Impact of private equity and venture capital on initial public offering underpricing : evidence from 76 Chinese firms trading on the U.S. exchanges

Impact of Private Equity and Venture Capital on

Initial Public Offering Underpricing

Evidence from 76 Chinese Firms Trading on the U.S. Exchanges

Jingjia Ni （10831045）

Supervisor Derya Güler

The impact of private equity and venture capital on initial public offerings (IPOs) has not reached consensus in existing literature. This paper investigates the different impact of private equity and venture capital on IPO underpricing based on 76 Chinese firms trading on the U.S. exchanges in the period 2000-2016. The level of underpricing is measured by the IPO first-day yield. The results show that private equity backed IPOs do not experience a significant level of underpricing, while venture capital backed firms tend to underprice issue prices. The difference between these two kinds of IPO is significant at 10%. These findings help to explain the underpricing phenomenon in the stock market and find out the mechanism behind IPO underpricing.

Statement of Originality

This document is written by Jingjia Ni who declares to take full responsibility for the contents of this document.

I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.

The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.

Table of Contents

I.

Introduction

Since 2000, many Chinese companies have chosen to go public in the American markets as a result of strict financial standards for Chinese listing and the America’s speedy registration system (Fong, 2011). On the one hand, it helps companies to attain more capital from foreign investors. On the other hand, it provides a convenient exit method, the way to realize profits, for the private equity and venture capital firms that have invested before the firm’s initial public offering (IPO).

Private equity and venture capital have become increasingly important for the IPO in the context of global equity markets (Levis, 2011). While both private equity and venture capital are fund providers for non-public companies and achieve revenue in the business of buying low and selling high, these two companies are fundamentally different in their focuses (Bodie, Kane & Marcus, 2014, p.44). Private equity focuses on saving poorly-performing companies from bankruptcy and turning them into profitable

enterprises (Hwang, 2012). Venture capital, on the contrary, mainly invests in young and newly developed companies or even some simple business ideas, which helps to explain the word “venture” in venture capital.

In light of the importance of IPO as an exit method for private equity and venture capital, it is expected to see a significant part of IPO literature dedicated to private equity backed and venture capital backed companies, especially concerning with the disputed underpricing problem (Levis, 2011). However, the mainstream academic research does not pay much attention into this issue, particularly the relation between private equity backed IPOs and IPO underpricing. Previous research has tried to analyze the venture capital backed IPOs, but the sample used is rather too old and focuses on American and European public companies. By analyzing the underpricing of private equity backed and venture capital backed IPOs with data from 76 Chinese companies that are listing in the U.S. exchanges, this paper can contribute to the existing research and further explore the underlying reasons for the unsolved underpricing problem.

The outline of this thesis is as follows: Chapter one is the introduction part, and a brief introduction about the paper will be explained. Chapter two will deal with the theoretical background about this paper, including the discussion about the extant literature relevant to this topic. Chapter three exhibits how the hypotheses are developed. Chapter four talks about the data collection as well as the model used. The result will be discussed in chapter five, together with the test of the hypotheses formed in Chapter 3. The final chapter is a brief conclusion about this paper.

II.

Theoretical Background

2.1 Initial Public Offering

Initial public offering (IPO) is the process of selling stock to the public for the first time (Berk & DeMarzo, 2011, p. 812). According to Berk and DeMarzo (2011, p.812), there are mainly two advantages of going public for a company: Greater liquidity and better access to capital. By going public, the company’s existing investors are able to diversify by selling their stock in the public stock markets and realize profits. Furthermore, the company has access to much larger amounts of capital through public trading. These reasons explain the developed popularity of going public these years.

Despite the advantages, there are also disadvantages of IPO. Greater liquidity leads to less of control, which undermines investors’ ability to monitor company’s operation and management (Berk & DeMarzo, 2011, p. 813). In addition, the occurrence of business scandals requires more thorough financial disclosure and tougher regulations for the board of directors. However, wither the design of the new rules or the compliance with the new standards is costly and time-consuming.

