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1 Introduction
1.1 Background to the research1
Initial public offerings (IPOs) have attracted a great deal of attention from academic researchers and financial practitioners. In particular the IPO market around the late 1990s and early 2000s addressed a lot of interesting questions about the pricing and performance of IPO companies. In this era, small and medium-size enterprises (SMEs) based on information and communication technology realised huge gains on their stock market debut. Although numerous studies have documented this aftermarket high initial return (or interchangeable underpricing) even before this period, the degree of the initial return was unprecedentedly high during this period (Ljungqvist and Wilhelm, 2003). Many researchers have wondered why the underpricing increased and the issuers “didn’t get upset about leaving money on the table in IPOs” (Loughran and Ritter, 2002). During this period the IPO market was regarded as a catalyst, attracting new issues by innovative and high-technology-oriented SMEs, which were seemingly growing without interruption with the advent of the new knowledge economy. The enormous growth of NASDAQ in the United States fostered the financing of high-tech SMEs and resulted in the establishment of similar types of stock markets in other countries. Most of these markets were born in the late 1990s, including AIM in the United Kingdom and the Euro.NM network in Europe. KOSDAQ (Korean Securities Dealers Automated Quotation), the secondary stock market in Korea, was launched in 1996 following this global trend, and it has played a substantial role in financing a number of Korean high-tech SMEs. The market capitalisation volume of KOSDAQ was one of the largest among global second-tier stock markets by the end of 1999. The growth of KOSDAQ was matched by a growth in the Korean venture capital (VC) industry; this pattern was also the case in other countries. However, with the collapse of global stock markets in the second quarter of 2000, the growth of KOSDAQ was brought to a halt, and it has not recovered its previous peak level of a decade ago.
The increasing underpricing in the short run, followed by underperformance in the long run, are general patterns that are found in the pricing and performance of IPOs around the globe (Ritter, 1991; Ritter and Welch, 2002; Loughran et al., 2003). KOSDAQ is not an exception in this respect. The pervasive nature of this underpricing and poor long-term performance around the globe has been explained in a number of ways. While most of the discussion has concentrated on the information asymmetry, agency problems, and conflicts of interest that come up between the issuing company, underwriter, and investor, it has been shown that a financial player who certifies and adds value to uncertain IPO firms can significantly ameliorate these problems, thereby leading to less underpricing and better long-run performance. A venture capital company, which features private, long-term, and risky equity finance with the aim of ultimately realising abnormal returns, has been considered an institution that can play this role for an IPO company (Wright and Robbie, 1998).
This book is an investigation of the performance of IPOs in Korea during this rapidly changing dot-com bubble-and-bust period (1999–2001), which is already about fifteen years ago but is still worth analysis in terms of venture capital participation, reputation, and conflicts of interests, particularly in the context of the development of a new secondary stock market in an emerging market. In a country such as Korea, in which firms generally relied on banks or other financial institutions, the remarkable expansion of KOSDAQ indicated that the Korean economy was experiencing a period of transition from a bank-based financial system to a newly emerging stock market-based financial system, even though the banks still played a major role in financing the national business system. The stock market-based financial system was promoted as an engine for economic growth by the Korean government following the foreign exchange crisis that occurred in 1997. However, the growth of KOSDAQ was widely criticised. Questions were raised about the pricing of IPO firms, especially their valuation relative to the fundamentals of the firms. The acute decline of KOSDAQ prices after March 2000, along with the global stock market crash, highlighted these questions. In this book, I focus on the role that reputable financial institutions such as banks may play in ameliorating the information asymmetry and agency conflicts inherent in high-tech SMEs and in adding value to them so that the companies’ IPO pricing and long-term performance do not deviate much from their original valuation at IPO. These reputation and related governance issues have been a major concern of scholars of international comparative financial systems (Mayer, 2002) and of those of stock market development and economic systems (Singh, 2003). The theoretical discussion and empirical analysis highlighting the role of highly reputable VCs and financial institutions in the valuation and long-term performance of IPO companies, in particular, with the dataset in an emerging market such as Korea in the volatile dot.com bubble-and-bust period (1999–2001) should be of interest to academic researchers, financial practitioners, and policy makers dealing with emerging market issues in major markets (including US/Europe ones).
