An Initial Public Offering or IPO is one of the most significant proceedings in a life of a growing company. From a theoretical perspective, our understandings of the true reasons of why companies go public are the following: to create liquidity, to fund growth opportunities, to enable insiders to cash out, to minimize cost of capital, to diversify risk, to increase transparency as the company will be subjected to certain requirements, to establish a market value or to enhance a company's reputation. Despite the large number of theoretical arguments, numerous researchers tried to empirically determine the reasons for IPOs.
Brau and Fawcett (2006) empirically corroborated the findings that companies doing IPOs share similar purposes. Following their survey, the most recurring response was the "creation of public shares for use in future acquisition". As a matter of fact, further studies have stressed that IPOs facilitate the acquisition activity for the acquiring company and for the targets as it creates a 'currency' or publicly-traded shares, which will be used in the acquisition process. Indeed, newly public firms have a strong appetite in term of acquisition which has been found to be greater than mature companies in a similar industry (Brau and Fawcett, 2006). For instance, banks going public are more likely to acquire as well as becoming targets when compared to banks remaining private (Rosen, Smart and Zutter, 2005).
The aim of this paper is to examine a relatively uncultivated motive for firms IPOs, which is the envy to acquire. In order to do so, the survey of Brau and Fawcett will be analysed in-depth, as well as commented using further discussions and evidences related to the acquisition activities of recent IPOs.
Going public has several advantages for the acquisition process. Indeed, an IPO may allow companies to pursue Mergers & Acquisition for two main reasons. On the one hand, the company will receive a substantial amount of cash, which will then be used in the acquisition process. Indeed, a strong correlation was found between the volumes of cash to finance M&A and the proceeds of IPOs, as the initial capital raised facilitates the acquisition procedure. On the other hand, the company has the possibility of paying the acquisition using 'overvalued stocks' (Celikyurt and al. 2009). Consequently, the shares will be used in the acquisition process instead of using cash. For instance, a rapidly growing company that has invested a substantial amount of cash into the business will prefer using stock-deal.
Companies with underpriced IPOs are more oriented towards the utilisation of shares in the acquisition process. Indeed, overvalued IPO firms find it easier to grow through the acquisition of other firms instead of investing in internal projects. Stock financed acquisition is closely related to the issue of underpricing which accounts for the price increases on the first day trading following the IPO. In most cases, this is caused by market overreaction. For instance, Purnanandan and Swaminathan (2004) advocated that underpricing and stock financed acquisition is positively related because IPOs underpricing is positively correlated with the overvaluation of stock. Hence, it appears that using overvalued stock for the acquisition process can be a very good alternative which may confirm the first motive of why firms go public as advocated by Brau and Fawcett (2006) in their empirical paper. However it is worth adding the argument developed by Rock (1986) who stressed that the issues of underpricing and overvaluation are insignificant for periods that extend two years the IPO because of evidences of long-run market underperformance and long-run operating underperformance. Indeed, many companies are doing well at the beginning but then are going so badly in market prices and operating performance which may affect the decision of a company to acquire in the long run.
Further studies have confirmed this strong appetite of newly public firms with regards to post-IPOs acquisition, namely Malmendier and Tate (2008). For instance, acquiring managers will expect that investors might be very optimistic in a takeover after an IPO, and hoping to find a very strong buy or sell. Given this overconfidence of investors, new IPO companies may be more tempted to acquire at a very early stage. However, Malmendier and Tate (2008) also added that the acquiring managers will destroy wealth by overpaying for acquisitions which will translate into poor stock price performance. This is referred as 'overconfidence' of the acquiring manager. Indeed, many CEOs will tend to overestimate their capabilities and overinvest in external growth. Thus, this also gives an explanation of why CFOs believe that a major reason for doing IPOs is the 'creation of public shares for future acquisition'. Moreover, Brau, Sutton and Couch (2007) analysed a sample of 4,795 IPOs and found that firms acquiring within the first year worse their long run underperformance by decreasing the three year holding period return by 28% when compared to firms that do not acquire in the first year.
In December 2007, Schering-Plough, a biopharmaceutical company that manufactures several drugs decided to finance its huge acquisition of Organon using stocks while it was up to more than 20% for the year. According to Schering-Plough's CEO, "it seems like a pretty good time to make a stock offering" as the company went public in August to 2007. However, the new corporation Schering-Plough-Organon was acquired by its compatriot Merck (NYSE: MRK) in July 2010 for $41 billion, thus creating a new giant in the pharmaceutical industry. We have here evidences of long-run underperformance of the 2007 acquisition of Organon by Schering-Plough which resulted in its takeover, as advocated by Brau, Sutton and Couch (2007).
This paper has previously discussed the reasons why IPO firms were much more involved in M&A activities in term of bidding. It is also important to highlight the fact that newly-public firms may also be acquired. It is important to bear in mind that the efficiency market hypothesis is a strong assumption, and thus some firms will be valued incorrectly. Managers are totally aware of that and will take advantage of stock market inefficiencies through being acquired. This is in contrast with Malmendier and Tate (2008) and Roll's (1986) explanations M&A in which financial markets are efficient and managers are irrational.
