Long-Run IPO Performance and the Role of Venture Capital 

By | May 1, 2023

IPOs only offer a partial exit to Venture Capitalists (VCs). When a VC-backed company goes public, the VC typically refrains from selling all shares at the IPO. Due to the high levels of information asymmetry at the IPO, selling a large fraction of the holdings sends a negative signal concerning the company’s valuation. Iliev and Lowry even report that 15% of the VCs increase their holdings post-IPO. VCs typically remain invested for three years following the IPO. Post-IPO VC involvement offers incentives to focus on value creation or act opportunistically to facilitate an exit. We examine whether VCs continue to create value after taking the portfolio company (PC) public. Prior research has tried to answer this question by studying the return patterns of VC-backed IPO companies over a 36- to 60-month period following the IPO. The consensus is that VC-backed companies outperform “regular” IPO companies but on par with benchmarks. However, due to the large heterogeneity in VC exit times [17 months (25th percentile) and 45 months (75th percentile)], using a fixed time horizon does not capture potential performance differences between portfolio companies where VCs are present or have exited. Consequently, our knowledge of VCs’ value creation impact after the IPO is limited. 

To examine the pre- and post-exit value creation in VC-backed companies, we hand-collect lead VC ownership and exit times for 448 U.S. VC-backed companies that went public from 2004 to 2014 and track their exiting behavior in the subsequent years to 2018. Following Brav and Gompers, we initially use a Fama-French three-factor model with a 60-month tracking period and similarly do not find that VC-backed IPOs outperform benchmarks. However, when we create portfolios distinguishing between VC presence and absence, we find an average monthly alpha of 0.88pp when the lead VC is present. Following the exit, the outperformance diminishes. This performance differential reveals the need to accommodate the exit time to fully capture the lead VCs’ role in post-IPO value creation and suggests that prior studies potentially underestimate the alphas of VC-backed IPOs. In the next set of tests, we relax the limitation of using a fixed holding period and include a PC in the VC’s present portfolio until the lead VC exits. Our three-factor model shows a similar outperformance but with a higher monthly alpha of 1.11pp when the lead VC is present. Since VC-backed companies invest heavily at low levels of profitability, we further include two additional risk factors– profitability and investments. Our augmented model shows an average monthly alpha of 1.79pp while the VCs are present. Following the VCs’ exit, some outperformance persists, but the monthly alphas reduce to 0.65pp. We also consider valuation effects and find that VC-backed IPOs exhibit higher pre-exit valuations. Since VC exits are not exogenously determined, we endogenize VC presence in instrumental variable regressions and examine the effect on Tobin’s Q. Our results show that PC valuations are higher when the lead VC is present. 

We explore numerous dimensions of monitoring and sources of long-term value creation when VCs are present and after VCs exit post-IPO. First, we study VC reputation’s role in capturing monitoring quality. Second, we study the role of syndicate size. Larger syndicates can create both short-term and long-term value; they allow VCs to share their specific knowledge and complementary skills, thereby adding more value to the PC. Furthermore, syndication can improve the selection process through improved screening, due diligence, and decision-making. Third, we further explore the role of a holding period before the IPO. We argue that the longer the holding period, the greater the influence of the VC. Moreover, we examine the role of financial details such as R&D and capital expenditures of companies’ portfolios among high and low-reputation VCs pre- and post-VC exit. 

A high degree of VC monitoring should be linked to PCs outperforming benchmarks during their presence, but following their exit, stock market performance reduces to mimic benchmarks. Monitoring to improve processes and investment into long-term value creation instead leads to continuous outperformance following the VCs’ departure. On the contrary, myopic behavior leads to short-term outperformance before the exit, followed by a sharp return decline. Our return patterns align with VCs continuing to add value after the IPO through monitoring. The data presented herein indicate that reputation, syndicate size, and the pre-IPO holding period all interact to positively impact long-term value creation manifested in positive post-exit alphas, which can result from greater long-term value creation and selection. The data also show higher alphas among firms’ portfolios with high R&D and low capital expenditures. Portfolios of high-reputation, VC-backed companies do not exhibit positive alphas after VCs exit unless both syndicate size and pre-IPO holding periods are above median levels. Portfolios of low-reputation, VC-backed companies do not exhibit positive alphas after VCs exit, regardless of syndicate size, pre-IPO holding periods, and capital and R&D expenditures. 

The consensus in the literature has been that VCs’ post-IPO value creation is largely priced in already at the IPO, not leading to any post-IPO overperformance. Showing that venture capital firms produce positive alphas following the IPO has implications for venture capital-backed IPOs as trading objects. Investing in venture capital-backed IPOs provides abnormal risk-adjusted returns above what is expected from a Fama-French three or five factor-framework. However, for average venture capital-backed IPO, it is crucial to sell your holdings at the time of the lead VC’s exit. This is not always the case since our study also shows that venture capital-backed IPO firms can continue creating value after the lead VC’s exit among portfolios that intersect each of these three conditions: (1) high- reputation VCs, (2) large VC syndicates, and (3) long pre-IPO holding periods. 

 

Anup Basnet is a lecturer of Finance at the University of Surrey.  

Magnus Blomkvist is an Associate Professor of Finance at EDHEC Business School.  

Douglas Cumming is the DeSantis Distinguished Professor of Finance and Entrepreneurship at the College of Business, Florida Atlantic University, and affiliated with the University of Birmingham and ECGI.  

This post was adapted from their paper, “Long-Run IPO Performance and the Role of Venture Capital,” available on SSRN. 

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