Underperformance Of Firms Research Articles

Underpricing of Initial Public Offerings: The Case of Portugal

This paper analyzes the initial public offering (IPO) underpricing phenomenon in Portugal. We show that the ‘hot issue’ market of 1987, coinciding with a speculative bubble in the stock market, is well explained by investor sentiment theories and that the issuing firms seized a ‘window of opportunity’ provided by excessive demand to offer and list their shares. In IPOs prior to the 1987 crash, underpricing is very high while there is a strong reversion to fundamentals in the long run. In the period 1988–2004, we find lower IPO underpricing and overall no evidence of long-run underperformance of IPO firms. Bookbuilding IPOs are more underpriced than other price setting systems IPOs, and firms with seasoned public offerings show abnormal returns in the long run.

CEOs vs. Directors: Who Calls the Shots When Firms Underperform?

We study the evolution of the board among firms experiencing a sudden negative performance shock and highlight the influence of the CEO in determining the changes. Over 40% of the original directors depart the board and boards become more independent in the three years following underperformance. The proportion of directors who work as consultants and of directors who are executives in other firms increases, while the proportion of directors in the financial industry, directors who hold multiple board seats, and directors representing large shareholders decreases. Influential CEOs are associated with smaller increases in board independence and less director turnover than less influential CEOs. Changes in the percentage of directors who are executives in other firms and directors who represent large shareholders are also negatively related to CEO influence. Together, these results show that influential CEOs continue to maintain their influence over the board following underperformance while less influential CEOs lose even more of their original influence. CEO influence and board changes are not related to subsequent changes in firm performance and the likelihood that firms will experience a financial restructuring event. We conclude that firms adjust their boards based on their own specific managerial and firm requirements.

Private Benefits and the Decision to Go Public

This paper focuses on the decision to go public when both seller and potential buyers have private benefits of control. The basic model by Zingales (1995) is extended in several aspects. Asymmetric information caused by uncertain private benefits leads to lower offering prices and a smaller fraction of the company being offered compared to models with perfect information. This result has implications for ownership structure and the allocation of cash flow claims and voting rights. Adverse selection effects also explain post-IPO underperformance of firms which are not subject to control transfers. Because some firms going public are never sold but nevertheless provide private benefits, an overestimation bias exists in prior estimates of control premiums. Finally, mandatory tender offers in the form of a fair price rule and an equal opportunity rule are discussed, which indicate a slight private and social superiority of takeover regulations.

Debt Financing, Venture Capital, and Initial Public Offerings

We examine the comparative roles of debt financing and venture capital in the performance of companies that go public. For a sample of more than 5,000 IPOs during the period 1980-2002, we find that firms with high debt financing tend to exhibit characteristics of lower valuation uncertainty and risk than firms that are backed by venture capital. We document a strong negative relation between debt financing and initial returns (or underpricing), after controlling for other factors affecting these returns. For the entire sample, one standard deviation change in leverage is associated with 7% lower underpricing. Our results are especially pronounced during periods with high valuation uncertainty. For example, during the 1999-2000 period, firms with high debt levels and without venture capitalist backing averaged 60% lower underpricing than firms with low use of debt financing but backed by venture capitalists. Our results confirm the theories of James and Wier (1990), who hypothesize that debt financing is associated with lower initial returns, and Ueda (2004) who hypothesizes about the comparative effects of banks and venture capitalists on IPO firms. Also consistent with Ueda's theory, we document that debt financing and venture capital tend to be substitutes. We also examine the comparative effects of debt financing and venture capital on the long-term performance of IPO firms. Overall, we find that high levels of debt financing are associated with negative aftermarket performance in the five years after the IPO, in contrast with the comparatively positive performance of venture capital-backed firms, after adjusting for market risk, size, and book-to-market effects. Brav and Gompers (1997) show that the negative long-term performance of IPOs is primarily associated with small firms that do not have venture capital backing. We find that firms with substantial debt financing tend to have especially low performance. Furthermore, we show that the firms characterized by Brav and Gompers as small (in market capitalization) and without venture capital are generally also firms with high debt financing. Thus, the characteristics of firms with extensive debt financing help to account for both their lower initial returns at the IPO, and their negative long-term performance following the IPO. While the underperformance of debt-backed firms demonstrates a statistically meaningful anomaly, it may suggest further need for incorporating the effect of debt in examining investment performance, as suggested recently by related results for non-IPO firms by Billett, Flannery, and Garfinkel (2005).

