Qigui Liu acknowledges the financial support from the National Natural Science Foundation of China (Grant No. 71702163) and the Fundamental Research Funds for the Central Universities.

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Abstract

We argue and provide evidence that instead of playing a monitoring role, venture capital (VC) investors collude with controlling shareholders in the IPO process of Chinese non-state-owned enterprises (non-SOEs). We show that VC-backed IPOs’ applications are more likely to be approved by regulators, especially in firms with excess control rights, but have worse post-IPO performance. Through investing in firms with excess control rights, VC investors are able to make higher exit returns. We further document that VC investors’ role in the IPO process is stronger when they have political connections, hold higher ownership, and when they make pre-IPO investment.

1 Introduction

The positive role played by venture capital (VC) investors in developed markets is widely documented in the literature, such that VC investors as institutional investors invest more in social responsibility (Cumming and Johan, 2007) and play an important monitoring role in VC-backed firms based on concern for their reputation (Gompers, 1995; Engel et al., 2002; Hochberg, 2012). This means that VC-backed initial public offerings (IPOs) usually outperform other IPOs (Degeorge and Zeckhauser, 1993; Holthausen and Larcker, 1996; Cao and Lerner, 2009; Guo et al., 2011; Krishnan et al., 2011; Rosenbusch et al., 2013) because VC investors as block-holders effectively mitigate the information asymmetry between managers and minority shareholders. Apparently, the monitoring arguments of VC investors are mostly based on the developed markets where the first type of agency problem (the classic manager–shareholder agency conflict) dominates. Indeed, VC investors are playing an increasingly important role in the emerging IPO market, particularly the Chinese market, where (i) the main agency conflicts are between large controlling shareholders (the ultimate owners) and minority shareholders (the so-called second type of agency problem), and (ii) the IPO market is highly regulated by the government, which means that all prospective IPO firms must get approval from the government before they can make go public. Under those institutional environments, there is still a lack of evidence about whether VC investors still play an active monitoring role or if they play different roles, such as helping firms to get their IPO approved by regulators, and whether VC investors collude with the controlling shareholders in the IPO process. This study attempts to fill this gap and provide fresh evidence to address those questions.

Typically, as an important early-stage investor of firms, VC investors enter the firm usually a few years before IPO. Conventional wisdom suggests that VC would play an important governance role in firms in which they invested (Baum and Silverman, 2004). In particular, VC investors monitor the firms through the process of screening, due diligence and active monitoring, especially in the developed markets (mostly in the US context) (Kaplan and Stromberg, 2001; Krishnan et al., 2011; Bernstein et al., 2016). VCs investors are able to, and they have strong incentive to, monitor the firms in which they invested because: (i) VC investors are usually institutional investors with a professional management team, which means that they have the knowledge needed to monitor the firms; (ii) by becoming an active monitor, they are able to ensure their investment performance, which they need to build industry reputation and attract investors to raise money. Therefore, in the US context, traditionally VCs usually invest in high-tech industries with more severe information asymmetry because they can then maximise their investment returns from managing the uncertainty. There are two important assumptions for the institutional setting underlying these arguments as follows: (i) the capital market is well developed, so VC investors can obtain positive abnormal returns if they monitor the opportunistic behaviour of managers from the secondary market; (ii) the government rarely intervenes in the IPO market, which means firms can freely enter the IPO market, and VC investors are unable to seek to profit from government regulatory powers. Under these institutional environments, VC investors tend to play an active monitoring role to maintain a better investment performance.

However, VC investors may play a different role in emerging markets where the market is not well developed (Bruton and Ahlstrom, 2003), under which circumstance their profit is derived mainly from the pre-IPO market rather than the secondary market,1 while the IPO market is still highly regulated by the government. Although many firms are eager to raise money from IPOs, only a small number can gain access to the IPO market by being approved by a government authority. Under these institutional settings, VC investors may have less incentive to play an active monitoring role and a strong incentive to seek rent opportunities from the state’s regulatory power by establishing connections with the government (Peng, 2003; Peng et al., 2008; Lu et al., 2013). We therefore predict that VC investors in an emerging market such as China may act as a financial intermediary between government regulators and non-state-owned enterprises (Non-SOEs); this means that VC investors may collude with the ultimate owners who control these firms in the IPO process. The mechanism is as follows: VC investors help firms gain access to the IPO market by utilising their established political connections; in return, the ultimate owners allow VC investors to make investment shortly before the IPO, with relatively low investment costs. By doing so, VC investors profit from the low investment costs, and the ultimate owners gain from the IPO by controlling more financial resources.

Anecdotal evidence supports the collusion theory of VC in the Chinese market, with typical examples being the ‘VC corruption’ and ‘VC factory’ that have been widely reported by the Chinese media. ‘VC corruption’ means that VC investors could enter pre-IPO firms at a very low cost shortly before the IPO, because they obtained inside information on whether it would be approved by the regulators. This has become a common phenomenon in the Chinese IPO capital market. For instance, Xiaoshi Wang, the former vice president of the screening committee of the China Securities Regulatory Commission (CSRC), went to jail in December 2005 for taking bribes from venture capitalists; Shaowu Li, the former manager of the VC department of Guosen Securities, was fired because he established his own VC company, which entered into three pre-IPO firms from 2001 to 2008 and made a profit of more than 30 million Chinese Yuan. ‘VC factory’ is another phenomenon in China, which refers to the fact that VC investors enter into many pre-IPO firms to make short money without considering the quality of the projects. A recent example is the Jiuding Investment Company, a VC firm established in 2007 with former CSRC executives as LPs (Limited Partners), who invested in 80 pre-IPO firms in 2011.

If VC investors collude during the IPO process in an emerging market, we further expect that they would play a more important role in some firms that have a high risk of expropriation by their ultimate owners, i.e., firms whose ultimate owners have excess control rights, which have been widely documented to be an important institutional factor that shapes corporate behaviours in emerging markets (Faccio et al., 2001; Faccio and Lang, 2002; Fan et al., 2011; Lin et al., 2011a,b). Prior literature has documented that the excess control rights of the ultimate owners are negatively associated with firm value or performance2 due to potential expropriation by those owners. In other words, ultimate owners with excess control rights benefit mainly from their expropriation rather than from cash dividends (Almeida and Wolfenzon, 2006). Thus, ultimate owners with excess control rights have a stronger incentive to make an IPO, which allows them to control more resources to expropriate. However, it is difficult for these firms to go public because the regulators or minority shareholders will expect potential expropriation from the ultimate owners, and therefore, ultimate owners with excess control rights should have a stronger incentive to seek channels that help them access the IPO market. VC investors in emerging markets provide such channels because they can usually capture rents from the institutional environment in an emerging market through their connections with the government (Peng, 2003; Peng et al., 2008).

By using the unique data of Chinese Non-SOEs, this study aims to provide empirical evidence for the following research questions: (i) Do VC investors play a positive role in assisting a firm’s access to the IPO market? (ii) Do minority shareholders benefit from the involvement of VC investors? (iii) How do VC investors’ characteristics influence the IPO process, if at all?

Our findings suggest that the involvement of VC investors does increase the probability of IPO approval, especially in firms with excess control rights. However, the interests of minority shareholders are actually destroyed in VC-backed IPOs, especially those with more excess control rights, because those firms have worse, lower, long-term post-IPO performance (2 and 3 years). We also document that one is usually able to invest VC in firms whose ultimate owners have excess control rights with lower investment costs and shorter investment duration, which explains why VC investors invest in firms with excess control rights. Moreover, rather than treat VC investors as a homogeneous group, we examine whether their characteristics influence the IPO process of VC-backed IPOs. We provide evidence that IPOs backed by pre-IPO VC investors and politically connected VC investors are more likely to be approved and show worse post-IPO performance, especially firms with excess control rights; and these effects are stronger when they hold more shares of VC-backed firms. The results provide additional evidence showing that VC investors, especially pre-IPO ones, increase IPO approval through their political and social connections. Finally, we try to address the endogeneity issue using various approaches and find our results are robust to those endogeneity tests.

