Growth Capital‐Backed IPOs

• Date: 01 November 2015
• Published date: 01 November 2015
• DOI: http://doi.org/10.1111/fire.12075
• Author: Jay R. Ritter

The Financial Review 50 (2015) 481–515

Growth Capital-Backed IPOs

Jay R. Ritter

University of Florida, Gainesville, FL 32611

Abstract

Growth capital investing is the financing of growing businesses that are investing in

tangible assets and the acquisition of other companies. Growth capital is common in retailing,

restaurant chains, and health care management, and represents 12% of all venture capital (VC)-

backed initial public offerings (IPOs). Since 1980, investing in growth capital-backed IPOs

has produced mean three-year style-adjusted buy-and-hold returns of +25.2%, in contrast to

style-adjusted returns of approximately zero for other VC-backed and buyout-backed IPOs.

One-third of growth capital-backed IPOs are rollups and these have produced much higher

returns for investors than rollups without a financial sponsor.

Keywords: buyouts, growth capital, growth equity, initial public offerings, long-run perfor-

mance, reverse LBOs, rollups, venture capital

JEL Classifications: G14, G24, G32

Correspondingauthor: Warrington College of Business Administration, University of Florida, Gainesville,

FL 32611; E-mail: jay.ritter@warrington.ufl.edu.

I want to thank Dan Bradley (the referee), Rob Cousin, Harry DeAngelo, Chris James, Jerry Hoberg, Po-

Hsuan Hsu, Marc Lipson, Jim Parrino, and Ivo Welchfor useful comments, as well as seminar participants

at the Chinese University of Hong Kong, the University of Hong Kong,the University of Maryland, the

2014 PrivateEquity Research conference, and the 2015 New Trends in Entrepreneurial Finance conference

in Trier, Germany. Leming Lin and Diana Shao provided very able research assistance. I want to thank

Jennifer Bethel and Laurie Krigman, as well as Junming Hsu, for providing lists of rollup IPOs, and Ninon

Sutton for providing a list of IPOs that made acquisitions within a year after the IPO.

C2015 The Eastern Finance Association 481

482 J. R. Ritter/The Financial Review 50 (2015) 481–515

1. Introduction

Private equity investing is normally divided into two categories, venture capital

(VC) and buyout investing, but there is a substantial category of investments that

do not fit cleanly into either of these two categories. The early-stage investment in

Facebook by Accel Partners is easy to classify as a VC investment, and the leveraged

buyout (LBO) in 1988 of tobacco and food company RJR Nabisco by Kohlberg

Kravis and Roberts is easy to classify, but what about the minority investment by

Bain Capital in big box office supply chain Staples early in its life cycle? What about

the investment of Welsh, Carson, Anderson, & Stowe and GTCR Golder, Rauner,

LLC in Select Medical Corp., where the business plan described in the April 2001

initial public offering (IPO) prospectus is “we operate specialty acute care hospitals

for long term stay patients and outpatient rehabilitation clinics. We began operations

in 1997 under the leadership of our current management team and have grown our

business through strategic acquisitions and internal development.” I classify both

Staples and Select Medical Corp. as growth capital-backed.

I define a growth capital-backed IPO on the basis of three criteria: (1) the issuing

company has a financial sponsor that provides equity capital and actively invests; (2)

the financial sponsor is not necessarily taking a controlling position, unlike a buyout;

and (3) the issuer has been investing in tangible assets as a material part of its business

and/or making significant acquisitions, unlike pure VC. A more detailed discussion

is contained in Section 2.

This paper is primarily descriptive, and focuses on the 344 growth capital-

backed U.S. IPOs from 1980 to 2012 that I have identified. The first contribution of

this paper is to define and identify growth capital-backed IPOs, and document how

large a fraction of the VC-backed IPO universe they are. When just two categories

of financial sponsors are used, growth capital is a subset of VC. Among IPOs from

1980 to 2012, I classify 12% of VC-backed firms as growth capital-backed, and will

refer to the others as “pure” VC-backed. The growth capital-backed IPOs are almost

entirely in industries that are normally not associated with VC investing.Alternatively

stated, investors in VC and growth equity funds have exposure to industries outside

of the technology and biotechnology sectors, and the returns reported for this asset

class are not exclusively from those sectors. The conventional view is that venture

capitalists only fund technology and biotechnology companies. Thus, a contribution

of this paper is to show that this assumption is not valid.