Besides the advantages and disadvantages, there are four characteristics of IPO that have puzzled the financial economists for a long time (Berk & DeMarzo, 2011, p. 820). Firstly, the IPO tend to be underpriced, which will be explained in detail in section 2.2. Secondly, the number of issues is highly cyclical—the number of issues changes with the time. Thirdly, given the high cost of IPO, the main reason for companies to go public is still unclear. Fourthly, the average performance of a newly public company is poor in the long run, and consequently, it is hard for investors to gain profits from three- to five- year buy and hold strategy.

The objective of this empirical study is to analyze the first puzzle of the IPO. That is, the paper will focus on the analysis of the IPO underpricing phenomenon and its relation to private equity and venture capital.

2.2 Underpricing

The IPO underpricing means that the stock price at the end of the first-day trading

is higher than the IPO price (Berk & DeMarzo, 2011, p. 820). The IPO first-day average return has been historically large around the world, which will be shown in appendix 1. This implies that IPO underpricing is a very common phenomenon. However, the positive first-day return means a loss for pre-IPO shareholders of the issuing company,

and in the underpricing situation, the pre-IPO shareholders actually sell the shares in their company in exchange for less they could get in the aftermarket. So what is the underlying reason for shareholders of the issuing company to put up with this phenomenon?

The researches about the underpricing phenomenon have been started since the 1990s. Ibbotson (1975) takes it as a mystery and fails to explain its existence. Ritter (1984) conjectures that the underpricing is related to the industry of the issuing company. Over time, there are mainly four explanations of underpricing developed. Firstly, the underwriters underprice the IPO with the aim to conform to certain IPO regulations (Tinic, 1998). Secondly, according to the ownership and control theory by Brennan and Franks (1997), the issuers use underpricing as a tool to decentralize the ownership of shares so that they can remain control for the company. Thirdly, issuers achieve revenues from the IPO through underpricing in order to compensate for their loss of shares (Thaler, 1980). Fourthly, Ljungqvist (2004) attributes the underpricing to information asymmetry. Due to the information asymmetry, the issuers are able to manipulate the IPO open price for their own interests.

2.3 Underpricing and Information Asymmetry

As mentioned in section 2.2, information asymmetry is essential to the explanation of underpricing (Rock, 1986). For example, when the principle and agent are in fact the same party, the information between the issuing company and the public is asymmetric, and a third party is required to help certify the true value of the company. Two prominent cases in which the principle and agent are the same party are: IPOs that are self-underwritten and IPOs that are underwritten by underwriters with pre-IPO stake. However, the impact on the IPO underpricing of these two cases is rather different. For self-underwritten IPOs, Muscarella and Vetsuypens (1989) find it has similar level of underpricing to regular IPOs. For the second case, conversely, it is found that underwriters with pre-IPO stake tend to minimize the underpricing (Ljungqvist & Wilhelm, 2003).

Generally, the most effective and easiest way to reduce information asymmetry between the company and the public is to hire prestigious underwriters to manage the offering, i.e. the principal and the agent are not the same party (Carter & Manaster, 1990). Empirical studies, nevertheless, indicate that even with reputable underwriters, the information asymmetry is not always reduced. Ljunqgvist (2004) believes that reputable

underwriters will only manage IPOs with high quality, which means reputable underwriters help to reduce information asymmetry and reduce the underpricing as well. In contrast to Ljunqgvist’s conjesture, Loughran and Ritter (2004) show that some investment banks may offer shares in the interest of the issuing company with the aim to please their long-term clients and in exchange for future business.