Our study contributes to the current literature by identifying the different roles played by VC investors in an emerging market, particularly as that role depends on local institutional settings. Rather than play a monitoring role, VC investors in an emerging market actually collude with the ultimate owners, in that they enable ultimate owners to control more resources by helping firms access the IPO market. In return, the ultimate owners allow VC investors to make pre-IPO VC investments (invest in firms within one year before an IPO) with low investment costs, which destroys the value of minority shareholders due to the worse post-IPO performance of VC-backed IPOs in the secondary market.

We also provide evidence that VC investors’ role in the IPO process is influenced by characteristics such as the duration of their investment and their political connections and ownership. This result confirms our argument that VC investors in an emerging market are more likely to benefit from their political connections and make quick money from their pre-IPO investments rather than from long-term VC investment, without much concern for their reputation.

Third, although the wealth implications of excess control rights have been widely documented by previous studies that usually emphasise the value-destroying consequences of corporate pyramid ownership structures, there is insufficient literature linking the corporate pyramid structure to firms’ IPO process. We focus on how the ultimate owners with excess control rights benefit from pyramid structures, and we identify the channels through which they overcome the IPO requirements and have their controlled firms listed.

The remainder of this paper is organised as follows: Section 2 describes the institutional background and develops our main hypotheses. Section 3 describes the samples selected, variable construction, and summary statistics. Section 4 presents the results of our main empirical and robustness tests. Section 5 concludes the paper.

2 Institutional environment and hypothesis development

2.1 Institutional environment of the Chinese IPO market

Historically, almost all Chinese firms were fully owned by the central and local governments, but since the late 1970s when the Chinese government introduced economic reforms, Non-SOEs have advanced and grown rapidly. According to a recent China Statistical Yearbook, privately owned firms account for more than two-thirds of Chinese GDP and more than 80 percent of employment (China Statistical Yearbook, 2016).

However, Non-SOEs in China have suffered both political and social discrimination. For ideological reasons, Non-SOEs in China have been considered an inferior form of ownership, and the political environment has been antagonistic towards the private sector (Li et al., 2008). In addition, the economic environment in China does not favour Non-SOEs because the Chinese government still controls most of the resources, and state-controlled firms still enjoy preferential status in obtaining bank loans – especially loans from state-owned commercial banks (Che, 2002; Brandt and Li, 2003); this means that entrepreneurs are always constrained by a lack of access to external funds. This is why Chinese entrepreneurs always have strong incentives to establish pyramid ownership structures to create internal capital markets that help relieve their external financing constraints (Fan et al., 2009). This type of structure allows the owners to access all the earnings of the firms they control (Almeida and Wolfenzon, 2006).

Another important channel for firms wishing to overcome financial constraints is using the public equity market rather than borrowing funds from banks, that is, to go public in the Chinese capital market. Despite this, it is still quite difficult for firms to go public, especially Non-SOEs, because, according to current Chinese security law, all prospective IPO firms must first submit an IPO application to the China Securities Regulatory Commission (CSRC) and are then not allowed to issue shares in the market until their application has been approved. Usually, an IPO application submitted to the CSRC is first examined by their officials, and if it meets basic legislative requirements, it is then passed on to the Stock Issuance Examination and Verification Committee (SIEVC) for further examination and verification (Yang, 2013).

The Chinese government (the CSRC) has promulgated a number of laws and regulations to guide the selection of an IPO. The regulations clearly outline some detailed minimum requirements on firms’ financial data. CSRC [2006] No. 32, for example, requires that ‘an issuer must have positive net profits in the past three financial years and the overall net profits in the past three years must exceed 30 million Chinese Yuan’, and that ‘an issuer’s overall operating cash flow in the past three years must exceed 50 million Yuan, or the overall sales revenue must exceed 300 million Yuan.’ In addition to those clearly outlined rules discussed above, the legislation also contains large amounts of soft, qualitative and ambiguous criteria.3 These ambiguous requirements cause serious problems because they entice owners to seek some relationship or connection with officials to help with their applications, given that the legal system is still weak, and the economy is dominated by relationships and networking (Liu et al., 2013). Indeed, VC investors are playing an increasingly important role in the IPO process of Chinese firms, and a related question is whether they also play a role in helping firms get their IPO application approved.

2.2 Hypothesis development

2.2.1 The role of VC in the IPO process

We first develop our hypothesis regarding the role of VC in the IPO process of Chinese Non-SOEs. Given that the Chinese IPO market is still regulated by the government, companies must still submit an IPO application to the CSRC, and they cannot issue new shares in the capital market until that application has been approved. Like the US capital market, VC has been playing an increasingly important role in IPOs in the Chinese capital market. Our sample shows that more than 50 percent of Chinese IPO cases are VC-backed, but there is still no evidence for the role of VC in the IPO process.4 Given that most VC investors in emerging markets seek rent from the government by establishing connections5 with it and through social networking, we expect to find that VC investors can enter prospective IPO firms shortly before their IPO application at low cost. Therefore, VC investors will have the incentive and ability to canvas regulators by using their own connections with the government if they are allocated some proportion of the shares from the ultimate owners before an IPO. Prior studies show that excess control rights of ultimate owners are associated with more severe agency conflicts between ultimate owners and minority shareholders (see, for instance, Claessens et al., 2002; Faccio et al., 2010; Lin et al., 2012; Liu and Tian, 2012). With the perception of the potential expropriation from ultimate owners, other things being equal, regulators are less likely to approve the IPO application made by those firms. As a result, firms whose ultimate owners have excess control rights always take higher risk in accessing the IPO market. Therefore, we also expect that if VC investors play a role in helping firms to go public, firms with excess control rights would need the help of VC investors more than other firms, and thus VC will play a more important role in firms whose ultimate owners have more excess control rights. Thus, we develop our first hypothesis as follows:

H1a: Compared to non-VC-backed IPOs, the IPO application of VC-backed IPOs is more likely to be approved by the regulators, especially in firms with excess control rights.

Venture capital investors play a positive role in helping firms’ ultimate owners bring their firms to the IPO market, so it would be interesting to further explore whether or not minority shareholders also benefit from the involvement of VC investors. If as expected, VC investors do not play a monitoring role in the IPO process, and minority shareholders perceive the potential risk of VC-backed IPOs that VC investors will cash out gradually after the lock-up period (usually 12 months after IPO), then it is reasonable to further expect that VC-backed IPOs may underperform non-VC-backed ones. Moreover, the potential expropriation risk of firms whose ultimate owners have excess control rights will strengthen the negative relationship between VC and long-term post-IPO performance. Thus, our second hypothesis is as follows:

H1b: VC-backed IPOs have a worse long-run post-IPO performance, especially in firms whose ultimate owners have excess control rights.

2.2.2 How VC benefits from investing in firms with excess control rights

Given that VC investors bring great benefits to ultimate owners by helping their firms go public, which destroys the interests of minority shareholders, one major concern that arises is the following: why do VC investors still invest in firms with excess control rights even though they can expect the potential expropriation risk by the ultimate owners? What benefits might VC investors obtain? One reasonable explanation is that VC investors would be able to gain other benefits (such as lower investment costs or to enter the pre-IPO firms shortly before the IPO) from the primary market to guarantee their profits and as compensation for the expropriation risk they take. Therefore, we argue that if as expected, VC investors collude with the ultimate owners, it is reasonable to further expect that VC investors may be able to (i) invest in firms with excess control rights with relatively lower investment costs and thus obtain higher investment returns; and (ii) invest in pre-IPO firms shortly before the IPO date (they may invest in pre-IPO firms one year before the IPO application is made, the so-called ‘pre-IPO VC investment’). Therefore, we further hypothesise the following:

H2: VC investors’ investment return and investment duration are higher/shorter when they invest in firms with excess control rights.

