Initial Public Offering

What is IPO?

IPO is Initial Public Offering, where company issue its share in primary market to raise capital from the public.

History of Indian IPO?

When was the first IPO issued? No one know it. But the IPO trend came in India in the eighties when a large number of companies, organization came out with public issues, which triggered a growth in the primary market. An entire industry of Merchant Bankers, Brokers, Agents and Retail Investors grew in the primary issues market. The interest in issues highlighted and people were ready to pay for the application forms also. During this period one of the biggest IPO was brought by Dhirubhai Ambani of Reliance Petrochemicals Pvt. Ltd. Later on this trend was carried on in nineties also and till today it is carried on and ahead also it will be carried on.

During eighties and nineties many of the companies just disappeared without a trace after the listing was done. There were estimated of over hundreds of companies which disappeared from the market after raising funds in the primary market. People lost all their income as the fundamentals of the company were not known by them. But in late nineties did not see much activity in the primary market. The shocking experience of retail investors of market crash in December 1992 and January 1993 kept them away from the market and made it difficult for companies to launch successful IPOs. During mid nineties the liberalisation came in India, which allowed Banks, insurance companies, mutual funds companies to invest in the primary as well as secondary market.

The primary issues market resurrected itself after 2003 largely triggered by the divestment programme of public sector companies. The issue of Maruti Udyog Limited, through which the government sold part of it stake in the company for Rs. 1000 crore, revived the interest of retails investors in the primary market. Further divestment by the government, including the one of biggest issues by Indian company ONGC, attracted more retail investors into the market. Further, taking advantage of the strength in the secondary market, many companies were lining up to raise capital from the market. Thus, on 4th October, 2007 India was named as seventh biggest IPO market of the world, till December 2007 there was boom seen in the Indian primary and secondary market. But eventually, public expectation went in vain when the biggest Indian IPO in India bust in the beginning of year in January 2008. Many investors lost their income, saving which they invested in the company. As per Security and Exchange board of India (SEBI) bulletin (2010), during January - December 2009, 17 companies accessed the primary market and raised Rs. 15,700 crore as against 37 issues and 103 issues in year 2008 and 2007 raising Rs. 18,500 crore and Rs. 34,200 crore respectively in 2008 and 2007. The amount mobilised by the IPOs was the lowest in five years. Many companies failed to rise up capital after the listing of the company. The share values were tumbling down and down. Thirty percent of top 10 IPOs were actually from 2008 and 2007, which could not hit the market earlier because of poor investor sentiment. Many companies waited for long time to get listed in 2009. In 2009 the Energy and Power sector were only two which were oversubscribed by more than 25% as compared to 2008 listing.

Hence, after IPOs of Rs. 15,700 crore by 17 companies during January-December 2009 some more than 40 companies are expected to raise more than 25,000 crore from the primary market. Nearly a double digit economic growth, a roaring bull market and expansion minded executives have set the stage for another high volume IPO activity in India, even market watcher predict this year (2010) could be record-buster.

Importance of the Study:

The decision to go public through an IPO is a critical decision for firms. The pricing of IPO and the correct valuation of IPO is always debatable amongst investors. The IPO price can be interpreted as underprice or overprice by the market. So, the analysis of IPO performance in the secondary market can be useful from an investor's point of view. The study will provide a valuable insight onto the performance of IPO on the first day of listing and later after the listing and thereby helps to understand the IPOs post issue performance.

Objective of the study:

To explore the performance of the IPOs and its acceptance in terms of the subscription and the price band offered.

To evaluate the stock return on the day of listing and the performance of the stock after the listing on BSE.

To analyse the market reaction and the performance of the of the stock when new IPO of the same company was opened.

