Biomarker of Quality? Venture-Backed Biotech IPOs and Insider Participation
Corporate financial managers of biotech firms need long-term financing to reach key milestones, and that requires a long-term capital structure.
In Hans Jeppsson’s article on venture capitalists and IPOs from our JACF Winter issue the author discusses how corporate financial managers of biotech firms must balance a mix of investors with different objectives and different investment horizons that includes traditional venture capitalists and also hedge funds and mutual funds. This study helps practitioners understand the complex role of exit decisions, as venture capitalists seek better exit strategies and performance. IPOs are financing but not “exit” moves.
In addition to certifying firm value, insider purchasing of shares in the IPO offering has two major consequences. First, venture capitalists reallocate large sums of capital from early-stage to late-stage deals that are expected to have lower risk (but also lower expected return) and shorter time to exit. Second, the speed at which VCs exit after the IPO depends on the firm ownership structure after the IPO and the stock liquidity. Going public with a significant participation by venture capitalists will probably increase the post-IPO ownership and decrease the free float of the stock, implying a delay of the exit and the realization of the capital gains from the investments.
Although this study has focused exclusively on the biotechnology industry, insider participation is not unique to it. Biotech’s venture brethren in the software and technology industries also have insider participation in IPOs. During 2003-2015, approximately 41 venture-backed firms outside of the biotechnology sector had insider participation.
Authored by Hans Jeppsson, University of Gothenburg
An Improved Method for Valuing Mature Companies and Estimating Terminal Value
The theory underlying discounted cash flow (DCF) models is uncontroversial in academia. Nevertheless, in practice, DCF models are applied inconsistently with very different valuation results.
In David Holland’s article on discounted cash flow models from our JACF Winter issue the author writes that the theory underlying discounted cash flow (DCF) models is uncontroversial in academia, the economic intuition behind them is straightforward, and the mathematics reassuringly simple. Nevertheless, in practice, they are applied inconsistently with very different valuation results. Because of the assumed infinite life (“going concern”) of a business enterprise, DCF models implicitly assume the ability to forecast future cash flows forever. This forces analysts to make assumptions about the terminal period using simplistic metrics such as P/E or EV/EBITDA to estimate terminal values or to embed a perpetual stream of excess profitability and value creation in the terminal period.
The author offers an uncomplicated alternative to these unrealistic assumptions. The first step is to introduce an adjustable fade rate called f. A fade rate of 100% brings about immediate convergence, and a fade rate of 0% specifies no fade and perpetual excess profitability. The notion that excess profits get competed away over time can be modeled by assuming that the spread of (ROIC – r) fades to zero and that economic profit dissipates.
Intrinsic value is very sensitive to the fade rate assumption and this helps explain the risk premium for quality stocks. The risk of owning quality stocks is that they lose their economic moat and competitive advantage. An adjustable fade rate provides an excellent means to value the effect of profitability attenuation in a DCF model.
Authored by David Holland, University of Cape Town Graduate School of Business
Fundamental Investors Reduce the Distraction on Management from Random Market “Noise”: Evidence from France
Some temporary market enthusiasm may cause management to make value-destroying decisions as the result of random and uninformed stock market volatility
In another of our articles from the JACF Winter issue. the authors find that financial markets have real effects on corporate decisions but that, unfortunately, some temporary market enthusiasm, unrelated to firm intrinsic value, may cause management to make value-destroying decisions as the result of random and uninformed stock market volatility. In particular, they are prone to making bad decisions after stock market overreactions to “surprise” earnings announcements.
This study shows a positive effect of greater long-term ownership on French listed firms. Fundamental investor ownership reduces the degree of market mispricing which serves long-run shareholder value maximization. A fundamental investor is one that, on average, hold his shares for at least two years, is in the top quartile of a firm ownership, and has an active allocation strategy. They are about 8% of all investors. Compared to non-fundamental investors, fundamental investors hold their positions on average three times longer and have positions 1.5 times larger. Fundamental investors are more present in firms which have more liquid stocks, which pay dividends, and which are relatively poorer performers and have relatively lower market-to-book than their industry peers.