The Going Public Decision and the Product Market

At what point in a firm’s life should it go public? How do a firm’s ex ante product market characteristics relate to its going public decision? Further, what are the implications of a firm going public on its post-IPO operating and product market performance? In this paper, we answer the above questions by conducting the first large sample study of the going public decisions of U.S. firms in the literature. We use the Longitudinal Research Database (LRD) of the U.S. Census Bureau, which covers the entire universe of private and public U.S. manufacturing firms. Our findings can be summarized as follows. First, a private firm’s product market characteristics (total factor productivity (TFP), size, sales growth, market share, industry competitiveness, capital intensity, and cash flow riskiness) significantly affect its likelihood of going public after controlling for its access to private financing (venture capital or bank loans). Second, private firms facing less information asymmetry and those with projects that are cheaper for outsiders to evaluate are more likely to go public. Third, as more firms in an industry go public, the concentration of that industry increases in subsequent years. The above results are robust to controlling for the interactions between various product market and firm specific variables. Fourth, IPOs of firms occur at the peak of their productivity cycle: the dynamics of TFP and sales growth exhibit an inverted U-shaped pattern, both in our univariate analysis and in our multivariate analysis using firms that remained private throughout as a benchmark. Finally, sales, capital expenditures, and other performance variables exhibit a consistently increasing pattern over the years before and after the IPO. The last two findings are consistent with the view that the widely documented post-IPO operating underperformance of firms is due to the real investment effects of going public rather than being due to earnings management immediately prior to the IPO.

Insider privatization with a tail: the screening contract and performance of privatized firms in rural China

This paper studies insider privatization in rural China and provides an explanation of why some firms have performed well after privatization but others have not. We show theoretically that the underperformance of insider-privatized firms could be due to the manager-cum-owner's lack of incentives after privatization. A screening theory predicts that the buyout price is correlated with the postprivatization incentives, and a firm's postprivatization performance increases with both the buyout price and postprivatization incentives. Drawing on data we collected in China, we find evidence supporting the theory. We also find that the buyout price decreases with the degree of information asymmetry.

The Fallacy of 'Only the Strong Survive': The Effects of Extrinsic Motivation on the Persistence Decisions of Underperforming Firms

According to economic theory, under-performing firms should be selected out of the market. However, research shows that these firms persist, often for long periods of time. In this article we explore the non-firm-performance factors that contribute to the decision to persist with an under-performing firm. Using the escalation of commitment literature we identify seven variables that are associated with the persistence decision: Personal sunk costs, personal opportunities, previous organizational success, perceived collective efficacy, environmental complexity, dynamism and munificence. We reconcile the economic and psychological views by finding that the extent to which some of these non-firm-performance factors influence the persistence decision is, in part, dependent upon the owner-managers' level of extrinsic motivation.

Politically-Connected CEOs, Corporate Governance and Post-IPO Performance of China's Partially Privatized Firms

Property rules of China's partial share issue privatization have created rent-seeking incentives for politicians that may hurt the performance and corporate governance of newly listed state enterprises. This study reports that almost 28% of the CEOs in the sample of 625 firms are ex- or current government bureaucrats. The three-year post-IPO average stock returns of the sample underperform the market by 20%, and the underperformance of firms with such politically-connected CEOs exceeds those without politically-connected CEOs by almost 30%. Firms with politically-connected CEOs are more likely to appoint other bureaucrats to boards of directors, while they appoint fewer directors with relevant professional background or prior business experience, nor any representative of minority shareholders. The presence of politically-connected CEOs is related to the unemployment and fiscal conditions of the firms' regions while unrelated to most firm characteristics. Overall, the results indicate that the appointment of politically-connected CEOs does not enhance shareholder value but rather fulfill political goals of politicians.

