In the paper, A Test of IPO Theories Using Reverse Mergers, which was recently made publicly available on SSRN, we investigate many of the current theories explaining why IPO returns are large and significantly positive on the issuance date. Reverse mergers are an alternative method to IPOs for going public, and announcement day price reaction to private reverse mergers is comparable to the initial day price reaction to IPOs. In a private reverse merger, a private firm goes public by exchanging their stock for the stock in a public firm. After a reverse merger there are new stockholders, but the private firm’s old stockholders own the majority of public stock in the surviving firm. When we use reverse mergers as an out-of-sample test, most of the theories developed thus far to explain the market’s reaction to IPOs appear to be invalid.
There are two important institutional differences between reverse mergers and IPOs. The first is that IPOs also serve a financing function, i.e. new shares are sold and equity capital is raised for the firm. In a reverse merger, while capital may be increased through simultaneous or subsequent PIPE or other equity offerings, the process is more indirect. The second important institutional difference, and the basis for our test of IPO theories, is that a reverse merger has no use of an underwriter. Most IPO theories explaining the first-day price “pop” depend on IPO regulations and the underwriters’ incentives and/or relationships with firm managers for motivation.
In this paper, we obtain a sample of reverse mergers for the period 1980 to 2008 from the Security Data Corporation (SDC)’s database. We divide our sample of reverse mergers into three subsamples: those that occur between two public firms (public-public), between a public bidder and a private target (public-private), and between a public bidder and a subsidiary of another firm (public-sub). Of the three subsamples, public-private reverse mergers are the most common.
The market reactions to public-public reverse mergers, which are not a method to go public, are similar to those for non-reverse mergers. In contrast, public-privates and public-subs have stock market reactions similar to IPOs, with bidder average excess returns of 21.8% and 18.7 respectively. The percentage of stock owned by the existing shareholders post-going public is also very similar between IPOs and public-private and public-sub reverse mergers. For IPOs, the average percentage retained by the existing shareholders is 70.7% and for public-private and public-sub reverse mergers, it is 68.1%.
In addition to reporting excess returns at announcement date, we regress the excess returns against the form of reverse merger and against the use of shells or other financing (either PIPE financing, or public equity offerings). We also regress the excess returns against the retained ownership by the target firm’s shareholders. The results confirm that public-private and public-sub reverse mergers have large and significantly positive stock market reactions, while public-public reverse mergers do not. The regression results also show that the stock market’s reaction is more positive the greater the percentage of ownership the target firm’s shareholders retain in the combined entity. Whether the bidder uses financing does not significantly affect the market’s reaction to the announcement.
This paper uses reverse mergers as a natural experiment to investigate many of the current theories explaining why IPO returns are large and significantly positive on the issuance date. Most explanations are driven by the incentives, oligopoly power, or superior information of the underwriters. Others revolve around behavioral considerations related to the manager’s investment decision process, market participants’ susceptibility to promotional activities, or the value enhancing effect of public market liquidity. Since reverse mergers do not use underwriters, involve no “road shows”, and are not bound by IPO regulations, most theories are by definition invalid. In addition, behavioral theories which are dependent on managers’ gains from future IPOs are also irrelevant to reverse mergers. This paper dictates that the finance literature needs to develop a theory that explains the initial price behavior of both IPOs and reverse mergers.
The full paper is available for download here.