4. Reputation Effects on IPO Activities
4.2 Equilibria of the Going-Public Decision
---t Firm’stypedepending on thequality of a firm’s management.
(G, B) (Good or bad).
Firm’s performance set as a signal of a firm’s reputation, either as ( ,1 )2 success or failure, {S,F}. : firm’1 s performance in the first period.
: firm’2 s performance in the second period.
Probability that a type-G firm will succeed.
SG P F B
P
.
d Decision of a firm going public.
(I, NI) (Going or Not going public).
p The probability to be a type-G firm.
pd Posterior that the firm is type-G, given the firm’sfinancing decision
dI,NI
and firm’s reputation
1,2 ,1{S,F},2{S,F}
.mt Probability that a firm will go public at time 1, given t
G,B and
S,F
.
Proportion of the stocks being sold in an IPO activity.
J Floatation cost of IPO.
---4.2 Equilibria of the Going-Public Decision
This paper uses the equilibrium concept of the Bayesian equilibrium defined below.
Definition: A Bayesian equilibrium is a set of conditional going public
probabilities, mt t
G,B ,
1,2
, and a set of investors’ beliefs, pd, d
I,NI ,
1,2
; where (i) mt maximizes a firm’sexpected value and (ii) pd satisfiesBaye’srule.The model constructed in the previous section has multiple Bayesian equilibria, which are consistent with any kind of beliefs. These equilibria are sets of mixed strategies containing pure strategies, where degenerate probability distributions are included (Fudenberg and Tirole, 1992). We now discuss the features of these equilibria.
Lemma 4.1 For each historical performance 1{S,F}, there exists a pooling equilibrium where both types of firms choose not to go public - that is,
t mt 0. Proof
Suppose that, by observing a firm going public, investors believe the firm to be type-B. Therefore, 0
1
I
p . It follows from (4.3) that NVt
1 and from (4.6) and (4.7) that VG VB 1J . By the assumption of 1/2, no matter what type the firm is, no firm will choose to go public.
Q.E.D.
Lemma 4.1 is a common result in the reputation model. If we make investors’
beliefs unfavorable to one of the IPO decisions such as going public in Lemma 4.1, then we make going public a zero-probability event and form a pure strategy,
t
mt 0. Here, a firm going public is associated with the belief of having bad quality, and thus this makes “not going public”an equilibrium. An equilibrium with a zero-probability event is defined as a degenerate equilibrium. This dissertation is not going to focus on the degenerate equilibrium.6 Lemma 4.2 eliminates the existence of a separating equilibrium.
Lemma 4.2 There exists no equilibrium such that one type of firms chooses to go public, while the other does not - that is, mt 1 and mt' 0.
6 The degenerate pooling equilibrium is due to the assumption of the investor’s homogeneous belief regarding a firm’s type, such as 0
1
C
p in Lemma 1. We avoid discussing the homogeneous belief case since it hardly happens in the real world.
Proof public is increasing in - that is, a type-B firm is likely to go public, which contradicts with the assumption of 1
1
I
p .
Q.E.D.
Lemma 4.2 eliminates the existence of a separating equilibrium and implies that no matter what type the firm is, the probability for a firm to go public is increasing in
. This supports the existence of the equilibrium with mixed strategies. We define an equilibrium which excludes pure strategies as a non-degenerate equilibrium.
Proposition 4.1 There exists a unique nondegenerate equilibrium where both type-G and type-B firms choose to go public - that is,mt 0 t,. Proof
The proofs in Lemma 4.1 and Lemma 4.2 imply that, in a non-degenerate equilibrium, mt 0 t,. The marginal benefit from going public is strictly greater for a type-G firm than that for a type-B firm as shown below.
0
From the inequality above, the signaling game results in three equilibria.
(1) 0
V . These inequalities support a separating equilibrium whereby the type-G firm goes public and the type-B one does not.
Lemma 2 eliminates this equilibrium.
(3) 0
V . For the type-G firm, the inequality,
1 0
V , implies either 0
1
Proposition 4.1 confirms a non-degenerate equilibrium, where for any level of a firm’s management quality and reputation, the probability to go public is positive.
Moreover, we propose that the propensity to go public is increasing in management quality and in a firm’s reputation.
Proposition 4.2 For any status of a firm’s reputation, the propensity to go public for a type-G firm is higher than that for a type-B firm. For any possible type of firm, the propensity to go public for a high reputation firm is also greater than that for a low reputation firm -that is, mG mB 0 and mtS mFt 0t.
Proof
The same reasoning in Proposition 4.1 applies well to prove Proposition 4.2.
0
7 For a rational manager whose objective is to maximize a firm’s expected value, she will choose the decision which has a higher expected value. Here, VG NVG 0 implies that for a type-G firm, the expected value of a going public firm will be larger than that of a not going public firm. Thus, the type-G firm chooses to go public and hence mG 1.