Insider Privatization with a Tail: The Buyout Price and Performance of Privatized Firms in Rural China

This paper studies insider privatization in transition economies. We show theoretically that the underperformance of insider-privatized firms could be due to the manager-cum-owner's lack of incentives after privatization. A screening theory predicts that a firm's postprivatization incentives increase with the firm's buyout price. The empirical results show that the buyout price decreases with the degree of information asymmetry and that a firm's postprivatization performance increases with the buyout price. We also find that the performance of premium-paying firms converges with that of private firms after privatization; in contrast, heavily discounted firms perform indistinguishably from government-owned firms.

Convertible bond calls: resolution of the information content puzzle

This study resolves the puzzling evidence on convertible bonds by documenting that conversion-forcing calls are indeed bad news. We find that the common stocks of calling firms substantially underperform their benchmarks by a median of 64% over the five-year post-call period. In contrast, firms that choose not to call their in-the-money convertibles exhibit no long-run abnormal performance. We show that studies drawing conclusions based on short-term price reversal immediately following the call fail to completely capture the valuation effect that occurs over a longer time horizon. We document that the market condition at the time of the call (issuance volume) and cash flow benefits related to the call (relation between dividend and after tax coupon payment) influence the post-call stock price performance. Our analysis also reveals that the post-call underperformance of high-growth firms is more pronounced than that of low-growth firms, indicating greater market exuberance associated with high-growth firms at the time of the call.

Investor Response to Sell-Side Analyst Revisions in IPO Recommendations: Do They Correct Expectations?

This paper tests for investor optimism in IPO firms by examining excess returns around sell-side-analyst revisions of recommendations. I pose the corrections hypothesis and the learning hypothesis. According to the corrections hypothesis, if investors correct their initially optimistic expectations, they should react more negatively to analyst upgrades and downgrades of IPO firms relative to benchmark non-IPO firms. A competing hypothesis is the learning hypothesis, which posits that investors should respond more positively to upgrades and more negatively to downgrades of IPO firms relative to benchmark non-IPO firms, because they learn more from all information events about new, immature firms. Examining benchmark performance-adjusted-excess-returns around all revisions issued in the first 3 years after IPO issue, I find that investors do learn more from analyst revisions for IPO firms. However the magnitude of the response to upgrades and downgrades is asymmetric. The negative response around downgrades dominates the positive response around upgrades. Overall, the abnormal return in the 3-days around all revisions is -1.80%. This correction is economically significant, and contributes 15.67% to the long-run underperformance of IPO firms. This result is robust to different specifications of benchmark firms.

Convertible Bond Calls: Resolution of the Information Content Puzzle

This study resolves the puzzling evidence on convertible bonds by documenting that conversion-forcing calls are indeed bad news. Supporting the long-term implications of Harris and Raviv (1985), we document that the common stocks of calling firms substantially underperform their benchmarks by a median of 64% over the five-year post-call period. In contrast, firms that choose not to call their in-the-money convertibles exhibit no long-run abnormal performance. We show that studies drawing conclusions based on short-term price reversal immediately following the call fail to completely capture the valuation effect that occurs over a longer time horizon. We document that the market condition at the time of the call (issuance volume) and cash flow benefits related to the call (relation between dividend and after tax coupon payment) influence the post-call stock price performance. Our analysis also reveals that the post-call underperformance of high-growth firms is more pronounced than that of low-growth firms, indicating greater market exuberance associated with high-growth firms at the time of the call.

Political Relationships, Global Financing and Corporate Transparency

This study examines the role of political connections for firms' financing strategies and their long-run financial performance. We view political connections as an example for domestic arrangements which can reduce the benefits of global financing. Consistent with this argument, we find that firms with close political ties are less likely than firms with weak connections to have publicly traded foreign securities. We also show that estimates of the performance consequences of foreign financing are severely biased if value-creating domestic arrangements such as political connections are ignored. Political relationships not only alter firms' financing strategies, they also impact the long-run performance of companies. Tracking returns across several changes in regimes, we document that firms have difficulty re-establishing connections with a new government when their patrons fall from power. As a result, closely-connected firms underperform under new regimes and subsequently increase their foreign financing.