2.4 Private Equity and Underpricing

Private equity firms invest in the private equity of existing companies through various methods, including leveraged buyout, venture capital and growth capital (Mogilevsky & Murgulov, 2012, p. 47). Compared to the venture capital firms, which invest in small brand-new companies, private equity firms involve in less risk and higher return possibilities. As a result, private equity can provide plenty of cheap debts with the support from other large investors, such as pension funds, hedge funds and investment banks. According to Baron (1982), investment banks can discount the issuer’s stock with their advanced information. Because of the close relationship between the private equity and the investment banks, it is expected that the private equity helps to reduce or even eliminate the information asymmetry between the company and the public, and thus the incentive for the issuers to underprice is also reduced. For Grinblatt et al (1989), who come up with the signaling theory, the private equity plays a different role. They argue that underpricing is used to signal the company’s quality to the market by informed issuers. Private equity firms help the issuers to obtain more information, hence increases the level of underpricing.

2.5 Venture Capital and Underpricing

Unlike the private equity firms, venture capital firms mainly invest in new technology, new marketing concepts and new products that have yet to be proven (Mogilevsky & Murgulov, 2012, p. 47). According to the existing literature, there are mainly two different opinions about the impact of venture capital on IPO underpricing.

Certification effect supports the idea that venture capital would work as a third party to help verify the true value of the target companies, thus decreasing the IPO underpricing. The empirical study by Megginson and Weiss (1991), based on the market data for America from 1983 to 1987, suggests that the level of underpricing is significantly lower for venture capital backed IPOs compared to regular IPOs. Lin and Smith (1998)

analyze the performance of the public companies in America from1979 to 1990, and reach a similar conclusion.

Amit et al (1990) however, argue that the introduction of venture capital would aggravate the IPO underpricing. This can be explained by the adverse selection effect (Pindyck & Rubinfeld, 2013, p. 634) and grandstanding effect (Gompers, 1996). According to adverse selection theory, the company with bad financial situation will have the most desire to lead in venture capital, but the venture capital cannot change the situation of the company fundamentally and therefore cannot work as a third party and help verify the true value of the company (Amit et al, 1990). Moreover, some venture capital companies will help premature companies to go public in order to gain reputation and build status in the industry in a short time, which causes high IPO underpricing (Gompers, 1996).

Up till now, there is no such theory that can well explain the relationship between the underpricing phenomenon and private equity backed or venture capital backed IPOs, let alone a theory that can generalize to different capital markets and different countries. This may result from the different financial systems, regulations and market atmosphere in different countries, as well as the different characteristics of investors in different countries. However, understanding the mechanism of IPO underpricing is key to the IPO researchers. Based on the reasons mentioned above, this paper will analyze the IPO underpricing phenomenon using the data from 76 Chinese companies listed on the U.S. exchanges during the period from 2000 to 2016, and discuss about the impact of private equity and venture capital on IPO first-day yield.

III. Hypothesis Development

In chapter II, the impact of private equity and venture capital on the IPO underpricing has been proved. However, the result of the impact remains for discussion. In the following part, the impact will be divided into two perspectives: The capital market perspective and the company management perspective. All the analysis in this paper will only focuses on the primary market, i.e. the secondary market will not be considered.

From the capital market perspective, the impact of private equity and venture capital on the stock price includes: The certification effect (Megginson & Weiss, 1991), to some extend, helps to eliminate the information asymmetry and rationalize the open price for new stocks; At the same time, since IPO plays an important role for the exit of the private equity and venture capital firms, these investors tend to reduce the issue price to avoid the IPO failure and gain more purchases in the primary market. Therefore, it is reasonable to believe that the involvement of private equity and venture capital improves the IPO first-day yield in the capital market respect.

From the company management perspective, the impact of private equity and venture capital on operation and management can be shown as follows: The participation of private equity and venture capital directly increase the cash flow of the company, and likewise the company’s management capacity; some private equity or venture capital firms provide the target company with professional expertise and help the company increase operation efficiency and sales performance. In a nutshell, private equity and venture capital help to strengthen the profitability and improve operation quality of the pre-IPO company.

No matter from the market’s respect or the company’s respect, private equity and venture capital have a positive effect on the first-day yield of the IPO. This result leads to the first and second hypotheses:

Hypothesis 1: Private equity increases the level of IPO underpricing. Hypothesis2: Venture capital increases the level of IPO underpricing.