There has been much theoretical and empirical research on the relationship between IPO performance and venture-capital-backing in the US and European settings. Numerous studies document underpricing in the short run and underperformance in the long run in the pricing of IPOs of common stock in global stock markets. Most of the discussion in the underpricing literature has concentrated on the information asymmetry problem that comes up between issuer, investor and underwriter. It examines the role of a reputable financial player certifying uncertain IPO firms as a way to significantly reduce the information gap. This decreases the degree of underpricing. IPO firms supported by reputable financial players would also be expected to show outperformance in the long term, because in order to maintain their reputational capital they would only bring better-quality IPO firms to the market and add further value to the firms following their due diligence before IPO.
The role of a venture capital company as a certifying agent and value-adding financial player for the IPO firms arises from several sources. Venture capitalists can develop expertise in the financing of technology-based firms and other SMEs. Venture capitalists not only supply funding, but also can intervene in the ownership and management in order to closely monitor the firms. They hold shares in the firms and serve as members of board of directors. They also tend to specialise in particular industry sectors and provide consulting services for corporate strategy to the firms. In order to minimise the agency costs and information asymmetries between themselves and the firms, venture capitalists employ various mechanisms such as staging of capital infusion, syndication of investment and use of convertible debt. Furthermore, facing reputational risk as repeated financial players who regularly raise new funds, venture capitalists are very cautious about the reputation build-up and often interact with other financial institutions and agencies such as underwriters. However, all venture capitalists are not the same: their quality is different. Some venture capitalists may be money-game players, being more interested in the short-term capital gain after IPO, rather than adding value through the mechanisms mentioned above. These venture capitalists incur conflicts of interest between issuing companies and investors, unlike the reputational venture capitalists.
The ownership structure of venture capitalists themselves may also affect IPO firm performances. Contrary to US and UK venture capitalists, who are mostly independents, Korean venture capitalists are generally captives of financial institutions or other corporate venturing companies. This feature of the Korean venture capital industry is rather closer to that of Germany and Japan. It might be expected that Korean venture capital companies will generally act as the same kind of certifying and value-adding financial agents. It is also likely, however, that the ownership of venture capitalists may result in different investment behaviour in relation to IPO firms, thus leading to different IPO performance. In a situation where a stock market experiences an enormous growth and the following sharp decline, as KOSDAQ did in the very volatile stock market situation over the period 1999–2001, the potential certification or conflict of interests factors that can be caused by venture capitalists’ affiliation with other financial institutions is an intriguing research topic. I therefore examine the impact of the quality of venture capital companies, especially in terms of its ownership structure and reputation on IPO performance. In particular, I test the possibility of a positive impact of bank-affiliated venture capitalists such as an information advantage of banking institutions, and a negative impact of security company-affiliated venture capitalists where conflicts of interest may lead to the tendency towards overvaluation of IPO firms.
To examine these issues required a substantial programme of data collection on the short- and long-term performance of IPO firms and their ownership structures, and the ownership and reputational characteristics of the venture capitalists who invested in the firms. The dataset is one of the original contributions of this book.
Measuring short-run underpricing in the Korean economy also poses methodological problems. Stock Market regulation in Korea imposed a daily limit of stock price changes on KOSDAQ and the limit changed in the period analysed in this book. This meant that I had to create a measure which adjusts for this, and which estimates when the suppressed price changes could be identified. The finance literature related to long-term performance methodology is also not straightforward. It suggests the use of buy and hold abnormal returns (BHARs). However, there are many benchmarks used to measure BHARs. I calculated BHARs employing five benchmarks that are recommended and commonly used in recent literature. Instead of deciding on the superiority of one method over another, I compared and interpreted the variations in performance they produced and use them as test of the robustness of our results to changes in benchmarks I employ univariate parametric and non-parametric tests and multivariate regression analysis in order to test our hypotheses.
This book analyses the determinants of IPO performance in a very particular national setting, KOSDAQ, in a very particular period 1999–2001 which is divided into “hot” and “cold” stock market situations. Very few studies in the literature have analysed Korean IPOs in this period. The detailed analysis of KOSDAQ will allow for an independent set of tests of IPO underpricing and the long-term performance and update the previous results in other studies. I expect that the academic readers of this book can understand the underpricing and long-term performance pattern of KOSDAQ IPOs over the period 1999–2001 when KOSDAQ experienced a dramatic surge and the following abrupt decline and how VC-backing and other reputational and institutional effects influenced the firm performances. This research could also give investors a new insight into the Korean IPO market, especially by comparing the performance of VC-backed and non-VC-backed IPOs. The Korean financial regulatory agencies could also benefit from this research by getting insights into the differences between successful and unsuccessful IPOs and the role of venture capital participation, and the quality and ownership of venture capitalists. This could assist in the design of a financial regulation system to foster high-quality venture capitalists and to help the conventional Korean venture capitalists to review their activities so as to bring about successful IPOs. The research in this book could also provide an input into developing-country government thinking in relation to promoting an active KOSDAQ type of stock market, and how the participation of venture capitalists and their institutional affiliation with large shareholders may lead to reducing information asymmetry and add value of IPO firms. It will also demonstrate the way in which these effects may be overwhelmed by the euphoria of stock market booms.
