Is The IPO Market Booming?

Our guest blogger today is Dr. Jay Ritter, renowned IPO researcher. Professor Ritter is the Cordell Professor of Finance at the University of Florida and has published more than 30 papers regarding equity issuance. Below, Dr. Ritter updates his previous post on the current IPO market.  

2013 saw more initial public offerings (IPOs) in the U.S. than in any year since 2007, and the financial press has been full of stories about the booming IPO market.

IPO volume tends to fall in bear markets and rise in bull markets. In the United States in 1980-2000, an average of 302 operating companies went public each year. Since then, volume has been much lower. Indeed, even with the S&P 500 increasing by 30% in 2013, only 156 operating companies went public last year. The low level of IPO activity compared with the 1980s and 1990s has frequently been attributed to a changed regulatory environment, with the Sarbanes-Oxley Act of 2002 being singled out for increasing the costs of being publicly traded. The Jumpstart Our Business Startups (JOBS) Act of 2012 reduces some of these burdens, especially for Emerging Growth Companies, defined as companies with less than $1 billion in annual revenue that have recently gone public.

In “Where Have All the IPOs Gone?”, which will be published in the Journal of Financial and Quantitative Analysis, Xiaohui Gao, Zhongyan Zhu, and I present an alternative explanation for the prolonged low level of small company IPO activity that has existed since 2000. We posit that there has been a structural change whereby getting big fast is more important than it used to be, especially for technology firms. We argue that organic growth (that is, internal growth) takes too long for a company with a hot new technology. Rather than going public and remaining as an independent firm, the company finds that its value-maximizing strategy is to sell out in a trade sale. The acquiring firm is willing to pay top dollar because it can create more value by rapidly integrating the new technology into its existing products, generating greater sales because it can certify the product with its brand name and use an extant marketing organization, rather than needing to hire new employees to expand. 

People frequently think of an IPO as part of the life-cycle of a successful firm founded by an entrepreneur, with the IPO being both a capital-raising event and a “liquidity event” that occurs once a firm has achieved a critical level of scale. In the 1980s and 1990s in the U.S., this framework was very descriptive of actual practice for many entrepreneurial firms. Since the tech-stock bubble burst in 2000, however, this framework is increasingly at odds with practice. Instead, venture capitalists have been operating with a “build to sell” model in which they exit from an investment in a successful portfolio firm via a trade sale, in which the entrepreneurial firm sells out to a larger firm in the same or a related industry, rather than remaining independent. In other words, the traditional life-cycle for a successful technology change has permanently changed.

Mangerial Idiosyncrasies And Corporate Capital Structure

Coming back for his second appearance, our guest blogger this week is Dr. Harry DeAngelo, the Kenneth King Stonier Chair in Business Administration at the Marshall School of Business at USC. Dr. DeAngelo is a noted expert on payout policy, capital structure, and corporate governance. Here, Dr. DeAngelo discusses how transitory debt can affect the capital structure decision. For a more detailed analysis, you can read the entire paper "Capital Structure Dynamics and Capital Structure" here. 

Corporate capital structures generally show a remarkable degree of variation over time.  One under-appreciated source of variation is the unique personal views about appropriate financial policies held by the people running a firm.  There is scope for managers’ idiosyncratic preferences to have a significant influence on the debt-equity mix when taxes and financial distress costs have only a second-order impact on firm value over a reasonably wide range of leverage ratios. 

Coca-Cola’s dramatic shift in capital structure in the 1980s (detailed below) provides a useful illustration of how the idiosyncratic views of top management can radically reshape financial policy.  The Coca-Cola case also highlights how debt can serve as a transitory vehicle for funding investment opportunities.  For more on the latter view, see my previous post.

