Competitive advantages of going public: Evidence from incumbent firms in the USA

Abstract

Industry incumbent firms (existing public peer firms) experience significant negative stock returns around large initial public offerings (IPO) events in the same industry (Hsu, Reed, & Rocholl, 2010), implying a competitive advantage shift resulting from IPO events. We investigate whether such large IPO events generate real impact in the long run and increase the risk and thus cost of equity of incumbent firms. Using data from 1998–2019, we found that within three years after large IPO events, industry incumbents exhibit positive abnormal returns even after controlling for known asset pricing factors. In addition, their default probability also increases. Using intertemporal capital asset pricing model (ICAPM), we show that incumbent firms’ stock returns become more sensitive to economic conditions, in other words, riskier. Following Hou and Robinson (2006), we propose that the increased risk to incumbent firms comes from industry competition. We provide empirical evidence that this is the case. Specifically, firms in industries with low product differentiability, a large number of public firms, and smaller market size have larger increases in expected returns. As robustness tests, we document that industry incumbents exhibit declines in unexpected earnings, which contradicts the notion that the observed positive returns can be attributed to persistent positive cash flow for industry incumbent