Overconfident Entrepreneurs and the Long Run Underperformance of Initial Public
Offerings
Abstract
This study provides a new explanation for long term underperformance of Initial Public Offerings (IPOs) by
taking an entrepreneurship view and exploring the overconfidence bias of entrepreneurs. It is suggested that
underperformance only exists for those IPO firms where their owners become excessively overconfident as a
result of pre IPO financial success. In fact, the presented results show that underperformance in operating return
only exists for those IPO firms with positive operating return before flotation. Whereas IPOs with negative
operating return pre flotation do not experience any underperformance in operating return over the next five
years after flotation. Indeed, these types of IPOs even experience significant increase in their operating
performance on years four and five after flotation compared to both IPO and pre IPO year. It is therefore, argued
that more overconfident entrepreneurs, who have experienced financial success in the past as evidenced by
positive operating returns as well as higher growth in sales than in operating expenses, allocate the money raised
through an IPO prematurely and excessively to risky opportunities rather than focusing on the cost of growing
and managing the costs associated with high growth. Hence, these IPO firms experience underperformance in
operating return in the long term.
Keywords: Initial Public Offerings, overconfidence, entrepreneurship, long term underperformance
1
Overconfident Entrepreneurs and the Long Run Underperformance of Initial Public
Offerings
1. Introduction
An Initial Public Offering (IPO) is an important stage in the life cycle of entrepreneurial
firms providing them with additional funds required to pursue growth opportunities (Daily et
al. 2003). The importance of the IPO in the life cycle of the privately held entrepreneurial
firms has generated an extensive body of research in this area. Many of these studies have
focused on the performance of entrepreneurial firms after an IPO to better understand their
success (see for example Brav and Gompers, 1997; Certo et al. 2001; Bruton et al., 2010:
Krishnan et al., 2011). The evidence on the long run performance of IPOs suggests the
stylised fact of underperformance in the long-term (see for example Ritter, 1991; Jain and
Kini, 1994; Loughran and Ritter, 1995; Pastor et al., 2009). The fact that IPO firms
underperform consistently and persistently has been documented across different markets
such as the US, the UK, Germany, Canada, Japan and so on (Shaw; 1971; Levis 1993;
Loughran and Ritter, 1995; Ljungqvist, 1997; Cai and Wei, 1997;). Many theories and
conjectures have been put forward to explain the underperformance of IPOs - signalling,
marketing, legal liabilities, price support, agency costs, heterogeneous expectations, market
timing (see for a summary, Jenkinson and Ljungqvist, 1998). The empirical evidence testing
the above theories, however, is largely inclusive and the underperformance of IPOs remains a
long lived puzzle.
Given the little consistency in the extant literature and the fact that a satisfactory explanation
for the long term underperformance of IPOs has yet to be found, this study casts light on this
significant issue by taking an entrepreneurship view and exploring the overconfidence bias of
entrepreneurs. In this paper we suggest that underperformance should only exist for those
IPO firms where their owners become excessively overconfident as a result of pre IPO
financial success. Given the sample firms have gone public at different points of time in the
past with many of them not being in the business (alive) anymore, direct measurement of
entrepreneurs’ overconfidence at the time of flotation is, at best, extremely difficult. To
overcome this problem we look at the pre IPO business success of the IPO firms and argue
that entrepreneurs’ overconfidence mirrors this recent business success. More specifically,
given that better firm performance in the past increases managerial overconfidence (Hayward
2
and Hambrick, 1997; Hayward et al., 2006) and the fact that an increase in overconfidence
(above a cut off point) reduces firm profitability (Goel and Thakor, 2008), we argue that
strong financial performance prior to flotation may lead to more overconfidence and hence,
underperformance of the IPO firm in the long term.
1. Theoretical Insights and the Derivation of Hypotheses
In this paper we investigate IPO underperformance from the new perspective of entrepreneurs
operating with an overconfidence bias. The overconfidence bias refers to the tendency of
individuals to consider themselves above average (Svenson, 1981; Kruger, 1999; Malmendier
and Tate, 2005b), overestimate their ability relative to their actual ability (Moore and Kim,
2003), being unrealistically optimistic about their future prospects (Taylor and Brown, 1988;
Weinstein and Klein, 2002), overestimating the probability of their success (Forbes, 2005)
and underestimating the probability of their failure (Wolosin et al, 1973), and finally having
an illusion of control (Langer, 1975; Keh et al., 2002; Malmendier and Tate, 2005b)1.
With the emergence of behavioural finance in the past few decades finance scholars have
started to consider behavioural explanations for some of the anomalies in the literature.
