) show that small, non-venture backed IPOs underperform even size and book-to-market matched portfolios. The objective of this paper is to examine the investment patterns of institutional investors, who are presumably aware of this evidence.[1]
Despite the poor performance of IPOs relative to various benchmarks, we find that institutions have been active investors in IPOs. They invested in nearly 90% of IPOs between 1980 and 2000. Perhaps even more surprising, they invested in 70% of the worst performing sector, i.e., small, non-venture backed IPOs.[2]
One potential explanation for institutions’ heavy investment in IPOs is that they are able ex ante to discriminate firm quality. Indeed, not all IPOs are poor investments. Over the past 20 years, the top 100 IPOs earned over 1000% in the first three years, compared to -99% for the bottom 100. The challenge for investors is to identify such winners and losers ahead of time. In the IPO market in particular, institutional investors may have a distinct advantage over individuals. Institutions have connections to venture capitalists and underwriters, and they are invited to road shows where they can obtain firm- and offer-specific information. From the San Francisco Chronicle in August 2004, “In a typical road show, large clients of the lead underwriters are invited to lunch at fancy hotels, where the company going public spills beans that weren’t included in the prospectus. This supposedly gives the large investors an edge over the poor schmoes who weren’t invited.”
If institutions possess an informational advantage over individuals, then institutions may be better able to identify the quality of firms issuing IPOs. Consistent with this conjecture, newly public firms with larger institutional shareholdings tend to perform better over several horizons than those with little institutional interest. However, the source of institutions’ higher returns is different at short versus long investment horizons.
Over short horizons, institutions are able to identify venture-backed firms that outperform market benchmarks. This suggests that venture capitalists may provide value-relevant information to institutional investors. However, over longer horizons of one to three years, we find no evidence that institutions can systematically identify the best performers in any sector of the IPO market. Over these long-run horizons, the difference in performance between firms with high and low institutional investment is driven entirely by the significantly negative abnormal returns of firms with little institutional interest.
These results suggest that individuals experience the greatest IPO underperformance. To more directly examine this conjecture, we isolate firms with no institutional presence shortly after the IPO – that is, firms with only individual investors. We show that these firms are more likely to have higher pre-IPO leverage, lower pre-IPO working capital ratios, and negative pre-IPO earnings. Moreover, these firms’ earnings become significantly more negative in the years after the IPO. We also show that these firms are extremely unlikely to ever garner institutional interest. When we examine long-run stock returns for these firms with only individual investors, we find that they substantially underperform – over a three-year horizon, they earn 16% below size and book-to-market matched firms. Finally, we examine the relation between long-run returns and publicly available information about offer quality. We find that institutional investors place more weight on such quality measures than do individuals, and we show that individuals could avoid the worst performers by simply investing in firms brought public by higher ranked underwriters and backed by venture capitalists, and in firms with more working capital, lower leverage, and positive earnings prior to the IPO. For example, a strategy of investing in firms with below-median leverage prior to the IPO and shorting those with above-median leverage would earn approximately fifty basis points per month over the three years following the offering.
Our results showing that firms with higher institutional investment outperform those with lower levels of institutional investment are consistent with a growing body of literature suggesting that institutions have an advantage over individuals. Gibson, Safieddine, and Sonti (2004) find that SEO firms with the largest increases in institutional investment around the offering earn significantly higher abnormal returns than those with the greatest decreases. Chemmanur, He, and Hu (2005) find that institutions possess private information about SEOs, and they are able to obtain greater allocations in better offerings. Chen, Harford, and Li (2004) find that institutions decrease their holdings in firms that subsequently make poor acquisitions. In a sample of 441 IPOs between 1997 and 2001, Boehmer, Boehmer, and Fishe (2005) find that underwriters provide institutions with more shares in firms that subsequently perform better.
Our paper contributes to this literature in several ways. First, using a large, comprehensive sample of IPOs over a twenty-year period, we demonstrate that the source of institutions’ advantage over individuals differs by investment horizon, with institutions beating market benchmarks only at very short horizons, but successfully avoiding the firms that tend to perform the worst over longer periods. Second, we find that institutional investors use publicly available firm and offer characteristics in choosing their IPO investments, but that individuals are more likely to disregard such quality measures. Third, we demonstrate that the most severe long-run IPO underperformance is concentrated in firms that attract only individual investors. Finally, our results indicate that while individuals suffer the most underperformance, this need not be the case – individuals could avoid the worst underperformers by simply paying closer attention to firm fundamentals.