1.2 Chapter plan
This book is organised as follows.
In Chapter 2, I provide an institutional description of the venture capital industry and the IPO market in Korean and other major countries. I introduce the institutional framework of venture capital, set out recent trends in the venture capital industry, and provide an account of the institutional framework of initial public offerings and IPO markets.
In Chapter 3, I review the literature regarding underpricing, and the long-term performance mechanisms of the certification and the value-adding role provided by venture capitalist. I derive the hypotheses for our empirical tests. I deal with how the information asymmetry between investors and issuers and the hot issue market phenomenon can affect underpricing and how the disappearance of information asymmetry and the timing of IPOs can influence long-term performance. I deal with the certification and value-adding role of venture capitalists, including internal mechanisms to minimise uncertainty, monitoring and screening functions, and external activities. I also discuss the impact of venture capitalists’ institutional affiliation with banks and security companies on the performance of IPO firms. I introduce the universal banking perspective and discuss how it applies to the certification and conflict of interests that a financial institutions-affiliated VC may cause. Following the literature review, I derive twelve testable hypotheses.
In Chapter 4, I present the dataset and discuss the methodology to be used to test the hypotheses. I document the sources of data and discuss sample selection issues. I give an account of the concepts and definitions of stock market performance in terms of underpricing and long-term performance and explain various types of benchmarks that will be used in order to adjust raw long-term performance. I set out the specification of the univariate tests and the multivariate regression model I use in Chapters 5, 6, and 7. In particular, I describe the independent dummy variables and several control variables that will be used in multivariate regressions and specify the multivariate regression models that I implement in order to test our hypotheses.
In Chapter 5, I describe the main characteristics of our IPO samples by comparing VC-backed and non-VC-backed IPOs. I cover the trend in IPOs, their industry distribution, and set out IPO sample characteristics, including ownership structure, sources of funds, and financial and operating performance prior to IPO. I compare these characteristics of KOSDAQ IPO samples with that of other major countries.
In Chapter 6, I report the results of a univariate and a multivariate analysis of underpricing. I compare underpricing across different types of IPOs: VC-backed and non-VC-backed, hot and cold issue market, age (young and old), market capitalisation (small and big), and industry (high-tech and non-high-tech), respectively. This analysis across different classification of IPOs is extended by cross-classification in more detail. I also compare underpricing across IPOs grouped by the institutional type of VC-backing (bank-affiliated, security company-affiliated, other institution-affiliated and non-VC-backed). I also report the result of multiple regressions on underpricing, which were carried out for IPOs for whole sample period, IPOs in the hot market, and IPOs in the cold market, respectively.
In Chapter 7, I present the results of univariate and multivariate analysis of long-term performance. I compare the long-term performance of IPOs, grouped by venture-capital-backing (VC-backed and non-VC-backed), hot issue market (hot and cold market), age (young and old), market capitalisation (small and big), industry (high-tech and non-high-tech), and the degree of underpricing (low and high), respectively. I also extend this analysis by cross-classification in more detail. I compare the long-term performance of different types of VC affiliation: bank-affiliated, security company-affiliated, other institution-affiliated and non-VC-backed. I document the result of multiple regressions on long-term performance, which were implemented for the hot-market period and the cold-market period, respectively.
In Chapter 8, I conclude the book by summarising the previous chapters and documenting an implication of the research.
Note
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2 Institutional description of the venture capital industry and the IPO market
2.1 Overview
I deal with the institutional aspects of the venture capital industry and the IPO market in this chapter. I document the basic concept and structure of the venture capital industry and the IPO market, and present the trend of venture capital investment and of the IPO market over the years in Korea and other major countries. The organisation of this chapter is as follows.
In Section 2.2, I introduce the definition and the main structure of venture capital investment and define terms that appear frequently in this chapter. I document the various stages of venture capital investing from seed investment to IPO and describe each step of venture capital investment decision-making. I then address the question how important v...