Overconfidence is one of the behavioural/cognitive biases which has been widely discussed.
Debondt and Thaler (1995) in their review of the micro foundations of behavioural finance
suggest that ‘perhaps the most robust finding in the psychology of judgement is that people
are overconfident’ (page 389). Svenson (1981), for instance, shows that majority of the
participants in his study rate their driving skills above average with 93% (69%) of the
American (Swedish) participants believing themselves to be more skilful than the median
driver. Consequently, overconfidence has been widely used in analysing the behaviour of
different market participants such as price takers, strategic-trading insiders and market
makers (Odean, 1998). Overconfidence has also been widely analyzed in the corporate
finance literature in the areas of merger and acquisition activities (see for example Roll,
1986; Hayward and Hambrick, 1997; Malmendier and Tate, 2008) and corporate financing
1
While overconfidence and optimism are similar constructs, they are not the identical (see … for a discussion of
the similarities and differences between these two terms). For the purposes of the current paper the differences
are not germane and we, therefore, follow quite an extensive literature (e.g see …) and use the term
overconfidence to also include optimism.
3
structures (see for example Heaton, 2002; Malmendier and Tate, 2005a, 2005b; Hayward et
al., 2006).
In the context of entrepreneurship, it is well recognised that entrepreneurs work under new,
unpredictable, and complex conditions which leave them with information overload and
hence, they are more prone to cognitive biases (Baron, 2000). One of these cognitive biases
which is suggested to affect entrepreneurs and is often considered as the most damaging of
the errors of judgement is overconfidence (Hayward et al., 2010). Indeed, the extant literature
has documented that entrepreneurs are generally more prone to overconfidence (see for
example Cooper et al., 1988; Busenitz and Barney, 1997; Forbes, 2005; Hayward et al., 2006,
2010). For instance, the results presented by Cooper et al. (1988) suggest that entrepreneurs
are optimistic about the future prospects of their newly formed firms with 81% of them
seeing their chance of success to be above 70% and 33% of them seeing it to be 100%. In
other words, the perceptions of entrepreneurs of their new businesses are supportive of the
fact that entrepreneurs perceive lower risk in establishing a venture (Simon et al., 2000).
Moreover, Palich and Bagby (1995) suggest that entrepreneurs perceive greater potential for
gain in highly uncertain situations. In addition, Keh et al. (2002) find that entrepreneurs
believe they are capable of influencing future outcomes and can take the appropriate actions
to hedge the risks.
Possible explanations for entrepreneurs being more overconfident have been discussed as
follows. Firstly, entrepreneurship attracts certain people who are less rational and more
spontaneous, as opposed to cautious people who would be attracted to larger organisations
(Busenitz and Barney (1997). Therefore, overconfident people are more likely to become
entrepreneurs. Secondly, overconfidence happens as a result of dealing with conditions
associated with the task of entrepreneurship such as high uncertainty and time pressure
(Forbes, 2005). For instance, entrepreneurs may unintentionally simplify their information
processing in order to reduce the stress and ambiguity embedded in the task of
entrepreneurship (Hansen and Allen, 1992). Finally, entrepreneurs are highly committed to
their firms’ performance and believe it is under their control, and, as such, are more prone to
overconfidence (Malmendier and Tate, 2005a). In this study we argue that IPO firm value is
destroyed over the longer term as a result of the actualisation of the overconfidence bias of
entrepreneurs given specific conditions.
4
While there is evidence (Forbes, 2005) that overconfidence is a latent feature of
entrepreneurship (one obvious example can be the high rate of venture start ups in spite of
high venture failure rates), we argue that certain financial conditions lead to its actualisation.
Indeed, our logic here is similar to that of Gervais and Odean (2001) who develop a dynamic
model of overconfidence among traders and propose that traders learn about their abilities
from their successes and failures. They suggest that traders, having a self attribution bias,
take too much credit for their success and become overconfident as a result of success. A
similar thing has been suggested to happen to entrepreneurs, in that their experience of
success would confirm their confidence in their judgement and in their ability to control
events (Kahneman, 2011, p. 256 ) and hence, it has been proposed that better firm
performance in the past increases entrepreneur overconfidence (Hayward and Hambrick,
1997; Hayward et al., 2006). In fact, the more successful the entrepreneurial firm, the more
likely it is that the entrepreneur takes credit for the success even when such success could be
attributed to other factors (Meindl et al., 1985). In other words, the self attribution bias causes
the successful entrepreneur to become overconfident since according to attribution theory
(Bem, 1965) individuals attribute successful events to their ability and disconfirming events
to external noise or bad luck.
