Equity Issues and Stock Repurchases of Initial Public Offerings

• Date: 01 January 2016
• Author: Wolfgang Drobetz,Wolfgang Bessler,Martin Seim,Jan Zimmermann
• DOI: http://doi.org/10.1111/eufm.12053
• Published date: 01 January 2016

Equity Issues and Stock Repurchases

of Initial Public Offerings

Wolfgang Bessler

Center for Financeand Banking, Justus‐Liebig‐University Giessen, LicherStrasse 74, Giessen, Germany

E-mail: Wolfgang.Bessler@wirtschaft.uni-giessen.de

Wolfgang Drobetz

School of Business, University of Hamburg, Germany

E-mail: wolfgang.drobetz@wiso.uni-hamburg.de

Martin Seim and Jan Zimmermann

Center for Finance and Banking, Justus‐Liebig‐University Giessen, Germany

E-mails: martin.seim@wirtschaft.uni-giessen.de; jan.zimmermann@wirtschaft.uni-giessen.de

Abstract

We investigate the financing strategies and valuation effects of 247 IPO firms at the

‘Neuer Markt’in Germany that either issued additional equity (SEO) or

repurchased shares (SRP) within five years after going public. IPOs issuing

additional equity exhibit a temporary outperformance before the event, but negative

announcement returns and a long‐run underperformance. In contrast, repurchas-

ing IPOs experience positive announcement returns and no long‐run under-

performance. Free cash flow problem resulting from mandatory equity issuance at

the IPO explain the SRP decision. Our findings for SEOs are consistent with a

staged financing strategy, while we find no evidence for market timing.

Keywords: Initial public offerings, share repurchases, seasoned equity offerings,

valuation effects

JEL classification: G32, G35

We are grateful to two anonymous referees, John Doukas (the editor), Henk von Eije, Laura

Field, Fred Kaen as well as participants at the European Financial Management (EFM)

Symposium on Entrepreneurial Finance & Venture Capital Markets in Montreal 2010, the

Financial Management Association Conference in New York 2010, the Financial

Management Association European Conference in Hamburg 2010, the Midwest Finance

Association Conference in Las Vegas 2010, the Annual Meeting of the Verein für

Socialpolitik in Kiel 2010, the Benelux Corporate Finance Day in Groningen 2010, the

Swiss Society for Financial Market Research Conference in Zurich 2011, and the Campus

for Finance Research Conference at the WHU‐Otto Beisheim School of Management in

Vallendar 2011 for helpful comments and suggestions. Correspondence: Wolfgang Bessler.

European Financial Management, Vol. 22, No. 1, 2016, 31–62

doi: 10.1111/eufm.12053

© 2014 John Wiley & Sons Ltd

1. Introduction

Entrepreneurial firms, especially high‐technology start‐ups, need substantial amounts of

equity to finance their research, product development, and growth opportunities. Early on,

founders, families and friends, and venture capitalists are the sole providers of equity,

whereas bank financing is typically rare. Successful entrepreneurial firms often need more

financial resources and may choose to raise additional equity by going public. If firms

perform well, and if they have profitable growth opportunities, then these initial public

offerings (IPOs) may issue even more equity through seasoned equity offerings (SEOs)

shortly after going public (DeAngelo et al., 2010; Hertzel et al., 2012). If staged financing

is the strategy investors favour when investing in entrepreneurial firms, then it is

surprising to observe that some IPO firms return equity to their shareholders by initiating a

share repurchase program (SRP) soon after going public. The objective of our paper is to

examine the motivation, valuation effects, and determinants for SRPs and SEOs of IPO

firms at the German ‘Neuer Markt’.

Europe’s stock exchanges established new market segments during the 1990s to foster

the capital market access for high‐technology start‐ups, providing them with sufficient

equity for financing their growth opportunities. However, most ‘new markets’closed

amidst legal and regulatory issues as well as dwindling investor interest by 2005.

Germany’s‘Neuer Markt’was initially one of the more successful ‘new markets’in terms

of number and performance of IPOs during this ‘new economy’period. As the French

‘Nouveau Marché’and Italy’s‘Nuovo Mercato’it was highly regulated, in contrast to

London’s‘Alternative Investment Market’(AIM) which is a private placement market

with minimal regulation (Vismara et al., 2012; Jenkinson and Ramadorai, 2013). In

comparison to the other ‘new markets’, the German Stock Exchange (Deutsche Börse)

imposed unique rules such as requiring firms to issue additional equity when going public

(Bessler et al., 2014). For many firms this resulted in high cash holdings, as at least half of

the offering proceeds had to come from issuing new shares. We analyse whether the

mandatory equity issuance rule was beneficial for IPOs and investors, given that it had

substantial implications for IPO firms’financial policies and strategies. The results add to

the current discussion among European regulators and politicians to re‐establish

organised stock market segments for start‐up firms, this time with an improved structure

and regulation.

