Underpricing of Private Equity and Venture Capital backed IPOs in the BRICS Countries.

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Underpricing of Private Equity and Venture Capital backed

IPOs in the BRICS Countries.

Master Thesis IBM/IFM

ABSTRACT

Over the last decade, the BRICS countries proved to be an interesting environment for Private Equity and Venture Capital firms. Both types of firms aim at enhancing the value of their

portfolio by improving the corporate governance, financial structure and operational performance of the portfolio firms, in order to divest them at a profit. As IPOs are the most profitable divestment strategy for these firms, it is relevant to study the initial performance of

Private Equity and Venture Capital backed IPOs. This research finds PE backed IPOs to experience significantly higher underpricing than Not backed IPOs, whilst VC backed IPOs

experienced significantly lower underpricing than Not backed IPOs. This is a Chinese phenomenon. In all other BRICS nations PE backed IPOs experience lower average underpricing than Not backed IPOs. These results are, however, only significant for India,

indicating that PE backing serves as a medium of certification in India.

Keywords: IPO, Underpricing, Private Equity, Venture Capital, BRICS, Grandstanding, Certification. JEL: G15, G12, G24, G32, G34.

Student name: Bas van Munster

Universities: Rijksuniversiteit Groningen/Uppsala University

Student number: s2066696

Course name: Master IBM/IFM

Department: Faculty of Economics and Business

Supervisor: Dr. J. von Eije

Second supervisor: Dr. H. Gonenc

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1. INTRODUCTION

During last decades Private Equity (PE) and Venture Capital (VC) funds gained an increasingly important role in the IPO market. In the most developed PE market, in the United States, 50% of all IPOs between 1980 and 2010 have been backed by some form of Private Equity (Ritter, 2011). PE and VC investments were initially a U.S. phenomenon, however over the last decades PE and VC fund flows have internationalized, with China becoming the largest net importer of PE capital (Aizenman & Kendall, 2008).

Previously the terms Private Equity and Venture Capital were used interchangeably, however recently a consensus about the definitions of PE and VC can be observed in literature. This article will be based upon the definitions proposed by Cumming & Johan (2009). They define Venture Capital as “risk capital for small private entrepreneurial firms” whilst describing Private Equity as “encompassing a broader array of investors, entrepreneurial firms and transactions, including later-stage investments, turnaround investments, and buyout transactions” (Cumming & Johan, 2009, p. IX), usually conducting highly leveraged acquisitions of more mature companies, in order to maximize the return on equity invested.

These definitions are supported by scholar like Hadrys, Mietzner, & Schiereck (2010) and Levis (2011), which were among the first to specifically research the differences between the short term and long run performance of PE backed, VC backed and Not backed IPOs. Levis (2011) identifies significantly lower underpricing for PE backed IPOs compared to their VC counterparts, whilst VC backed IPOs are significantly lower underpriced compared to Not backed IPOs.

Although PE and VC funds target different companies, they have rather similar operating strategies. They both attract funding from institutional investors (e.g. pensions funds and insurance firms), which is being leveraged with debt (e.g. bank loans/bonds) in order to acquire a portfolio of companies (Heed, 2010). PE/VC funds aim to enhance the value of their portfolio, by optimizing the internal processes and financial structures of their portfolio firms, in order to divest these firms after a number of years against a substantial profit (Povaly, 2006; Cumming & Johan, 2010).

Research has identified IPOs as the most profitable way for PE/VC funds to divest their investments (Gompers, 1996; Gompers & Lerner, 2001; Neus & Walz, 2005; Da Rin, Hellmann, & Puri, 2011). As PE/VC backed IPOs constitute a continuously rising share of the IPO market, it is important for investors to have an idea of the returns of these PE/VC backed shares. As of today, substantial effort has been put in place to create a better understanding of the long-run returns of PE and VC backed IPOs. The concept of initial returns or underpricing on PE/VC backed IPOs has however not been as thoroughly researched.

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between the expected underpricing of an initial public offering and the ex-ante uncertainty about its value”. However explanations for underpricing differ among scholars and so do the theories explaining the effect of PE/VC backing on the underpricing of IPOs. Current literature proposes two different theories with regard to underpricing of PE/VC backed IPOs.

1. The certification theory is based on the idea that PE/VC backing certifies the value assigned

to the IPO by the underwriting syndicate, by putting the reputation of the PE/VC-fund at stake (Megginson & Weiss, 1991). As according to Beatty & Ritter (1986) underpricing is a compensation for the ex-ante uncertainty of an IPO, and as certification by a PE/VC-fund is thought to reduce this uncertainty, investors are expected to demand less underpricing from a PE/VC-backed IPO.

2. The grandstanding theory, developed by Gompers (1996) contradicts the certification theory.

The grandstanding theory implies that especially young PE/VC-funds desire to take their portfolio companies public in an early stage, which comprises more risk for investors. According to the grandstanding theory, these young PE/VC-funds desire early stage IPOs for two reasons. First of all, to gain the favour of investors which invest in the IPO, by transferring wealth to them, in order to ease future IPOs initiated by the PE/VC-fund. Second is to show potential investors in the PE/VC-fund, the funds capability of profitably liquidating portfolio companies, which should enable them to raise capital for new funds and secure their future existence (Lee & Wahal, 2004). As these early stage IPOs comprise an increased ex-ante risk, investors are expected to require a higher return and thus a higher IPO underpricing.

These theories were however developed and tested, based on a sample consisting mainly of companies from the US and other developed economies (Povaly, 2006). However literature still lacks a deeper understanding of underpricing in emerging markets and the relation between IPO underpricing and PE/VC fund involvement with IPOs in emerging markets. According to Hoskisson, Eden, Lau, & Wright (2000), “emerging economies can be defined based on two criteria: a rapid pace of economic development, and government policies favouring economic liberalization and the adoption of a free-market system”. As a substantial and growing percentage of IPOs worldwide occur in emerging markets, whilst simultaneously a significant and increasing stream of PE/VC funds flow to these markets (Klonowski, 2011; Pracianoy & Cigerza, 2007), a deeper understanding of underpricing of PE/VC backed IPOs in emerging markets is essential.

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BRIC nations account for 40% of the world's population, 25% of its landmass, and most importantly, 15% of the world's GDP” (Klonowski, 2011, p. 24). South Africa has been added to the ‘BRIC’ nations, as it has been common practice since 2010, this being the result of its rapid economic growth and status as an emerging market (Gammeltoft, 2008; Matthew, 2012).

Based on the ‘certification theory’ PE/VC backed IPOs in the BRICS countries, would endure less underpricing than their Not backed counterparts. As according to the ‘certification theory’, PE backing certifies the value of the IPO, which should reduce the agency problems due to improved corporate governance systems. One could expect the mitigating effect on underpricing, of an PE/VC backed IPO to be even stronger in a institutionally lesser developed country. This because uncertainty in institutionally lesser developed nations is higher than in more institutionally developed environments. PE/VC fund backing of an IPO should reduce this uncertainty, due to a reduction of the agency problem, improved corporate governance and a certification of the value assigned to an IPO by investment underwriting syndicate.

