Initial public offerings in the UK: an examination of the role of venture capital

Abstract

Following the seminal work of Ibboston and Jaffe (1975) and then Ritter (1991) several studies, using different sample sets and different periods of time, have documented that initial public offerings (IPOs) are both underpriced and are underperforming market index reference portfolios. A growing body of literature has-been trying to develop an explanation for the IPO anomalies. The involvement of venture capitalists in the public offerings has been regarded as empirical evidence to test the underpricing and the long-term underperformance. As such, it is argued that venture capitalists can affect both the pricing of the offering and the performance of the shares following the IPO. The common claim of these explanations is that companies backed at the IPO by venture capitalists are regarded by potential investors as lower risk, and hence issuers do not need to underprice to attract investors. Similarly, companies backed by venture capitalists are expected to exhibit a positive abnormal return in the long-term. To assess whether the above claim holds on the U.K. initial public offering market, a sample of venture capital backed IPOs that went public in the period 1992-1996 was matched with a sample of non venture capital backed IPOs. Consistent with the prevailing belief that venture capitalists reduce the uncertainty at the offering, venture capital backed IPOs are found to be less underpriced than the non venture capital backed IPOs. The comparison of the long-term performance of VC-backed and non-VC-backed IPOs yielded mixed results depending on the method used to compute the abnormal returns. The cumulative average returns show that venture capital IPOs are underperforming market portfolios whereas non-venture backed IPOs have relatively outperformed the market portfolios at the end of the 36(^th) month after floatation. On the other hand, a rather contrasting result was found using the buy and hold method as a measure of the abnormal returns. Both venture capital and non venture capital IPOs appear to outperform the market portfolios. Similar results were also documented by Shah (1995) and Allen, Morkel-Kingsbury et al. (1999) where IPOs on average outperformed the market indices. Based on these results it is hard to state that VC-backed IPOs have outperformed non-VC-backed IPOs, or vice versa, at the end of the 3 year period after floatation. However, the results of the long-term returns provide further evidence that the abnormal returns are highlysensitive to the methodology employed. Segmentation of the returns according to themarket floatation showed that IPOs floated on the AIM market are more underpricedand more underperforming than IPOs floated on the LSE market. Finally, contrary tothe expectation, the survival analyses showed that VC-backed IPOs have a lowerprobability of survival than comparable non-VC-backed IPOs.