The paper is organized as follows. Section II describes the data and methodology. Section III presents evidence on institutional investment patterns in IPOs over the past 20 years. Section IV examines the relation between these institutional holdings and IPO long-run performance, while Section V examines the determinants of institutional investment. In Section VI, we focus our attention on firms with only individual investors, while Section VII seeks to determine whether individual investors could earn higher returns by paying more attention to fundamentals. Section VIII concludes.
II. Data and Methodology
Our dataset consists of firms that went public between 1980 and 2000, as listed on the Securities Data Company (SDC) database. We omit financial institutions (SIC codes 6000-6999), utilities (SIC codes 4900-4999), closed-end funds, ADRs, unit offerings, and IPOs with an offer price less than five dollars. Firms are also required to have CRSP data. Our final sample consists of 5907 IPOs.
For each firm, we collect the offer date, offer price, initial file range, proceeds, underwriter name(s), whether the issue was backed by a venture capitalist, and the over-allotment option (if available) from SDC. We use Loughran and Ritter’s (2004) updated measures of Carter and Manaster’s (1990) underwriter quality to rank each underwriter. Ranks range from 0 to 9.1, with higher ranks representing higher quality underwriters. We define the price run-up as the percent difference between the midpoint of the filing range and the offer price, and we compute the initial return as the percent difference between the offer price and the first after-market closing price from CRSP, where this price must be within 14 days of the offer date. We also collect data on the age for firms in our sample, where age represents the number of years since the company was founded.[3]
Since 1978, the SEC has required all institutions with more than $100 million of securities under discretionary management to report holdings of all common stock positions greater than 10,000 shares or $200,000 on a quarterly basis (at the end of March, June, September, and December).[4] We obtain these data on 13F institutional ownership in electronic form from CDA/Spectrum for 1980-2000. Specifically, for each IPO firm we obtain the total number of shares owned by each institution.
Because we are interested in voluntary post-IPO holdings by each institution (as opposed to initial allocations that institutions receive), we collect the institutional holdings at least one month after the IPO. Thus, for an IPO on February 21st, we collect institutional holdings as of the end of March. However, for an IPO on March 3rd, we collect institutional holdings as of the end of June. Ideally, we would also like to exclude institutions that owned shares prior to the IPO. Thus, following Dor (2004), we first omit any institution listed as a venture capitalist on SDC or whose name suggests it is a venture capitalist (e.g., Acacia Venture Partners). Second, we omit any institution that is listed as owning more than 15% of the shares offered in the IPO. This is based on the assumption that one entity is extremely unlikely to receive such a large allocation in the IPO, suggesting that it probably owned these shares prior to the IPO.
We define institutional ownership percentage as the number of shares owned by institutions divided by the estimated public float. For a recent IPO, the float should be approximately equal to the total number of shares offered in the IPO, which is equal to shares offered as listed in the prospectus plus the overallotment option.[5] In cases where sufficient data are available, this is the formula we use to obtain the float. Because SDC does not provide data on the over-allotment option sold for all issues, in some cases we must estimate it. Based on Aggarwal’s (2000) findings regarding the relation between the initial return and the size of the over-allotment option, we assume that those issues with an initial return less than or equal to 5% have a float equal to 105% of shares offered. For those issues with an initial return greater than 5%, the float equals 115% of shares offered. Using these estimates, average (median) institutional ownership as a percent of the public float equals 25% (24%).
Figure 1 indicates that institutional ownership in IPOs has increased dramatically over time. The solid line in Panel A illustrates that institutions have invested in an increasing number of IPOs over our sample period: they invested in approximately 70% of IPOs in 1980, compared to over 95% in 2000. Panel A also demonstrates that this pattern of increased institutional interest in IPOs does not appear to be correlated with the volume of IPOs (shown in the gray bars).
Panel B of Figure 1 shows that the mean and median institutional ownership as a percent of the public float has also increased dramatically, from less than 10% in 1980 to approximately 35% in 2000. The finding of dramatic increases in institutional ownership over time is similar to the pattern documented by Gompers and Metrick (2001) for the overall market.
