Operating Profit Behavior around IPOs in a Rational Equilibrium with Asymmetric Information

Abstract

In this paper we determine the strategic exercise of an IPO option in a framework of asymmetric information. Private owners are exposed to the idiosyncratic risk of the firm while public investors are not fully informed about the type of the firm. Idiosyncratic risk creates an incentive for private owners to sell out to investors in a public offering. However, asymmetric information about the type of the firm creates an incentive for high type firms to engage public investors in a learning process before entering the IPO market. The equilibrium is characterized by intervals of firms entering the IPO market, where the intervals depend on the history of cash flow realizations. In equilibrium, owners use cash-flow realizations to signal to investors. We find that owners will tend to go public in years of extra-ordinary cash-flow realizations, and will refrain from entering the IPO market in years of poor relative performance. Consistent with empirical evidence, our theory predicts a significant appreciation in operating margins in the years leading up to the IPO, and significant declines in operating margins thereafter. We show that this behavior will persist even after one controls for some suitably defined peer group, and for the health of the overall economy. We also predict abnormal returns to equity in the pre-IPO period; a negative return at the announcement of the IPO, tendency of firms to go public after extra-ordinary years; and a shorter time to going public when idiosyncratic risk is high. Closed form solutions are provided for all relevant statistics.