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E-MailGordon M. Phillips is Laurence F. Whittemore Professor of Business Administration at Dartmouth College Tuck School of Business. This post is based on a recent paper by Mr. Phillips; Borja Larrain, Associate Professor of Finance at the Pontificia Universidad Católica de Chile; Giorgo Sertsios, Sheldon B. Lubar Associate Professor of Finance at the University of Wisconsin Milwaukee Lubar School of Business; and Francisco Urzúa, City University of London.
Going public is a key decision for many firms. Whether or not going public is good for firms has been called into question by authors and the press who have written that firms after they go public may be myopic as the public markets may cause firms to suboptimally focus on the short-term at the expense of the long term. We raise an alternative perspective and examine whether going public may be optimally be associated with a change in strategy to raise funds for commercialization and also to focus on increasing profitability. We examine firms in 16 countries around the world that file for IPOs using a sample of 3,400 firms. For a benchmark for IPO firms, we use firms that file for an IPO but withdraw and do not complete their IPO. For all these firms, our data contains pre- and post-IPO-attempt information irrespective of whether firms complete or withdraw their IPO. In particular, the post-withdrawal profitability of private firms has not been previously considered. We also build unique measures of commercialization decisions for both public and private firms.
Explanations for why firms go public include diversification and liquidity for previous owners, as well as to raise capital for expansion. There are conflicting benefits and costs of going public. There is the positive effect of additional capital that allows the firm to undertake new investment opportunities. There are also potential agency costs as going public changes concentrated ownership to dispersed ownership where the incentives of managers and investors can diverge, or managers faced with stock market pressure can become myopic. The stylized fact in the literature so far is that, on average, profitability falls after IPOs, which seems to speak against the benefits of public status. In addition, recent evidence shows that IPO firms have lower patenting rates and fewer citations after going public. These results could be interpreted as evidence of short-termism or agency costs of being public. However, being public may might alternatively be associated with an optimal change in strategy to raise funds for commercialization and to focus on increasing profitability. (A recent WSJ article on UBER raises this possibility saying “Mr. Khosrowshahi (CEO) has moved to restructure Uber to deliver on a promise to make the company profitable, … The company has promised to be profitable on an adjusted basis before interest, taxes, depreciation and amortization by the end of next year (2021).” (Wall Street Journal, December 7, 2020)).
In order to provide a definitive answer to whether or not going public helps firms commercialize and improve their profitability, we distinguish the selection and causal effects of going public. Selection means that firms time their IPO decisions according to their life-cycle, profitability shocks, or industry shocks. The dynamics of these other variables can explain many post-IPO outcomes, and not going public in itself. The true causal effect of going public, instead, refers to changes that happen to firms because they go public, and not simply changes that are correlated with the going public decision. Isolating and estimating this causal effect has been elusive. In this paper, we fill this gap and also examine unique measures of ex post commercialization for IPO firms.
We use withdrawn IPOs as counterfactuals for completed IPOs, and recognize that the decision to withdraw is still endogenous. Therefore, a second crucial element of our estimation strategy is to consider the likelihood of IPO completion. Following recent research, we use market returns over the previous 30 days to instrument for the IPO decision. These 30 days coincide with the marketing and book-building phase of the IPO. Firms that pull their IPOs usually blame poor market conditions for the withdrawal. In line with previous evidence, we find that positive market returns in the previous 30 days increase the likelihood of IPO completion by 6.9% (from an unconditional probability of 87%). The pre-choice return is basically uncorrelated with firm characteristics of candidate IPOs, so it a valid way to control for the endogeneity of going public. Market returns in this short window are unlikely to directly affect firm outcomes several years after the attempt, which is what the econometric restrictions requires. In short, our identification strategy is based on the idea that good returns are simply a nudge for some firms that are at the margin between listing or not, but have no effect on the firm except for their impact on the going public decision.
When not considering the fact that going public is an endogenous decision, we find that the effect on profitability (return on assets, ROA) of completing an IPO versus withdrawing is basically zero. As in the previous literature, we find that the ROA of IPO firms goes down after going public. However, firms that withdraw their IPOs also experience a similar decline in profitability. This suggests that the previously documented post-IPO drop in profitability is related to selection issues or the choice of counterfactual.
When we examine the IPO decision controlling for the endogeneity of this decision, we find a significant increase in profitability associated with going public—evidence consistent with a shift to commercialization. Hence, when we isolate the arguably exogenous transitions to listed status we find a positive effect instead of negative effect. ROA in completed IPOs increases by close to one standard deviation of profitability in this sample. The effect is large, but plausible. Our findings are consistent with a large increase in profitability is likely to be needed to compensate for the equally large costs of going public (close to 5% of firm value according to the latest research).
Besides profitability, we find that there is a large (but noisy) effect on asset growth and sales, and a large (and more precisely estimated) effect in the number of subsidiaries and the number of countries a firm operates in. We find that patenting falls after going public, particularly in countries with high levels of investor protection and information disclosure. Overall, our results suggest that going public is associated with shifting firms away from exploration or innovation and towards commercialization where growth is focused on segments with strong margins that also have higher profitability.
The complete paper is available for download here.