In order to compare the performance of firms according to their level of institutional ownership, we form portfolios based on institutional ownership. The simplest approach would be to rank all IPOs based on the percent of shares owned by institutions and form portfolios based on this ranking. However, as indicated by Figure 1, this would bias the high institutional holding portfolios toward more recent IPOs. In addition, it would likely also bias the high institutional holdings portfolios toward larger companies, as Gompers and Metrick show that institutions tend to favor bigger firms. Thus, we want to control for both year and company size in forming the portfolios. Institutions’ preference for larger companies stems in large part from their preference for more liquid companies. For a recent IPO, proceeds raised is likely to be a better estimate of liquidity than market capitalization. The majority of shares that were outstanding prior to the IPO and not sold in the IPO are restricted under lock-up agreements, meaning they cannot be traded and do not contribute to firm liquidity. For this reason, we use proceeds as our size measure.
Following Nagel’s (2004) methodology, we estimate cross-sectional regressions each year of institutional ownership on size:
(1)
where INSTi,t is the institutional holdings for firm i (as a percent of public float) measured at Quarter 1 and proceedsi is the IPO proceeds of firm i.[6] We use the regression residual for each firm to group firms into quintiles annually, where Quintile 1 (Q1) represents firms with the lowest residual institutional ownership, and Quintile5 (Q5) represents firms with the highest residual institutional ownership. Finally, we combine quintiles across years to form our five portfolios, based on institutional ownership net of firm size. Thus, Q1 includes all IPOs across our 21-year sample period that had the lowest residual institutional ownership in each year, while Q5 includes all IPOs across the 21-year sample period that had the highest residual institutional ownership in eachyear.[7] Throughout the remainder of the paper, we refer to residual institutional ownership as just institutional ownership.
Descriptive statistics for the full sample and for each institutional holding quintile are provided in Table 1. Over the entire period, institutional investors held an average (median) of 25.2% (24.0%) of the public float at Quarter1. There is considerable dispersion in institutional holdings across the quintiles, with average holdings of 6.7% of the public float (median=0%) for the smallest quintile, compared to 33.3% (median=31%) for the largest quintile. In addition, Table 1 indicates that we have successfully controlled for firm size in our formation of institutional holdings quintiles, as there is no significant difference between Q1 and Q5 for either proceeds raised or market capitalization.
Table 1 shows several significant differences between the firms with the lowest and highest institutional holdings. For example, firms with the lowest institutional holdings tend to be younger on average (10.3 years for Q1 vs. 12.7 years for Q5), are less likely to be venture backed (32.1% venture backed in Q1 vs. 37.1% in Q5), have higher average initial returns (22.9% for Q1 vs. 14.7% for Q5), and have a lower median EBIT in the year before the IPO (6.0% for Q1 vs. 11.3% for Q5). The relation between institutional ownership and EBIT is particularly strong, as EBIT increases monotonically across the quintiles. Finally, there is no evidence of significant relations between institutional holding quintile and either book-to-market ratio, underwriter rank, or leverage. Across the entire sample, the average book-to-market ratio is 0.40, the average underwriter rank is 7.1, and median leverage is 66.2%.
III.Institutional Investment Patterns
Stoll and Curley (1970), Ritter (1991), Loughran and Ritter (1995), and Ritter and Welch (2002) find that IPOs tend to significantly underperform a variety of benchmarks. Brav and Gompers (1997) show that this underperformance is concentrated among small, non-venture backed IPOs. The first panel of Table 2 confirms that similar patterns also exist in our sample. Intercepts from four-factor regressions of equally weighted monthly post-IPO returns over a three-year time horizon indicate that on average, IPOs experience significant underperformance in the three years after the IPO.[8] As shown in the table, this result is driven by non-venture backed firms. Moreover, the underperformance within the non-venture backed category is greater for small IPOs than for large IPOs. For the smallest tercile, non-venture backed IPOs experience average underperformance of 63 basis points per month over the first three years. Interestingly, the second panel of Table 2 shows that IPO underperformance is not limited to the long-run: small non-venture backed firms significantly underperform their benchmarks in the very first quarter.
If institutions are aware of the historical long-run performance of IPOs, then one might expect them to avoid those types of IPOs that have been shown to perform worst. Thus, we examine the investment patterns of institutional investors in IPOs by venture capital backing and size groupings (where firms are classified into small, medium, and large terciles, based on market capitalization as done in Brav and Gompers (1997)).