Moreover, according to Camerer and Lovallo (1999) entrepreneurs’ overconfidence can get
stronger as they experience success and advance to a new level or as they suggest “as cream
rises to the top, hubris does too”. More specifically, Camerer and Lovallo (1999) create
experimental entry games in which the success of entering subjects depend on their relative
skills compared to other entrants. They find that excessive entry, caused by overconfidence,
is much larger when participants know that the payoff depends on their skill. They suggest
that the stronger overconfidence observed here is due to insufficient weighting of the
comparison group (reference group neglect) by the highly skilled individuals. Consequently,
they suggest that overconfidence gets stronger as people advance to a new level since they
see their success as a signal of their relative skill and neglect the quality of their competitors.
Therefore, it is proposed that entrepreneurs become more overconfident if their firms
experience greater success. A further issue is that managers become overconfident as a result
of success and will rely on a single way of conducting business that has worked in the past
while neglecting other approaches and this can lead to declining performance (Miller, 1993;
Audia et al., 2000).
5
Hypothesis Development
Psychological research has documented certain advantages for overconfidence by suggesting
that it enhances motivation, encourages persistence at tasks and leads to more effective
performance (Taylor and Brown, 1988). Indeed, overconfident individuals work harder and
spend more time on their tasks (Felson, 1984) and this increases their chances of success.
Moreover, overconfidence may help individuals to go for more ambitious goals and persist in
spite of obstacles and difficulties (Benabou and Tirole, 2002). With respect to entrepreneurial
activity overconfidence would help entrepreneurs in effective decision making under
situations with high environmental uncertainty and complexity (Busenitz and Barney, 1997).
In addition, overconfidence creates substantial enthusiasm without which many ventures
would never be established (Busenitz and Barney, 1997). In fact, through being
overconfident, entrepreneurs maintain a positive mode that is useful in obtaining the
necessary resources, raising the morale of their employees, and enhancing their future
prospects (Kahneman, 2011). Moreover, it has also been suggested that moderate
entrepreneurial overconfidence reduces underinvestment inefficiency (Goel and Thakor,
2008).
Overconfidence also plays an important role in the IPO decision of entrepreneurial firms. It is
well accepted that an important stage in the life cycle of entrepreneurial firms is when
entrepreneurs decide to take their firms public. More specifically, an IPO provides firms with
expanded access to equity capital and allows firms to generate funds for growth (Fama and
French, 2004). However, the supply of funds for IPOs is not unlimited and entrepreneurs
seeking an IPO have to be able to ‘stand out from the crowd’ and convince investors and their
professional advisors that their firm is worth investing in. In the UK, for instance, most of the
SMEs go public via a “placing” in which the shares are bought by large institutional investors
who are clients of the issuing bank or brokers (Jenkinson and Ljungqvist, 1998). Considering
the fact that professional investors are very busy people, overconfidence can be beneficial in
convincing them of the credibility of the venture (Russo and Schoemaker, 1992; Busenitz and
Barney, 1997). Moreover, given the general underperformance and failure of IPOs, investors
are always on the lookout for the investment which promises stellar returns that can help
balance the returns of the overall portfolio. Hence, confidence, indeed over-confidence, is
6
needed to attract funds in a competitive situation. This overselling of firms (the j curve of
sales growth) is achieved either through showing extraordinary effort prior to flotation or by
borrowing future performance (Degeorge and Zeckhauser, 1993) and is added to by a
tendency for entrepreneurs to overestimate the future outcomes of their firms as a result of
believing that the firm’s performance is under their control2 (Malmendier and Tate, 2005a).
Therefore, it is expected (and is not surprising to see) that IPO firms show an increase in
accounting performance (sales and operating returns) prior to flotation.
While there are benefits to an entrepreneur from being overconfident, it is not without costs.
In essence, overconfidence may be helpful in the early stages of entrepreneurship because of
the lower risk perception, which allows entrepreneurs to generate the high commitment
needed for success (Simon et al., 2000). However, entrepreneurs have to increase learning so
that their venture can adjust to unfolding realities and avoid any damage caused by initial
misperceptions (Simon et al., 2000). An increase in the entrepreneur overconfidence is,
therefore, documented to inversely affect firm value (Goel and Thakor, 2008). This is
because more overconfident entrepreneurs are more likely to underestimate risk (Gervais and
Odean, 2001), go for risky opportunities (Simon and Houghton, 2003), take risks in
mobilising resources (Hayward et al., 2006, 2010), overvalue their own corporate projects
and invest in negative net present value projects (Heaton, 2002), and, generally, apply more
aggressive corporate policies. For instance, Heaton (2002) develops a model to explore the
relationship between managerial optimism and the benefits and costs of free cash flow. He
finds that overconfident managers may invest in negative net present value projects even
when they are loyal to shareholders since they overvalue their own corporate projects. In
addition, Simon and Houghton (2003) suggest that more overconfident managers are more
likely to introduce risky products that are less likely to succeed.