Authored by Alexandre Garel, Auckland University of Technology, and Jean-Florent Rérolle, Morrow Somali
Clawbacks” are much discussed in the context of senior executive compensation
“Clawbacks” are much discussed in the context of senior executive compensation, yet the discussion has largely ignored the presence of holdbacks that are already in place in many firms. Holdbacks are deferred compensation that is potentially foregone in the event that the CEO leaves the firm without good reason or they are dismissed for wrong-doing. They are explicit or written features of a CEOs employment contract, as Stuart Gillan writes in the sixth article of the Winter 30.1 issue.
Holdbacks are already in use at 70% of S&P 500 firms and average $18.4 million each. Firms with higher CEO replacement costs, greater information asymmetry, a recent bad experience (fraud, lawsuit, or restatement), or in more certain environments are more likely to have a holdback. In contrast, clawback adoptions are mainly driven by firms’ bad experiences and external pressure from shareholders. Holdbacks and incentive-based compensation are substitutes, as termination incentives can reduce the need for incentive compensation. As managers reasonably demand a premium for accepting risky compensation, a measure of abnormal compensation is positively associated with holdbacks, but there is no significant association between clawbacks and holdbacks.
These findings suggest that the holdbacks many firms already have in place could help an “ex-post settling up” in the event of financial misconduct, or even simply misstated financials. As companies have more control over the amounts held back ex-ante, holdbacks are potentially more efficient.
Authored by Stuart Gillan, University of Georgia, and Nga Nguyen, Marquette University
Firms with stronger governance are less risky, generate higher equity returns and perform significantly better during market downturns
In our fifth article of the Winter 30.1 issue our authors discuss how good internal governance helps firms perform better.
Firms with stronger governance are less risky, generate higher equity returns and perform significantly better during market downturns
Although few doubt that good internal governance helps firms perform better, the statistical evidence is actually mixed because the positive effects of good corporate governance matters much more so at some times than others. The statistical link is strongest during “flights to quality,” when market sentiment turns bearish and pessimistic but weakens for long periods of time during bull markets and low market volatility. Using more than ten years’ evidence from Australian firms, the authors show that internal governance is related to both firm value and performance and that firms with stronger governance are less risky, generate higher equity returns and perform significantly better during market downturns. When risk aversion is high, demand for well-governed firms increases and investors discount the value of firms with potential agency conflicts. This time-varying relationship between internal governance and returns may explain both the limited explanatory power of governance on firm value and the mixed empirical evidence reported in previous studies.
Firms with strong internal governance do earn significantly higher stock returns compared with firms with weak governance; but that also means that the value of governance is not fully incorporated into prices, thereby explaining the limited explanatory power of governance on firm value.
Authored by Peter Brooke, Platypus Asset Management, Paul Docherty, Monash University,
Jim Psaros, The University of Newcastle and Michael Seamer, The University of Newcastle
The fourth article in our Winter 30.1 issue deals with “Say on Pay” rules, those corporate practices giving shareholders the right to vote on executive compensation. The assumption behind “Say on Pay” is that managers may be overpaid because directors fail to provide adequate oversight. Stephen O’Byrne questions this underlying assumption.
O’Byrne provides substantial evidence that directors do a poor job overseeing executive pay and that directors have weak incentives to pursue shareholder interests in executive pay.
“Say on Pay voting is sensitive to differences in pay for performance, but so forgiving that extraordinary pay premiums are required to elicit a majority ‘no’ vote.”
The common corporate practice of providing competitive target compensation regardless of past performance leads to low alignment of pay and performance. Unfortunately, directors have little incentive to protect shareholder interests “because they are paid labor providers, just like management, not stewards of substantial personal capital.”
Authored by Stephen O’Byrne, Shareholder Value Advisors
Financial Flexibility and Opportunity Capture: Bridging the Gap Between Finance and Strategy
In our third article of the Winter 30.1 issue we look at whether logically, the practice of corporate finance and corporate strategy should be closely coordinated, but in reality there remains a massive gap between the two. This can lead strategically oriented firms to de-emphasize or even discard NPV. Neither financial theory nor competitive strategy has been very open to the economic value of investment opportunity capture. Strategy must recognize that financial flexibility provides powerful advantages and financial theory must evaluate entire strategic programs rather than discrete, stand-alone projects.