Literature Review


This chapter discusses various studies on IPOs performance in Indian history as well as global history. The first step of the firm is to decide whether to go public or not. So, first, the study points out various reasons that motivates firms to go public. In short, it reviews numerous studies conducted on IPOs that have analysed and determinants relating to the decision of the firms going public. The next part reviews the most extensively studied phenomena in IPOs i.e. IPO underpricing. It has been divided into two parts. The first part covers the prior researches on IPOs underpricing in India and second part covers the prior researches done on IPO underpricing in rest of the world. It also gives a theoretical framework on initial underpricing. Thereafter studies on the long run performance of IPOs reviewed along with the theoretical base. It has been found that there is no consensus as to the preferred method of a long-run performance measurement adopted by many researchers. Apart from this, this chapter also shows the reaction of investors to FPOs b analysing several researchers, which documented the effect of FPOs on the existing stock price.

Prior researches on IPOs:

Krishnamurthi and Kumar (1994) analysed 98 Ipos for the period of 1992 to 1993 and reported and average initial underpricing of 35%. Their result suggest that there is no difference in the direction of performance of the issues post listing in short run but in the long run the issues that trapped the market through thr book building route seened to perform far beter than the ones that raised money through fixed price offer. Relatively little work was done by Krishnamurthi and Kumar(1994) so far on underpricing of IPOs, Shah (1995) carried it forward.

Shah(1995) found that the mean initial unadjusted returns of IPOs was 105% on the equally weighted basis and the mean initial was 114%. Using the adverse selection explaination of Rock (1986), Shah (1995) argued that one of the main factor for severe underpricing in Indian IPOs was that the IPOs relied mainly on retail uniformed investors.

Busaba and Change (2002), indicated the underpricing for a comprehensive data set of 105 IPOs of Eurpoean property companies. The found that the IPO market for property shares was to be hot for an investments. The IPO market showed a high returns in the property indices averaging 10.69 percent during the 100 prior days to the IPO compared to 4.56 percent for the general equity market indices. However, the recovery in Western European property markets and lack of quality property stock in Eastern European countries has created a large financing need for property companies which can be met by going public. Thus, the supply side aspects were more likely than market-timing characteristics to be the major driver behind the current hot IPO market.

Rajesh Agarwal (2005), states when the dot-com companies fetched outrageous share prices during the initial public offerings in the late 1990's many people thought the market is riding of the interent. In his research he examine the scope of market manipulation by looking at 908 IPOs between 1998 to 2000, of which 173 were name in class-action lawsuits against their Investment bank underwriters. His research shows that how the investment banks were manipulating the market in the late 1990s and offers lesson that to be learned.

Jaitly and Sharma (2004) examined Indian IPOs after the end of CCI issue price regulation. The sample size was 39 IPOs issued in 1993 to 1994. The finding indicated an average first day of 72% returns. The study tested the hypothesis using two variables i.e. age and size of the companies which were independent variables and offer price which was dependent variable. Age of companies was positively related to the offer price, showing that the older companies had better IPO prices. Size of the company also had a positive relationship with the offer price.

The study also examined whether the end of CCI price regulation influenced IPO offer prices. Using the Ceiling Price determined by the CCI pricing method, they calculated the initial returns and found that the initial return would be much higher if the price regulation was still in place. Jaitly and Sharma (2004) concluded that the end of the IPO price involvement reduced the initial underpricing during the post CCI de-regulation period.

The Level of Underpricing, was supposed to be lower during 1999 to 2000 year as it was in 1999, SEBI introduced the process of price discovery to make the IPO price more accurate. It was not so and the average initial underpricing was nearly 100% during the period 1999 to 2000. The proable reasons for thins has been explained in the studies cited below.

Pandey (2005), based on an analysis of a sample of 84 IPOs during 1999 to 2000, found that large number of companies had continued to follow the fixed price route for placing their stocks in Indian IPO markets in spite of having the option of book building. Therefore, this could be the reason for such a high initial underpricing during the years 1999 to 2000 in spite of having more accurate methods of IPO pricing. There could be many reason for opting the method of fixed price method by issuers, but the requirements of the issue making fixed preice offerings, in the prevailing the IPO regulation in India. Were more onerous than for an issuer using the book building roué and hence lesser regulatory restriction can't explain as to why firms continued to prefer fixed price offering.