  

Coca-Cola’s “levering up” of the 1980s: The appointment of Roberto Goizueta as CEO in 1980 marked a sharp shift in Coca-Cola’s financial policies toward more aggressive use of debt, including a willingness to borrow to make acquisitions (e.g., to acquire Columbia Pictures in 1982).  The CEO’s letter to shareholders in the 1985 annual report spelled out the firm’s new financial principles: “In the financial arena, The Coca-Cola Company is pursuing a more aggressive policy.  We are using greater financial leverage whenever strategic investment opportunities are available.  We are reinvesting a larger portion of our earnings by increasing dividends at a lesser rate than earnings per share growth….And, we are continuing to repurchase our common shares when excess cash or debt capacity exceed near-term investment requirements.”  In a 1984 interview, the firm’s CFO stated “We can go up to $1 billion without hurting our triple-A rating, and we would not hesitate to do so if something unusual comes along….” and “we will not hesitate to be a double-A company.  I want to make that very clear.”  The firm did, in fact, lose its triple-A rating because of its more aggressive use of debt. 

The Coca-Cola case study is from “How Stable Are Corporate Capital Structures?” by Harry DeAngelo and Richard Roll, which is forthcoming in the Journal of Finance.  The case appears in the paper’s Internet Appendix, which also contains case studies of 23 other firms that, like Coca-Cola, were (i) in the Dow Jones Industrial Average at some point, and that were (ii) publicly held from before the Great Depression until at least 2000.

Capital Structure Dynamics And Transitory Debt

Our guest blogger this week is Dr. Harry DeAngelo, the Kenneth King Stonier Chair in Business Administration at the Marshall School of Business at USC. Dr. DeAngelo is a noted expert on payout policy, capital structure, and corporate governance. Here, Dr. DeAngelo discusses how transitory debt can affect the capital structure decision. For a more detailed analysis, you can read the entire paper "Capital Structure Dynamics and Capital Structure" here. 

According to the tradeoff theory of capital structure, firms select an optimal leverage ratio by balancing the tax advantages of debt against the potential costs of financial distress.

For simplicity, consider a version of the tradeoff theory in which firms face a corporate tax rate of 35%.  Interest payments are tax deductible, but dividend payments are not. Suppose also that any debt-to-assets ratio over 0.45 is almost certain to result in costly financial distress while those less than or equal to 0.45 imply no chance of distress.  The latter knife-edge structure is, of course, unrealistic. But let’s stick with the assumption in order to illustrate an economically important feature of corporate capital structure decisions that is omitted from the traditional tradeoff arguments about optimal capital structure.

What is the optimal capital structure for our hypothetical firm? According to the traditional tradeoff logic, the optimal leverage ratio is 0.45. The firm gets maximum tax benefits by levering up to 0.45, and it runs no risk of incurring financial distress costs. So, by the usual tradeoff logic, the optimal strategy is to fully exhaust debt capacity (take leverage up 0.45) to capture the tax benefits of debt.

That logic is fine in a simple static setting in which a firm is only concerned with balancing tax benefits and distress costs while holding investment policy fixed.

But things change fundamentally when we look at the problem dynamically and recognize that debt policy is about more than finding the right mix of interest and dividend payouts. Importantly, firms issue debt because it is a low (transaction and asymmetric information) cost vehicle for raising funds for investment.

It is no longer attractive for the firm to lever all the way up to 0.45. Why not? The reason is that the firm would like to have unused borrowing capacity that it can tap in the future if a really attractive investment opportunity arrives.  The rational policy is to keep some “dry powder” – untapped debt capacity – available. The one exception would be if the firm currently had an outstanding investment opportunity and probable future investment opportunities that are much less attractive. In that case, it would be rational to exhaust debt capacity today instead of saving “dry powder” for future use.

What should a firm with untapped debt capacity do when an attractive investment opportunity arrives and it doesn’t have sufficient resources to fund it? In most cases, the right response is to borrow to fund that investment and then use future earnings to pay down debt and restore the option to borrow to meet future funding needs.

The firm’s ideal “target” leverage ratio is less than 0.45 once one takes into account the value of the option to borrow to meet future funding needs.

Traditional tradeoff theories view corporate capital structures as having only “permanent” debt and equity components. The dynamic theory that we have sketched here recognizes that capital structures also have a “transitory” debt component that involves the exercise of the option to borrow and then the restoration of that option by subsequently paying down debt.