Based on the ‘grandstanding theory’ one would on the contrary expect a higher underpricing of PE/VC backed IPOs, as especially young funds are tempted to get their portfolio companies public in an early stage. In institutionally lesser developed countries one could argue to expect even higher underpricing of these IPOs, as again these environments comprise more risk than more developed nations.

The conflicting expected effect of PE/VC backing on IPO underpricing resulted in the following research question:

Are Private Equity and Venture Capital backed IPOs in the BRICS countries more or less underpriced than those which are Not backed?

By answering this research question, this paper contributes to a better understanding of PE/VC backing of IPOs in emerging economies, and the effect PE/VC backing has on IPO underpricing. Hereby testing if in the BRICS nations the ‘grandstanding theory’ or the ‘certification theory’ plays a more important role in the underpricing of PE/VC backed IPOs. Additionally this paper will aim to identify if those factors influencing underpricing in developed economies, have the same effect on underpricing of IPOs in emerging economies. It is important to further investigate the effects of PE backing of IPOs in emerging markets, since a significant and growing number of emerging market IPOs is PE/VC backed, whilst current literature about this topic is very thin and usually limited to specific countries like South Africa (Alli, Subrahmanyam, & Gleason, 2010), China (Chan, Wang, & Wei, 2004) and Brazil (Saito & Maciel, 2006).

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make these markets increasingly interesting for both investors and PE-funds. As a deeper understanding reduces uncertainty, stock market investors will be capable of making better decisions with regard to PE/VC backed IPOs in emerging markets. Secondly, shareholders of private companies evaluating the possibility of PE/VC funding will be more willing to deal with PE/VC funds, if it is proven that PE/VC backed IPOs experience less underpricing than Not backed IPOs. As this results in a reduced amount of money being left on the table, by the owners.

Using a sample of 1298 IPOs by companies from the BRICS nations, which consists of Private Equity backed, Venture Capital backed and Not backed issues between 2000-2012, this paper demonstrates that (1) VC backed IPOs from the BRICS countries are on average significantly less underpriced than Not backed and PE backed IPOs, (2) PE backed IPOs from the BRICS countries are on average significantly higher underpriced than Not backed and VC backed IPOs. (3) These findings are, however, fully attributable to the large number of Chinese IPOs, as higher underpricing of PE backed IPOs compared to Not backed IPOs is proven to be a Chinese phenomenon. (4) In all other BRICS nations PE backed IPOs face lower average underpricing than Not backed IPOs, and significantly so for the Indian sample. These are interesting findings, as one would expect based on the ‘certification theory’ to see lower underpricing levels for both PE and VC backed IPOs, whilst on the contrary the ‘grandstanding theory’ argues for higher underpricing of both PE and VC backed IPOs.

This paper will proceed as follows; section two consists of a review of current literature on IPOs in the BRICS countries and the effect of PE/VC backing on IPO underpricing. Section three outlines the research methodology consisting of a sample description, variables description and the research design. Section four will present the empirical results and findings. Section five presents the conclusions and will include a discussion of the results and directions for further research.

2. LITERATURE REVIEW

Private Equity and Venture Capital in emerging markets

Over the last decades Private Equity and Venture Capital funds have proven to be an increasingly important phenomenon. Total funds raised by U.S. PE/VC funds have continued to increase from $148 billion during 1980-1995, to $668 billion raised during 1996-2004, reaching $794 billion during the PE/VC boom period between 2005-2008 (Harris, Jenkinson, & Kaplan, 2012). Simultaneously PE/VC backed IPOs became of substantial and increasing importance to the IPO market. Between 1980 and 2012 50% of all IPOs in the United States, have been backed by some form of Private Equity (Ritter, 2011).

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liquid capital markets, a favourable taxation system, investor protection and corporate governance mechanisms, a favourable human and social environment with substantial amounts of human capital, an entrepreneurial culture, and market opportunities like innovation and the development of high-tech industries.

Especially developed economies meet these requirements, and as a result PE-fund activity expanded among these nations during the last two decades. The result is a substantial PE activity in for example The United Kingdom, Australia, Sweden, The Netherlands, Germany and France. However economic growth in these nations has stagnated due to the 2007-2008 financial crises and the current European sovereign debt crisis. As an answer to this development a substantial number of PE-funds shifted part of their attention to emerging markets like the BRICS nations, which are not only characterized by significant economic growth, but also by increased investor protection (Woeller, 2012). Simultaneously a large number of new funds have been established in these countries, funded by both foreign and local capital.

However, although emerging markets are attractive to PE-funds due to their economic growth, investing in these markets is still part of the learning curve for most PE-funds, which have to customize to operating in emerging economies. As Klonowski (2011) states, “The true race among global Private Equity players is to establish their local footprint, develop local contacts, nurture local relationships, gain operating experience, learn local customs and the local business climate, and develop a strong local pool of investment professionals ahead of more prosperous times in the future”. Research into PE activity in emerging markets is in general positive. Research by Minardi, Ferrari, & AraújoTavares (2012) into 108 Brazilian IPOs confirms that PE investments has a positive relation to post IPO performance, but only for IPOs which were issued in the 2004–2006 period. Whilst research by Agmon & Avi (2009) found that PE investments have a positive effect on the international expansion of companies from emerging economies and supports the economic growth of nations in which PE/VC funds are active. This being accomplished because PE-funds manage to take the competitive advantage of the emerging market firm global.

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IPOs

Private Equity and Venture Capital funds usually hold their investment portfolio for a limited period, generally 7 to 10 years, then divesting it before the fund closes (Povaly, 2006). During this holding period PE/VC funds aspire to create value to their portfolio by applying superior selection skills, implementing value adding activities as strategic, marketing, financial, and human resource restructuring and advice, and the provision of additional financial resources (Cumming & Johan, 2010; Manigart & Wright, 2011). Besides these activities, PE funds strive to enhance the corporate governance and control systems of their portfolio companies. These activities are supposed to create pre-divestment value, however they might also benefit the performance of the firm after it is divested by the PE fund (Filatochev, Wright, & Arberk, 2006).

There are several ways PE funds can divest their portfolio. Research by Da Rin, Hellmann, & Puri (2011) identified that the most common exit route, for PE and VC deals is the sale to another corporation, this accounts for 38% of all exits. The second most common exit route is secondary buyouts which accounts for 24%, and has increased in importance over the last decade. In contrast, Initial Public Offerings (IPOs) on the contrary, only account for 13% of exits and this exit type seems to have decreased in popularity over time. Various researchers however, identified IPOs as the most profitable way for PE/VC funds to divest their investments (Gompers, 1996; Gompers & Lerner, 2001; Neus & Walz, 2005; Da Rin, Hellmann, & Puri, 2011). As a result, the potential of an IPO plays an important role in PE/VC investment decision making process (Black & Gilson, 1998).