Compared to the firms backed by venture capital, the private equity backed firms tend to be larger, more profitable, and are usually underwritten by big investment banks. As a result, it is difficult to dispute the fact that private equity backed companies are more informed than venture capital backed companies. However, in section 2.4, it has been shown that this information advantage would lead to different results with different theories. If the IPO underpricing is used as a signal for higher quality firms, then the

more informed the companies are the higher level of IPO underpricing. If the incentive for IPO underpricing comes from the information asymmetry between the issuers and the public, then the involvement of the private equity means the information asymmetry is reduced, so does the level of underpricing. This paper will focus more on the relation between the listing company and the public, instead of the quality of the company itself, so we hypothesize the following.

Hypothesis 3: Private equity backed IPOs exhibit lower level of underpricing than concurrent venture capital backed IPOs.

These hypotheses can also be written as the following tests: Hypothesis 1: 𝐻!: 𝛽!" = 0 𝐻_!: 𝛽_!" > 0 Hypothesis 2: 𝐻_!: 𝛽_!" = 0 𝐻_!: 𝛽_!" > 0 Hypothesis 3: 𝐻_!: 𝛽_!" = 𝛽_!" 𝐻_!: 𝛽_!" < 𝛽_!"

The concrete explanation for these t-tests will be discussed in details in chapter IV.

IV. Methodology

4.1 Data Source and Sample Selection

In order to answer the research question, data in respect of IPO information for the research companies are collected. The data used are from U.S. Securities and Exchange Commission (SEC). Observations are Chinese companies listed either on New York Stock Exchange (NYSE) or NASDAQ Exchange between 2000 and 2016. The information gathered for the following research includes company scale, offer characteristics and investment background (whether private equity backed or venture capital backed), all of which can be found in the F-1 filing (registration statement for certain foreign private issuers) of the company on SEC.

There are in total 91 Chinese companies going public since the year 2000. However, a number of data are dropped for various reasons, succinctly summarized in Table 1. In the beginning, there were some state-owned Chinese companies going public in the U.S. exchanges, and there is no F-1 filings for these companies, take the China Unicom as an example. In total, there are 5 state-owned companies in the data set, and they are removed not only because of the missing information, but also because of the different company characteristics from other companies.

There are 10 companies backed by both private equity companies and venture capital companies. In order to analyze the impact of private equity and venture capital on the IPO underpricing respectively, it is better to drop these 10 companies from the sample.

Table 1. Number of Sample Removals by Reasons Number of companies Reasons for removal

91

-5

Total number of companies

1. Exclude state-owned companies

87

-10

Non state-owned companies

2. Exclude companies that are both private equity backed and venture capital backed

76 Remaining Sample

4.2 Underpricing Model

In the extant literature, the IPO first-day yield is used as a parameter to measure the level of underpricing. As a result, the following equation will be employed to calculate the first-day yield (YIELD) for an offer:

𝑌𝐼𝐸𝐿𝐷 =𝑃!− 𝑃! 𝑃_! ，

Where 𝑃! stands for the first-day closing price in the aftermarket and 𝑃! is the

IPO price. The result of this equation will be used as a proxy for underpricing in the regression equation.

Mogilevsky and Murgulov (2012) analyze the impact of private equity and venture capital on IPO underpricing with the following model.

𝑌𝐼𝐸𝐿𝐷! = 𝛽!+ 𝛽!𝑃𝐸 + 𝛽!𝑉𝐶 + 𝛽!𝑆𝐸𝑂 + 𝛽!𝐿𝑁!"#+ 𝛽!𝐿𝑁!""#$"+ 𝛽!𝐿𝑁!"#$%%&' + 𝛽_!𝑀𝐾𝑇_!"#$%+ 𝛽_!𝑅𝑂𝐴 + 𝛽_!𝑅𝐸𝑇𝐴𝐼𝑁𝐸𝐷 + 𝛽_!"𝑁𝑌𝑆𝐸 + 𝛽!!𝑁𝐴𝑆𝐷𝐴𝑄 + 𝛽!" 𝑌𝐸𝐴𝑅! + 𝜀!! !"!! !!! 1 Where the meaning of variables are summarized in Table 2.