However, they found that there was a clear difference in issuers opting for book building route and fixed offerings. Typically, the book building process had been opted for by the issuers offerings a small proportion of their stocks but intending to mobilise large amount of money. On the other hand, fixed price offerings were made by issuers expecting to raise smaller amount of money by placing large portion of their stocks.

The underpricing of IPOs is not only in India but also in other countries. A large number of studies is being carried out on IPOs around the world witnessed the underpricing of IPOs. All studies prove a high occurrence of large initial returns on the very first day of listing. Some of the similar observations has been raised in Australia (Noti and Hadjia, 1983), in Japan (Dawson and Hiraki, 1985), in Singapore (Sunders and Lim, 1990), Rajesh Agarwal and others in 2002, Thomas J. Boulton and others in 2006 and many more. The average underpricing seems to be even more in the emerging markets. In Malaysia new issues produced a very large return of 166% on the first day of listing. Thus we can see the new issues underpricing exist in many countries around the world.

The highest average initial return was evident up to 388% in China, whereas the lowest was 4.20% in France during 1983-92. It can be seen that emerging market IPOs where more underpriced than US or European market. There could be many reasons for this like political and bureaucratic meddling. Prior to the 1998 partial deregulation, Koran firms had to price their shares at book value. In Japan, the Japanese Recruit Cosmos Company scandal became byword for corruption. In 1989 the Prima Minister of Japan was forced to resign when it was revealed that the Recruit Cosmos Company had attempted to buy political influence via target allocation of highly underpriced shares in its spin-off Cosmos subsidiary.

The scenario of underpricing did not end in nineties, there are various studies carried out after nineties, which prove underpricing still exists in the market of various countries. The cities below are not only looking for Level of Underpricing but also looking on issue size, firm size, managers role in underpricing, etc.

Numerous studies show that IPOs are underpriced (Ibbotson, 1975, Ritter, 1984, Hanley, 1993). One important rationale for the underpricing of IPOs is the "winner's curse" explanation introduced by Rock (1986). Rock argues that rationing will result if IPO demand is unexpectedly strong. Informed investors will attempt to buy shares only when an issue is underpriced. Uninformed investors do not know which issues will be underpriced or overpriced, and so they will be allocated only a fraction of the most desirable new issues, and allocated all of the least desirable new issues. Faced with this adverse selection problem, uninformed investors will usually submit purchase orders only if IPOs are underpriced enough to compensate them for the bias in the allocation of new issues. Beatty and Ritter (1986), Koh and Walter (1989), provide empirical evidence consistent with Rock's (1986) model. One implication of Rock's model is that greater underpricing will result for firms that informed investors identify as having good quality. The signalling models in Allen and Faulhaber (1989), Welch (1989), and Grinblatt and Hwang (1989) suggest that in order to signal their good quality, IPO firms are intentionally underpriced. Low-quality firms must invest in imitation expenses to appear to be high-quality firms; and with some probability this imitation is discovered between offerings (Welch, 1989). The underpricing of high-quality firms at the initial public offering adds sufficient signaling costs to the imitation expenses of low-quality firms and makes the expected gain from imitation negative. Thus, low-quality firms abandon the imitation strategy and voluntarily reveal their quality. This argument implies that low-quality firms do not underprice their IPOs as much as do high-quality firms, so investors correctly perceive underpricing as a signal of the firm's quality.

Rajesh Aggarwal, Laurie Krigman, Kent Womack (2002) found managers usually do not sell any of their own shares in an initial public offering but instead wait until the end of the lock up period. They develop a model in which managers strategically underprice IPOs in order to maximize personal wealth from selling shares at lock up expiration. First day underpricing initiates information momentum .Their coverage was positively correlated with stock returns and insider selling at the lockup expiration. They tested the it model using a sample of 618 IPOs from 1994 to 1999.They found that firms in which managers retain more shares and hold more options have greater first day underpricing. Schultz and Zaman (2001) examine internet IPOs in the 1990s and suggest that managers may avoid selling their shares in the IPO due to severe underpricing, preferring to sell later at higher valuation. By intentionally underpricing, managers can sell at higher valuations at their first opportunity following the IPO around the lockup expiration. Loughan and Ritter (2001) argue, on prospect theory, that due to the positive covariance between managerial wealth changes and underpricing, managers are not unhappy with highly underpriced deals.