An initial public offering (IPO) is the offering of a company’s shares to the public for the first time resulting in a listing on a stock exchange, this process is also known ‘going public’. Companies have various reasons to go public. Research by Brau & Fawcett (2006) identified that (1) the primary motivation for going public is raising money in order to facilitate acquisitions. Other reasons identified by IPO literature were (2) ‘reducing the cost of capital’, which is in line with the (Modigliani & Miller, 1963) theorem, (3) ‘strategic motivations’ as a first mover advantage, prestige and a broader ownership base. The last important motivation for a firm to conduct and IPO, is (4) “the opportunity for insiders to cash out” (Brau & Fawcett, 2006, p. 406). Obviously the opportunity to cash out is the most important reason for a PE backed company to conduct and IPO, since the PE-fund is expected to divest its portfolio and return the profits to the funds participants (Black & Gilson, 1998).

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reached a certain point in their business growth cycle, a point which several firms in one market can reach simultaneously due to market developments. Third, research by Lowery & Schwert (2002) identified that a period of positive initial performance of IPOs creates a surge in the amount of IPOs in the market, as companies with the ambition of going public, want to reap the benefits of this bull market.

Underpricing

The classical definition of underpricing or initial performance is the percentage of difference between the closing price of a share on its first trading day and the initial offer price. Underpricing hereby transfers wealth from selling shareholders to investors, by offering the shares at a discount of their market value. According to the laws of supply and demand, the share price of IPOs should be driven towards its intrinsic value within one trading day in an efficient market.

The offering price is the price at which shares are offered to the public by an underwriter or underwriting syndicate. The offering price is influenced by several factors such as the company’s current, past and forecasted performance. Besides being influenced by company specific information, also the macroeconomic conditions, stock market trends and overall investor confidence and demand for the share play a role in establishing the offer price (Benveniste & Spindt, 1989).

In the 1970s and 1980s the underpricing of initial public offerings was being irrefutable proved (Ibbotson, 1975; Ibbotson & Jaffe, 1975; Ritter, 1984; Rock, 1986). As Ibbotson & Jaffe (1975) were unable to account for their findings, of owners leaving money on the table for investors, they termed the phenomenon a ‘mystery’. Beatty & Ritter (1986, p. 213) argued that there is “an equilibrium relation between the expected underpricing of an initial public offering and the ex-ante uncertainty about its value”. Stating that “an investment banker who ‘cheats’ on this underpricing equilibrium will lose either potential investors (if it doesn't underprice enough) or issuers (if it underprices too much), and thus forfeit the value of its reputation capital” (Beatty & Ritter, 1986, p. 213). Interestingly, underpricing has strongly fluctuated over time in the U.S. Whilst in the 1980s the average first day returns was 7%, it almost doubled to 15% during 1990-1998. During the internet bubble of 1999-2000 the average first day return jumped to 65%, whilst after this bubble it stagnated to 12% from 2001-2003 (Loughran & Ritter, 2004).

Reasons for IPO underpricing

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in a perspective, Ritter & Welch (2002) found that IPOs had an average first day return of 18.8% whilst the comparable daily market return was only 0.05 per cent on average.

When Ibbotson (1975) first proved the concept of underpricing, he offered a list of possible explanations for the phenomena. This list was later explored and supplemented by other authors. Extensive research into current literature by Brau & Fawcett (2006) identified 8 subgroups in the numerous explanations for underpricing. It is found that both the underwriting syndicate and the issuing firm have motivations to underprice the offering, at the benefit of investors in the new issue.

First of all, underpricing exists due to uncertainty regarding the ex-ante value of the IPO. The desired compensation for this uncertainty is being increased by the asymmetric information between the issuing firm and potential investors. Compensation for this asymmetry of information results in an offer price which is lower than the estimated future market price (Alli, Subrahmanyam, & Gleason, 2010). According to Beatty & Ritter (1986) “there is an equilibrium relation between the expected underpricing of an initial public offering and the ex-ante uncertainty about its value”, which is being enforced by the IPO underwriters. An implication of this finding is that the issuing firm has an incentive to voluntary disclose information in order to reduce the ex-ante uncertainty and thus the desired underpricing (Beatty & Ritter, 1986). Research by Hopp & Dreher (2013) argues that high-quality firms use underpricing to signal their high-quality, by being able to afford underpricing of their IPO, whilst making up for this incurred costs during a seasoned offering in the future.

Second, there is an information asymmetry between the underwriter and the issuer which could cause underpricing. Underwriters exploit this information asymmetry to underprice issues, which decreases the need for their marketing efforts and increases their popularity among the buy side (Baron & Holmstrom, 1980; Baron, 1982; Brau & Fawcett, 2006). However, underwriters which enforce to much underpricing might be penalized by potential clients, which see too much money left on the table during current issues being supervised by these underwriters.

Third, underpricing is a result of an asymmetric supply of information between informed and uninformed investors. Due to this information asymmetry, informed investors will heavily subscribe on underpriced shares, whilst not subscribing on IPOs baring a low underpricing or overpricing. As a result uninformed investors will receive a larger allotment of shares which constitute limited underpricing or overpricing. This phenomena is referred to by Beatty & Ritter (1986) as a “winner’s curse”, they state ´if one is allocated the requested number of shares, one can expect that the initial return will be less than average´. According to Rock (1986) and Brau & Fawcett (2006) IPOs are underpriced in order to “compensate uninformed outside investors for the risk that they will end up with the less successful IPOs”.

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Ljungqvist (2001) argue that underpricing of shares comes with cost savings at other marketing techniques. Research by Boehmer & Fishe (2001) identified that underpricing increases the trading volume of the equity after the offering, which is profitable to the underwriters when they subsequently are the market makers for the IPO firm.

Fifth, research suggests that underwriters underprice IPOs to protect their reputation and avoid future litigations from investors, due to possible overpricing based on inaccurate information or too optimistic forecasting (Ibbotson, 1975; Drake & Vetsuypens, 1993). Brau & Fawcett (2006) found that CFOs experience an aspiration of underwriters to obtain goodwill among institutional investors as the second-most important reason for underpricing.

Sixth, underpricing helps to broaden the ownership base of the company going public, because more investors will be encouraged to commit due diligence and subsequently buy the shares. Issuing firms favour dispersed ownership, since it increases liquidity and aftermarket trading (Booth & Chua, 1996). Dispersed ownership also helps existing owners to retain control over their firms and entrench the existing management, by circumventing the creation of blockholders (Brennan & Franks, 1997).

Seventh, is a somewhat unique explanation being proposed by Loughran & Ritter (2002). They argue that selling shareholders are satisfied with their new-found wealth. According to the prospect theory, this results in selling shareholders which not significantly concerned with the underpricing of their IPO (Brau & Fawcett, 2006).

The eighth and final motivation for underpricing is to facilitate questionable practices. Ljungqvist and Wilhelm (2003) argue that underpricing is used to enrich family, friends and employees of the selling shareholders, by using a directed share program, which will profit from the initial return of the IPO. Whilst Maynard (2002) and Griffith (2004) suggest that underwriters use underpricing to enrich management of potential clients, in order to attract more business. This was done through the, now prohibited process of ‘spinning’, whereby executives of potential clients get allocated underpriced shares by the investment bank underwriting the IPO.

