Why do companies go public?

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Motivation: 1. Why do some large firms stay private? IPO seems to

be a choice, not a necessary stage! 2. US data can not test it, but
Italy can!
Results:
Industry M/B and sales, followed by growth rate and profitability
have strongest positive effect on the likelihood of going public.
Investment, leverage, profitability, interest rate, and credit
concentration tend to decrease after listing. (Strange!!)
Independent firms are more likely to go public after high sales, high
industry M/B, high profitability, high growth and high investment,
and to reduce their leverage, investment, profitability, interest rate,
and credit concentration after IPO.
Carve-outs (subsidiaries going IPO) are more likely to go public
after high industry M/B and high profitability only, and to reduce
their profitability after IPO.other are insignificant
Controlling shareholders of independent firms do not divest
significantly after IPO but carve-outs do. But in both cases
controlling shareholders experience abnormal turnovers in three
years after IPO.

Why do companies go public?

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Conclusions:
Evidence is inconsistent with high growth opportunity
hypothesis. Firms do not go public to finance future
investment and growth.
Independent firms go public to re-balance their balance
sheet accounts and capital structure after high growth and
investment. Carve-outs choose best listing time to maximize
proceeds. Carve-outs are driven by financial rather than real
factors.
Evidence on bank credit suggests stronger bargaining
power and increased information for borrowers after IPO.
Evidence on changes in ownership of controlling group
does not support the portfolio diversification hypothesis.
Evidence on reallocation of control suggests IPO as a stage
in the eventual sale of a company.

high growth opportunity hypothesis = Firms goes IPO for

High Growth opportunity
Adjust their balance to optimum level : ex. Rebalance their
debt ratio that too high before IPO
On carve-out, Parent firm will wait until M/B ratio is very
high then split the subsidiaries on IPO.
portfolio diversification hypothesis : before IPO controlling
shareholder hold un-diversivied portfolio (too many share
that they hold). After IPO, they immediately sell their share to
hold diversified portfolio

Why do companies go public?

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(1)
(2)
(3)

Data:
All firms must satisfy the minimum listing requirements, which may change
during sampling period. Once listed, the firm is taken out of sample.
For carve-outs, the fixed flotation (majority fixed) cost may be born (sunk
cost) by their parent firms, ie, no economies of scale. Besides before
carve-outs, they may have access to bank credit through their parent firms.
Therefore they must be separately considered.
After screening, only 40 independent firms and 29 carve-outs get listed
during 1982 and 1992. (criticize : samples too few)
Table 1 reports summary statistics. Compared to firms eligible to go public
but did not, IPO firms appear to be larger, older, more leveraged, have
lower loan interest rate, have higher investment, borrow from more banks,
and rely more on external financing .
Why are IPO firms in Italy or other Continental European countries much
larger and older than US firms?
high agency cost due to lack of enforcement of minority property rights
implicit fixed cost of a higher visibility to the tax and legal authorities
absence of Venture Capital or liquid stock market dedicated to small cap
firms

 High flotation cost lower probability of IPO

To satisfy the requirement for IPO, the large shareholder
should sell their shares
Flotation cost mostly fix regardless the increase number of
shares. Issues more share will reduce the fix flotation cost
Venture capital invest to private firms with potential growth.
After invest, they will put pressure to board director to mak
profit quickly and force to go public, therefore they will sell
their share.

hypothesis

What firms choose IPO

Consequence after IPO

Adverse selection and moral Old and big firms Positive Low equity retention by initial
hazard cost
owners after IPO will have
worse performance
Fixed flotation cost

Big, independent firms

positive

Confidentiality cost

Non high tech firms positive

Overcome borrowing
constraint (growth
opportunity)

High leverage, growth,

investment, industry M/B
positive

High investment, less

leverage, less or no change in
payout

Best way for initial owners

to maximize proceeds from
eventual sales of the firm

positive

Higher turnover by initial

owner

Diversification

Risky firms positive

Initial owners sell shares

Increase liquidity

Big firms positive

Diffuse ownership

Stock market monitoring

High investment positive

Use stock-based incentive,

high investment

More investor recognition

Diffuse ownership

Increase bargaining power

with banks

High interest rate, high

Lower interest rate, lower
credit concentration positive credit concentration

Window of opportunity
(timing / overvaluation)

High industry M/B positive

Underperformance, no
increase in investment

 Adverse selection : because information asymmetric, mostly bad

firm will do the overprice IPO. One solution to handle this problem
is including more government monitoring to firms. Underwriter also
take part as the solution when they have more information to many
firms and can distinguish between bad-good quality firms and can
setup best price. (before IPO)
Moral Hazard : also because information asymmetric, mostly firm
tend to change their behavior after the IPO. To

Why do companies go public?

