In this opinion piece, Vinay B. Nair, a senior fellow at the Wharton Financial Institutions Center, discusses why the attention given to IPOs should not be focused on their returns, but rather on their broader economic benefits — specifically, the fostering of transparency, innovation and acquisitions. Nair is also a senior fellow at the Center of Law and Business at New York University and a Visiting Professor at the Indian School of Business.

It has been a busy season for IPO news. Last year, more than 150 firms went public in India — a record — and many realized spectacular returns on the opening day. Such activity soon brought IPOs to the forefront of media coverage.

These days, much is being written about the ailing IPO market: The euphoria of spectacular returns was sobered earlier this year by a withdrawn public offering by realty firm Emaar MGF. Additionally, Reliance Power saw its IPO shunned by the equity market, which dropped a spectacular 17% on the first day.

Much of the attention on IPOs has focused on returns. The research across different countries and periods has uncovered three consistent patterns. The best-known is the frequent incidence of large returns on the first trading day accruing to investors in IPOs of common stock. In the U.S. — a long-active IPO market — only 15% of the firms that went public over the last 25 years had a negative return on the first day, whereas two-thirds of these firms had a positive return.

A second pattern is that the IPO market is cyclical. High initial returns for firms that go public tend to be followed by other mimicking firms, giving rise to high IPO volume and “hot issue” markets. Such hot issue markets show a strong tendency to follow periods of high stock market returns. It is not surprising, then, that many Indian companies went public in the last few years and some are attempting to ride the tailcoats of this trend.

The third pattern is the poor stock price performance of IPOs in the long run. Measured from the market price at the end of the first day of trading, IPOs tend to underperform their comparables over the next three to five years. This is especially true for IPOs issued in hot markets, and for firms that go public with less than three years of an operating history, smaller revenues and negative earnings.

Opaque to Transparent

But there is more to IPOs than returns. Firms going public provide a terrific boost to the economy for at least three reasons.

First, they provide more transparency into the functioning of the economy. Public firms report their financial numbers in a timely and transparent manner, providing valuable information on the state of the economy. In the past, with so many notoriously opaque private firms, how the corporate sector was performing was as much guesswork as reality. This new spurt of IPOs will, in the future, provide up-to-date and valuable information to policy makers and to investors interested in India.

Good data is only a start. The bigger benefit might come from the ability of markets to interpret this data. Transparent information allows asset markets to price securities with more certainty and efficiency. Having several investors scrutinize public information and reflect their opinion in stock prices is a boon for the firm and the economy itself. Managers can now place more confidence in information on stock prices to allocate capital. For example, one could assess the attractiveness of a potential acquisition based on the stock market reaction to the announcement. This stock reaction is more likely to be the “wisdom of the crowds,” as more firms are public and provide transparent information.

At the same time, in the hands of a capable regulator, timely information and more efficient prices can spur actions that will prevent deep recessions or spiraling inflation.

Promoting Innovation

Second, the wave of IPOs we have witnessed will also spur innovation. In many countries with less active IPO markets, valuing young start-up companies is an entirely subjective exercise. This makes it very difficult for the parties on opposite sides of the negotiating table to agree on any kind of financial transaction. With active IPO markets, one could follow the path of a similar predecessor that went public and at least develop a ballpark figure, making agreements more likely. The uncertainty in valuation still remains but is lowered due to precedent.

Additionally, knowing that IPOs provide a mechanism to exit their investments, venture capitalists and other financiers of innovation are more willing to back young companies. The importance of the exit cannot be understated. You might have a wonderful business idea that will make customers, employees and managers happy, but if exit in a liquid form is unlikely before the end of the venture fund’s life, you will not find interested venture capitalists. An active IPO market provides an attractive exit opportunity and spurs venture activity.

M&A Targets

Third, increasing IPOs and the transition from a private economy to a public economy will spur an active market in mergers and acquisitions. Luigi Zingales, a professor of entrepreneurship and finance at the University of Chicago, was one of the first researchers to point out that it is easier for a potential acquirer to spot a potential takeover target when it is public. This allows potential acquirers to find targets more easily. Moreover, acquirers can pressure public targets using offer prices.

At the same time, a public firm also has the additional ‘currency’ of stock to pursue acquisitions. Many firms go public to pursue an aggressive acquisition strategy. Putting these together, a wave of IPOs will soon lead to an active market for corporate control, and better allocation of resources in the long run.

These benefits of fostering transparency, innovation and acquisitions are often lost amid the din of returns. But over time, they are more important than the fast profits — and sometimes equally fast losses — that IPO news tends to focus on.