Table 2. Meaning of Variables in Regression Model 𝟏

Type Symbol Name Calculation

Dependent variable 𝑌𝐼𝐸𝐿𝐷 First-day yield 𝑌𝐼𝐸𝐿𝐷 =𝑃!− 𝑃! 𝑃! Independent

Variables

𝑃𝐸 Private Equity 1, if private equity backed; 0, if otherwise

𝑉𝐶 Venture Capital 1, if venture capital backed; 0, if otherwise

Control Variables SEO Seasoned equity offering 1, if the firm raised money in a

seasoned equity offering in the three years

following IPO; 1, if otherwise

𝐿𝑁_𝐴𝐺𝐸 Natural logarithm of 1+age of firm in years ln(1+age) 𝐿𝑁_𝐴𝑆𝑆𝐸𝑇 Natural logarithm of total pre-IPO assets ln(assets) 𝐿𝑁_𝑃𝑅𝑂𝐶𝐸𝐸𝐷𝑆 Natural logarithm of the value of proceeds ln(proceeds)

MKT_SHA RE

Market share of the lead underwriter in the

year of the IPO

Market share%

𝑅𝑂𝐴 Return on assets 𝑅𝑂𝐴 = 𝐸𝐵𝐼𝑇

𝐴𝑠𝑠𝑒𝑡𝑠 𝑅𝐸𝑇𝐴𝐼𝑁𝐸𝐷 The percentage retained Retained%

Table 2 (con.). Meaning of Variables in Regression Model 𝟏

Type Symbol Name Calculation

𝑁𝑌𝑆𝐸 Dummy variable for the exchange 1, if listed on NYSE exchange; 0, if otherwise

NASDAQ Dummy variable for the exchange 1, if listed on NASDAQ exchange; 0, if

otherwise

𝑌𝐸𝐴𝑅! !"!!

!!!

Dummy variable for year to control for the

changing market conditions

𝑌𝐸𝐴𝑅! !"!!

!!!

In this paper, the model above is adopted, but some control variables are dropped due to the differences between these two empirical studies. Firstly, the seasoned equity offering (SEO) will not be used. SEO is the sale of stock by a company that has already been public, and in this paper, only companies that are first publicly traded will be considered (Berk & DeMarzo, 2011, p. 826). Secondly, the market share of the lead underwriter will be removed from the model as well. This paper focuses on the impact of private equity and venture capital on the IPO underpricing, and the impact from underwriter will not be measured. Thirdly, one of the two dummy variables that control for the effect from different exchanges is deleted, since all the Chinese companies that go public in the American exchanges listed on either NYSE or NASDAQ, and there is no third option. In order to avoid perfect multicollinearity, the case where one of the regressors is a perfect linear function of the other regressors, either NYSE or NASDAQ should be removed from the regression model. In this paper, the variable NASDAQ will be deleted, but it does not matter which one to remove. Fourthly, the dummy variable controls for changing market period is removed. This paper does not take the period into consideration and there is no need to include this variable.

In a nutshell, the model that will be used for analysis in this paper is:

𝑌𝐼𝐸𝐿𝐷 = 𝛽_!+ 𝛽_!𝑃𝐸 + 𝛽_!𝑉𝐶 + 𝛽_!𝐿𝑁_!"#+ 𝛽_!𝐿𝑁_!""#$" + 𝛽_!𝐿𝑁_!"#$%%&'+ 𝛽_!𝑅𝑂𝐴 + 𝛽_!𝑅𝐸𝑇𝐴𝐼𝑁𝐸𝐷 + 𝛽_!𝑁𝑌𝑆𝐸 + 𝜀, 2 Where 𝛽 stands for the coefficient of the correspondent variable, and 𝜀 is the error term for the model.