2.2.3 The heterogeneity of VC and its effect in the IPO process

Our last hypothesis relates to how VC investors’ characteristics affect IPO approval. If as expected, VC investors play an important role in helping firms access the IPO market, it is reasonable to predict that their role should be stronger if they invest in pre-IPO firms within one year (pre-IPO VC investors), because firms are less likely to allow them to invest shortly before an IPO unless the firms themselves benefit from VC investments. Moreover, we expect that VC investors’ role will also be strengthened when they have political connections and when they hold more shares of pre-IPO firms, because the former means they are better able to communicate with the regulators and the latter indicates they have a stronger incentive to do so. Thus, our last hypothesis is as follows:

H3a: Compared to IPOs backed by long-term VC, IPOs backed by pre-IPO VC investors are more likely to get approved and have a worse post-IPO performance, especially in firms with excess control rights.
H3b: Compared to IPOs backed by VC investors without political connections, IPOs backed by VC investors with political connections are less likely to be approved and have a worse post-IPO performance, especially in firms with excess control rights.
H3c: Compared to IPOs backed by VC investors who hold less ownership of IPO firms, IPOs backed by VC investors who hold more ownership of IPO firms are less likely to be approved and have a worse post-IPO performance, especially in firms with excess control rights.

3 Data, variables, and summary statistics

3.1 Data collection

Our sample covers all IPO applications, including both VC-backed and non-VC-backed ones, screened by the CSRC between 1 January 2006 and 31 December 2010. Our research period starts in 2006 because firms whose IPO applications were not approved were also required to disclose their prospectuses to the public, as did those who were approved after 2006. In addition, to calculate 36 months of long-term post-IPO performance, we require that firms go public for at least 3 years when we collected the data. Therefore, this is the largest IPO sample we could obtain when we conducted our study.

Information regarding IPO applications was collected manually from the CSRC website, and the regulatory decisions regarding IPO applications compiled from announcements publicly available from the CSRC website.6 Information about the pre-IPO cash flow rights and control rights of the ultimate owners7 was collected manually from the prospectus disclosed either by firms who had applied previously or by their underwriters. Information regarding VC investors, such as VC investment duration, exit return and VC investors’ political connections, was also compiled manually either from firms’ prospectuses or from the database by the Zero2IPO Group.8 IPO process information and pre-IPO financial information regarding firms with IPO applications were collected either from the IPO research database of Chinese firms (2006–2010) provided by the CSMAR dataset, or manually from firms’ prospectuses.9 Stock and market return information was collected from the Stock Return Data database of the CSMAR dataset. Other related data used in the study were collected either from the CSMAR dataset or manually from official websites. We excluded (i) state-controlled firms (firms whose ultimate owners are local or central government) for the following reasons: first, globally, most of the listed firms around the world are Non-SOEs, and previous studies on the topic of pyramid ownership structure mainly focused on Non-SOEs (Claessens et al., 2000, 2002; Faccio et al., 2010); second, Chinese Non-SOEs have a similar ownership structure and corporate governance characteristics to firms in other East Asian countries, as documented by Faccio et al. (2010); third, SOEs in China have different objectives and principal–agent frameworks compared to those Non-SOEs, so the main agency issue in state-controlled firms is the conflict between shareholders and managers, rather than the one between controlling shareholders and minority shareholders (Rousseau and Xiao, 2007); and (ii) IPO applications whose relevant information cannot be acquired.10 Our final sample consists of 749 cases of IPO applications from 2006 to 2010, 417 of which are VC-backed, and the other 332 are not VC-backed, while 612 cases are finally approved to go public.

3.2 Measuring variables

3.2.1 Definition of key variables

We define a dummy variable ‘VC’, which equals 1 if the pre-IPO firm has at least one VC investor (an investor is defined as a VC investor if the name of the investor has the words ‘investment,’ ‘venture investment,’ or ‘limited partnership,’ etc.) as block shareholders, as disclosed in the firm’s prospectus11 and 0 otherwise. We further define the following variables to capture the characteristics of VC investors. VC investors’ investment return (VCRETURN) is the exit return of VC investors. VC investors’ investment duration (VCDURATION) is defined as the average number of years between the initial VC investment year and the IPO year. Pre-IPO VC investment (PREIPOVC) is defined as a dummy equal to 1 if the firm has VC investors that invest within 1 year prior to the IPO year. VC investors’ political connections (VCPC) is defined as a dummy equal to 1 if the firm is backed by state-owned (controlled) VC or VC investors with political connections via top executives and 0 for other firms. VC investors’ ownership (VCOWN) is the shares held by VC investors as a percentage of total outstanding shares of the pre-IPO firms.

According to previous studies, such as Claessens et al. (2002), Faccio and Lang (2002), Lin et al. (2011a,b) (2012), the excess control rights of the ultimate owner are defined as ‘EXCESS’, which is the divergence between the control rights and cash flow rights of the ultimate owner. While the cash flow rights are measured by the sum of the products of the proportion of ownership along the control chains, the control rights are measured by the minimum proportion of ownership along the control chains.

Regarding the key dependent variables, IPO approval is defined as a dummy variable ‘APPROVAL’ that is equal to 1 if the firm’s IPO application is approved by the CSRC and 0 otherwise; this definition follows Liu et al. (2013). Post-IPO performance is measured by the market, industry and size-adjusted cumulative abnormal returns (CARs) and buy-and-hold abnormal returns (BAHRs) for 12, 24, and 36 months after the IPO. Barber and Lyon (1997) argue that matching firms are the most appropriate benchmark for measuring the long-term returns and for yielding well-specified statistical tests, while Perry and Williams (1994) claim that firms classified under the same industry and of similar size are subject to similar economic and competitive factors and thus have comparable operating, investing, and financing opportunity sets. Therefore, we calculated post-IPO market performance by using the return of firms within the same market, industry and size as benchmark returns.

3.2.2 Other variables

We also include several control variables in our regression, including firms’ pre-IPO financial data and other factors that may have an impact on our dependent variables, as indicated in previous studies. The detailed definitions and calculations of all the variables used in this paper are reported in Table 1.

Table 1. Variable definition

Variable names	Variable definitions
VC	A dummy variable that equals 1 if the firm has at least one VC investor
VCRETURN	VCs' exit return as provided by the ZERO2IPO database
VCDURATION	The average investment duration of VCs measured by the number of years between the investment year and the IPO year
PREIPOVC	A dummy that equals 1 if the firm is backed by at least one VC investor that invests in the pre-IPO firm within one year prior to the IPO
VCPC	A dummy variable that equals 1 if the firm is backed by at least one state-owned (controlled) VC or for non-state-owned (controlled) VCs who have politically connected executives,† and 0 otherwise
APPROVAL	A dummy variable that equals 1 if the firm’s IPO application is approved by the CSRC and 0 otherwise
CAR(BAHR)12	Twelve months post-IPO market, industry and size-adjusted performance measured by both CAR and BAHR
CAR(BAHR)24	Twenty-four months post-IPO market, industry and size-adjusted performance measured by both CAR and BAHR
CAR(BAHR)36	Thirty-six months post-IPO market, industry and size-adjusted performance measured by both CAR and BAHR
EXCESS	Ultimate owner's control rights minus cash flow rights
CASHFLOW	Pre-IPO cash flow rights of the ultimate owner
ROE	Pre-IPO earnings to total equity
LEVERAGE	Pre-IPO leverage ratio (total debt to total assets)
CURRENT	Pre-IPO current ratio
SIZE	Pre-IPO natural logarithm of total assets
AGE	Pre-IPO firm age
PCCEO	Political connections of the firm’s CEO/chairman: defined as a dummy variable that equals 1 if the firm’s CEO/chairman is currently or was formerly a governmental official/a deputy of the People’s Congress or People’s Political Consultative Conference
TOP_UNDERWRITER	A dummy variable that equals 1 if the underwriter is one of the top 5 investment banks in China
TIMING	A dummy variable that equals 1 if the IPO application is submitted after 31 March 2009

† Similar to the definition of firms’ political connections, a VC is defined as having politically connected executives if the CEO or chairman or other top executives is currently or was formerly an officer of the government or military or a deputy of the People's Congress or People's Political Consultative Conference (Liu et al., 2013).