You can think of this view of capital structure as the corporate analog of the manner in which a rational individual will manage his or her credit card: Use the borrowing capacity to meet unanticipated funding needs and then repay the debt to free up debt capacity for future use.

The logic here is based on “Capital Structure Dynamics and Transitory Debt” by Harry DeAngelo, Linda DeAngelo, and Toni Whited in the Journal of Financial Economics (2011, pp. 235-261).

The Equity Risk Premium In Emerging Markets

Back for his second appearance as our guest blogger is Dr. Aswath Damodaran from the Stern School at NYU. Dr. Damodaran is a noted expert on valuation and publishes his own blog, Musings on Markets.  Here, he discusses the equity risk premium in emerging markets, a shortened version of his more detailed post. If you are interested in more on the U.S equity, check out Dr. Damodaran’s updated article on the U.S. equity risk premium.

As you have figured out from the textbook, estimating the U.S equity risk premium (ERP) is not a simple task. Things get even more complicated when we are attempting to estimate the ERP in emerging markets. In a recent discussion, Dr. Damodaran examines the factors that affect the ERP in emerging markets. The first factor is the sovereign credit rating and credit default spreads. A country with a higher probability of default on sovereign debt is more risky, and therefore would have a higher ERP as financial instability in the government would extend to the private market as well. Next is the country risk score, which measures economic, political, and legal risks in the country. Finally, the volatility of the individual country’s equity market as measured by standard deviation impacts the ERP. Using this method, Guinea, Sudan, Somolia, and Zimbabwe share the highest ERP, at 22.25 percent. In contrast, the ERP for the U.S is 5.75 percent.  

A Tangled Web Of Values: Enterprise Value, Firm Value, And Market Cap

Our guest blogger this week is Dr. Aswath Damodaran from the Stern School at NYU. Dr. Damodaran is a noted expert on valuation and publishes his own blog, Musings on Markets. Dr. Damodaran has published numerous articles, including his updated article on the equity risk premium. Here, he discusses the different methods of valuing a company, a shortened version of his more detailed post.

Investors, analysts, and financial journalists use different measures of value to make their investment cases, and it is not a surprise that these different value measures sometimes lead to confusion. For instance, at the peak of Apple's glory early last year, there were several articles making the point that Apple had become the most valuable company in history, using the market capitalization of the company to back the assertion. A few days ago, in a reflection of Apple's fall from grace, an article in WSJ noted that Google had exceeded Apple's value, using enterprise value as the measure of value. What are these different measures of value for the same firm? Why do they differ and what do they measure? Which one is the best measure of value?

So what are the different measures of value? The first measure is the market value of equity, which measures the difference between the market value of all assets and the market value of debt. The second measure of market value is firm value, the sum of the market value of equity and the market value of debt. The third measure of market value nets out the market value of cash & other non-operating assets from firm value to arrive at enterprise value. One of the features of enterprise value is that it is relatively immune (though not completely so) from purely financial transactions. 

Each of these measures has problems. For example, to find the market values of equity, you need updated "market" values for equity, debt and cash/non-operating assets. In practice, the only number that you can get on an updated (and current) basis for most companies is the market price of the traded shares. You also must adjust for non-traded shares, management options, and convertible securities. To get from that price to composite market values often requires assumptions and approximations, which sometimes are merited but can sometimes lead to systematic errors in value estimates. When valuing debt, you must value non-traded debt and off balance sheet debt. Even cash presents problems when dealing with operating versus non-operating cash and cash trapped offshore.

When it comes to which value estimate is the best, I am an agnostic, and I think each one carries information to investors. The PE ratio may be old fashioned, but it still is a useful measure of value for individual investors in companies, and enterprise value has its appeal in other contexts. Understanding what each value measure is capturing and being consistent in how it is computed, compared and scaled is far more important than finding the one best measure of value.

CEO Narcissism

Making his second appearance in a row as a guest blogger is Dr. Richard Roll. Although much of our discussions in the textbook discuss the right way for corporate decision-making (a positive NPV), other factors can affect decisions and results in corporations. Here, Dr. Roll discuss how narcissism can affect the results of mergers and acquisitions. 