The elaborate definitions and calculation methods of the variables will be concluded in table 3.

company and the public. The older the company is or the larger number of the assets the company owns indicates more information to be publicly available. The proceeds raised from the IPO are an important parameter as well. According to Beatty and Ritter (1986), smaller offerings are more speculative and demand higher initial returns. ROA (or return on asset) is a measure for the firm’s performance. With higher ROA, it is expected that the firm performs well pre-IPO and the level of underpricing will be reduced as well. For the variable “Retained”, it is assumed to be positively related to the level of underpricing, and if the percentage of ownership retained post-IPO reduced, the level of underpricing will also be reduced since pre-IPO owners stand to lose more from underpricing. For the dummy variable NYSE, it is used to control for the different levels of underpricing between different stock exchanges.

Table 3. Meaning of Variables in Regression Model 𝟐

Type Symbol Name Calculation

Dependent variable 𝑌𝐼𝐸𝐿𝐷 First-day yield 𝑌𝐼𝐸𝐿𝐷 =𝑃!_𝑃− 𝑃! ! Independent Variables 𝑃𝐸 Private Equity 1, if private equity

backed; 0, if otherwise

𝑉𝐶 Venture Capital 1, if venture capital backed; 0, if otherwise

Control Variables 𝐿𝑁_𝐴𝐺𝐸 Natural logarithm of 1+age of firm in years ln(1+age) 𝐿𝑁_𝐴𝑆𝑆𝐸𝑇 Natural logarithm of total pre-IPO assets ln(assets) 𝐿𝑁_𝑃𝑅𝑂𝐶𝐸𝐸𝐷𝑆 Natural logarithm of the value of proceeds ln(proceeds)

𝑅𝑂𝐴 Return on assets 𝑅𝑂𝐴 =_{𝐴𝑠𝑠𝑒𝑡𝑠}𝐸𝐵𝐼𝑇 𝑅𝐸𝑇𝐴𝐼𝑁𝐸𝐷 The percentage retained Retained%

𝑁𝑌𝑆𝐸 Dummy variable for the exchange 1, if listed on NYSE exchange; 0, if otherwise

4.3 Data Collection

With the 76 selected samples and the regression model, we need to collect the value of variables in the model for further analysis.

company’s investment background. In order to find out whether a company is private equity backed or venture capital backed, the part “Principal and Selling Shareholders” in the F-1 filing has been manually checked for every company. It results in a sample of 19 private equity backed deals, 23 venture capital backed deals, and 34 non-sponsored deals.

For the variable LN_AGE, the official website of each company is used to find out the founding year and IPO year of correspondent company. The total pre-IPO assets of the firm can be found in the consolidated financial balance sheet in the F-1. “Proceeds” is found in the “Use of Proceeds” part in the F-1. ROA is the return on asset for the firm before the IPO, and is calculated by net profit (can be found in the consolidated income statement in F-1) over total pre-IPO assets. The percentage of shares held in the firm post-IPO by the pre-IPO owners can be found in the part called “Shares Eligible for Future Sale”. Table 4 is the summary of the descriptive statistics for the data collected of the three-subgroups (i.e. private equity backed, venture capital backed and non-sponsored IPOs).

Table 4. Descriptive Statistics for Three Subgroups

Variables PE backed (19) VC backed (23) Non-sponsored (34)

First-day Yield (percent) Mean -8.6151 33.6957 -3.0687 Std. dev. 8.1745 94.1426 6.0008 Minimum -26.91 1.27 -24.53 Maximum 2.07 457.89 4.10

Age (years) Mean 11.7895 6.6956 5.9706

Std. dev. 10.9675 4.1934 4.0263

Minimum 5 2 1

Maximum 54 20 16

Pre-IPO assets ($) Mean 3879500000 120844672 577959377

Std. dev. 11200000000 129394318 1968800000

Minimum 32298381 5229116 9617946

Table 4 (con.). Descriptive Statistics for Three Subgroups

Variables PE backed (19) VC backed (23) Non-sponsored (34)