Another problem with overconfidence is that it can cause persistence which although usually
beneficial can be also costly (Kahneman, 2011). The cost of persistence has been documented
in the study of Astebro and Bernhardt (1999) which has investigated the social rate of return
of the Canadian Investor’s Assistance Program. They find that a considerable proportion of
overconfident inventors continue working on their unpromising projects after receiving
2
This is because entrepreneurs’ wealth is tied up in their firms (Pastor et al., 2009).
7
disconfirming news and as a result double their initial loss before stopping their projects
(Kahneman, 2011).
In the context of IPOs we argue that more overconfident entrepreneurs, who have
experienced financial success in the past as evidenced by positive operating returns as well as
higher growth in sales than in operating expenses, allocate the money raised through an IPO
prematurely and excessively to risky opportunities rather than focusing on the cost of
growing and managing the costs (operating expenses) associated with high growth (growth in
sales). In other words, their overconfidence feeds through to financial mismanagement and
this results in under delivering against promises (Hayward et al., 2010). Hence, we expect
these IPO firms to show a higher growth in operating expenses than sales post flotation
suggesting that they do not allocate the raised money efficiently and they lose control of costs
in their businesses (financial mismanagement) which leads to underperformance in the long
term. In other words, these IPO firms fail to equilibrate between different aspects of growth
after flotation - they keep growing sales (showing significant growth in sales) after flotation
but fail to maintain a balance between growth and the associated costs and hence,
underperform in the long run. Overall, our argument here is in line with the Bragger et al.
(2003) finding that “earlier success can sow the seeds of future failure”. More specifically,
they investigate the behaviour of participants in their study who played the role of vice
president for marketing in a failing venture. They find that participants who experience an
earlier profitable decision making scenario invest more resources in the failing scenario than
those participants with no such prior experience. What we expect to happen in the case of
IPOs is that firms with better past performance under-deliver as a result of overconfidence
being built over the time of success.
Given the above stated arguments and applying the above to the IPO process, we expect
entrepreneurs’ overconfidence to increase in those firms which are performing well pre
flotation as evidenced by positive operating returns as well as higher growth in sales than in
operating expenses. Furthermore, extreme overconfidence (caused by good past performance)
reduces firm value and hurts the shareholders (Goel and Thakor, 2008) post the IPO. This
leads to the following two hypotheses:
H1: Firms with positive operating returns pre flotation experience underperformance in
operating returns in the long term.
8
H2: Firms with positive operating returns pre flotation show a higher growth rate in operating
expenses than sales post flotation.
However, without good performance pre IPO, the overconfidence bias within entrepreneurs
remains latent and this has positive benefits for post IPO performance. More specifically, a
moderate degree of overconfidence is to the benefit of shareholders since it reduces
underinvestment inefficiency (Goel and Thakor, 2008). Consequently, we expect that
underperformance disappears for those firms performing poorly pre flotation (with negative
pre IPO operating returns and lower growth in sales than in operating expenses). The owners
of these firms, being aware of their poor financial situation, put all their efforts to improving
the situation and try to get the best out of the equity finance provided through the IPO.
Subsequently, it is expected that these firms manage the situation with the help of the
available finance and hence, underperformance should not be the case for them in the long
term.
H3: Firms with negative operating return pre flotation do not experience underperformance in
operating return post the IPO.
H4: Firms with negative operating return pre flotation show a lower growth rate in operating
expenses than sales post flotation.
2. Data and Methodology
Sample:
The sample used for this study comprises all the British companies that have been
listed on the Alternative Investment Market (AIM) from the time it was first launched in June
1995 until the end of 20083. AIM is the junior market to the London Stock Exchange for
listing smaller, growing companies from across the globe. AIM has derived competitive
strength from its location in the City of London financial services cluster as well as from its
distinctive regulatory system tailored to the needs of small companies (Arcot et al., 2007).