Brau and Fawcett (2006) stressed that IPOs create a 'currency' or public shares for a firm that can also be used in being acquired in a stock deal. A few number of theorists advocated that process of going public is widely used to ease the future sale of the company in order to increase the expected takeover premium, namely Zingales (1995), Mello and Parsons (1998). Indeed, the decision of going public can be initiated by the envy to eventually sell the company because doing an IPO will allow its owner to maximize the total proceeds from its eventual sale (Zingales, 1995). As a result of market overreaction, the owners may find it attractive to sell their shares at a higher price to another company. Recently, Rau and Stouraitis (2008) compared IPOs and M&A in terms of 'waves' and advocated that most IPO's waves are followed by M&A waves. They found that 3% of M&A of newly public firms are done with cash and 2% are stock-financed. However, their paper focused on those newly public firms being the target and not the acquirer which may account for these relatively low results.
The main question that arises here is that: why a firm would pay a significant cost for doing an IPO and then would choose to be acquired soon afterward? A study has been performed by Dai (2005) explaining the 'double exits' strategy. This often takes place in venture-backed firms indicating that the process of being acquired does not result from faulty IPOs. In fact, venture capitalists repeatedly perform this strategy of taking a firm a public and then selling it back to satisfy their liquidity needs. As a matter of fact, venture capitalists are very much short term oriented when compared to entrepreneurs that are usually much more long term oriented. This difference in horizon may account for the fact that entrepreneurs will prefer to exit later on, whereas venture capitalists will be more interested in short term profits. However, in 1997, Loughran and Vijh studied post-IPOs M&A and found that acquirers making stock acquisitions offer will often result in negative reaction of the market with significant negative long-run abnormal returns when compared to those cash tender offers that often result in positive long-run abnormal returns.
However, it is relatively hard to view Mergers & Acquisitions as a first motive for firms deciding to do an IPO as it encompasses a relatively long term perspective. It is also fundamental to bear in mind that Brau and Fawcett's empirical study was performed during the internet boom in 2000.
At the time, many companies were overvalued and thus, driving the price of their stocks at an irrational level. For instance, this overvaluation during the boom may have increased managers' hunger to pursue acquisition. Hence, this has fuelled many decisions to go public during the period of the study. Schultz and Zaman (2001) have stressed that most newly-public internet companies that went public during the internet boom engaged in a large amount of acquisition activity. During the technology bubble, companies and their acquisition managers were highly confident and optimistic when talking about Mergers & Acquisitions. This could have inflated the survey performed by Brau and Fawcett during 2000 and 2002. This raised questions of whether the survey can be generalized to other periods.
During the period 1999 and 2000, the number of underpriced companies that went public reached a very large number. For instance, Ljungqvis and Wilhelm (2003) studied the level of underpricing of companies that went public during the dotcom bubble and found that four years before, first-day returns on IPOs were around 17%, whereas in 1999, accounted for 73% and 89% in 2000. This irrational and irresponsible willingness of investment banks and other actors to incur such low prices mostly caused the bubble to bust. It is then relatively understandable that most technology companies at the time of the boom were tempted to go public and to benefit from the irrational reasoning of investors and to be acquired.
For instance, at the time of the boom, Healtheon, a pharmaceutical company, decided to use its overvalued stock to finance most acquisitions of other leaders in the industry. In 1999, the company paid a high price to acquire WebMD.com and OnHealth, two newly-public firms. Even if those two acquisitions gave to Healtheon the access to internet consumer health market, WebMD.com lost $6.5 billion on revenue in the first 9 months following the acquisition. Again we have evidence of long-run operating underperformance. Hence, the dot-com stocks distorted market signals, another consequence resulting from underpricing activities of Investment banks which destroyed wealth of the acquiring companies.
As a conclusion, this paper analysed Brau and Fawcett's empirical study and especially the reason why CFOs during 2000 and 2002 largely went public to create new shares to use in the acquisition process instead of using cash. There are evidences to suggest that the decision to go public is a relatively complex decision that is hardly explainable by one single theory and especially in relatively short timeframe as used by Brau and Fawcett. Indeed, firms seek manifold benefits in doing an IPO. These motivations are not only due to the creation of a 'currency', such as shares, that will be used in the acquisition process both for the acquirer and the targeted firms, but also in other reasons discussed at the beginning of this paper. On the one hand, if the firm is the acquirer, then using overvalued stocks can save a large amount of cash but may results in long-run market underperformance and long-run operating underperformance. It also results in a problem of overconfidence of acquiring managers that will overpay for acquisition. On the other hand, the 'exit strategy' may encourage firms to go public to benefit from the first-day returns and then expect to be acquired right after their IPO. By doing so, the newly-public firm can benefit from the market overreaction in order to sell at a higher price per share. This will also benefit all stakeholders due to a transfer of risk, especially if the company is in a relatively early stage of growth with a lot of uncertainties surrounding its future performance. It is then required to revisit the survey conducted by Braw and Fawcett and improve certain ideas they developed. The strategy of using shares for future acquisition is more related to the overall market and industry conditions and not IPO market conditions. This has been demonstrated by the 'dot-com bubble' which has encouraged relatively unprepared firms to go public and then expect to be acquired to pass risk and uncertainties to other economic agents but also to obtain a higher value per share. However, empirical studies have shown that in the long-run, the market realises that it was wrong as the trend afterward is going down gradually and slowly.