3.3 Descriptive analysis and univariate test

3.3.1 Summary statistics

Table 2 presents the summary statistics of our sample. Panel A of Table 2 presents the results of pre-IPO information for all the IPO applications; from this panel, we find that on average, 83 percent of the IPO applications were approved by the CSRC, and 56 percent of the firms were backed by VC. Regarding VC characteristics, our results show that within the 417 VC-backed IPOs, the average VC investment price is 5.23 times that of the book value of equity, with average investment duration of 3.36 years. A total of 123 IPOs are backed by pre-IPO VC investors (29 percent), which means that VC investors invest in those firms within one year prior to the IPO, while 51 percent of firms are backed by VC investors with political connections, and the average VC ownership is 16 percent.

Table 2. Summary statistics

Variable	Obs	Mean	Median	Std. dev.	Min	Max
Panel A: Summary statistics of pre-IPO information
APPROVAL	749	0.83	1.00	0.38	0.00	1.00
VC	749	0.56	1.00	0.50	0.00	1.00
VCRETURN	417	5.34	1.95	24.07	0.28	41.65
VCDURATION	417	3.36	3.00	1.68	1	11
PREIPOPE	417	0.29	0.00	0.46	0	1
VCPC	417	0.51	1	0.50	0	1
VCOWN	417	0.16	0.14	0.10	0.02	0.43
EXCESS	749	0.06	0.00	0.10	0.00	0.65
CASHFLOW	749	0.52	0.51	0.21	0.00	1.00
ROE	749	0.29	0.27	0.11	0.04	0.92
LEVERAGE	749	0.52	0.53	0.17	0.06	2.17
CURRENT	749	1.74	1.42	1.20	0.44	14.34
SIZE (million yuan)	749	506.00	301.00	749.00	36.30	9380.00
PCCEO	749	0.44	0.00	0.50	0.00	1.00
TOP_UNERWRITER	749	0.04	0.00	0.19	0.00	1.00
Panel B: Summary statistics of post-IPO performance
CAR12 (%)	612	−10.88	−12.85	34.95	−125.21	113.34
CAR24 (%)	612	−14.72	−17.80	49.56	−246.60	139.86
CAR36 (%)	612	−18.13	−22.47	59.13	−220.89	221.67
BAHR12 (%)	612	−14.23	−13.06	43.49	−248.19	159.88
BAHR24 (%)	612	−15.54	−20.00	50.21	−262.41	278.61
BAHR36 (%)	612	−20.56	−27.17	79.16	−304.62	265.35

This table presents the number of observations, mean, median, maximum, minimum, and standard deviation for all variables used in the paper. Definitions of all the variables are reported in Table 1. Panel A presents the results of the IPO application information and includes both successful and unsuccessful IPO cases. Panel B presents IPO characteristic information only for the sample of successful IPO cases.

In addition, the average excess control rights and cash flow rights of the owners are 6 percent and 52 percent, respectively. We also show that the average return on equity, leverage ratio, current ratio and firm size are 29 percent, 52 percent, and 1.74 and 506 million Chinese Yuan, respectively. Lastly, approximately 44 percent of the firms that submit IPO applications have a politically connected CEO/chairman, and only 4 percent of prospective IPO firms actually seek top underwriters as a proxy for good underwriter reputations. Panel B of Table 2 reports the post-IPO performance of Chinese IPOs. We show that the post-IPO performance in China is quite low, while long-term post-IPO performance is even lower than the short-term performance, indicating that the overall performance of listed firms in the Chinese market deteriorates after the public listing.

3.3.2 Univariate test

Table 3 presents the results of the univariate test of our sample. Panel A presents the univariate test results of IPO approval and VC in different types of firms to show whether VC matters in IPO approval. Our results show that VC-backed firms have significantly higher IPO approval rates than non-VC-backed firms (87 versus 77 percent), and 59 percent of approved IPOs are VC-backed, while only 41 percent of rejected IPOs are VC-backed. These results suggest that VC investors do help firms access the IPO market. In addition, Panel B further indicates that VC investors’ role is more pronounced in firms whose ultimate owners have high excess control rights. Those results are consistent with our hypothesis H1a.

Table 3. Univariate test

Panel A: IPO approval (VC) in different types of firms
	VC	NVC	Difference	p-value
APPROVAL	0.87	0.77	0.10	0.00***

	APPROVAL	NON-APPROVAL	Difference	p-value
VC	0.59	0.41	0.18	0.00***

Panel B: IPO approval in firms with high and low excess control rights
	VC	NVC	Difference	P-value
APPROVAL
HEXCESS	0.91	0.77	0.14	0.00***
LEXCESS	0.83	0.78	0.05	0.12

Panel C: Post-IPO performance in firms with and without VC in subsamples of firms with and without excess control rights
		VC (%)	NVC (%)	Difference (%)	P-value
CAR12		−28.39	−10.88	−17.51	0.06*
CAR24		−36.59	−14.37	−22.22	0.02**
CAR36		−42.83	−9.18	−33.65	0.00***
CAR12	HEXCESS	−44.37	−18.60	−25.77	0.03**
CAR12	LEXCESS	−12.33	−5.80	−6.53	0.28
CAR24	HEXCESS	−52.96	−24.61	−28.36	0.00***
CAR24	LEXCESS	−14.17	−8.06	−6.11	0.12
CAR36 †	HEXCESS	−54.36	−13.39	−40.97	0.00***
CAR36 †	LEXCESS	−11.71	−4.73	−6.98	0.21

Panel D: VC investment return and VC duration in firms with and without excess control rights
	EXCESS	NON-EXCESS	Difference	p-value
VCRETURN	9.13	4.26	4.87	0.06*
VCDURATION	2.44	4.31	2.13	0.03**

Panel E: VC characteristics and IPO approval
		Obs.	Mean (%)	Diff (%)	p-value
All VC-backed IPOs
PREIPOVC	Yes	123	0.93	0.09	0.01**
PREIPOVC	No	294	0.84	0.09	0.01**
VCPC	Yes	215	0.93	0.11	0.00***
VCPC	No	202	0.82	0.11	0.00***
VCOWN	High	208	0.82	0.10	0.01**
	Low	209	0.92
VC-backed IPOs with excess control rights
PREIPOVC	Yes	55	0.96	0.11	0.03**
PREIPOVC	No	131	0.85	0.11	0.03**
VCPC	Yes	100	0.95	0.15	0.00**
VCPC	No	86	0.80	0.15	0.00**
VCOWN	High	97	0.84	0.08	0.07*
	Low	89	0.92
VC-backed IPOs without excess control rights
PREIPOVC	Yes	68	0.91	0.06	0.20
PREIPOVC	No	163	0.85	0.06	0.20
VCPC	Yes	115	0.90	0.07	0.11
VCPC	No	116	0.83	0.07	0.11
VCOWN	High	115	0.89	0.09	0.06*
VCOWN	Low	116	0.80

Panel A compares the probability of IPO approval rates in VC- and non-VC-backed firms. VC and NVC represent VC- and non-VC-backed firms, respectively. APPROVAL and NON-APPROVAL represent firms whose IPO applications are approved and not approved, respectively. Panel B compares the probability of IPO approval rates in VC-backed and non-VC-backed firms and in firms with high and low levels of excess control rights. HEXCESS and LEXCESS refer to the firms whose excess control rights are above and below the mean of the sample. Panel C compares post-IPO performance in VC- and non-VC-backed firms based on firms with high and low excess control rights. HEXCESS and LEXCESS refer to the firms whose excess control rights are above and below the mean of the sample. Panel D presents the average VC investment cost and VC duration for VC-backed IPOs. Panel E presents the IPO approval rate between different types of IPOs: IPOs backed by pre-IPO VC investment or not, IPOs backed by politically connected VC or not and IPOs backed by VCs with high and low VC ownership. *, ** and *** indicate significance at 10, 5 and 1 percent levels, respectively.
† The univariate test results for BAHRs, which are similar to the results of CARs are also conducted but not reported here due to limited space.