The effectiveness of financial systems and IPO underpricing

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with a relatively long operating and profitability history. They also argue that countries which reduce regulatory intervention and leave the setting of offering prices to the market should face less short-run underpricing (Loughran, Ritter, & Rydqvist, 1994 Updated 2011).

Hopp & Dreher (2013) complement this research by focusing on the effectiveness of nations’ financial systems, concluding that “better investor protection and better institutional environments reduce the perceived risk of investing, and attenuate the problem of asymmetric information, thereby causing lower underpricing across countries”. Hopp & Dreher (2013) also state that a regulatory environment which demands disclosure reduces the uncertainty regarding the IPO and thus reduces the required level of underpricing. Ljungqvist (2006) focuses on the level of development of financial institutions and the importance of experienced underwriters, stating that experienced underwriters find it easier to gain investors trust, due to their reputation, which should have a diminishing effect on the level of underpricing.

During the last decades emerging economies have experienced a period of institutional development, economic reform and a transition to a free-market economy. Simultaneously the legal infrastructure has been reformed, improving investor protection, and creating a more favourable environment for PE investments. However, although the BRICS countries made great progress reforming their economies, their institutional environment are not as favourable to investors as those of developed economies due to limited investor protection and corporate governance systems (Groh, Lieser, & Liechtenstein, 2010; Klonowski, 2011; Leeds & Sunderland, 2005), which creates an investment risk and uncertainty for Private Equity funds (Klonowski, 2011). According to Ahlstrom & Bruton (2006), emerging economies like China and Russia are known for their volatility, unpredictability and underdeveloped institutional environments. As a result one could expect relatively high underpricing of IPOs in the BRICS economies.

A detailed description of the institutional development, market characteristics, IPOs and IPO underpricing in the BRICS nations can be found in Appendix 1. This information can be used to gain a deeper understanding into the difference in IPO underpricing in the BRICS nations.

The effect of PE/VC backing on the underpricing of IPOs

The effect of PE/VC-backing on the underpricing of IPOs has intrigued scholars over the last two decades. Research into this relation resulted in two prevailing, but contradicting theories, the certification theory and the grandstanding theory. Up until now, research has found evidence for both theories and one has not ruled out the other.

The certification theory; The foundation for the certification theory is based on pioneering

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stronger PE/VC-fund interference, measured by the variables of percentage ownership, duration of board service, the number of PE-funds having a share in the company undergoing the IPO and the age of the PE/VC-fund, reduces IPO underpricing. This being the result of a reduction of the agency problem. Research by Filatochev, Wright, & Arberk (2006) contributed that the tightened post-investment governance and monitoring activities of portfolio companies by PE/VC funds creates additional long term value. Florian & Simsek (2007) add that due to thorough due diligence prior to their investment and the monitoring role which PE-funds play, they will in general be capable of accurately pricing the IPO and thus be able to avert overpricing. Based on the research by Barry, Muscarella, Peavy, & Vetsuypens (1990), Megginson & Weiss (1991) develop the ‘’, which provided a clear explanation of why PE/VC-funds would want to avert overpricing. The certification theory implies that PE/VC backing can certify the value assigned to the enterprise by the underwriting syndicate, since the ‘reputational capital’ of the PE fund is at risk (e.g., in case a PE/VC backed IPO would be overpriced, investors will be reluctant to invest in future IPOs backed by the PE/VC-fund). Theoretically the ‘certification’ of the offer price of an IPO by a PE/VC-fund should result in a reduced risk faced by investors. As underpricing is a compensation for ex-ante uncertainty of an IPO (Rock, 1986), less underpricing of PE/VC backed IPOs will be required to compensate the investor for the risk taken while investing in the IPO due to the certification by the PE/VC-fund (Megginson & Weiss, 1991; Daily, Certo, Dalton, & Roengpitya, 2003; Krishnan, Ivanov, Masulis, & Singh, 2011; Fenn, Liang, & Prowse, 1997).

The grandstanding theory developed by Gompers (1996) contradicts the certification theory,

implying that especially young PE/VC funds are likely to ‘grandstand’ by taking their portfolio companies public in an earlier stage, comprising more investor risk (Gompers, 1996; Gompers & Lerner, 1997; Gompers & Lerner, 2001; Lee & Wahal, 2004). This in in order to establish a reputation as a high quality seller, in order to be able to successfully raise capital for new funds, whilst accepting higher underpricing than IPOs backed by more mature PE/VC-funds (Gompers, 1996). The pressure on PE/VC-firms to establish a reputation of being capable of taking portfolio companies public is essential, as the PE/VC-funds they manage typically have a finite life of approximately ten years. In order to guarantee its existence PE/VC-firms will need to raise capital in order to establish new funds. Gompers (1996) gives examples of PE/VC-firms which were unable to raise capital for new funds, up until they took a portfolio company public. Since establishing a reputation is so important, Gompers (1996) argues that especially young PE/VC-firms are willing to accept the cost of disproportionate underpricing an IPO, since taking a portfolio company public signals quality. Gompers (1996) and Lee & Wahal (2004) argue that more established PE-funds on the contrary have less problems raising capital and will thus take their portfolio companies public at more optimal moments.

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era’s in which these companies have been taken public and on which these hypothesis have been tested should also be taken into account.1

Levis (2011) was the first to distinguish among PE and VC backing, and found significant differences in the level of underpricing and IPO characteristics. Levis (2011) identified based on a sample of 1,595 UK IPOs, PE-backed IPOs to be more profitable, larger in terms of assets and sales and experiencing lower underpricing than their VC and Not backed counterparts. VC backed IPOs were identified to be larger than Not backed, and smaller than PE backed IPOs in terms of asset size, sales and profitability. Underpricing was identified to be highest for Not backed IPOs, average for VC backed IPOs and lowest for PE backed IPOs.

3. METHODOLOGY

Sample

A wide range of markets can be classified as emerging markets. However due to limited resources the focus of this research will be on the BRICS countries, Brazil, Russia, India, China and South Africa. Due to the rather large size of these economies and rapid economic growth of these nations, which results in a substantial number of IPOs, a sufficient sample is available.

The data are obtained from the Thomson One Banker database (T1B), which comprehensively gathers information derived from annual reports and prospectuses. T1B is frequently used for research on IPO underpricing (Loughran & Ritter, Why Has IPO Underpricing Changed Over Time?, 2004; Bruton, Chahine, & Filatotchev, 2009; Liu & Ritter, 2011). Since this research is focused on the relation between underpricing and PE-backing of IPOs in emerging markets, a list was compiled with all the IPOs in the BRICS countries between January 1, 2000 and December 31, 2012, of which the underpricing2 is identified by T1B3. This resulted in a list of 1972 IPOs, which is shown in Table 1, panel A. The data regarding the control variables used should normally be present in IPO prospectuses

1_{Literature about Private Equity fund activities is in general positive. Most of the empirical research in this field}

identified better long-run post-investment growth and performance for PE backed IPOs than for those IPOs which were not Private Equity backed (Manigart & Wright, 2011; Minardi, Ferrari, & AraújoTavares, 2012; Levis, 2011; Van Frederikslust & Van der Geest, 2001; Brav & Gompers, 1997). This being the result of the value adding activities which lead to professionalization of the portfolio companies (Cumming & Johan, 2010; Colombo & Grilli, 2010), selection skills of the investment managers (Baum & Silverman, 2004), and an improved access to financial resources (Vanacker & Manigart, 2010).