Necessarily, the financial discussion of cost of capital and capital structure has to change. The authors offer two specific concepts to bridge the Gap between Finance and Strategy:
1) Reserve Financial Capacity is the annual sum of Free Cash Flow, Financing Flexibility and Cash Reserves over the period envisioned for strategy execution. Individual projects must belong to strategic programs in the sense that they either: 1) keep the base business running; 2) preserve an existing competitive position; or 3) form part of a program to enhance advantage or fashion a strategic breakout.
2) Strategically Sustainable Cost of Capital is the true, blended cost of capital required to complete an entire capital program.
These concepts provide financial rigor to firms with well-defined strategies and allow managements to wield Financial Flexibility as a strategic weapon, creating options on unique buying opportunities, such as at the bottom of industry cycles. The paper includes flowcharts illustrating how the standards of judicial review apply to various categories of business decisions that directors may have to make. It concludes with practical suggestions for directors and General Counsels to establish business judgment rule protection for board decisions or, where applicable, withstand more stringent standards of review.
Authored by Stephen V. Arbogast, Kenan-Flagler Business School, University of North Carolina at Chapel Hill and Dr. Praveen Kumar, C.T. Bauer College of Business, University of Houston.
The second article of our Winter 30.1 issue of the Journal of Applied Finance deals with whether directors may wonder if their fiduciary duties have changed. The authors synthesize the latest decisions of the Delaware courts on the standards of conduct for directors and the standards by which their conduct is reviewed. While directors should expect uncertainty in corporate life, neither the fiduciary duties of directors nor the protections afforded them have changed. Disinterested and independent directors, acting in good faith to make decisions they deem in the best interests of the corporation, continue to have broad protections under the business judgment rule. This legal framework enables and encourages active directors to make hard choices when they need to do so.
The paper includes flowcharts illustrating how the standards of judicial review apply to various categories of business decisions that directors may have to make. It concludes with practical suggestions for directors and General Counsels to establish business judgment rule protection for board decisions or, where applicable, withstand more stringent standards of review.
Written by Ira M. Millstein, Ellen J. Odoner, and Aabha Sharma, of Weil, Gotshal & Manges.
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Eclipse of the Public Corporation or Eclipse of the Public Markets?
In our Winter 30.1 issue of the Journal of Applied Finance our first article looks back at Michael Jensen’s 1989 article “The Eclipse of the Public Corporation.” The authors find some of his predictions have been borne out but other important ones, not. Jensen concluded that the publicly held corporation was in decline and had outlived its usefulness in many sectors. He argued that agency costs made public corporations an inefficient form of organization and that new private organizational forms promoted by private equity firms would likely replace the public firm.
The number of public firms in the U.S. has declined significantly but there are still many hugely profitable and successful public companies. U.S. public markets are still well-suited for firms with mostly tangible assets. So, what we are really witnessing is an eclipse not of public corporations, but of the public markets as the place where young firms with mostly intangible capital seek their funding.
This is especially true when the usefulness of the intangible assets has yet to be proven. Sometimes the market is extremely optimistic about some intangible assets, but otherwise firms with unproven intangible assets may be better off funding themselves privately. This evolution has a downside: investors limited to public markets are cut off from investing in high intangible-asset firms. Additionally, as fewer firms remain publicly listed, fewer firms will be transparent to society.
By authors Craig Doidge, University of Toronto, Kathleen M. Kahle, University of Arizona, G. Andrew Karolyi, Cornell University, and René M. Stulz of Ohio State University.
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The Trendsetter: Where a California Pension Plan Sees Opportunity Now
Chris Ailman was a SASB panelist in our Spring 2017 issue of The Journal of Applied Corporate Finance. He gives his investment outlook and elaborates on what ESG means to him in an article in Barron’s entitled The Trendsetter: Christopher Ailman of CalSTRS.
See Wiley’s Online Library to access the full text of our SASB roundtable.