IPO proceeds ($) Mean 791263158 81508695.7 309423676

Std. dev. 1873200000 53378578.6 1215300000 Minimum 25000000 6000000 2447500 Maximum 8130000000 256500000 7175000000 ROA Mean 0.049251 0.0395 0.035069 Std. dev. 0.1890259 0.3863 0.2522459 Minimum -0.4115 -1.2627 -0.9346 Maximum 0.5168 0.6126 0.4748 Retained Ownership (percent) Mean 83.3126 83.0670 78.2294 Std. dev. 8.5006 6.5290 7.56359 Minimum 66.67 70.00 52.70 Maximum 93.30 94.10 94.90

V. Results

5.1 Results for Hypotheses 1&2

With the data and regression model, the ordinary least squares (OLS) regressions are performed in the SPSS, a statistical analysis software. The OLS is a simple and reliable regression method, which produces linear regressions with coefficients as close as possible to the observed data (Stock & Watson, 2011, p.162). Table 5 is the correlation matrix for all the variables in this model. This matrix is used to check the mullicollinearity (also called collinearity and intercorrelation). According to rule of thumb, if the absolute value of correlation between two variables are higher than 0.7, then there is intercorrelation problem in this model and correlated variables should be deleted to improve the quality of the regression (Keller & Warrack, 2003, pp.714-715). Fortunately, according to the correlation matrix, there is no collinearity between variables and we can continue the regression with the defined model.

Table 5. Correlation Matrix (Pearson Bivariate Correlations)

Variable Yield PE VC In-age Ln-assets Ln-proceeds ROA Retained NYSE

Yield 1.00 PE -0.163 1.00 VC 0.330 -0.380 1.00 In-age -0.045 0.391 -0.040 1.00 Ln-assets -0.161 0.368 -0.207 0.339 1.00 Ln-proceeds -0.109 0.349 -0.242 0.060 0.613 1.00 ROA 0.075 0.019 -0.001 -0.095 -0.040 -0.158 1.00 Retained -0.066 0.175 0.178 0.246 0.170 0.100 -0.147 1.00 NYSE -0.157 0.273 -0.086 0.062 0.275 0.205 -0.003 0.069 1.00

The regression model is performed in the SPSS, and the estimated OLS coefficients are summarized in Table 6, together with their value of t-statics and p-value.

Table 6. Estimated Coefficients for Regression Model

Value T-statistic P-value

Intercept 57.180 0.482 0.631 PE 1.740 0.096 0.924 VC 40.406 2.668 0.010*** Ln-age 2.609 0.246 0.807 Ln-assets -3.172 -0.614 0.541 Ln-proceeds 3.198 0.471 0.639 ROA 13.354 0.593 0.555 Retained -0.769 -0.901 0.371 NYSE -12.242 -0.941 0.350

Note: *, **, *** significant at alpha 0.10, 0.05 and 0.01 level, respectively.

As can be seen from Table 6, the impact of private equity on IPO underpricing is not significant. Specifically, there is insufficient evidence to prove that private equity has a positive effect on underpricing problem. This result is against the original hypothesis. This finding does not support the signaling theory put forward by Grinblatt et al (1989) that firm underprices its IPO price with the aim to signal its good quality. Besides, all the control variables are not significant in this regression, which means the previous analysis with regard to the offering characteristics may not applicable in this sample, and other factors should be considered.

Venture capital, on the contrary, shows a significant positive effect (at alpha 0.1), as hypothesized, indicating the adverse selection and grandpricing effect are applicable in this sample.

5.2 Results for Hypothesis 3

The regression performed in section 5.1 is used to check the significance of the impact of private equity and venture capital on IPO underpricing respectively, and in order to test the difference of the impact in private equity and venture capital, another test is required. In this paper, the t-test of the means for two independent variables is applied. This test is performed in two steps. Firstly, the descriptive statistics of the three sub-groups, i.e. the private equity backed, the venture capital backed and non-sponsored

IPOs, is summarized (shown in Table 4).