Methodology: probit model
Pr(IPOi,t=1) = F(1SIZEi,t-1 + 2CAPEXi,t-1 + 3GROWTHi,t + 4ROAi,t-1 +
5LEVERAGEi,t-1 + 6MTBi,t + 7RCCi,t-1 + 8HERFINDAHLi,t-1 +
tYEARt)
F(z) is the standard normal cumulative distribution function (cdf),
F(z) 0 as z -, F(z) 1 as z + and is non-linear,
F(z) = -z (v) dv
where (z) is the standard normal density, (z) = (2)-0.5exp(-z2/2)
The partial effect of SIZE on the probability of IPO is obtained from
partial derivative: F(z)/SIZE = 1[dF(z)/dz] where dF(z)/dz = (z)
1. F is the cdf of a continuous random variable, is a probability
density function. F is a strictly increasing cdf, and so (z) >0 for all
z. Therefore the partial effect always has the same sign as 1
2. However g(z) depends on the level of each variable! So there is no
easy answer for the scale of any partial effect! So p. 43 is incorrect!
3. But relative partial effect is certain. The ratio of the partial effects for
SIZE and ROA is 1/4
4. The largest partial effect of SIZE occurs when z=0. When z=o, (z)

Why do companies go public?

Tax law makes IPO easier in year 1984 through 1986. Expect
the coefficients of these three year dummies to be positive.
Put dummy variables during this 3 years, if IPO happened on
those 3 years then = 1, otherwise = 0
Some unobservable firm-specific effect may be correlated with
regressors. For example, industry M/B may capture growth
opportunity (+) or overvaluation (+) but may also reflect
confidentiality (-) or cultural bias (+). For example,
entrepreneurs of traditional business are likely to resist IPO for
the cultural bias and these firms are more likely to have low
M/B. Solutions: Patents? Dummy for high tech firms?
Why report standard error for each coefficient?
Why is the SIZE (subsidiary) insignificant for carve-outs?
1. Fixed flotation cost is partly sunk for subsidiaries.
2. Size may proxy reputation for independent firms and therefore
large firms will suffer less adverse selection or moral hazard.
For carve out, subsidiaries borrow the reputation from their

Higher M/B, Higher Growth opportunity or M/B show window opportunity to that firm.
M/B its not very good variables, since it conclude into 4 conclusion.
Cultural bias : resist go public based on cultural act of the firm (family owned,group
owned)
Standard error for each coefficient : to inform about significant result.
F test : to test each coefficent equal to 0 (gamma 1+2+3+4...n=0), if reject F-test, at least
one of coefficient not equal to 0
For carve-out subsidiary, parent firm will pay for flotation cost, then carve-out firms will not
get benefit of economy of scale effect
To further evaluate and distinguish with the industry effect, in further examination we
could test the next years effect and minus the industry influence (e.g interest rate firm
i interest rate industry)
.

Why do companies go public?

Yit = + j=03jIPOi,t-j + 4IPOi,t-n + j=03 jQUOTi,t-j + ui + dt + eit
ui is firm-specific effect and dt is calendar year specific effect.
Include QUOT to capture the effect of meeting the listing
requirement. This will correct the sample selection bias: more
profitable firms will be qualified for listing.
To deal with the endogenous selection bias: firms that went public
have chosen to do so, should run the two-stage regression. Should
first estimate equation 1 and then include this estimated probability
of listing into equation 2.
Also include lagged values of dependent variable and other lagged
dependent variables into equation 2.
What are the meanings of 0 through 4?

CEit = + 3jIPOi,t-j + 32IPOi,t- + 33IPOi,t-+ 34IPOi,t- 4IPOi,t-n + j=03

jQUOTi,t-j + ui + dt + eit

Beta 0-3, firm do the IPO on the year, year1, year-2, year-3 respectively. All dummy
variable. If B0 is positive then its mean CE
on that year is greater than not IPO. If B1
is positive, CE after 1 year after IPO is
greater rather than before the IPO

Why do companies go public?

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Why do ROA declines after IPO?

Statistical coincidence - mean reversion (in the long
run, varibles tend to act reverse from mean): so include
the first lag of ROA and ROA in the year before IPO into
the equation 2 but results remain the same
Window dressing: public firms tend to inflate profit but
private firms tend to deflate profit. High inflation rate in
Italy makes government encourage public firms to step
up the book value of asset.
Cash raised in IPO is temporarily invested in interest
earning financial assets
Moral hazard and adverse selection: change of the
incumbents stake at IPO is positively related to change
in post IPO ROA
Time the IPO

Why do companies go public?

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Why do bank credit interest rate falls after IPO?

Improvement in credit quality: leverage reduced and firms
become safer. So include ROA, Leverage, and Size to control for
risk. Results remain the same!
More information about borrowers
More outside financing options to weaken bank bargaining power
Initial owners divest very little of their holdings. This is true even if
we factor in how much the new equity raised at IPO or in
subsequent years was purchased by initial owners.
In 40.6% of cases, control group does not sell its equity and
demands new funds from outside investors. In another 40.6% of
cases, control group divests and does not raise new equity.
In the three years after the IPO, control group sells out the
controlling stake to an outsider in 13.6% of cases. This may be
due to (1) ease of transferring control of a public firm, (2) bad post
IPO performance , or (3) IPO as a step for controlling group to sell
the firm eventually.