The initial sample of this study consists of 1070 companies which have their main base of
operation in the UK. However, in the empirical section, where the performance is measured
3
The crisis period post 2008 was not chosen because of the relative scarcity of IPOs in the UK during this
period. It is far from clear that the few firms that managed to get an IPO away during the crisis period are at all
typical.
9
pre and post flotation it is observed that there are missing values on performance measures.
Therefore, the maximum number of IPOs which have contributed to our analysis has reduced
to 762 firms. Throughout the empirical section the number of observations is reported for
each year pre and post flotation and a Mann-Whitney U test is used to compare the
differences in the unequal observations. Table 1 provides some descriptive statistics on the
initial sample. Panel A of Table 1 shows the number of AIM British flotations per year. It
shows that at the start of the market in 1995 only 15 British firms had entered the market. The
number of flotations generally increased through time and it can be seen that in 2000 this
number reached 158. After 2000 the table suggests that the number of IPOs lowered for the
subsequent three years but then increased again, and in 2004, 2005 and 2006 higher than
average numbers of flotations were observed. In 2007, with the start of the financial crisis,
the number of British IPOs had decreased to 60 firms and in 2008 only 9 flotations were
observed. Panel B shows characteristics of the sample firms at IPO. It shows that the average
age of IPO firms at IPO is slightly more than 38 months with half of them younger than 7
months old. This suggests that the sample firms are very young and are at a very early stage
of their life cycles. Panel B also suggests that the average market value at IPO is almost £23m
with half of the firms having a market value of less than £11.97m. The minimum and
maximum amounts of market value show that the size of AIM firms at IPO ranges from
£200,000 to £703.96m. With regards to the amount of monies raised at AIM, Table 1, Panel
B shows that firms raised on average £8.13m with a median of £3.2m and a standard
deviation of £19.52m. The minimum and maximum amounts of monies raised suggest that
AIM is a market that has provided growing firms with equity finance at different levels
ranging from £50,000 to £388.97m. Finally, Table 1, Panel B shows that the average issue
price of AIM firms is 69.38 pence, the minimum is 0.2 pence, and the maximum is 750
pence.
Methodology:
In order to test the hypotheses developed earlier, we investigate the performance of British
AIM IPOs by carefully examining two performance measures, namely operating return and
the ratio of operating expenses over sales. For this purpose, the change in performance
measure is calculated as the percentage change in the median levels. More specifically we
look at the rate of change in median levels as follows:
10
[median value of performance measure i (t2) – median value of performance measure i (t1)]/ |
median value of performance measure i (t1) | , where i represents the IPO firm, t1 represents
a pre-IPO fiscal year, and t2 represents a post-IPO fiscal year. The reason for using the
median versus the mean is that performance measures may be skewed and the mean is
sensitive to outliers; therefore, the median provides a better measure of the central tendency.4
In order to test whether the difference in the median levels are significant the Mann-Whitney
U test which is a nonparametric alternative to the two sample t-test is used. The MannWhitney U test is one of the most powerful nonparametric tests for comparing two
populations when the normality assumption is questionable. It tests the null hypothesis that
two populations are the same against the alternative hypothesis that a particular population
tends to have larger values than the other.
4. Empirical Analysis
Underperformance in Operating Return
Operating return is a measure of the efficiency of asset utilization which is defined as
Earnings Before Interest and Taxes (EBIT) divided by total assets. Given the arguments
developed earlier that underperformance occurs for those IPO firms whose entrepreneurs
become overconfident as a result of recent financial success, sample firms are divided into
two groups based on their operating return pre flotation. Hence, changes in the operating
return of the IPOs with positive operating return pre flotation are examined separately from
those of IPOs with negative operating return pre flotation; Figures 1 and 2 show median
levels of operating return for IPOs with positive and negative operating return pre flotation,
respectively.
Figure 1 shows that the operating return of IPOs with positive operating return pre flotation
generally increases pre flotation and starts to decrease post flotation. The figure is indicative
of underperformance for this group of IPOs compared to both the IPO and pre IPO years.
Furthermore, the results of the Mann-Whitney U test, examining the significance of
difference in median operating return, presented in Panel A of Table 2, suggest that the
decline in median operating return compared to both the IPO and pre IPO years is statistically
4
Jain and Kini (1994), Kim, Kitsabunnarat and Nofsinger (2004), and Wang (2005) have also applied the median
rather than the mean to measure the post-IPO operating performance.
11
significant. Therefore, it is concluded that IPO firms with positive operating return pre
flotation experience underperformance in operating return in the long term.
