THE ROLES OF INSTITUTIONAL INVESTORS IN THE FAILURE OF NEWLY PUBLIC STOCKS

• Published date: 01 December 2019
• Date: 01 December 2019
• DOI: http://doi.org/10.1111/jfir.12195
• Author: Hong Qian,Santhosh Ramalingegowda,Zhaodong (Ken) Zhong

The Journal of Financial Research Vol. XLII, No. 4 Pages 757–788 Winter 2019

DOI: 10.1111/jfir.12195

THE ROLES OF INSTITUTIONAL INVESTORS IN THE FAILURE OF NEWLY

PUBLIC STOCKS

Hong Qian

Oakland University

Santhosh Ramalingegowda

University of Georgia

Zhaodong (Ken) Zhong

Rutgers University

Abstract

In this article, we study two negative events that can happen to newly public stocks:

(1) the price drops at least 50% from the closing price on the first trading date within

one year after the initial public offering (IPO) (initial failure) and (2) the firm is

delisted for negative reasons within three years after the IPO (final failure). We find

that high investor sentiment at the time of IPO can lead to both initial failure and

final failure of IPO firms, whereas monitoring by external professionals plays a more

important role in averting final failure than initial failure. Exploring the roles of

different types of institutional investors, we find that transient (i.e., short‐term

trading) institutions sell before initial failure. In contrast, dedicated (i.e., monitoring)

institutions focus on long‐term performance and may stay with stocks suffering

temporary initial failure, but their selling typically signals the imminent final failure

of newly public firms.

JEL Classification: G24, G32

I. Introduction

Initial public offerings (IPOs) are typically viewed as an event that benefits both

issuers and investors. For issuers, IPOs enable them to raise additional capital to fuel

their growth. For investors, IPO stocks allow them to diversify their portfolios. Many

IPO firms also experience substantial price increases on the first trading day, and some

of these firms, such as Google, continue to do well in the aftermarket. However, not all

investors in IPO stocks are as lucky as those who invested in Google. Some newly

public stocks experience difficulty in the aftermarket despite the hype from investment

banks and the media. For example, Internet phone provider Vonage lost about 30% of

its value in its first seven days of trading. Pets.com was one of the most beloved of all

dot‐coms, but went out of business just nine months after going public. Among the

stocks that fall out of favor with investors soon after their IPO, some manage to turn

We are grateful for comments from the editor (William Elliott) and an anonymous referee.

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© 2019 The Southern Finance Association and the Southwestern Finance Association

around and avoid the fatal destiny of bankruptcy. Facebook is one of the most well‐

known cases in recent years. Its IPO attracted a lot of attention and was one of the

biggest offerings in history, with an offer price of $38 per share and a market

capitalization of over $104 billion. The stock price of Facebook shot up to as much as

$47.50 on its first trading day, but ended up closing at $27.72 per share two weeks

later. It fell further over the next few months to $17.55, a more than 50% drop from its

offer price. Facebook later made a huge comeback and became a market darling again.

About three years after its IPO, its stock price rose above $100. For investors able to

stay with the company, their patience paid off.

Intrigued by these anecdotal cases, we study the performance of newly issued

stocks and focus on two negative events: initial failure and final failure. A newly public

firm is defined as going through initial failure if its month‐end price drops at least 50%

from the closing price on the first trading date within one year after the IPO. It is said to

end up in final failure if it is delisted for a negative reason (such as bankruptcy or

liquidation) within three years after its IPO.

1

Among a sample of 3,650 IPOs from

1994 to 2010, 1,162 stocks (32%) experienced price declines of more than 50% within

one year after the IPO, and 346 stocks (9%) were delisted for negative reasons within

three years after the IPO. Many stocks (231 of 346 stocks) that experienced final failure

had also experienced initial failure. But many stocks (931 of 1,162 stocks) that

experienced initial failure survived three years after the IPO.