We again do not focus on the pure strategy (defined as the degenerate equilibrium) where both types of firms choose to go public.8 The remaining mixed strategies, mG 1 and mB (0,1), imply that the propensity for a type-G firm to go public is higher than that for a type-B firm. Moreover, the other mixed strategies,
1
t
mS and mFt (0,1)t, indicate that the propensity to go public for a good reputation firm is higher than that for a bad reputation firm. Combined with these two sets of semi-pooling equilibria, Table 4.2 shows a probability matrix, which is the joint probability of the going public decision as a function of a firm’s management quality and its reputation.
Table 4.2 Probability Matrix of Going Public as a Function of a Firm’s Quality and Its Reputation
Reputation
Type
S F
G 1 ≧ ( 0 , 1 ]
≦ ≦
B ( 0 , 1 ] ＞ (0,1)
8 The reasoning for footnote 4 applies here.
4.3 Main Reputation Effects and Empirical Evidence
According to the two semi-pooling equilibria in Proposition 4.2, we define two reputation effects on IPO activities. The first, the equilibrium mG 1 supports the reputation-enhancing and reputation-building effects here, implying that going public is regarded as a reputation-enhancing or a reputation-building activity. Thus, the firm possessing good management quality as well as a good reputation chooses to go public to enhance its reputation value. The firm with good management quality but suffering from a bad reputation now chooses to go public to build up its reputation.
The second mSt 1t supports a reputation-maintaining effect. It implies that going public maintains a firm’s reputation. Thus, a firm with a good reputation chooses to go public to maintain its reputation status, even though it is poorly operated now. We also find some empirical phenomena in accordance with the two reputation effects.
4.3.1 Reputation-Enhancing and Reputation-Building Effects
The result in Proposition 4.2, mG 1 and mB (0,1), gives an answer to the question –what kind of firm goes public? Firms with good management quality choose to go public, even though some suffer bad reputations. However, why would the good firms share their golden pot with others? We prove herein that due to asymmetric information, the good firms go public so as not to be regarded as the bad ones. On the other hand, the good firms believe that going public conveys good news of firms’prospects and enhances their reputations. In fact, no matter how good-quality firms performed in the past, they believe that they will succeed in their new projects and their underpriced new equities will revert to the intrinsic value.
Thus, those good firms with a good past go public to enhance their reputations and those with a poor past go public to build their reputations. Reputation feeds back to the returns of the new issues as well as the remaining equities. These are regarded as the reputation-enhancing and reputation-building effects.
The reputation model we formalize here has good predictions on the results from the investigative and empirical research. In an overview of the decision to go public, Roell (1996) summarized that a public listing could be regarded as a marketing device
and enhances a company’s image and publicity. This publicity induces outside investors to learn more about the firm and leads to a run-up in the share price on the first trading day (Chemmanur, 1993). Maksimovic and Pichler (2001) stated that public trading can add value to the firm as it inspires more faith in the firm from other investors, customers, creditors, and suppliers. An academic survey conducted by Brau and Fawcett (2006) found that high-tech firms view an IPO more as a strategic reputation-enhancing move than as a financing decision. Chemmanur and Paeglis (2005) directly examined the relationship between the quality and reputation of a firm’s management and its post-IPO operation performance. The result showed that firms with higher management quality have stronger post-IPO performance.
4.3.2 Reputation-Maintaining Effect
The other result in Proposition 4.2 gives the other answer to the question of who chooses to go public. The equilibrium of mSt 1 and mtF (0,1)t implies that a firm with a good reputation chooses to go public. We further find that some firms take advantage of their good names to go public no matter whether they are well or poorly operated. Hence, going public is regarded as a reputation-maintaining mechanism. Reputations directly add value to the new issues as well as the remaining equities. We regard this as the reputation-maintaining effect.
Some financial indicators, such as a history of strong earnings, higher cash flows, and the firm’s market value, etc. serve as signals of good reputation. The prediction of the reputation-maintaining effect is consistent with some empirical evidence.
Empirical studies suggest that IPO firms are either older or larger with a track record (e.g. Panago et al., 1998; Chemmanur and Fulghieri, 1999, etc.) or young, but with higher cash flows (e.g. Schultz, 2003; Benninga et al., 2005, etc.). Chemmanur and Fulghieri (1999) found that public firms are older and larger. Only firms with entrepreneurs who has accumulated a significant track record for successful performance find it optimal to go public. A study of the determinants of IPOs in Italy indicated that the likelihood of an IPO increases in firm size and the industry’s market-to-book ratio (Panago et al., 1998). Firms who grow faster and are more profitable before an IPO also tend to go public. Hence, due to a lack of enforcement of minority property rights, Italian firms need a long track record in order to capture
investors’trust before going public.
The reputation-maintaining effect can be applied to explain an IPO’s timing.
Ritter (1984) showed that entrepreneurs time their decisions to go public.
Furthermore, IPOs tend to cluster during periods in which investors place relatively high values on the cash flows of firms that went public (Loughran et al., 1994).
Benninga et al. (2005) proved that IPOs come in waves. Entrepreneurs choose to go public when the “public”cash flow valuation of their firm is relatively high. If the market expects a low valuation of the cash flows, then firms generally remain private.
Thus, high values on the cash flows of firms as well as high growth before the IPO motivate them to list their shares publicly since going public adds value to the firm’s equity.
4.4 Over-Going Public, IPO Mispricing, and Long-Run Underperformance