In Panel C, we report the post-IPO performance of firms with and without VC investors and in firms with high and low excess control rights. Overall, we observe that VC-backed IPOs have worse long-term post-IPO performance (12, 24 and 36 months after an IPO) in all groups of firms (whether the ultimate owners have excess control rights or not). More importantly, our results show that in the subsample of firms with excess control rights, VC-backed IPOs have significantly lower post-IPO performance, while in firms without excess control rights, the differences between VC-backed and non-VC-backed IPOs are all statistically insignificant. Our results confirm our hypothesis H1b.

The univariate test results on the comparison of average VC exit return and duration between firms with and without excess control rights are reported in Panel D. Interestingly, we find from Panel D that VC investors’ investment return and duration are higher/shorter in firms with excess control rights, which is consistent with our hypothesis H2.

Panel E of Table 3 presents the IPO approval rate between different types of IPOs as follows: IPOs backed by or not by pre-IPO VC investment, IPOs backed or not by politically connected VC investors, IPOs backed by VC investors with high and low VC ownership. As expected, the results show that compared to other VC-backed IPOs, IPOs backed by pre-IPO VC investment, politically connected VC investors and VC investors with higher VC ownership are more likely to be approved, while all the results are more pronounced in firms with excess control rights. Similar results have been found between VC characteristics and post-IPO performance. To save space, the results are not reported. Overall, our hypotheses H3a, H3b and H3c are also confirmed.

4 Empirical analysis

4.1 Regression model

We conduct our empirical tests using a series of regression models in such a way that the baseline regression model can generally be specified in the following equation:

$urn:x-wiley:08105391:media:acfi12602:acfi12602-math-0001$ ()

The dependent variables in Equation (1) can be measures of IPO approval rate (APPROVAL) or post-IPO performances (PERFORMANCE). VC and EXCESS are a VC-backing dummy and the excess control rights of ultimate owners. X is a vector of control variables, while the definition and calculation of these control variables are detailed in Table 1. We include the industry, year, and listing board dummy variables in all the regression models to control for the specific effects of industry, time and the listing board.

4.2 The role of VC in the IPO process

4.2.1 The effects of VC investment on IPO approval

We begin our empirical tests to provide evidence for our hypothesis H1a, that the involvement of VC investors helps firms to access the IPO market, especially for firms with excess control rights. To test this hypothesis, we conduct two regressions that relate VC, as well as the interaction of VC and excess control rights, to an IPO approval dummy. The results are reported in Table 4. As expected, we find from the first column that VC is statistically positively associated with the probability of IPO approval without including the interaction of VC and excess control rights. This result suggests that VC-backed firms usually have better access to the IPO market. In addition, we show in column 2 of Table 4 that the interaction term of VC and excess control rights is also positively associated with IPO approval, and the sum of the coefficients of VC and the interaction term is statistically significantly different from 0, which indicates that VC helps those firms with excess control rights to access the IPO market, a result that supports our hypothesis H1a. Return on equity (ROE) and firm size are significantly positively associated with IPO approval, while leverage is negatively associated with IPO approval, indicating that regulators prefer high profitability and large firms rather than high leverage and small firms. Firms whose CEO/chairman has political connections are more likely to get approved, which is a reasonable result because those types of firms are able to communicate with the regulators more effectively (Liu et al., 2013). However, we find no evidence that firms with top underwriters as a proxy for their good reputation gain significantly higher approval than those with other underwriters. These results indicate that the effects of excess control rights and VC on IPO approval remain significant after controlling for firms’ political connections and the underwriter’s reputation.

Table 4. The effect of VC investment on IPO approval

Variables	APPROVAL
VC	0.73***	0.40
VC	(0.00)	(0.12)
EXCESS	0.79	−1.58
EXCESS	(0.49)	(0.27)
EXCESSVC*		6.62***
EXCESSVC*		(0.01)
CASHFLOW	0.58	0.66
CASHFLOW	(0.30)	(0.25)
ROE	0.03**	2.65**
ROE	(0.02)	(0.03)
SIZE	0.55***	0.58***
SIZE	(0.01)	(0.00)
LEVERAGE	−0.02**	−2.38**
LEVERAGE	(0.03)	(0.03)
CURRENT	−0.21*	−0.18
CURRENT	(0.07)	(0.14)
TOP_UNDREWRITER	0.06	−0.03
TOP_UNDREWRITER	(0.93)	(0.96)
PCCEO	0.56**	0.56**
PCCEO	(0.02)	(0.02)
_cons	−11.19***	−12.65***
_cons	(0.00)	(0.00)
Industry, Year, Listed board	Yes	Yes
Obs.	749	749
Pseudo R²	0.14	0.16
Sum test:
VC + EXCESS × VC = 0		7.02***
VC + EXCESS × VC = 0		(0.00)

This table presents the results of the regression on the effect of VC and excess control rights on the probability of IPO approval. The dependent variable is the IPO approval dummy variable, so logit regression models are estimated. Definitions of all other independent variables are reported in Table 1. Regression coefficients are reported in the same row as the variables. p-values are displayed in parentheses. *, ** and *** indicate significance at 10, 5 and 1 percent levels, respectively.

4.2.2 The effect of VC investment on post-IPO performance

We have provided comprehensive evidence that VC investors help firms, especially those with excess control rights, to overcome the potential risk that their application may be rejected by regulators. Another related concern is whether the minority shareholders’ interest will be strengthened or impaired by VC-backed IPOs. Considering this concern, we further test the effect of VC on post-IPO performance to provide evidence for this issue. The results are reported in Table 5.

Table 5. The effect of VC investment on post-IPO performance

Panel A: Cumulative abnormal return (CAR) as measure of performance
Variables	CAR12	CAR24	CAR36
VC	−0.05	−0.06*	−0.01**
VC	(0.36)	(0.07)	(0.03)
EXCESS	−0.59	−0.81*	−0.72
EXCESS	(0.15)	(0.08)	(0.22)
EXCESS × VC	−1.10**	−1.92***	−2.07***
EXCESS × VC	(0.02)	(0.00)	(0.00)
Control variables	Yes	Yes	Yes
Industry, Year, Listed board	Yes	Yes	Yes
Obs.	611	611	611
Adj. R²	0.16	0.18	0.17
Sum test
VC + EXCESS × VC = 0	−1.15***	−1.98***	−2.08***
VC + EXCESS × VC = 0	(0.00)	(0.00)	(0.00)

Panel B: Buy-and-hold abnormal return (BAHR) as measure of performance
Variables	BAHR12	BAHR24	BAHR36
EXCESS	−0.53	−0.61**	−0.91**
EXCESS	(0.18)	(0.02)	(0.02)
VC	−0.05	−0.05*	−0.03*
VC	(0.34)	(0.10)	(0.08)
EXCESS × VC	−0.79*	−1.82***	−1.68**
EXCESS × VC	(0.09)	(0.00)	(0.04)
Control variables	Yes	Yes	Yes
Industry, Year, Listed board	Yes	Yes	Yes
Obs.	611	611	611
Adj. R²	0.26	0.16	0.21
Sum test (p-value)
VC + EXCESS × VC = 0	−0.84***	−1.87***	−1.71***
VC + EXCESS × VC = 0	(0.00)	(0.00)	(0.00)

This table presents the results of the regression on the effect of VC and excess control rights on market, industry and size-adjusted post-IPO performance. CAR12, CAR24 and CAR36 (Panel A) and BAHR12, BAHR24 and BAHR36 (Panel B) are post-IPO cumulative abnormal returns 12, 24 and 36 months after IPO. Control variables include ultimate owner’s cash flow rights; average 3 years sales growth rate before IPO; firm size; current ratio; leverage ratio; and firm age. Definitions of those control variables are reported in Table 1. Regression coefficients are reported in the same row as the variables. p-values are displayed in parentheses. *, ** and *** indicate significance at 10, 5 and 1 percent levels, respectively.

