Financial Distress Risk in Initial Public Offerings: How Much Do Venture Capitalists Matter?

On January 7th 2016, Thomson Reuters and the National Venture Capital Association (NVCA) published their Exit Poll Report, which stated that in the U.S. 77 venture capital (VC)-backed initial public offerings (IPOs) raised $9.4 billion in 2015. Over the same period, 93 non-VC-backed U.S. companies went public, raising $23.9 billion (Ernest & Young – IPO Global Trends 2015). For experts in the field of VC investments these numbers cannot appear surprising: the contribution by VCs to the growth of American stock exchanges is a well-documented phenomenon (e.g., Megginson and Weiss, 1991; Lee and Wahal, 2004; Nahata, 2008). Although there are hundreds of papers on the role of VC in the financial markets, whether there is a significant relationship between the presence of a VC investor in the firm’s ownership structure and the post-IPO level of financial risk has been non sufficiently investigated.

In our opinion, there are at least three reasonable arguments supporting the idea that VCs contribute to financial market stability by bringing public firms that show a lower risk of financial distress. Firstly, VCs undertake an intensive screening and selection process in order to pick “winning firms” that have favorable future business prospects (e.g., Chemmanur, Krishnan, and Nandy, 2011). The screening process involves selecting firms with specific characteristics that should lead to a lower risk of financial distress during the post-investment period (screening effect). Secondly, VCs supply portfolio firms with the equity capital needed to expand their business, and enable firms to have a robust capital structure to meet any contracted principal and interest payments (financial effect) (e.g., Croce, Martí, and Murtinu, 2013). Finally, VCs are also builders of “winning firms” because they add value to portfolio firms by providing them with coaching, effective monitoring and valuable business contacts (e.g., Cumming, Grilli, and Murtinu, 2014). As a result, the level of financial soundness of firms brought public with VC-backing is likely to be higher than that of non-VC-backed firms, even though their financial soundness at the VC’s investment date might well be analogous to that of non-VC-backed firms (value-added effect). This should be even more true for companies backed by highly reputable VCs, as several studies (e.g., Krishnan, Ivanov, Masulis, and Singh, 2011) show that more reputable VCs are able to select better-quality firms and exhibit more active post-IPO involvement in the corporate governance of their investee firms.

As such, our paper contributes to the ongoing debate about the role played by VCs in the IPOs by examining the following research questions: Are VC-backed IPO firms less financially distressed than other IPO firms and, if so, do VCs contribute to the financial stability of portfolio companies after the IPO? If VC investors do reduce the financial risk of investee firms, is this risk-reduction caused by VCs’ screening of portfolio companies or by the direct effect of VC investments in reducing financial risk? Finally, are certain types of VC firms (high reputation vs. low reputation) better at reducing the financial distress risk of investee firms than other ones?

These questions have picked up impetus in the wake of the 2008-2009 financial crisis, which emphasized the need for managers and regulators to keep the risk-taking of financial institutions and public companies at reasonable levels.

Using a sample of 1,593 US firms that go public between 1990 and 2007, we find that VC-backed IPOs experience lower levels of financial distress risk post-offering than comparable non-VC-backed IPOs. After controlling for endogeneity, we find that this result is related to two main factors. First, the screening done by VC-investors involves selecting firms with specific characteristics that should lead to a lower risk of financial distress, both during the VC financing, and after the IPO. Secondly, VCs reduce risks when they supply portfolio firms with the needed equity capital to expand their business and with coaching, monitoring and valuable business contacts. Our paper also reports interesting evidence about the role of VC reputation in explaining post-IPO risk of financial distress. We find that companies backed by more reputable VCs exhibit higher levels of financial distress risk, but despite this they show superior operating performance. This result is related to investee firm decisions in terms of capital structure (high use of debt e less to retain earnings) and investment selection (lower level of liquidity of their assets).

REFERENCES

Chemmanur, T. J., K. Krishnan, and D. K. Nandy. 2011. How does venture capital financing improve efficiency in private firms? A look beneath the surface. Review of Financial Studies 24: 4037–4090.

Croce, A., J. Martí, and S. Murtinu. 2013. The impact of venture capital on the productivity growth of European entrepreneurial firms: ‘Screening’ or ‘value added’ effect? Journal of Business Venturing 28: 489-510.

Cumming, D. J., L. Grilli, and S. Murtinu. 2014. Governmental and independent venture capital investments in Europe: A firm-level performance analysis. Journal of Corporate Finance, forthcoming.

Krishnan, C. N. V., V. I. Ivanov, R. W. Masulis, and A. K Singh. 2011. Venture capital reputation, post-IPO performance, and corporate governance. Journal of Financial and Quantitative Analysis 46: 1295-1333.

Lee, P. M., and S. Wahal. 2004. Grandstanding, certification and the underpricing of venture capital backed IPOs. Journal of Financial Economics 73: 375-407.

Megginson, W. L., and K. A. Weiss. 1991. Venture capitalist certification in initial public offerings. Journal of Finance 46: 879-903.

Nahata, R. 2008. Venture capital reputation and investment performance. Journal of Financial Economics 90: 127-151.

The preceding post comes to us from William L. Megginson, Professor and Price Chair in Finance at The University of Oklahoma, Antonio Meles, Associate Professor of Finance at the Second University of Naples, Gabriele Sampagnaro, Associate Professor of Finance at the University of Naples Parthenope, and Vincenzo Verdoliva, Assistant Professor Of Finance at the Kingston University of London.  The post is based on their paper, which is entitled “Financial Distress Risk in Initial Public Offerings: How Much Do Venture Capitalists Matter?” and available here.