SEQUENTIAL DIVESTITURE THROUGH INITIAL PUBLIC OFFERINGS Jeffrey J. Reuer Fisher College of Business Ohio State University 2100 Neil Avenue Columbus, OH 43210 USA Tel. (614) 292-3045 Fax: (614) 292-7962 e-mail: reuerj@cob.ohio-state.edu Jung-Chin Shen Strategy and Management Department INSEAD Boulevard de Constance 77305 Fontainebleau Cedex, France Tel.: (33) 1 60 72 44 73 Fax: (33) 1 60 74 55 00 E-mail: jung-chin.shen@insead.fr March 2002 JEL Codes: G30, D80, L10 In developing this research, we have benefited from comments and suggestions from Jean Helwege, Konstantina Kiousis, Mitchell Koza, and Subi Rangan. We also gratefully acknowledge financial support from INSEAD’s R&D Department.
SEQUENTIAL DIVESTITURE THROUGH INITIAL PUBLIC OFFERINGS Abstract An initial public offering (IPO) is often seen as a natural end state in a firm’s development, whereby ownership rights are reallocated to accomplish a financing objective. However, the decision to go public is also an important corporate strategy choice that can have implications for the transfer of control rights. The analysis situates IPOs within an extended M&A process and considers private firms’ decisions to undertake an IPO prior to divestiture rather than undergo an outright sale. We develop the argument that IPOs can ameliorate ex ante transaction costs in the market for corporate control when search costs are nontrivial and when information asymmetries increase the risk of adverse selection. The empirical evidence suggests that sequential divestiture is more likely in industries with spatially-dispersed firms and for firms with significant intangible resources. Investments in strategic alliances attenuate the impact of intangibles on the propensity of firms to divest sequentially through IPOs. 2
INTRODUCTION Despite the dramatic rise in initial public offerings (IPOs) in recent years and the potential significance of the going public decision in a firm’s evolution, IPOs have not figured highly on the research agenda of strategy scholars. Rather, IPOs have tended to be seen as vehicles to finance growth or cash out following an entrepreneurial firm’s development. Based on traditional finance theory, IPOs can also be assessed in terms of the tradeoffs between the benefits from relaxing owner-managers’ liquidity constraints and the agency costs that arise after the firm is publicly held (e.g., Jensen & Meckling, 1976). These conventional perspectives therefore focus on the firm’s access to capital and the transfer of ownership rights. In short, the IPO tends to be seen as a natural end state that addresses a purely financial objective. Recent descriptive findings and anecdotal evidence challenge these views, however. They indicate that IPOs are often part of a larger process of transferring control rights in organizations (e.g., Mikkelson, Partch, & Shah, 1997). For instance, in newly-public Italian firms, the controlling stake is sold to an outsider 13.6 percent of the time, which is roughly twice the rate for the Italian economy in general (Pagano, Panetta, & Zingales, 1998). Not only are control changes more likely to happen in newly-public firms than private firms, but newly-public firms experience a greater rate of acquisition than established public firms (Field & Mulherin, 1999). Practitioners also suggest that firms can use an IPO as a means of “teeing up” a company for subsequent sale (Rock, 1994). Taken together, these results indicate that transactions in capital markets and in the market for corporate control are not independent as is often assumed. An important question that follows is why private firms would incur the substantial costs of using IPOs as part of a sequential divestiture process rather than just selling the firm outright. For instance, Ritter (1987) finds that registration and underwriting costs alone represent 14 3
percent of the proceeds raised. The indirect costs associated with underpricing, or the positive abnormal returns in early trading that represent wealth transfers from existing to new shareholders, are 15 percent on average (Ibbotson, 1975; Ibbotson, Sindelar, & Ritter, 1988; Ritter, 1984; Smith, 1986). Other costs relate to significant managerial time and organizational disruption surrounding the going-public event (Blowers, Griffith, & Milan, 1999). Several formal models have been recently developed to explain why IPOs might be an attractive component of firms’ divestiture efforts. Zingales (1995) suggests that a firm can use a two-stage sale to maximize total proceeds by relying on the capital market to auction off cash flow rights and the market for corporate control to negotiate the sale of the private benefits of control. In his model, the seller can obtain the value of the cash flow rights by selling them in a competitive market to dispersed investors rather than through direct bargaining with a single bidder. Therefore, the IPO transaction allows the firm to avoid haggling over a portion of its value. Mello and Parsons (1998) emphasize the information an owner obtains by going public regarding the value of the firm, and Ellingsen and Rydqvist (1997) develop a model focusing on the screening function of the stock market for firms undergoing divestiture. Despite this theoretical progress, Pagano, Pannetta, and Zingales (1998) conclude that “[t]he decision to go public is one of the most important and least studied questions in corporate finance” (p. 27). However, in research that has focused on the decision to go public, the decision tends to be considered in terms of “two major alternatives: to remain private or to become a public corporation” (Smith, 1986: 19). Although scholars have recently begun to frame the going-public decision based on the choice between private and public financing (e.g., Chemmanur & Fulghieri, 1999), the models discussed above and the emerging findings on the higher propensity of newly-public firms to be acquired underscores the value of assessing IPOs 4
in a comparative institutional light. Related research on mergers and acquisitions has done just that in many studies on firms’ choices between M&A, internal development, and alliances (e.g., Chatterjee, 1990; Hennart & Reddy, 1997; Mitchell & Singh, 1992; Shaver, 1998). However, this stream of research has also generally neglected sell-side considerations in acquisitions (e.g., Bergh, 1995; Duhaime & Grant, 1984; Harrigan, 1981; Klein, 1986; Ravenscraft & Scherer, 1991) and the potential role that IPOs in particular play within a more extended M&A process. In this paper, we empirically examine private firms’ decisions to use sequential divestitures through IPOs rather than outright sales. We suggest that a firm may use an initial public offering prior to divestiture in order to increase the firm’s visibility vis-à-vis potential acquirers, and this can be efficient when parties’ understanding of the identity or availability of potential exchange partners is incomplete. Sellers may also have to contend with buyers’ valuation difficulties stemming from asymmetric information. Specifically, when the seller is unable to credibly and efficiently demonstrate the value of the firm, it may not be able to obtain a selling price that reflects the business’ value. The process of going public not only increases the information available on a firm, but it can provide signals on the firm’s quality that can mitigate the effects of asymmetric information. The empirical evidence suggests that firms use sequential divestiture in the presence of search costs as well as when intangible resources increase the risk of adverse selection. Strategic alliances offer alternative signals to would-be acquirers and attenuate the impact of intangibles on a firm’s proclivity to use IPOs prior to divestiture. THEORY AND HYPOTHESES Search for Exchange Partners In many markets, including the M&A market, potential buyers and sellers, prices, and other conditions routinely change, stimulating search processes in order to locate potential 5
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