Chemmanur (1993) argues that owner- managers of high quality firms will underprice the IPO in order to induce investors to produce information about the firm. The more information that is produced, the more likel it is that a high quality firm is revealed to be high quality, allowing the firms to sell shares in a secondary offerings at prices closer to the firm true vale. Spiess and Pettway (1997) empirically test Chemmanur's (1993) model, they found no evidence that firms recovers the cost of an underpriced IPO in either higher secondary offering proceeds.

Field and Hanka (2001), Brav and Gompers (2000), Ofek and Richardson (2000) Bradley and Jordon, Roten and Yi (2000) show that stock prices for new issues regularly decline at the time of the lockup expiration. It is consistent with the presence of downward sloping demand curves for the stocks in which additional supply becomes available.

Norton Grafinkle, Burton G. Malkiel and Costion Bantas (2002) examines two issues regarding initial public offerings (IPOs) of 775 firms that came to market between July, 1997 and December,1999 including a time Shiller (2000) describes as” bubble period”. The study of underpricing of new issues indicates that first day excess returns are greater for venture. Second, investors look at the longer run performance of IPOs and the effect of Lock up provision. They find statistically significant increase in trading volume on the day following the unlock date. Prices begin to fall, prior to the end of the lock up period as the market anticipates the selling that is likely to follow. There is a substantial negative return for shareholders who buy new issues in the open market immediately after the IPO.

Drobetz, Wolfgang, Kammermann, Matthias and Waelchli (2003) examined both initial and long-term performance of Swiss IPOs for the period from 1983 to 2000.They compared their study with similar study conducted in US. In the US the study by Ritter and Welch (2002) reported that, at the end of trading IPOs traded at 18.6% above the price at which the company issued them. Swiss firms initially used fixed price offer method. Later these followed a book building mechanism. Therefore, the study also examined whether the book building led to more accurate pricing of Swiss IPOs. They analysed five possible hypotheses for underpricing.

They found that the average market adjusted initial return was 34.97%. Their result support thr Ex ante Uncertainty Hypothesis, the Signaling Hypothesis, and Market Cyclicality Hypothesis as possible explanations for the underpricing phenomena on the Swiss IPO market. They also found the evidence for lower initial returns under increased competition among investment bankers. Hey reported that the pricing of IPO was more accurate than the book building was used compared to fixed price offers.

Thomas J. Boulton, Scott B. Smart, Chad J. Zutter (2006), examine a sample of 4,485 IPOs across 35 countries from 2000-2004, they found that country level governance characteristics explains differences in the international cross section of IPO underpricing. They found that underpricing is generally higher in countries with corporate governance systems that strengthen the position of investors relative to insiders. They also considered relation between country level governance and IPO firm values. They found only mixed support for the prediction that investors assign a higher valuation to IPO firms in countries strong corporate governance.

In the 1980s, the average first-day return on initial public offerings (IPOs) was 7%. The average first-day return doubled to almost 15% during 1990-1998, before jumping to 65% during the internet bubble years of 1999-2000 and then reverting to 12% during 2001-2003. The argument that in the later periods there was less focus on maximizing IPO proceeds due to an increased emphasis on research coverage. Furthermore, allocations of hot IPOs to the personal brokerage accounts of issuing firm executives created an incentive to seek rather than avoid underwriters with a reputation for severe under pricing. The three hypotheses for the change in underpricing: 1) the changing risk composition hypothesis, 2) the realignment of incentives hypothesis, and 3) a new hypothesis, the changing issuer objective function hypothesis. The changing issuer objective function hypothesis has two components, the spinning hypothesis and the analyst lust hypothesis.