Figure 2 shows that the operating return of IPOs with negative operating return pre flotation
generally increases pre and post flotation. In fact, results of the Mann-Whitney U test
presented in Panel B of Table 2 suggest that increase in operating return in years 0, 4, and 5
compared to year -1 is statistically significant. Considering year 0 as the base of comparison,
it is observed that increase in years 4 and 5 is statistically significant. The results, therefore,
suggest that IPOs with negative operating return pre flotation do not experience any
significant underperformance in the long term. On the contrary, they even experience
significant increase in operating return within four or five years of flotation.
Overall, the results presented in Table 2 suggest that IPOs with positive operating return pre
flotation significantly underperform in operating return relative to both the IPO and pre IPO
years. Whereas IPOs with negative operating return pre flotation do not experience any
significant underperformance in operating return compared to both the IPO and pre IPO
years.
Therefore, the results presented in Table 2 support hypotheses one and three
developed earlier in the paper.
Ratio of Operating Expenses over Sales
In this section we look at the IPO performance by carefully examining the changes in sales
and operating expenses pre and post flotation. Firstly, we look at changes in sales to show
that IPO firms generally show growth in sales pre and post flotation. Sales is defined as the
net sales or revenue which represents gross sales and other operating revenue less discounts,
returns, and allowances. Figure 3 depicts median sales levels for IPO firms in a nine year
window surrounding IPO. It shows that sales levels generally start to increase pre flotation
and continue to go up after IPO for both IPOs with positive and negative operating return pre
flotation. The rate of change in median sales levels pre and post flotation are presented in
Table 3. The Table also presents the Mann-Whitney U test results comparing median levels
of sales across time.
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Panel A of Table 3 shows the changes in median sales levels for IPOs with positive operating
return pre flotation. With regards to the increase in the median sales pre flotation Panel A
suggests that the increase from year -3 to 0 and from year -2 to 0 is statistically significant.
Respecting the post flotation increase in the median sales levels, Panel A suggests that
increase on years 1 to 5 compared to IPO year is statistically significant.
Panel B of Table 3 presents the changes in median sales levels for IPOs with negative
operating return at IPO year. The rates of change in median sales suggest that median sales
level generally increase pre and post flotation. However, the results of the Mann-Whitney U
test suggest that only the increase post flotation on years 1 to 5 compared to the IPO year is
statistically significant.
Overall, Table 3 suggests that median sales level significantly increases post flotation for
both IPO groups; however, the growth rate for IPOs with negative operating return pre
flotation is considerably higher. Nevertheless, looking only at changes in sales is not
indicative enough. In order to test hypotheses two and four developed earlier in the paper we
need to look at the changes in sales and operating expenses simultaneously.
Figures 4 and 5 show the ratio of operating expenses over sales for a nine year window
surrounding the IPO year for firms with positive and negative operating return pre flotation,
respectively.
Figure 4 shows that the ratio of operating expenses over sales of the IPOs with positive
operating return pre flotation decreases until the IPO year and increases for the next five
years post flotation. Moreover, the results of the Mann-Whitney U test presented in Panel A
of Table 4 suggest that the decrease in the ratio pre flotation and the increase post flotation
compared to the IPO year is statistically significant. This result supports our second
hypothesis that firms with a positive operating return pre flotation show a higher growth in
operating expenses than sales post flotation.
13
The above results suggest that those IPO firms which experience financial success pre
flotation, as evidenced by having higher growth in sales than operating expenses and positive
operating return pre flotation, perform poorly post flotation by showing slower growth in
sales than operating expenses. The
observed pattern is helpful in explaining the
underperformance of these IPO firms by proposing that owners of these firms become
excessively overconfident as a result of past financial success. These are financially stronger
firms with positive operating return and a faster growth rate in sales than in operating
expenses hence, their managers are likely to attribute the success to their expertise and put
less effort in managing the firm and generally lose control of the company post flotation.
This excessive overconfidence will therefore contribute to underperformance in operating
return of this group of IPOs post flotation.
In contrast, Figure 5 suggests that the ratio of operating expenses over sales for firms with
negative operating return pre flotation generally increases pre flotation and decreases in the
subsequent years post flotation. Furthermore, Panel B of Table 4 shows that increase in the
ratio pre flotation compared to the IPO year is statistically significant. Moreover, Panel B
suggests that decrease in the ratio on years 2 to 5 after flotation compared to IPO year is also
statistically significant. The observed pattern suggests that operating expenses grow faster
than sales pre flotation and slower post flotation for the firms with negative operating return
pre flotation. As it was shown earlier this group of IPOs do not either experience any
significant underperformance in operating return post flotation. Therefore, it seems that the
performance of this group of IPOs (IPOs which are performing poorly pre flotation with
negative operating return and higher growth rate in operating expenses than sales) improves
post flotation. We argue that with the lack of financial success in this group of IPOs pre
flotation entrepreneurial overconfidence has not yet been actualised, hence; these IPOs do not
experience any significant underperformance post flotation.
