Reducing Asymmetric Information in Venture Capital Backed IPOs

Escobari, Diego and Serrano, Alejandro (2015): Reducing Asymmetric Information in Venture Capital Backed IPOs. Forthcoming in: Managerial Finance

Abstract

Purpose – The purpose of this paper is to model asymmetric information and study the profitability of venture capital (VC) backed initial public offerings (IPOs). Our mixtures approach endogenously separates IPOs into differentiated groups based on their returns’ determinants. We also analyze the factors that affect the probability that IPOs belong to a specific group.

Design/methodology/approach – We propose a new method to model asymmetric information between investors and firms in VC backed IPOs. Our approach allows us to identify differentiated companies under incomplete information. We use a sample of 2,404 U.S. firms from 1980 through 2012 to estimate our mixture model via maximum likelihood.

Findings – We find strong evidence that companies can be separated into two groups based on how IPO returns are determined. For companies in the first group the results are similar to previous studies. For companies in the second group we find that profitability is mainly affected by the reputation of the seed VC and capital expenditures. Tangible assets and age help explain group affiliation. We also motivate our findings for a continuum of heterogeneous IPO groups.

Practical implications – The proposed mixture approach helps decrease asymmetric information for investors, regulators, and companies.

Originality/value – Our mixture methods help decrease asymmetric information between investors and firms improving the probability of making profitable investments. Separating between groups of IPOs is crucial because different determinants of an IPO operating performance can potentially have opposite effects for different groups.

• Item Type: MPRA Paper
• Language: English
• Keywords: Venture Capital, Mixture Model, Initial Public Offerings
• Subjects: C - Mathematical and Quantitative Methods > C3 - Multiple or Simultaneous Equation Models ; Multiple Variables > C31 - Cross-Sectional Models ; Spatial Models ; Treatment Effect Models ; Quantile Regressions ; Social Interaction Models; D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D82 - Asymmetric and Private Information ; Mechanism Design; G - Financial Economics > G2 - Financial Institutions and Services > G24 - Investment Banking ; Venture Capital ; Brokerage ; Ratings and Ratings Agencies; G - Financial Economics > G3 - Corporate Finance and Governance > G32 - Financing Policy ; Financial Risk and Risk Management ; Capital and Ownership Structure ; Value of Firms ; Goodwill

References

Boyer, C.M. (2004), “When should an investor buy a newly issued stock?”, Managerial Finance, Vol. 30 No. 1, pp. 5-16.

Escobari, D. (2014), “Estimating dynamic demand for airlines”, Economics Letters, Vol. 124 No. 1, pp. 26-29.

Gan, L. and Hernandez, M. (2013), “Making friends with your neighbors? Agglomeration and tacit collusion in the lodging industry”, Review of Economics and Statistics, Vol. 95 No. 3, pp. 1002-1017.

Gan, L. and Mosquera, R. (2008), “An empirical study of the credit market with unobserved consumer types”, Working Paper no. 13873, National Bureau of Economic Research, Cambridge, MA.

Gan, L., Huang, F. and Mayer, A. (2011), “A simple test of private information in the insurance markets with heterogeneous insurance demand”, Working Paper no. 16738, National Bureau of Economic Research, Cambridge, MA.

Gompers, P.A. (1995), “Optimal investments, monitoring, and the staging of venture capital”, Journal of Finance, Vol. 50 No. 5, pp. 1461-1489.

Ibbotson, R.G. (1975), “Price performance of common stock new issues”, Journal of Financial Economics, Vol. 2 No. 3, pp. 235-272.

Jain, B.A. and Kini, O. (1994), “The post-issue operating performance of IPO firms”, Journal of Finance, Vol. 49 No. 5, pp. 1699-1726.

Jain, B.A. and Kini, O. (1995), “Venture capitalist participation and the post-issue operating performance of IPO firms”, Managerial and Decision Economics, Vol. 16 No. 6, pp. 593-606.

Jones, T.L. and us Swaleheen, M. (2010), “Endogenous examination of underwriter reputation and IPO returns”, Managerial Finance, Vol. 36 No. 4, pp. 284-193.

Kaplan, S.N. and Strömberg, P. (2004), “Characteristics, contracts, and actions: evidence from venture capitalist analyses”, Journal of Finance, Vol. 59 No. 5, pp. 2177-2210.

Krishnan, C.N.V., Ivanov, V.I., Masulis, R.W. and Singh, A.K. (2011), “Venture capital reputation, post-IPO performance, and corporate governance”, Journal of Financial and Quantitative Analysis, Vol. 46 No. 5, pp. 1295-1333.

Lee, L.F. and Porter, R. (1984), “Switching regression models with imperfect sample separation information: application on cartel stability”, Econometrica, Vol. 52 No. 2, pp. 391-418.

Loughran, T. and Ritter, J.R. (1995), “The new issues puzzle”, Journal of Finance, Vol. 50 No. 1, pp. 23-51.

Loughran, T. and Ritter, J.R. (2004), “Why has IPO underpricing changed over time?”, Financial Management, Vol. 33 No. 3, pp. 5-37.

Nahata, R. (2008), “Venture capital reputation and investment performance”, Journal of Financial Economics, Vol. 90 No. 2, pp. 127-151.

Ritter, J.R. (1987), “The costs of going public”, Journal of Financial Economics, Vol. 19 No. 2, pp. 269-281.

Sørensen, M. (2007), “How smart Is smart money? A two-sided matching model of venture capital”, Journal of Finance, Vol. 62 No. 6, pp. 2725-2762.

Tian, X. (2011), “The causes and consequences of venture capital stage financing”, Journal of Financial Economics, Vol. 101 No. 1, pp. 132-159.

Tian, X. (2012), “The role of venture capital syndication in value creation for entrepreneurial firms”, Review of Finance, Vol. 16 No. 1, pp. 245-283.

Yip, Y., Su, Y. and Ang, J.B. (2009), “Effects of underwriters, venture capital and industry on long-term initial public offering performance”, Managerial Finance, Vol. 35 No. 8, pp. 700-715.