2_{Underpricing is calculated as ((Closing price first trading date – Offer Price) / Offer price) *100}

3_{For a number of IPOs T1B identified the Closing price of the first trading date and the offer price, however the}

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and annual reports, however for 674 IPOs the T1B database was not comprehensive and these observations have therefore been deleted, resulting in a final sample of 1298 IPOs4.

*** Insert Table 1 about here ***

As can be seen in panel B, the majority of IPOs (61.94%) was in the 2009-2012 period which is interesting because during these years the financial crisis was affecting returns on stocks at a global scale. During the 2005-2008 period, which was characterized by economic growth and high underpricing, there were relatively many IPOs which were PE backed. Whilst relatively many IPOs were VC backed during the 2009-2012 period, which was characterized by relatively low underpricing. Panel C shows a total of 1178 industrial IPOs, whilst financial (87) and utility (33) IPOs were far less common. Panel D shows that the sample is strongly biased towards China, as the sample consists for 92.6% of Chinese IPOs (1202), whilst the number of Brazilian (41), Russian (14), Indian (30) and South African (11) IPOs is far smaller.

In panel E the different characteristics of the PE, VC and Not backed IPOs are studied in a greater extent. It is observed that PE backed IPOs have significantly (at the 0.05 level) larger assets than Not backed IPOs. PE backed IPOs are in this sample also larger than VC backed IPOs, however this difference is not significant. PE backed IPOs being larger than VC and Not backed is in line with current literature, as PE funds focus on large companies with stable operating cash flows, whilst VC funds participate in young entrepreneurial firms.

The debt to asset ratio of Not backed and PE backed firms is almost the same with 28% and 25% respectively. VC backed IPOs have however a debt to asset ratio of 19%, which is significantly lower than both Not backed and PE backed IPOs. This is line with literature, as VC funds invest in young entrepreneurial firms, often without a track record of stable operating cash flows, which usually have a far more risky nature than PE an Not backed companies. As increasing the debt to asset ratio would only increase the risk of bankruptcy, on can often observe low levels of debt for VC backed IPOs.

Interestingly the profitability ratio, calculated as the net income the year before the IPO divided by the assets, is almost the same across all three different groups. Research into the difference of profitability levels of PE, VC and Not backed IPOs has so far identified more stable profitability

4

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levels for PE backed IPOs, whilst a deeper understanding of the differences in profitability levels is lacking. One could however argue based on these findings, that neither PE nor VC backed IPOs provide signs of grandstanding with respect to profitability: as profitability levels are almost the same across all three groups, one could argue that PE and VC funds do not disinvest their portfolio through IPOs before their profitability levels at similar levels with Not backed IPOs.

It can be observed that both PE and VC backed IPOs significantly more often make use of a prestigious bookrunner with 43% and 35%, than Not backed IPOs 29%. PE backed IPOs are most often backed by a prestigious bookrunner, however not significantly more than VC backed IPOs.

The average holding period for this sample is 3.26 years for VC backed IPOs, whilst PE backed IPOs were held for 2.77 years on average. Although this difference is not significant, it is in line with literature, which argues that VC funds hold their investments longer in order to raise profitability levels and increase the value of their investment.

From Table 1: panel E, it can further be observed that VC backed IPOs were founded the latest, on average 1.2 years later than PE backed IPOs and 2.3 years later than Not backed IPOs. VC backed IPOs were founded significantly later than Not backed IPOs. The difference between VC and PE backed IPOs is however not significant.

Variables

Dependent Variable: Initial IPO performance

The dependent variable in this research is the initial return of the IPO, or the underpricing.

Independent Variable: PE or VC or Not backed

The independent variable will be whether an IPO firm is backed by Private Equity, by Venture Capital or Not backed at all, as indicated by the ThomsonOne database. Since the ThomsonOne database is based on the information made public in prospectuses it should contain accurate information regarding the pre-IPO ownership of the company. This method is consistent with prior research (Povaly, 2006; Katz, 2009; Aizenman & Kendall, 2008). ThomsonOne is referred to as “a comprehensive data source for deals done worldwide that includes over 30 years of historical data” by Aizenman & Kendall (2008, p. 2).

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created for ‘PE backed’, ‘VC backed’ and ‘Not backed’. The ‘Not backed’ dummy serves as the benchmark, in order to be able to test the difference between ‘VC backed’ and ‘PE backed’ firms.

Control Variables and their expected effect on IPO underpricing

A total of seven control variables were applied to control for their effect on IPO underpricing. The variables used are; Issue Date, Country of Origin, Leverage, Profitability, Company Size, Prestigious Bookrunner and industry group. These variables and their expected effect on IPO underpricing will be outlined below.

Issue Date: Research by Ljungqvist (2006) identified that IPO underpricing varies to a great

extent over time. Companies tend to go public in waves, which are named by Ritter (1991) as ‘Windows of opportunity’. These windows of opportunity have been discussed in a broad range of empirical papers (Ritter & Welch, 2002; Brau & Fawcett, 2006; Ljungqvist, 2006; Hopp & Dreher, 2013). In general more IPOs tend to occur during strong bull markets, however these IPOs also endure more underpricing than IPOs in bearish markets. In order to control for the effects of issue date on IPO underpricing, the sample has been split in 3 different issue date groups (2000-2004, 2005-2008, 2009-2012) for which the following dummy variables were created (ID0004, ID0508, ID0912). The years 2000-2004 can be seen as a recovery period from the dotcom bubble, so average underpricing is expected, whilst 2005-2008 represents a strong bull market, thus high underpricing is expected, whilst 2009-2012 represent the US mortgage crisis and the European financial crisis, leading to low expected underpricing. The 2000-2004 timeframe will be used as the benchmark in the regression analysis, as it’s interesting to compare this period of economic recovery with a period of strong economic growth (2005-2008) and a period of international financial downturn (2009-2012). Expected effect on IPO underpricing: 2005-2008(+), 2008-2012(-).

Country of Origin: Various scholars studied the international differences in underpricing of

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South-Africa. For each country a dummy is created. China will be used as a benchmark in the regression analysis, as it is the dominant country with most IPOs in the sample, and as research has identified China as the country with highest IPO underpricing. Expected effect on IPO underpricing: Brazil, Russia, India, South Africa (-).