Table 5 presents the effects of VC and excess control rights of ultimate owners on post-IPO performance. As discussed above, we calculate 12-, 24- and 36-month markets, industry- and size-adjusted CARs and BAHRs as measurements for post-IPO performance. Our results show that the VC dummy is negatively correlated with post-IPO performance, and the coefficients are statistically significant for 24 and 36 months. These results indicate that minority shareholders do expect that VC investors will exit the firm after a 12-month lock-up period, and thus, they tend to pay a lower price for VC-backed IPOs. Furthermore, we show that the interaction term of excess control rights and the VC dummy are significantly negatively associated with post-IPO long-term performance in all regressions using 12, 24 and 36 months as performance measures. These results support our hypothesis H1b and indicate that involvement of VC investors impairs the interests of minority shareholders, especially when the ultimate owners have excess control rights.

In brief, results in Tables 4 and 5 provide empirical evidence that VC investors play a collusive rather than a monitoring role in VC-backed IPOs, in that VC investors help controlling shareholders (ultimate owners) access the IPO market, although this impairs the minority shareholders’ long-term interest.

4.3 Why VC investors invest in firms with excess control rights

Thus far, we have provided evidence that VC investors play a key role in the IPO process of firms, particularly those with excess control rights. However, we still do not know the reason VC investors invest in firms with excess control rights and how VC benefits from their investment in those firms. This question is important because by investing in firms with excess control rights, VC investors also risk being expropriated. To answer this question, we further conduct two regressions regarding the effect of excess control rights on VC investment return and duration using a sample of VC-backed IPOs only.

We first conduct a regression to examine the effect of excess control rights on VC investment return using a sample of VC-backed IPOs. One possible explanation may be that ultimate owners who have excess control rights may compromise VC investors by allowing them to invest in their controlled firms at a relatively low cost, resulting in a higher exit return. The regression equation is as follows:

$urn:x-wiley:08105391:media:acfi12602:acfi12602-math-0002$ ()

The sample in Equation (2) only includes VC-backed firms, the dependent variable VCRETURN is VC’s exit return as provided by the ZERO2IPO database; the main independent variable EXCESS is a measure of excess control rights of ultimate owners and X is a vector of control variables. The regression results are reported in the first column of Table 6.

Table 6. The effect of excess control rights on VC investment return: VC-backed sample

Variables	VCRETURN	VCDURATION
EXCESS	22.51***	−2.05***
EXCESS	(0.01)	(0.01)
CASHFLOW	−8.71	−0.06
CASHFLOW	(0.13)	(0.87)
LEVERAGE	−1.07**	−0.01***
LEVERAGE	(0.03)	(0.01)
ROE	1.10**	−0.02***
ROE	(0.02)	(0.00)
SIZE	−6.22***	0.36***
SIZE	(0.00)	(0.00)
_cons	−23.11	−1.88
_cons	(0.36)	(0.46)
Industry, Year, Listed board	Yes	Yes
Obs.	417	417
Adj. R²	0.32	0.26

This table presents the results of the regression on the effect of excess control rights on VC investment return/VC investment duration using a sample of VC-backed firms. VCRETURN is VCs' exit return as provided by the ZERO2IPO database. VCDURATION is the average VC investment duration when firms’ IPO application is disclosed. Definitions of all other independent variables are reported in Table 1. Regression coefficients are reported in the same row as the variables. p-values are displayed in parentheses. *, ** and *** indicate significance at 10, 5 and 1 percent levels, resapectively.

As expected, we find that after controlling for other factors, the coefficients of excess control rights are consistently negative and are significant within the 5 percent level both statistically and economically. The results suggest that, other things being equal, VC investors usually invest in firms whose ultimate owner has excess control rights with low investment prices. Thus, we provide evidence that VC investors do have an incentive to invest in firms with excess control rights because they usually enter the firms with low investment prices.

As discussed earlier, the other benefit VC investors might obtain from investing in firms with excess control rights is that VC investors may be allowed to make their investment shortly prior to the IPO application, i.e., to make a pre-IPO VC investment, resulting in short investment duration in firms with excess control rights. By doing so, VC investors shorten their investment cycle and reduce their investment risk. Thus, we should observe a negative relationship between excess control rights and VC investors’ investment duration. Therefore, we also examine the effect of excess control rights on VC investors’ investment duration in our VC sample using the following equation:

$urn:x-wiley:08105391:media:acfi12602:acfi12602-math-0003$ ()

The dependent variable VCDURATION is the average VC investment duration (measured by the average number of years between the VC initial investment date and IPO application date). EXCESS is ultimate owner’s excess control rights and X is a vector of control variables. The regression results are reported in the second column of Table 6.

The results in Table 6 clearly show that there is a significantly negative relationship between ultimate owner’s excess control rights and VC investment return/duration, which is consistent with our hypothesis H2.

Overall, our results in Table 6 provide an explanation for VC investment behaviour in firms with excess control rights.

4.4 The characteristics of VC investors and their effect on the IPO process

One assumption underlying our study is that VC investors, especially those who make pre-IPO VC investments, tend to make quick money by investing in pre-IPO firms shortly before an IPO, and they are able to help firms’ IPO approval due to their political connections. To provide direct evidence for this assumption, we further examine whether pre-IPO VC investment and VC investors’ political connections have an impact on the IPO approval and post-IPO performance in the subsample of VC-backed IPOs. Our study defines pre-IPO VC investment as a dummy equal to 1 if the pre-IPO firm is backed by VC investors that invest in the firm within one year prior to the IPO application, and we define VC investors’ connections with the government (either state-owned/controlled, or connections with the government via top VC executives or controlled/managed by subordinates) as a proxy of VC investors’ political connections because government intervention still has great impact on the Chinese economy, resulting in state-controlled firms and firms with politically connected executives who have priority in accessing most resources. We also define VCOWN to measure VC investors’ ownership in prospective IPO firms. Our results regarding the effect of pre-IPO investment and VC investors’ political connections on IPO approval are reported in Table 7.

Table 7. The effect of pre-IPO VC investment, VCs’ political connections and the ownership of VC investors on IPO approval

Variables	APPROVAL
Variables	ALL	EXCESS	NON-EXCESS	ALL	EXCESS	NON-EXCESS
PREIPOPE	1.12***	1.76**	0.79**
PREIPOPE	(0.01)	(0.03)	(0.03)
VCPC				0.87***	1.44***	0.58
VCPC				(0.01)	(0.01)	(0.19)
VCOWN	3.19*	5.98**	1.56	1.77*	4.25***	0.16
VCOWN	(0.07)	(0.05)	(0.48)	(0.06)	(0.01)	(0.94)
Control variables	Yes	Yes	Yes	Yes	Yes	Yes
Industry, Year, Listed board	Yes	Yes	Yes	Yes	Yes	Yes
Obs.	417.00	186.00	231.00	417.00	186.00	231.00
Pseudo R²	0.09	0.16	0.05	0.08	0.17	0.04

This table presents the regression results on how IPO approval rate is influenced by VCs’ characteristics like pre-IPO VC investment, VCs’ political connections and VCs’ ownership. EXCESS and NON-EXCESS refer to firms with and without excess control rights. Control variables include return on equity, firm size, leverage ratio, current ratio, underwriter reputation and firms’ political connections. Variables are defined in Table 1. Regression coefficients are reported in the same row as the variables. p-values are displayed in parentheses. *, ** and *** indicate significance at 10, 5 and 1 percent levels, respectively.