The growth capital-backed companies tend to be moderate in size. I would

speculate that firms that are financed with growth capital are more likely to go public

than sell out in a trade sale, compared to pure VC-backed companies, so this 12%

number may be an overestimate of the importance of growth capital to the limited

partners (LPs) of VC funds.1

1On the other hand, I would conjecture that growth capital investing is less risky than the financing of

startups, where many investments are written off with no exit via an IPO or a trade sale. I do not know

which of these offsetting effects dominates.

J. R. Ritter/The Financial Review 50 (2015) 481–515 483

The second contribution of this paper is that it documents the long-run returns

on financial sponsor-backed IPOs from 1980 to 2012, and for the three categories

of financial sponsor-backed IPOs. I find that growth capital-backed IPOs have had

high long-run returns, outperforming both VC-backed and buyout-backed IPOs, as

well as outperforming IPOs that did not have a financial sponsor. To be specific, the

average growth capital-backed IPO produced a style-adjusted three-year buy-and-

hold return (BHAR) of 25.2%, measured from the closing market price on the day

of the IPO until the earlier of its three-year anniversary, delisting date, or December

31, 2014. For other IPOs, the average style-adjusted three-year BHAR is −2.6%

for VC-backed IPOs, 0.7% for buyout-backed IPOs, and −14.2% for IPOs without a

financial sponsor.For style adjustments, I control for both size (market capitalization)

and the book-to-market ratio. Ideally, I would also like to analyze the returns earned

by LPs on growth capital investing. Unfortunately, many funds invest in two out of

the three categories of privateequity, making it difficult to clearly identify the realized

returns without information at the transaction level.

In addition to reporting BHARs, I also report the results from Fama and French

(1993) three-factor time series regressions. In these regressions, the abnormal returns

on portfolios of VC-, growth capital-, and buyout-backed IPOs are economically

and statistically indistinguishable from zero, while an equally weighted portfolio

of IPOs without a financial sponsor underperforms by 40 basis points (bp) per

month. The difference in results for the growth capital-backed IPOs between the

high style-adjusted BHARs and insignificantly small three-factor model alphas is

primarily attributable to the differentportfolio strategies that are implicit. With equally

weighted BHARs, each IPO is being weighted equally and not rebalanced as gains are

compounded, whereas the time series regression results equally weight each calendar

month and rebalance each portfolio on a monthly basis.

The third contribution of this paper is to report the nonstationarity of the outper-

formance of VC-backed IPOs. When subperiods are analyzed, growth capital-backed

IPOs have outperformed the market in all subperiods when three-year BHARs are

used. The outperformance of VC-backed IPOs that has been documented by other

authors for the 1980s and 1990s, however, is not present for VC-backed IPOs from

1999 to 2000 or 2001 to 2012. Indeed, VC-backed IPOs from 1999 to 2012 have

done substantially worse than IPOs with no financial sponsor, reversing the pattern

documented by Brav and Gompers (1997) and others using IPOs from earlier peri-

ods. These findings, however, are sensitive to the portfolio strategy that is used. In

Fama-French three-factor calendar time series regressions, most categories of IPOs,

including VC-backed deals, have produced higher alphas (albeit without statistical

reliability) during the 1999–2013 period than they did from 1983 to 1998.

The fourth contribution of the paper is to report the long-run returns on a large

sample of rollup IPOs. Rollups are companies whose growth is primarily accom-

plished by acquisitions within an industry, rather than through internal (organic)

growth. Not all rollups have a financial sponsor. I classify 54% of rollup IPOs as

financial sponsor-backed. Of the growth capital-backed IPOs from 1980 to 2012