Leverage: Leverage is based on the debt to asset ratio, which is calculated by dividing the debt

by the assets. The general consensus is that high leveraged firms are a sign of quality, as “debt (with the threat of bankruptcy) imposes a hard budget constraint on managers, limits management's control over the firm’s cash flows, and raises the risk of firm's undiversified stock ownership” (Su, 1999, p. 43; Kim , Pukthuanthong-Le, & Walker, 2008). However Su (1999) found that for Chinese IPOs this theory was not applicable, as high leverage was a sign of a failing firm, being kept from bankruptcy with cheap state borrowed capital. It is however doubtful if these companies would initiate an IPO, as this would further increase the risk of bankruptcy. Expected effect on IPO underpricing: Leverage (-).

Profitability: Profitability is measured by dividing the net income with the total assets.

Research into the effect of profitability is relatively thin. Purnanandam & Swaminathan (2007) found that firms which are overvalued are usually “characterized by lower initial sales and EBITDA profit margins”. They find that very optimistic future forecasts cause this overpricing. Based on this theory, one would expect underpricing of firms with a high profitability ratio. However, one could also argue that firms which high profitability ratio’s comprise less of a risk, and therefore require less underpricing, as Teoh, Welch, & Wong (1998) argue that a high current profitability is a signal of future strong performance. Based on the latter explanation, the expected effect on IPO underpricing: Profitability (-).

Company Size: In order to measure the size of the IPO company, the LN of the firm’s assets is

used. This because the range of the sample firm’s assets is very large. Based on the ex-ante uncertainty theorem by Ritter (1984), one would expect firm size to act as an uncertainty reducing proxy. As the firm has a substantial size, it can be expected to have a relatively long and profitable operating history and thus comprise reduced ex-ante uncertainty (Loughran, Ritter, & Rydqvist, 1994 Updated 2011), whilst the value of the firm’s assets certify a part of the value assigned to the IPO company (Giudici & Paleari, 1999). It is thus expected that the higher the LN of the firm’s asserts, the lower the underpricing. Expected effect on IPO underpricing: Company size (-).

Prestigious Bookrunner: IPOs being underwritten by a top-5 most used bookrunners in their

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Industry Group: Relatively little is known about the effect of industry groups on underpricing.

Mauer & Senbet (1992) argue that the main difference between the underpricing per industry group, results from the difference in operating history. They argue that especially young high-tech companies and entrepreneurial firms, which often do not have a positive income history, face significant underpricing. Whilst for example financial institutions usually have a long and profitable operating history, reducing uncertainty and thus required underpricing. On the other hand, one could argue for lower expected underpricing for industrial and utility firms due to their large fixed assets base. The sample is divided in three industry groups; ‘Industrial’, ‘Finance’, and ‘Utility’. As more detailed industry information is not available, it is impossible to define expected effect on IPO underpricing based on current literature. For each industry group a dummy is created. Industrial will be used as the benchmark in the regression, as it is the largest group.

Research Design

In order to answer the research question, the research is divided into five steps.

1. The first step is to calculate the individual IPO underpricing.

In order to calculate the IPOunderpricing , the following equation is used:

1 = − ,

, × 100

In equation (1) the IPO underpricing , which is the return of a firm i on its first trading day t, is

calculated by the difference between the offering price _, and the first closing price as a

percentage of the offering price. This method is consistent with prior research into IPO underpricing (Ibbotson, 1975; Rock, 1986; Barry, Muscarella, Peavy, & Vetsuypens, 1990; Bruton, Chahine, & Filatotchev, 2009)5.

.

2. The second step is to test whether the conditions for applying Ordinary Least Square (OLS) techniques apply.

5_{Another method to calculate IPO underpricing is the Average Abnormal Return (AAR), which is calculated as}

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The OLS estimator is consistent when the errors are serially uncorrelated, homoscedastic and when there is no perfect multicollinearity. Further a normal distribution of the errors is required. The descriptive statistics which can be found in appendix 2, demonstrate a non-normal distribution of the initial returns. However, when a substantially large sample is applied the abnormal distribution of the initial returns should no longer be seen as a problem (Lumley, Diehr, Emerson, & Chen, 2002; Kuzma & Bohnenblust, 2005). Lumley, Diehr, Emerson, & Chen(2002) show based on simulations, that even extreme skewness is mitigated with sample sizes of 500. As this research is based on a relatively large sample of N=1298, we consider that use of the OLS model is valid .

Lumley, Diehr, Emerson, & Chen (2002) further point out the importance of homogeneity of errors variance. The condition of homoscedasticity, is according to MacKinlay (1997) unrealistic to assume for event studies. Homoscedasticity is however guaranteed by applying White’s heteroskedasticity-consistent standard errors estimator during the regressions, as proposed by White (1980).

The test for multicollinearity is twofold, both the correlation matrix and the Variance Inflation Factor (VIF) are employed. From the correlation matrix which can be found in appendix 3, we can see that the dummies ‘Not backed’ and ‘VC backed’, ‘ID0508’ and ‘ID0912’ (issue date 2005-2008 and issue date 2009-2012) and, ‘Industrial’ and ‘Financial’ are relatively negatively correlated. However when examining the Centered Variance inflation Factor (VIF) scores, to be found in appendix 4, it is found that multicollinearity among the control variables is relatively low. None exceeds the critical threshold of 10 provided by Gross (2003) for the Centered VIF, and neither the threshold of 4 provided by Kutner, Nachtsheim, Neter, & Li (2004) as an indication for moderate multicollinearity. Correcting for multicollinearity is therefore deemed unnecessary. Finally it should be noted that as the sample is based on event studies and not on serial data, the condition of serially uncorrelated data is not violated.

3. The third step is to test whether the underpricing of PE and VC backed IPOs differs significantly from Not backed IPOs.

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the ANOVA when comparing the means of non-normal distributed samples, since it is based on measuring the medians instead of the means.

Second, an ANOVA Post Hoc analysis is carried out using the Games-Howell test, in order to identify if the means of underpricing differs significantly among each of the specific samples of PE/VC and Not backed IPOs. The Games-Howell test is recommended by Toothaker (1993) as it is robust for unequal variances and unequal sample sizes. The results of the ANOVA Post Hoc analysis using the Games-Howell test can be found in column 4 and 5 of Table 2.

4. Fourth, a testable model is build consisting of dependent, independent and control variables on which Ordinary Least Squares (OLS) regressions can be conducted. This in order to analyse the relationship between the degree of underpricing, PE and VC backing and the various control variables.

The following regression model is created in order to answer the research question:

= + ∑*_+,$#_$%& '( ) + ∑_+,$* #_*-../ 0( + ∑4_+,$#₁23/ & + ∑*_+,$#₄- /. &5 3/ + #₆7 8 ( + #₉ 3: (; < & +

#₌23 ( &> ? + #_@ . '33) / + A

• Underpricing = IPO underpricing

• TypeBacked = dummy proxy for backing type effects. Here Not backed is chosen as the benchmark. Dummy 1= PE backed. Dummy 2 = VC backed. As only one ‘TypeBacked’ is applicable per IPO, the two remaining options are identified with a ’0’.