Consistent with our hypothesis H3a, H3b and H3c regarding the IPO approval, our results show that firms have significantly higher IPO approval rates if the firm is backed by pre-IPO VC investment, VC investors with political connections, and when VC investors hold more shares in the pre-IPO firm, while the results are more pronounced in firms with excess control rights.

We also conduct similar regressions to examine the effect of VC investor characteristics on post-IPO performance, reported in Table 8, where CARs and BAHRs are used to measure post-IPO performance. We find from Table 8 that pre-IPO VC investment, VC investors’ political connections, and the ownership of VC investors are all statistically significantly negatively correlated with post-IPO performance in firms with excess control rights, while the coefficients of these variables appear to be insignificant in firms without excess control rights. The results are also consistent with our hypothesis H3a, H3b and H3c.

Table 8. The effect of VC characteristics on post-IPO performance

Panel A: CARs as measure of post-IPO long-run performance
Variables	CAR12		CAR24		CAR36
Variables	EXCESS	NON-EXCESS	EXCESS	NON-EXCESS	EXCESS	NON-EXCESS
PREIPOVC	−0.11*	−0.07	−0.15**	−0.06	−0.21**	−0.12
PREIPOVC	(0.06)	(0.22)	(0.05)	(0.31)	(0.04)	(0.14)
VCPC	−0.09**	−0.04	−0.11*	−0.03**	−0.14**	−0.04
VCPC	(0.05)	(0.30)	(0.06)	(0.05)	(0.05)	(0.64)
VCOWN	−0.50	0.16	0.59	0.02	0.77	0.19
VCOWN	(0.48)	(0.45)	(0.51)	(0.95)	(0.43)	(0.63)
Control variables	Yes	Yes	Yes	Yes	Yes	Yes
Industry, Year, Market	Yes	Yes	Yes	Yes	Yes	Yes
Obs.	161	197	161	197	161	197
Adj. R²	0.06	0.06	0.12	0.07	0.12	0.10

Panel B: BAHRs as measure of post-IPO long-run performance
Variables	BAHR12		BAHR24		BAHR36
PREIPOVC	−0.09*	−0.05*	−0.03*	−0.01	−0.09*	−0.05
PREIPOVC	(0.06)	(0.09)	(0.09)	(0.13)	(0.08)	(0.25)
VCPC	−0.06**	−0.04	−0.07*	−0.03	−0.13*	−0.02
VCPC	(0.04)	(0.11)	(0.07)	(0.64)	(0.06)	(0.85)
VCOWN	−0.61	−0.13	−0.48*	−0.27	−0.35	0.12
VCOWN	(0.39)	(0.97)	(0.09)	(0.80)	(0.76)	(0.98)
Control variables	Yes	Yes	Yes	Yes	Yes	Yes
Industry, Year, Market	Yes	Yes	Yes	Yes	Yes	Yes
Obs.	161	197	161	197	161	197
Adj. R²	0.04	0.05	0.08	0.05	0.04	0.03

This table presents the regression results on how post-IPO performance is influenced by VCs’ characteristics like pre-IPO VC investment, VCs’ political connections and VCs’ ownership. EXCESS and NON-EXCESS refer to firms with and without excess control rights. Control variables include ultimate owner’s cash flow rights; average 3 years sales growth rate before IPO; firm size; current ratio; leverage ratio; and firm age. Variables are defined in Table 1. Regression coefficients are reported in the same row as the variables. p-values are displayed in parentheses. *, ** and *** indicate significance at 10, 5 and 1 percent levels, respectively.

4.5 Endogeneity issue

Our findings may suffer from an endogeneity issue for the following two reasons. First, it is possible that VC investors may choose firms that they know have a good chance of being approved for an IPO. For instance, VC investors may choose to invest in firms whose top executives have political connections, and it is those connections that help firms’ IPO application get approved (Liu et al., 2013). Second, there may be some concern that the types of firms that get approved for an IPO are the types that need the financial backing of VC to reach that point (e.g. high-tech Non-SOEs). The aim of this section is to address the endogeneity issue caused by the above concerns.

To address the endogeneity issue arising from the first concern, we conduct new regressions to investigate the effect of VC on the IPO process in firms with and without political connections. To do so, we separate our full sample of firms into two subsamples according to whether the firms in which VC investors have invested have political connections (the variable CONNECTION in Table 1). Our regression results are reported in Tables 9 and 10, where Table 9 presents the effect of VC investors on IPO approval, and Table 10 presents the results of VC investors on post-IPO performance.

Table 9. The effect of VC investors on the probability of IPO approval in firms with and without politically connected managers

Variables	APPROVAL
Variables	Firms with PCCEO		Firms without PCCEO
VC	0.38	0.24	0.86***	0.55*
VC	(0.19)	(0.22)	(0.00)	(0.07)
EXCESS	0.61	1.33	−0.51	−1.12*
EXCESS	(0.72)	(0.41)	(0.22)	(0.08)
EXCESS × VC		4.89		7.55***
EXCESS × VC		(0.19)		(0.00)
Control variables	Yes	Yes	Yes	Yes
Industry, Year, Market	Yes	Yes	Yes	Yes
Obs.	330	330	419	419
Pseudo R²	0.10	0.11	0.17	0.19
Sum test
VC + EXCESS × VC = 0		5.1***		8.10***
VC + EXCESS × VC = 0		(0.00)		(0.00)

This table presents the results of the regression on the effect of VC on the probability of IPO approval in firms with and without political connections. The dependent variable is the IPO approval dummy variable, so a logit regression model is estimated. Columns 1 and 2 report the results of firms with politically connected managers, while columns 3 and 4 report the results of firms without politically connected managers. Control variables include ultimate owner’s cash flow rights, return on equity, firm size, leverage ratio, current ratio and underwriter reputation. Definitions of all other independent variables are reported in Table 1. Regression coefficients are reported in the same row as the variables. p-values are displayed in parentheses. *, ** and *** indicate significance at 10, 5 and 1 percent levels, respectively.

Table 10. Effect of VC on post-IPO performance in firms with and without political connections

Panel A: Cumulative abnormal return (CAR) as measure of performance
Variables	CAR12	CAR24	CAR36	CAR12	CAR24	CAR36
Variables	Firms with PCCEO			Firms without PCCEO
VC	−0.02	−0.03	−0.01**	−0.07	−0.08**	−0.06***
VC	(0.23)	(0.18)	(0.03)	(0.15)	(0.03)	(0.00)
EXCESS	−0.46	−0.98*	−0.47	−0.81*	−1.02**	−0.96**
EXCESS	(0.21)	(0.07)	(0.17)	(0.08)	(0.04)	(0.04)
EXCESS × VC	−0.87	−1.88	−1.67*	−1.36***	−2.56***	−2.11***
EXCESS × VC	(0.12)	(0.11)	(0.07)	(0.00)	(0.00)	(0.00)
Control variables	Yes	Yes	Yes	Yes	Yes	Yes
Industry, Year, Market	Yes	Yes	Yes	Yes	Yes	Yes
Obs.	302	302	302	309	309	309
Adj. R²	0.15	0.16	0.16	0.17	0.19	0.21
Sum test
VC + EXCESS × VC = 0	−0.89***	−1.91***	−1.68***	−1.43***	−2.64***	−2.15***
VC + EXCESS × VC = 0	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)	(0.00)