Overall, the presented results in Table 4 support hypotheses two and four developed earlier in
the paper.
The presented results suggest that underperformance exists only for those IPO firms with
positive operating returns pre flotation and we argue that this is caused as a result of
14
entrepreneurs’ excessive overconfidence caused by experiencing financial success in their
firms’ performance in pre IPO years.
5. Conclusion
This paper introduces a new explanation of IPO long term underperformance. More
specifically, the paper explores the overconfidence bias of entrepreneurs in explaining the
long term underperformance of their firms after an IPO. It is argued that underperformance
only exists for those IPO firms where their owners become excessively overconfident as a
result of recent financial success.
The presented results show that underperformance in operating return only exists for those
IPO firms with positive operating return before flotation. The results also show that IPOs
with positive operating return before flotation show a higher growth rate in sales than
operating expenses pre flotation and experience a significant lower growth rate in sales
compared to operating expenses after flotation. On the other hand, investigating the
performance of IPOs with negative operating return pre flotation shows that these types of
IPOs do not experience any underperformance in operating return over the next five years
after flotation. In fact, these types of IPOs even experience significant increase in their
operating performance on years four and five after flotation compared to both IPO and pre
IPO year.
The existence of underperformance for IPOs with strong past financial performance may
suggest that the owners of these firms become excessively overconfidence as a result of past
financial success and hence, allocate the money raised through IPO prematurely and
excessively to risky opportunities rather than focusing on the cost of growing and managing
the cost associated with high growth. Indeed, it can be argued that the managers of these
companies are likely to attribute the success to their expertise and put less effort in managing
the firm after IPO and generally lose control of the company post flotation. This excessive
overconfidence will therefore contribute to underperformance in operating return of this
group of IPOs post flotation.
15
Overall, it can be concluded that IPO firms with strong financial performance pre flotation do
not allocate the raised money efficiently to keep sustainable growth in their accounting
performance and in general they lose control of cost in their business. More specifically, it is
suggested that stronger financial performance prior to flotation may lead to overconfidence
and hence, underperformance of the IPO firm in the long term.
16
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20
Table 1 : Descriptive statistics
IPOs
15
79
54
31
51
158
83
43
51
167
162
107
60
Panel B: Characteristics of the sample firms at the time of IPO
Age (Months)
Market Value (£m)
Money Raised (£m)
Issue Price (p)
38.39
22.97
8.13
69.38
7
11.97
3.2
55
Standard Deviation
83.75
42.74
19.52
64.58
Kurtosis
51.59
96.54
164.51
12.88
Min
0
0.20
0.05
0.2
Max
994
703.96
388.97
750
Mean
Median
21
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
Panel A: Distribution of AIM British IPOs by year
9
Figure 1 Operating return for IPOs with positive operating return pre flotation in a
nine year window surrounding IPO
The figure depicts medians of the operating return for IPOs with positive operating return pre flotation for a nine
year window (-3 to +5 years) surrounding the flotation year.
0.12
0.1
0.08
0.06
0.04
0.02
0
Observation number
-3
-2
58
149
-1
230
0
1
2
3
4
5
356
319
270
196
135
94
Figure 2 Operating return for IPOs with negative operating return pre flotation in a
nine year window surrounding the IPO
The figure depicts medians of the operating return for IPOs with negative operating return pre flotation for a
nine year window (-3 to +5 years) surrounding the flotation year.
0
-3
-2
-1
0
1
2
3
4
5
-0.1
-0.2
-0.3
-0.4
-0.5
-0.6
Observation number
43
115
222
403
352
273
22
196
148
120
Table 2 Change in operating return post flotation
Panel A of the table presents results of the Mann-Whitney U test examining significance of changes in operating
return for IPOs with positive operating return pre flotation. Panel B provides the same results for IPOs with
negative operating return pre flotation.