• IssueDate = dummy proxy for issue date effects. Here ID0004 (issue date between 2000-2004) is chosen as the benchmark. Dummy 1= ID0508. Dummy 2 = ID0912. As only one ‘IssueDate’ is applicable per IPO, the two remaining options are identified with a ’0’.

• CountryOrigin = dummy proxy for country of origin effects. Here China is chosen as the benchmark. Dummy 1= Brazil. Dummy 2 = Russia. Dummy 3 = India. Dummy 4 = South Africa. As only one ‘CountryOrigin’ is applicable per IPO, the four remaining options are identified with a ’0’.

• IndustryGroup = dummy proxy for industry group effects. Here Industrial is chosen as the benchmark. Dummy 1= Financial. Dummy 2 = Utility. As only one ‘IndustryGroup’ is applicable per IPO, the two remaining options are identified with a ’0’.

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• Profitability = the companies profitability at the moment of the IPO, calculated by dividing the net income by the total assets.

• CompanySize = the companies size at the moment of the IPO. Based on the natural log (LN) of the assets.

• PrestigeBookrunner = dummy proxy for prestigious bookrunner effects indicating if the IPO had a prestigious bookrunner: Dummy 1 = the observation had a prestigious bookrunner. Dummy 0 = the observation did not have a prestigious bookrunner.

• A = Disturbance term

• = Initial Public Offering indicator

5. The fifth step is to test the model based on ordinary least square regressions.

The previously described model which is based on the dependent variable ‘Underpricing’, the independent variables PE/VC/Not backed dummies, and 7 control variables will be tested by running a regression using the White’s heteroskedasticity consistent standard errors and covariance. A total of three different regressions will be carried out. Regression 1: Leaves out VC backed IPOs, testing the model by comparing PE backed and Not backed IPOs. Regression 2: leaves out PE backed IPOs, testing the model by comparing VC and Not backed IPOs. Regression 3: Will be based on the previously mentioned model, testing it by including PE, VC and Not backed IPOs. The regression results can be found in Table 3.

6. The sixth and final step is to test for the robustness of the model. In order to do so, five more regressions are run based on the following techniques:

• Dummy Outliers: In order to eliminate the effect of outliers in the sample, the previous three regressions will be run again using a dummy to identify IPO underpricing outliers. This dummy identifies IPO underpricing outliers, which outline more than 2 times the STD. Mean = 49.1% STD = 73.1%, STD 2x = 146.3% so a maximum of 195.4% and a minimum of -97.2% border. A total of 59 observations were identified as extreme outliers. Of these 59 outliers, 14 are PE backed, 2 are VC backed and 43 are Not backed. All outliers are above the maximum of 195.4, ranging from 195.7% to 570.8% underpricing. The results of Robustness test regressions 1- 3 can be found in Table 4.

• Exclusion of China: The sample is highly skewed towards China, with 1202 Chinese

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second excluding both the Chinese observations as well as significant outliers, based on the above mentioned technique. In the sample excluding the Chinese observations, only one significant outlier, an Indian Not backed IPO was discovered. The results of Robustness test regressions excluding China can be found in Table 5.

4. RESULTS

Based on the One Way ANOVA and Kruskal Wallis analysis, Table 2, one can observe significant difference between the underpricing of PE, VC and Not backed IPOs. Whilst a underpricing of 49% is observed for the total sample, the highest underpricing is found for PE backed IPOs at 70%. On the contrary, VC backed IPOs experience a significantly (at the 0.05 level) lower underpricing of only 25%. Not backed IPOs experience an average underpricing of 52%, which is significantly higher than VC backed IPOs and 19% lower than PE backed IPOs, this difference is however not significant. These findings are remarkable, as based on the certification theory one would expect to see lower underpricing for both PE and VC backed IPOs. Whilst based on the grandstanding theory one would expect higher underpricing of PE/VC backed IPOs. This is in sharp contrast with the results, which identify VC as experiencing the lowest underpricing, whilst PE backed IPOs experience the highest underpricing.

When looking at the individual country, an average underpricing of Brazil (5%), Russia (6%), India (30%), China (52%) and South Africa (2%) is found. From the ANOVA and Kruskal Wallis test results, a significant difference among the three groups is observed for Chinese IPOs. This is most likely the result of the strong bias towards Chinese IPOs in the sample and the relatively low numbers of Brazilian, Russian, Indian and South African IPOs. As a result, the comparison of underpricing among PE, VC and Not backed IPOs is relatively similar for the Chinese IPOs and the total sample. With underpricing in China being the lowest for VC backed IPOs (25%), being significantly lower than both Not backed (50%) and PE backed (76%) IPOs.

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The differences in average underpricing show substantial fluctuation over time. During the bull market of 2005-2008 underpricing reached the highest level, with an average underpricing of 80%, compared to 2000-2004 (64%) and 2009-2012 (33.9%). This is line with current literature which identifies bull markets as timeframes characterized by high IPO underpricing (McGuinness, 1992). When comparing the underpricing of PE, VC and Not backed IPOs, significant results are found for the 2005-2008 and the 2009-2012 timeframe. During the 2000-2004 timeframe out of 193 IPOs, there was only one VC backed IPO and none PE backed IPO. It is likely that this is the result of the relatively recent nature of Private Equity and Venture Capital existence in emerging markets. During the 2005-2008 period which is marked by substantial IPO underpricing, VC backed IPOs (31%) faced significantly lower underpricing than both PE (124%) and Not backed IPOs (75%).The substantial difference between PE and Not backed IPO underpricing is also significant. During the 2009-2012 period, which was marked by a global financial crisis, IPO underpricing reached its lowest levels over the 2000-2012 period. As during the 2005-2008 period, VC backed IPOs remained to be underpriced the least with an average of 25%, compared to Not backed (37%) and PE backed (39%).

The sample was also broken down on industry type. The different industries and their average underpricing are Industrial (60%), Financial (25%), and Utility (45%). As the industrial group is relatively large compared to the other groups, a certain bias towards industrial IPO underpricing can be expected in the total sample. Significant differences between the underpricing of PE backed, VC backed and Not backed IPOs were found only in the industrial group. The differences in underpricing of financial IPOs is relatively small among PE, VC and Not backed IPOs, and no significant differences were found. In the case of the Utility IPOs sample the difference in average IPO underpricing is large among PE, VC and Not backed IPOs, however due to the very low number of observations, no significant differences were found.

Ordinary Least Square analysis

It is remarkably to see that nearly all (Table 2: panel 1, 3 and 4), except for the Indian sample, significant ANOVA Post Hoc test results identify significantly higher IPO underpricing for PE backed IPOs compared to VC backed IPOs. In order to identify the effect of the control variables on the underpricing of VC, PE and Not backed IPOs, three Ordinary Least Squares regressions (OLS) were carried out. The results of these analyses can be found in Table 4. Regression 1 tests the regression model, but it excludes VC backed IPOs, thus comparing PE and Not backed IPOs. Regression 2 tests the regression model, but it excludes PE backed IPOs, thus comparing VC and Not backed IPOs. Regression 3 includes both PE, VC and Not backed IPOs as intended in the model which is developed.