1

Our study contributes to the research on SRPs and SEOs of IPO firms by analysing both

financial activities in the context of the special rules and regulation of the ‘Neuer Markt’.

For established firms, undervaluation signalling and the free cash flow hypothesis are the

1

For an overview of the current state of IPO research, see the special issue on ‘IPOs’in this

journal (Vol. 15, 2009) and especially the introduction by Jenkinson (2009) as well as the

handbook of Levis and Vismara (2013). Survey evidence on motivations for going public in

Europe is provided by Bancel and Mittoo (2009). For country‐studies of IPOs during the ‘new

market’period, see for Italy Caselli et al. (2009) on IPOs and VC, Meles (2011) on IPOs and

PE, and Boreiko and Lombardo (2011) on market structure. Vandemaele (2003) provides

evidence on market structure and flotation choice in France, and Pownall et al. (2014) on the

integration of the Euronext markets. A comparison of IPOs during the new economy period is

offered by Ritter (2003) for IPOs in Europe and the USA, by Goergen et al. (2009) for IPOs in

France and Germany, and by Chahine et al. (2007) for IPOs in France and the UK.

© 2014 John Wiley & Sons Ltd

32 Wolfgang Bessler, Wolfgang Drobetz, Martin Seim and Jan Zimmermann

common explanations for SRPs. For IPOs, only a few studies investigate share repurchase

activities (Chen et al., 2012; Bessler et al., 2014). Our results suggest that the rules

directly relating to the mandatory equity issuance at the IPO had a significant effect on

both the SRP and SEO likelihood. We find that IPOs are more likely to repurchase shares

the more pre‐IPO owners sell their equity stake at the IPO (the exit ratio), which is

consistent with the free cash flow hypothesis. The SEO likelihood increases with the

fraction of new equity issued at the IPO (the dilution factor) as well as with growth

opportunities, for which staged financing is an explanation, i.e., firms raise only a fraction

of their required equity at the IPO. Moreover, IPOs at the ‘Neuer Markt’experience, on

average, a high underpricing and an inferior long‐run performance. However, by

returning surplus cash to shareholders, repurchasing IPOs are able to generate signi-

ficantly positive abnormal returns at the announcement and to deter subsequent

underperformance. In contrast, IPOs issuing additional equity underperform the market

before and subsequent to the SEO, but experience a pre‐announcement run‐up.

We structure our paper as follows. In Section 2, we review the literature on share

repurchases and seasoned equity offerings as well as the main reasons for IPO firms to

implement these financial activities. Section 3 describes our data and methodology. In

Section 4, we present and discuss our empirical results by structuring the discussion into

three subsections: short‐term valuation effects (4.1), long‐run performance (4.2), and a

logistic regression analysis of the SRP and SEO likelihood (4.3). Finally, Section 5

concludes.

2. Review of the Literature

A large body of literature analyses the financing strategies and valuation effects of IPO

firms. We discuss the relevant literature by first providing the framework and perspective

for our own analysis (2.1) and by describing the issues and empirical results for share

repurchases (2.2) and seasoned equity offerings (2.3). We then review the empirical

evidence for initial public offerings in Germany, with a particular focus on the regulatory

environment of the German ‘Neuer Markt’(2.4).

2.1. Review of the issues

One of the most importantdecisions faced by young entrepreneurial firms is whetherto go

public, raise external equity, and diversify their ownershipstructure. Academic studies on

IPOs usually analyse underpricing and the determinants of short‐and long‐run

performance. From this research, three main phenomena have emerged: first‐day under-

pricing, long‐rununderperformance, and hot issue periods(‘windows of opportunity’). For

many countries, includingGermany, various factors add to comprehend these phenomena.

These are underwriter reputation and analyst behaviour (Bradley et al., 2008; Bessler and

Stanzel, 2009), venture capital backing, ownership structure, exit behaviour and lock‐up

periods (Lerner,1994; Brav and Gompers, 2003; Bessler and Kurth, 2007) as well as R&D

and patents (Wagner and Cockburn, 2010; Bessler and Bittelmeyer, 2008).

Following the IPO, management must ensure that sufficient funds for financing the

firm’s operations and growth opportunities are accessible. Specifically, firms must

generate sufficient cash flows from operations or, alternatively, raise external funds at the

IPO and/or by issuing new debt or equity subsequent to the IPO. In contrast, successful

and ‘cash rich’firms have to determine their payout policy, i.e., distributing cash flows to

© 2014 John Wiley & Sons Ltd

Equity Issues and Stock Repurchases of Initial Public Offerings 33