Panel B: Buy-and-hold abnormal return (BAHR) as measure of performance
	BAHR12	BAHR24	BAHR36	BAHR12	BAHR24	BAHR36
VC	−0.05	−0.05	−0.03*	−0.07	−0.08**	−0.07***
VC	(0.34)	(0.11)	(0.08)	(0.12)	(0.03)	(0.00)
EXCESS	−0.47	−0.63**	−0.86**	−0.73*	−0.92**	−1.06**
EXCESS	(0.18)	(0.02)	(0.02)	(0.07)	(0.03)	(0.03)
EXCESS × VC	−0.79	−1.82	−1.68**	−0.83**	−2.11***	−1.88***
EXCESS × VC	(0.15)	(0.13)	(0.04)	(0.02)	(0.00)	(0.00)
Control variables	Yes	Yes	Yes	Yes	Yes	Yes
Industry, Year, Market	Yes	Yes	Yes	Yes	Yes	Yes
Obs.	302	302	302	309	309	309
Adj. R²	0.26	0.16	0.21	0.33	0.21	0.34
Sum test
VC + EXCESS × VC = 0	−0.84***	−1.87***	−1.71***	−0.90***	−2.09***	−1.95***
VC + EXCESS × VC = 0	(0.00)	(0.00)	(0.00)	(0.01)	(0.01)	(0.01)

This table presents the results of the regression on the effect of VC on market, industry and size-adjusted post-IPO performance in firms with and without politically connected managers. The dependent variables are post-IPO performance measured by 12, 24 and 36 months CARs (Panel A) and BAHRs (Panel B). Control variables include ultimate owner’s cash flow rights; average 3 years sales growth rate before IPO; firm size; current ratio; leverage ratio; and firm age. Columns 1–3 report the results of firms with political connections, and columns 4–6 report the results of firms without political connections. Definitions of those control variables are reported in Table 1. Regression coefficients are reported in the same row as the variables. p-values are displayed in parentheses. *, ** and *** indicate significance at 10, 5 and 1 percent levels, respectively.

From our results in Table 9, VC investors are found to play a more important and more significant role in helping firms to access the IPO market in the subsample of firms without political connections, compared to those with political connections. Given that politically connected managers also play a role in helping firms access the IPO market (Liu et al., 2013), our results suggest that VC investors and politically connected ones are substitutes, which is to say that VC investors tend to play a more pronounced role when firms do not have politically connected managers. Our results are also contrary to our first endogeneity concern that VC investors may seek to invest in politically connected firms, and that their role in helping firms to access the IPO market is driven by politically connected managers. Similarly, our results in Table 10 are consistent with those in Table 9, in that the underperformance of VC-backed IPOs is more pronounced in firms without politically connected managers.

Our results are less likely to suffer from potential endogeneity issue caused by the reverse causality problem because our key independent variables, VC and excess control rights, are both pre-determined and cannot be influenced by our dependent variables, such as IPO approval or post-IPO performance.

To address our second concern, we further separate our sample into different groups (i.e. high-tech vs. non-high-tech firms) and conduct regressions to see whether VC plays a more significant role in high-tech firms. A firm is classified as a high-technology firm if it operates in a high-technology industry. Our results show that there is no significant difference between the results of high-tech and non-high-tech samples, which indicates that such a selection problem does not exist. To save space, the results are not reported but are available from the authors upon request. Finally, in order to address the potential problems caused by measurement error of key variables, we further use the number of VC and ownership of VC in a VC-backed firm as new measures of VC investments. Similar results12 are achieved, suggesting our main findings are robust.

5 Conclusion

This study examines the interactive role of VC investors in the process of firms going public in the Chinese capital market. We document that the involvement of VC investors does improve the probability of a firm’s IPO being approved by the CSRC, especially in firms whose ultimate owners have excess control rights. In addition, VC-backed IPOs, especially those with excess control rights, are found to have poorer long-term post-IPO performance. We also provide evidence that VC investors are usually able to gain higher investment return and make more pre-IPO investments in firms with excess control rights. In addition, we find that VC investors’ role in the IPO process is determined by characteristics such as being strengthened by pre-IPO VC investment, VC investors’ political connections and VC investors’ ownership. In particular, we find that the IPOs backed by pre-IPO VC investors, VC investors with political connections and VC investors with higher ownership are more likely to be approved compared to IPOs backed by other VC investors; meanwhile, we find that IPOs backed by pre-IPO VC investors and VC investors with political connections also have worse post-IPO market performance. Finally, our results are found to be robust after addressing the endogeneity issue using different methods.

Overall, our findings confirm that VC investors play a different role in an emerging market compared to that in developed markets. Previous studies have shown that VC investors play an active monitoring role in the US market, but our findings indicate that in emerging markets where the IPO market is highly regulated and government intervention still prevalent, VC investors tend to make quick money by investing in pre-IPO firms within one year prior to an IPO, and they help the ultimate owners list their firms in the IPO market using their established political connections, in return for which the ultimate owners with excess control rights allow VC investors to obtain a higher investment return. However, the interests of minority shareholders are actually destroyed. Overall, we reveal the winners and losers in the IPO process in an emerging market.

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1 Our data show that the average post-IPO performance in the Chinese market is −10.88 percent for 12 months, −14.72 percent for 24 months and −18.13 percent for 36 months, which means that it is less likely, if not impossible, for VC investors to make a profit from the secondary market.
2 See Claessens et al. (2000, b), Faccio and Lang (2002), Lemmon and Lins (2003), Maury and Pajuste (2004), Wei and Zhang (2008), and Gompers et al. (2010).
3 CSRC [2006] No. 30, for example, requires that ‘an issuer shall not have any major debt-paying risk or be involved with any major contingent issue such as guaranty, litigation, and arbitration that may negatively affect its business operations’, and that ‘an issuer shall not be under any circumstances where its capability of making profits continuously is materially affected.’ One circumstance listed in the regulation states that the issuer’s ‘industrial status or business environment has greatly changed or will greatly change.’ Another example of this ambiguity is the statement that ‘the amount of raised funds shall be commensurate to an issuer’s present business scale, financial status, technical level and management capability.’ The purpose of these qualitative provisions is to give CSRC officials the flexibility to select better performing firms with a potential for growth.
4 Wang et al. (2018) document that VC investors' political connections matter to IPO earnings management of Chinese firms, but they do not mention whether VC investors play a role in the IPO process.
5 Anecdotal evidence shows that VC investors usually have well-established relationships and social connections with government officials. For instance, Wen Yunsong, the son of the Chinese prime minister, was a former CEO and an important partner in New Horizon Capital and one of the best-known VC investors in China.
6 The CSRC always discloses regulatory decisions at the CSRC website once the screening process has been completed.
7 The CSRC defines the ‘ultimate owner’ of a publicly listed company as (i) the largest shareholder, or (ii) the shareholder with more voting power than the largest shareholder, or (iii) the shareholder with shareholding or voting rights above 30 percent of the total shares, or (iv) the shareholder who can determine over half the board members.
8 Zero2IPO Group, one of the leading VC/PE research institutions in China, is a pioneer in China’s entrepreneurship and investment industry, and positioned as China’s leading entrepreneurial and investment service platform and investment firm.
9 As the IPO research database of Chinese firms only includes pre-IPO and financial information of successful IPO firms, we manually collected the information about unsuccessful IPO firms.
10 We dropped two IPO application cases without relevant information.
11 We double-checked all the VC-backed firms to see whether those shareholders whose names have those words are VC investors by checking against the VC investor name list on the database provided by the Zero2IPO Group.
12 The results are not reported due to limited space.

Citing Literature

Volume61, Issue1

March 2021

Pages 1017-1046

Monitoring or colluding: the role of venture capital investors in the IPO process

Abstract

1 Introduction

2 Institutional environment and hypothesis development