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All three regressions identified a significant difference in the underpricing of VC, PE and Not backed IPOs. The underpricing of VC backed IPOs in identified to be significantly lower than the underpricing of the benchmark group of Not backed IPOs, which is in line with the certification theory (Megginson & Weiss, 1991), but in sharp contrast with the grandstanding theory proposed by Gompers (1996). Interestingly, PE backed IPOs experience significantly higher underpricing compared to Not backed IPOs in both regressions one and three, and thus significantly higher underpricing than VC backed IPOs, this potentially being the result of grandstanding by PE funds. These results oppose the findings of Megginson & Weiss (1991) among others, which argue for the certification role of PE funds to reduce IPO underpricing and may therefore be an indicator of grandstanding. In order to control for issue date, the 2000-2004 period is used to serve as a benchmark. The anticipated outcomes are all correct, with IPO underpricing being significantly lower in the 2009-2012 period as compared to the benchmark and IPO underpricing being significantly higher for the 2005-2008 period compared to the 2000-2004 period, in all three regressions.

The underpricing of IPOs differs significantly among countries. China, which accounts for the majority of the IPOs in the sample, is used as a benchmark. Brazil, Russia and South Africa experience significantly lower average underpricing than China in all three regressions. India faces significantly lower average underpricing than China only in regressions three, which uses the entire sample. The insignificance of the India variable in regression 1 and 2 is most likely caused by the relatively small Indian IPO sample.

The effect of size, measured by the LN of the assets, was found to significantly influence IPO underpricing by all 3 regressions. The observed significantly lower underpricing of companies which are larger in size, is in line with current literature of Loughran, Ritter, & Rydqvist (1994 Updated 2011) and Giudici & Paleari (1999), which argue that larger firms face lower ex-ante risk and that a larger assets base certifies a portion of the value assigned to an IPO.

As argued for by scholars, high leverage is a signal of firm quality as it constraints spending behaviour of managers and imposes solid budget constraints on management (Su, 1999; Kim , Pukthuanthong-Le, & Walker, 2008). The OLS regressions have however not identified the debt to asset ratio to be a significant factor influencing IPO underpricing in any of the three regressions.

Profitability on the contrary was found to have significant negative effect on IPO underpricing in all 3 regressions. This is in line with research by Teoh, Welch, & Wong (1998), which argue that strong current performance is a signal of strong future performance. As a result, strongly profitable companies should encompass lower ex-ante uncertainty and thus a lower IPO undepricing would be required.

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In order to distinguish the level of underpricing among different industries, the IPOs were organized in 3 different subsamples, industrial, financial and utility. Industrial IPOs which constitute for the majority of the sample were used as a benchmark. It was found that financial IPOs face significantly lower underpricing than industrial IPOs, with significant results in regression 1 and 3. Utility IPOs faced on average higher underpricing, however these results were not significant. It could be argued that the significantly lower levels of IPO underpricing of the Financials, is the result of long operating histories as argued for by Mauer & Senbet (1992), however both the Industrial and Utility sample could possess long operating histories as well. The argument of limited underpricing of Industrial and Utility firms, due to a high fixed assets basis is however invalidated, for this specific sample.

Robustness testing

In order to test the robustness of the model, five additional regressions are carried out. Robustness test regressions 1-3 test the previous three regressions, whilst identifying and excluding the effect of outliers. In total there are 59 outliers in the sample, all having an IPO underpricing above 195.4%. Of these 59 outliers 43 are Not backed IPOs, 14 are PE backed and 2 are VC backed.

The last two regressions are run while excluding the Chinese observations from the sample. Robustness test ‘regression excluding China A’ is carried out as regression three, whilst ‘regression excluding China B’ excludes the significant outliers, in this case one Indian Not backed IPO.

Robustness tests regressions 1-3, which can be found in Table 4, identify a number of remarkable points. First of all, the issue period 2005-2008 which in the original regressions had significantly higher underpricing than the benchmark of issue period 2000-2004, has lower average underpricing when excluding the outliers in all three robustness test regressions. This result is however not significant, and it is reasonable to expect that this is caused by the relatively high number of outliers during this period (39 out of 59 outliers in the total sample). The second interesting finding is the significantly positive effect of a prestigious bookrunner which is found in all three regressions, whilst this effect was significant in the original regression only for the sample of VC backed and Not backed IPOs.

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Robustness tests ‘Regressions excluding China ’, in Table 5 test the model, whilst excluding the Chinese observations. The sample is highly skewed towards China, with 1202 Chinese IPOs and 96 IPOs in the other BRICS countries. This makes it interesting to study if the results of the regressions based on the total sample are based on Chinese observations, or if they are applicable to all the BRICS nations. The outcomes of these regressions show mainly the same signs, however both Regression A and B identify higher underpricing for VC backed IPOs compared to Not backed IPOs. These results are however not significant. As a result it can be concluded that the results of Regressions 1-3 in Table 3, are mainly the result of Chinese domination of the sample.

5. DISCUSSION AND CONCLUSION

Using a sample of 1298 IPOs of companies from the BRICS countries, consisting of Private Equity backed, Venture Capital backed and Not backed issues from 2000-2012, this paper demonstrates that (1) VC backed IPOs from the BRICS countries are on average significantly less underpriced than Not backed and PE backed IPOs, (2) PE backed IPOs from China are on average significantly higher underpriced than Not backed and VC backed IPOs. This (3) in sharp contrast with India, where PE backed IPOs experienced a significantly lower underpricing than Not backed IPOs. In Brazil, Russia and South Africa, the average PE backed IPO underpricing was also lower than Not backed IPO underpricing, however these results were not significant. However for the total sample, of all BRICS country IPOs the underpricing of PE backed IPOs is higher than the underpricing of Not backed IPOs. This is being caused by the sample, which is highly skewed towards China, with 1202 of the total sample of 1298 IPOs being Chinese IPOs. As a result one can conclude that (4) higher IPO underpricing of PE backed IPOs compared to Not backed IPOs is a Chinese phenomenon. It is further found that (5) underpricing in China is significantly higher than in Brazil, Russia, India and South Africa for both the PE and Not backed sample (regression 1), the VC and Not backed sample (regression 2) and the total sample (regression 3).

When looking at the timeframes, the 2005-2008 period faced the highest IPO underpricing, significantly higher than during the 2000-2004 period, and the 2008-2012 period which was characterized by the lowest average underpricing. The effect of size is also significant, the larger the assets of the firm, the lower the IPO underpricing. Whilst the leverage ratio and the use of a prestigious bookrunner was found to not have a significant impact on IPO underpricing. Financial IPOs were identified to have significant lower underpricing than industrial IPOs, which is interesting as financials typically have lower fixed assets, whilst utility IPOs faced higher underpricing than industrials. This difference is however not significant.

Underpricing of Private Equity and Venture Capital backed IPOs in the BRICS Countries.