Panel A: Changes in median operating performance for IPOs with positive operating return pre flotation
Year -1 to 0
Year -1 to 1
Year -1 to 2
Year -1 to 3
Year -1 to 4
Year -1 to 5
Year 0 to 1
Year 0 to 2
Year 0 to 3
Year 0 to 4
Year 0 to 5
Rate of change in median (%)
Asymptotic Significance
-5.19
-20.22
-23.24
-29.03
-41.49
-47.72
-15.85
-19.04
-25.15
-38.28
-44.86
0.588
0.000***
0.000***
0.000***
0.000***
0.000***
0.000***
0.000***
0.000***
0.000***
0.000***
Panel B: Changes in median operating performance for IPOs with negative operating return pre flotation
Rate of change in median (%)
Asymptotic Significance
Year -1 to 0
Year -1 to 1
Year -1 to 2
Year -1 to 3
Year -1 to 4
Year -1 to 5
Year 0 to 1
Year 0 to 2
Year 0 to 3
Year 0 to 4
Year 0 to 5
37.76
21.10
15.11
23.00
54.11
79.99
-26.75
-36.39
-23.70
26.27
67.84
23
0.057*
0.241
0.236
0.125
0.000***
0.000***
0.155
0.165
0.656
0.007***
0.000***
Figure 3 Sales levels in a nine year window surrounding IPO
The figure depicts medians of the sales level for IPOs with positive and negative operating return pre flotation
for a nine year window (-3 to +5 years) surrounding the flotation year.
18000000
16000000
14000000
12000000
10000000
Sales for IPOs with negative operating return pre flotation
sales for neg ebit IPOs
8000000
Sales
pos with
ebitpositive
IPOs operating return pre flotation
Salesfor
for IPOs
6000000
4000000
2000000
0
-3
-2
-1
0
1
2
3
4
5
24
Table 3 Change in median sales post flotation
The table presents changes in the medians of the sales of AIM IPO firms and the relative significance levels for
firms with positive and negative operating return pre flotation.
Panel A: Changes in median sales for IPOs with positive operating return pre flotation
Rate of change in median (%)
Asymptotic Significance
Year -3 to 0
Year -2 to 0
Year -1 to 0
Year 0 to 1
Year 0 to 2
Year 0 to 3
Year 0 to 4
Year 0 to 5
36.59
25.29
4.09
47.34
80.22
96.83
67.70
76.97
0.021**
0.028**
0.181
0.000***
0.000***
0.000***
0.000***
0.000***
Panel B: Changes in median sales for IPOs with negative operating return pre flotation
Rate of change in median (%)
Asymptotic Significance
Year -3 to 0
Year -2 to 0
Year -1 to 0
Year 0 to 1
Year 0 to 2
Year 0 to 3
Year 0 to 4
Year 0 to 5
19.27
14.29
1.63
174.77
350.55
391.76
654.21
868.01
25
0.539
0.854
0.621
0.000***
0.000***
0.000***
0.000***
0.000***
Figure 4 Operating expenses over sales for IPOs with positive operating return pre
flotation in a nine year window surrounding the IPO
The figure depicts medians of the operating expenses over sales for IPOs with positive operating return pre
flotation for a nine year window (-3 to +5 years) surrounding the flotation year.
0.98
0.96
0.94
0.92
0.9
0.88
0.86
-3
-2
-1
0
1
2
3
4
5
Figure 5 Operating expenses over sales for IPOs with negative operating return pre
flotation in a nine year window surrounding the IPO
The figure depicts medians of the operating expenses over sales for IPOs with negative operating return pre
flotation for a nine year window (-3 to +5 years) surrounding the flotation year.
2.5
2
1.5
1
0.5
0
-3
-2
-1
0
1
2
26
3
4
5
Table 4 Changes in median operating expenses over sales
The table presents changes in the medians of the operating expenses over sales of AIM IPO firms and the
relative significance levels for firms with positive and negative operating return pre flotation.
Panel A: Changes in median operating expenses over sales for IPOs with positive operating return pre flotation
Change in median (%)
Asymptotic Significance
Year -3 to 0
Year -2 to 0
Year -1 to 0
Year 0 to 1
Year 0 to 2
Year 0 to 3
Year 0 to 4
Year 0 to 5
-5.81
-4.41
-3.30
1.66
4.20
4.91
5.96
7.09
0.000***
0.000***
0.000***
0.005***
0.000***
0.000***
0.000***
0.000***
Panel B: Changes in median operating expenses over sales for IPOs with negative operating return pre flotation
Year -3 to 0
Year -2 to 0
Year -1 to 0
Year 0 to 1
Year 0 to 2
Year 0 to 3
Year 0 to 4
Year 0 to 5
30.53
41.48
26.89
-3.33
-16.72
-27.66
-38.85
-42.88
0.000***
0.000***
0.001***
0.340
0.016**
0.000***
0.000***
0.000***
27