Why New Issues and High-Accrual Firms Underperform: The Role of Analysts' Credulity

Why New Issues and High-Accrual Firms Underperform: The Role of Analysts' Credulity

Why New Issues and High-Accrual Firms Underperform: The Role of Analysts’ Credulity

We find that analysts' forecast errors are predicted by past accounting accruals (adjustments to cash flows to obtain reported earnings) among both equity issuers and nonissuers. Analysts are more optimistic for the subsequent four years for issuers reporting higher issue-year accruals. The predictive power is greater for discretionary accruals than nondiscretionary accruals and is independent of the presence of an underwriting affiliation. Predicted forecast errors from accruals significantly explain the long-term underperformance of new issuers. The predictability of forecast errors among nonissuers suggests that analysts' credulity about accruals management more generally contributes to market inefficiency. Copyright 2002, Oxford University Press.

Deregulation, Consolidation, and Efficiency: Evidence from the Spanish Insurance Industry

This paper provides new information on the effects of deregulation and consolidation in financial services markets by analyzing the Spanish insurance industry. The sample period 1989-1998 spans the introduction of the European Union?s Third Generation Insurance Directives, which deregulated the EU insurance market. Deregulation has led to dramatic changes in the Spanish insurance market; the number of firms declined by 35 percent and average firm size increased by 275 percent. We analyze the causes and effects of consolidation using modern frontier efficiency analysis to estimate cost, technical, and allocative efficiency, as well as using Malmquist analysis to measure total factor productivity change. The results show that many small, inefficient, and financially under-performing firms were eliminated from the market due to insolvency or liquidation and that acquirers in the mergers and acquisitions market prefer relatively efficient target firms. As a result, the market experienced significant growth in total factor productivity over the sample period. Consolidation reduced the number of firms operating with increasing returns to scale but also increased the number operating with decreasing returns to scale. Hence, many large firms should focus on improving efficiency rather than on further growth.

Why Do New Issues and High-Accrual Firms Underperform: The Role of Analysts' Credulity

We find that analysts' forecast errors are predicted by past accounting accruals (adjustments to cash flows to obtain reported earnings) among both equity issuers and non-issuers. Analysts are more optimistic for the subsequent four years for issuers reporting higher issue-year accruals. The predictive power is greater for discretionary accruals than non-discretionary accruals, and is independent of the presence of an underwriting affiliation. Predicted forecast errors from accruals partially explain the long-term underperformance of new issuers. The predictability of forecast errors also for non-issuers with high accruals suggests that analysts' credulity about accruals management more generally contributes to market inefficiency.

Disciplinary Takeovers and Industry Effects

This paper presents a disciplinary explanation for some seemingly paradoxi- cal stylized facts from the takeover literature. Most notable among these are: () 1 hostile takeovers are predicted better by industry-wide than by firm- () specific performance failures; and 2 gains from a successful bid for a specific firm extend to other firms in the same industry. Our explanation is based on the idea that managerial incentives based on relative performance evaluation may induce an inefficient industry-wide equilibrium in which all firms underperform with respect to a value-maximizing firm, but no firm underperforms with respect to the industry average. A takeover can serve as a means to destroy such an inefficient industry-wide incentive equilibrium.

Disciplinary Takeovers and Industry Effects

This paper presents a disciplinary explanation for some seemingly paradoxical stylized facts from the takeover literature. Most notable among these are: (1) hostile takeovers are predicted better by industry‐wide than by firm‐specific performance failures; and (2) gains from a successful bid for a specific firm extend to other firms in the same industry. Our explanation is based on the idea that managerial incentives based on relative performance evaluation may induce an inefficient industry‐wide equilibrium in which all firms underperform with respect to a value‐maximizing firm, but no firm underperforms with respect to the industry average. A takeover can serve as a means to destroy such an inefficient industry‐wide incentive equilibrium.