IPOs, Operating Activities, and IPO Underperformance

(ProQuest: ... denotes formulae omitted.)IntroductionThis paper examines the relation between the operating activities of newly public firms and post-IPO underperformance. IPO underperformance is one of the most widely studied new issues puzzle. Prior research has found it difficult to reconcile why newly public firms-who report high capital expenditures, high sales growth, and high earnings-tend to underperform, as measured by their low cash flows and low stock returns. We examine the operating activities of these firms to test several hypotheses for underperformance. We find evidence that newly public firms make excess investments in inventory and capital expenditures, generate higher sales growth for a given level of inventory, but generate lower subsequent cash flows from their accruals. Our tests support the hypothesis that managers take advantage of windows of opportunity in the IPO market. Our findings do not support the accounting window dressing hypothesis.We focus on the operating activities of newly public firms for several reasons. First, previous research has noted that firms issuing equity continue to invest heavily in projects, even while their performance deteriorates (Loughran and Ritter, 1997); this is argued to be attributed to managers taking on negative NPV projects. Examination of managerial decisions throughout the operating cycle allows us to isolate the type of projects that lead to underperformance. For example, one of the first decisions after the IPO involves using proceeds to acquire inventory and capital assets; if these purchases are excessive, or if they fail to generate sales growth, then the result is underperformance. Another decision faced by newly public firms is to establish policies on extending credit to customers for sales (through the use of accruals); if these sales do not subsequently generate cash, then this also leads to underperformance. Our results provide crucial information concerning the incentives and decisions made by managers after the IPO.We also examine post-IPO operating activities to ascertain whether firms hypothesized to window dress their financials around an IPO tend to make poor operating decisions as well. Under the window dressing hypothesis, managers have incentives during an IPO to record income-increasing accruals, which results in firms reporting higher earnings (Teoh, Welch, and Wong, 1998). If these managers use accruals to mislead the market about the growth options of the firm, then these high earnings will be followed by low operating cash flows. Under this hypothesis, we predict that firms reporting high abnormal accruals in the year of IPO will have lower cash collections from their accruals. Contrary to our predictions, these firms have a higher mapping of accruals to subsequent period cash flow.Our focus on operating activities extends the findings of prior studies, which argues that operating variables are less vulnerable to managerial manipulations. Much attention in IPO research has focused on window dressing as an explanation for underperformance. With window dressing, managers use accruals to record a fictitious accounts receivable and a corresponding fictitious increase in sales; such manipulation is argued to have relatively low costs, as this requires altering the firm's accounting entries. In contrast, operating variables such as inventory investments, capital expenditures, and operating cash flow involve real activities and the acquisition of physical objects. Manipulating the firm's inventory balance and capital expenditures upward would be costly, as no corresponding inventory or asset would exist.For our sample, we identify firms with an IPO date (obtained from Jay Ritter's listing of founding dates or the CRSP Events file), Compustat information in the year of IPO, and sufficient data to calculate changes in inventory, revenue, and accounts receivables; our final sample contains 6,973 firms and 54,907 firm-year observations. …