We first look at the effect of investor sentiment and professional monitoring on

initial and final failures. Investing in newly public stocks is considered risky by many

investors as these stocks often have volatile returns and their performance varies

widely in the aftermarket (Lowry, Officer, and Schwert 2010). These small, young

firms are often unprofitable and do not pay dividends (Jain and Kini 1994; Kale, Kini,

and Payne 2012). Baker and Wurgler (2006) document that investor sentiment has a

greater effect on stocks whose valuations are highly subjective. IPO underpricing (also

referred to as initial return) increases with valuation uncertainty (Ritter and Welch

2002). Therefore, we conjecture that stocks with higher initial returns are more likely

to be affected by investor sentiment. We expect that stocks that receive high initial

returns and are issued in a hot market are more likely to drop in value when investor

sentiment shifts. In addition, Yung, Çolak, and Wang (2008) find that firms that issue

IPOs in hot markets when investor sentiment is high are less likely to survive.

Furthermore, because newly public firms are typically at an early stage in their

business, they often benefit from monitoring by experienced external professionals. An

increased probability of IPO firm survival has been attributed to prestigious

underwriters, venture capitalists (VCs), and high‐quality auditors for their involvement

before and after the IPO (Schultz 1993; Jain and Kini 1999, 2000; Demers and Joos

2007; Iliev and Lowry 2017). Following this line of reasoning, we posit that

monitoring by external professionals helps IPO stocks avoid initial failure as well.

1

When we revise the threshold of initial failure to 75% below the closing price on the first trading date and

extend the final failure window to five years after the IPO, the results remain largely the same.

758 The Journal of Financial Research

To empirically examine the effects of investor sentiment and professional

monitoring on initial and final failures, we run logistic regressions and Cox regressions

(proportional hazard model) that control for operating performance and firm quality

(Seguin and Smoller 1997; Hensler, Rutherford, and Springer 1997; Shumway 2001).

Regarding initial failure, we find that higher investor sentiment is associated with an

increased failure rate, whereas professional monitoring by underwriters and VCs is

generally unrelated to the probability of initial failure. Regarding final failure, stocks

issued in hot IPO markets are more likely to be delisted for negative reasons. Our

results also indicate that prestigious underwriters and VCs exert some effort to prevent

newly public firms from experiencing final failure. We further compare the relative

importance of sentiment and monitoring in predicting initial and final failures by

applying the methodology of Heinze and Schemper (2003). Results show that initial

failure is driven more by investor sentiment, whereas professional monitoring matters

more for the long‐term success of newly public stocks.

Next, we study institutional ownership before initial and final failures, and

explore the roles played by different types of institutional investors. The literature finds

that IPO firms with high initial institutional ownership generate more significant

returns (e.g., Field and Lowry 2009), undertake more successful merger and acquisition

(M&A) activity (Anderson and Huang 2017), and are less likely to subsequently go

private (Bharath and Dittmar 2010). The literature also shows that institutional

investors’post‐IPO trades predict future return performance (e.g., Chemmanur, Hu,

and Huang 2010). We extend this literature by examining the following questions: Do

post‐IPO ownership changes by institutional investors with short trading horizons

predict initial failure? Do institutional investors with monitoring incentives patiently

hold firm stock through initial failure but sell before final failure? Following Bushee

(1998, 2001), we classify institutional investors with relatively high turnover and small

holdings as transient institutions and those with relatively low turnover and large

holdings as dedicated institutions. Transient institutions have less incentive to monitor

firms because they mainly engage in short‐term trading, and they may trade more

actively to exploit their information advantage (Ke and Petroni 2004; Yan and Zhang

2009). On the contrary, dedicated institutions have more incentive to monitor because

they follow buy‐and‐hold strategies and invest large stakes in a few companies (Bushee

1998; Chen, Harford, and Li 2007). They do sell before final failure, however, as it

leads to a persistent loss well beyond their investment horizon.

Examining the change in ownership of our IPO stocks, we observe a significant

reduction in average transient institutional ownership and a slight increase in average

dedicated institutional ownership in the quarter of the initial failure. There is a gradual

decline in average transient institutional ownership in stocks before final failure. In

contrast, the decrease in average dedicated institutional ownership occurs right before the

quarter of the final failure. To systematically test the effects of changing ownership in the

IPO aftermarket, we adopt Cox regressions with time‐dependent covariates. Our analysis

demonstrates that the change in transient institutional ownership is negatively associated

with initial failure, but not with final failure. Conversely, the change in dedicated

institutional ownership is negatively associated with final failure, but not with initial

failure. The results are consistent with the view that transient institutions sell ahead of

759The Roles of Institutional Investors