Successive Cohorts Of IPO Firms: Why Do IPOs Seem To Be Getting Riskier?
Tuck School of Business at Dartmouth
Senyo Y. Tse
Texas A&M University – Lowry Mays College & Graduate School of Business
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January 15, 2016
European Financial Management Journal, Forthcoming
Prior studies show that the risk level of each new cohort of listed firms is higher than its predecessor’s. We find that these risk differences are persistent and investigate two potential explanations: (1) Each cohort adopts and retains operating innovations that are associated with higher risks and (2) increasing numbers of younger and less-experienced firms are represented in each new cohort. Our results support the first explanation. Each new cohort uses riskier production technologies and operates in more competitive product markets than its predecessor.
Successive Cohorts Of IPO Firms: Why Do IPOs Seem To Be Getting Riskier? – Introduction
Prior studies conclude that successive cohorts of initial public offering (IPO) firms exhibit increasing risks. Fama and French (2004) find that firms listed after 1970 (new-list firms) display lower profitability and survival rates, higher growth, and more volatile profits than firms listed before 1970 (pre-1970 firms). Similarly, Brown and Kapadia (2007) find that the stock returns for each new 10-year cohort of IPO firms are more volatile than can be explained by multifactor models. Although the authors do not formally test for it, their evidence indicates that risk differences across cohorts persist (Brown and Kapadia, 2007, Figure 2, p. 366). Both studies attribute their findings to increases over time in IPO investors’ risk appetite and, thus, to changes outside the firm. We reason that risk differences across cohorts should be related to their distinctive business practices, which could be caused by shifts in investors’ risk appetite or other factors. To date, however, researchers have not systematically examined differences in successive cohorts’ operating characteristics and strategic choices.
In this study, we confirm persistent risk differences between successive cohorts, which we refer to as the cohort risk phenomenon. We show that the survival rate of each new-list cohort over successive five-year periods remains relatively constant and significantly lower than the survival rate of pre-1970 firms. In addition, there are statistically significant differences in the idiosyncratic and earnings volatility of successive cohorts that persist over long periods. More importantly, we provide a business strategy explanation of the cohort risk phenomenon. We show that successive cohorts adopt and retain innovations in their production functions, reflected in the monotonically increasing use of intangible assets and the declining use of material inputs, and operate in increasingly fragmented and competitive product markets that are associated with higher risk. Thus, we contribute to the literature by systematically documenting the nature of the changes within firms that lead Brown and Kapadia (2007, p. 359) to conclude that there is “a fundamental change in the character of a typical publicly traded firm” and Fama and French (2004, p. 231) to conclude that there is increasing right-skewness in growth and left-skewness in the profits of listed firms. Our findings should interest researchers who examine changes in the economic conditions in which public firms are born, live, and die.
We derive our business strategy explanation from an extensive prior literature. Porter (1980) and Prahalad and Hamel (1990) argue that new firms must differentiate their products or achieve cost leadership to earn economic rents. Since the 1970s, physical assets have become less distinct and a smaller source of competitive advantage (Zingales, 2000), which is evident from a gradual shift in manufacturing operations from the United States to low-cost economies (Apte et al., 2008). Thus, several economists argue that new-list US firms are more likely to offer innovative products and customer-centric services and are less likely to compete by manufacturing commodity products more inexpensively than their predecessors (Shapiro and Varian, 1998; Payne and Frow, 2005; Baumol and Schramm, 2010; Brickley and Zimmerman, 2010). These changes are likely to increase firm risk, because they increase intangible inputs—such as research and development (R&D), information technology (IT), databases, and expert human capital—with future benefits that are less certain than those from tangible assets (Kothari et al., 2002; Comin and Philippon, 2005; Demers and Joos, 2007; Apte et al., 2008).
Economic developments are also likely to increase risk because they increase the rivalry in product markets and the pace at which firms launch new products. The US consumer population has shifted toward those who rely more on digitized versions of physical products (such as newspapers), have lower brand loyalty, and more frequently demand new products and services (Zeller, 2006; Giere, 2008; Howe and Strauss, 2008; Cudaback, 2013). Firms that rely on human capital, intangible inputs, and online delivery mechanisms can more quickly offer innovative products and services than firms that rely on factories, warehouses, and physical distribution networks which take a long time to build (Shapiro and Varian, 1998). A new firm whose principal resource is knowledge residing with employees can quickly imitate its rival’s products by hiring its employees (Cockburn and Griliches, 1988). Thus, new cohorts, characterized by more intangible production functions, are likely to face more competitive and rapidly changing market conditions than old cohorts are (D’Aveni, 1994; Thomas and D’Aveni, 2009).
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