Next, in order to test the significance of the differences within variables, the following t-statistic is employed.

𝑡 = 𝑥!− 𝑥! − (𝑢!− 𝑢!) 𝑠_!!_{∙ (}1

𝑛_!+𝑛1_!)

The above t-test is used to compare two means with independent samples ((Keller & Warrack, 2003, p.451). The difference between private equity backed IPO and venture capital backed IPO is analyzed, but in this test, the difference between private equity backed and non-sponsored IPO and the difference between venture capital backed and non-sponsored IPO are also tested as comparison. The results are shown in Table 7.

Table 7: Difference in Mean Tests of Firm and Offering Characteristics for Three Subgroups

T-statistics (with P-value in

parentheses)

PE and VC PE and Non-sponsored VC and Non-sponsored

First-day Yield (percent) -1.949

(0.058)* -2.828 (0.007)*** 2.280 (0.027)** Age (years) 2.057 (0.046)** 2.792 (0.007)*** 0.656 (0.515) Pre-IPO assets ($) 1.614 (0.114) 1.686 (0.098)* -1.109 (0.272) IPO proceeds ($) 1.821 (0.076)* 1.136 (0.261) -0.896 (0.374) ROA 0.100 (0.920) 0.214 (0.832) 0.052 (0.958)

Retained Ownership (percent) 0.106

(0.916)

2.171

(0.035)**

2.417

(0.019)**

Note: *, **, *** significant at alpha 0.10, 0.05 and 0.01 level, respectively.

firms are significantly different from the venture capital backed firms. In face, compared to the non-sponsored companies, private equity backed IPOs have significantly smaller level of underpricing, while venture capital backed firms have significantly larger level of underpricing. This may result from various results. The age of the company is definitely relevant. From the Table 7, it can be seen that the IPO firms with private equity involved are significantly older than venture capital backed firms and non-sponsored firms as well. Another factor that can help explain the results is the pre-IPO assets. Private equity backed IPOs have larger pre-IPO assets, indicating that these firms are larger in scale and less information asymmetric. These findings are consistent with the theory by Baron (1982). Since private equity tend to invest in firms that are older in age and larger in scale, it helps to reduce or even eliminate the information asymmetry between the company and the public, and the incentive for the issuers to underprice is reduced.

IV. Conclusion

This paper attempts to tackle the impact of private equity and venture capital on the IPO underpricing phenomenon. With the data set of 76 Chinese companies listed on the U.S. exchanges, it is found that venture capital does have a positive impact on the IPO underpricing, while private equity does not show a significant influence on the underpricing. When compare the difference of private equity and venture capital, it shows that the positive impact of the venture capital on underpricing is significantly higher than the impact of private equity with a 10% significant level. These findings help us to reexamine some previous theories mentioned in the chapter II.

Firstly, Megginson and Weiss (1991) believe that the certification effect of the venture capital backed IPOs help to decrease the information asymmetry and hence reduce the IPO underpricing. Private equity firms, which are often larger in scale and higher profile than venture capital firms, can work as a third party to help verify the true value of the IPO as well. Hence, the private equity backed IPOs do not show a significant level of underpricing. Secondly, the positive effect of venture capital on IPO underpricing in a way prove the “grandstanding” hypothesis by Gompers (1996), but it does not apply to the private equity firms as underpricing is not significant in private equity backed companies.

As mentioned in section 5.1, one shortcoming of this analysis is that the control variables in the regression model are not significant, which results in relatively larger standard error of this model and improper estimation of the corresponding coefficients. As a result, it is strongly recommend to lead in some other relevant factors and perform the regression again.

In conclusion, these results indicate that the underpricing phenomenon is in part related to outside investors of the company, but the impact is rather small and depends on the characteristics of the investor.

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Appendix

Appendix 1. International Comparison of First-day IPO Returns