CEO narcissism seems to influence the takeover process.

In mergers and acquisition (M&A) events, more narcissistic target firm CEOs obtain higher bid premiums; i.e., higher offers relative to the previously prevailing market price.

Acquiring firm shareholders react less favorably to a takeover announcement when the target CEO is more narcissistic. In that case the acquiring firm’s stock price falls upon the M&A announcement. 

Among acquiring CEOs, narcissism is associated with initiating deals and negotiating faster.

Acquirer and target CEO narcissism are both associated with a lower probability of deal completion. They also make it less likely that the target CEO will be employed by the merged firm. 

All these results hold after controlling for acquirer and target CEO overconfidence, which suggests that narcissism captures a distinct personality trait.

In this research, narcissism is measured by the relative prevalence of first person personal pronoun usage in more than 1,700 transcripts of CEO extemporaneous speeches and interviews. CEOs in general have higher than average narcissism scores but there is substantial variation in the scores across CEOs.

Diversification In A Multi-Factor World

Our guest blogger this week is Dr. Richard Roll from UCLA. Dr. Roll has published more than 100 articles and is perhaps most famous for stating that CAPM would never be tested in his lifetime as CAPM holds theoretically but is almost impossible to test empirically. Originally an aeronautical engineer, Dr. Roll wrote the operating manual for NASA's Saturn V rocket. Here, he discusses how correlation does not affect diversification in a multi-factor world.

In a multi-factor world, diversification benefits do not generally depend on correlation. This is because correlation, say between two investment portfolios, is a very poor measure of whether the portfolios are explained by the same underlying factors. If the factor loading (betas) are disparate, two portfolios can be perfectly explained by the same factors, yet their simple correlation can be zero or even negative.

In general, the individual assets in two portfolios can be re-weighted to make portfolio betas congruent. This implies that true diversification benefits depend only on the idiosyncratic volatility that remains after re-weighting to align betas. Similarly, the risk reduction from adding an asset to an existing portfolio does not depend on the asset’s correlation with the portfolio, contrary to the prescription in many investment textbooks.

These implications evince the fundamental importance of measuring the underlying factors and estimating factor sensitivities for every asset. Several methods for measuring factors have been investigated in previous literature, but an easy-to-implement general method is simply to specify a group of heterogeneous indexes or traded portfolios. Exchange Traded Funds (ETFs) could be well-suited for this purpose.

Where Have All The IPOs Gone?

In what will be a recurring feature on our blog, today we present our first guest blogger, Dr. Jay Ritter, renowned IPO researcher. Professor Ritter is the Cordell Professor of Finance at the University of Florida and has published more than 30 papers regarding equity issuance. Here, Dr. Ritter discusses the results of his recent research about the shrinking number of IPOs since 2000.

During 1980-2000, an average of 310 companies per year went public in the U.S. Since the technology bubble burst in 2000, the average has been only 99 initial public offerings (IPOs) per year, with the drop especially precipitous among small firms. Many have blamed the Sarbanes-Oxley Act of 2002 and the 2003 Global Settlement’s effects on analyst coverage for the decline in IPO activity. Xiaohui Gao, Zhongyan Zhu, and I offer the economies of scope hypothesis as an alternative explanation. We posit that the advantages of selling out to a larger organization, which can speed a product to market and realize economies of scope, have increased relative to the benefits of operating as an independent firm. Consistent with this hypothesis, we document that small company IPOs have had declining profitability and an increasing likelihood of being involved in acquisitions, either as an acquiring firm or as a target. Both the profitability trend and the acquisition trend started in the early 1990s.

Alternatively stated, the reason that few small high-tech companies have been going public rather than selling out to a larger firm in a “trade sale” is that getting big fast is more important than it used to be. Remaining as an independent firm and growing organically is not the profit-maximizing strategy for most startup tech firms because it takes too long. Thus, the decline of small company IPOs is not a private market versus public market issue, but is instead a big company versus small company issue.