Reasons for Initial Underpricing: A Theoretical Base

Changing risk composition hypothesis

The changing risk composition hypothesis, introduced by Ritter (1984), assumes that riskier IPOs will be underpriced by more than less-risky IPOs. This prediction follows from models where underpricing arises as an equilibrium condition to induce investors to participate in the IPO market. If the proportion of IPOs that represent risky stocks increases, there should be greater average underpricing. Risk can reflect either technological or valuation uncertainty. Although there have been some changes in the characteristics of firms going public, these changes are found to be too minor to explain much of the variation in underpricing over time if there is a stationary risk-return relation.

Realignment of incentives hypothesis

The realignment of incentives hypothesis, introduced by Ljungqvist and Wilhelm (2003), argues that the managers of issuing firms acquiesced in leaving money on the table during the 1999-2000 bubble period. (Money on the table is the change between the offer price and the first closing market price, multiplied by the number of shares sold.) The hypothesized reasons for the increased acquiescence are reduced chief executive officer (CEO) ownership, fewer IPOs containing secondary shares, increased ownership fragmentation, and an increased frequency and size of "friends and family" share allocations. These changes made issuing firm decision-makers less motivated to bargain for a higher offer price.

The realignment of incentives hypothesis is similar to the changing risk composition hypothesis in that it is changes in the characteristics of ownership, rather than any nonstationarities in the pricing relations, that are associated with changes in average underpricing. It differs from the changing risk composition hypothesis, however, in that underpricing is not determined solely by the investor demand side of the market.

Changing issuer objective function hypothesis

The changing issuer objective function hypothesis argues that, holding constant the level of managerial ownership and other characteristics, issuing firms became more willing to accept underpricing. Hypothesize that, during sample period, there are two reasons for why issuers became more willing to leave money on the table. The first reason is an increased emphasis on analyst coverage. As issuers placed more importance on hiring a lead underwriter with a highly ranked analyst to cover the firm, they became less concerned about avoiding underwriters with a reputation for excessive underpricing. We call this desire to hire an underwriter with an influential but bullish analyst the analyst lust hypothesis. This results in each issuer facing a local oligopoly of underwriters, no matter how many competing underwriters there are in total, because there are typically only five Institutional Investor all-star analysts covering any industry. As Hoberg (2003) shows, the more market power that underwriters have, the more underpricing there will be in equilibrium. The second reason for a greater willingness to leave money on the table by issuers is the co-opting of decision-makers through side payments. Beginning in the 1990s, underwriters set up personal brokerage accounts for venture capitalists and the executives of issuing firms in order to allocate hot IPOs to them.

Winner's curse hypothesis

The winner's curse hypothesis introduced by Rock (1986). In this investors are divided into two categories viz. Informed and uninformed. It states that, in any bidding situation, a party which unknowingly overestimates the value of a given object tends to bid higher than its competitors and is, therefore, more likely to win it. In a takeover the magnitude of the winner's curse is defined as the difference between the bid premium of the winning bidder and the maximum offerable premium conditional on the capital market's estimate of expected takeover gains. The magnitude of the winner's curse is predicted to increase with (1) increase in the divergence of opinion amongst acquirers with respect to the size of takeover gains, (2) increase in the degree of competition for control of the target firm and (3) increase in the pre-acquisition profitability of the winning bidder. The empirical results provide support for the winner's course hypothesis.

Signaling Hypothesis

In many markets, sellers have more information about an attribute of the product than prospective buyers. In such situations, sellers have an incentive not to reveal the attribute of the product (for example, by inflating its quality). However, if each seller is able to choose an action (called a signal) which can be observed by the buyer, it may be used to reveal information about the product. The hypothesis that sellers engage in such actions is called signaling hypothesis. The signaling hypothesis has been extensively applied to several fields including labor economics, industrial organization, finance, macroeconomics, and political economy.

Monopsony Power Hypothesis

The Monopsony Power Hypothesis by Ritter (1984) provides an alternative explanation to the phenomenon of Baron and Holmstrom (1980) and Baron (1982). Investment banker community in a small economy has full information on the number of firms that will go public in the following period, given that investment bankers take side with the institutional investors, they attempt to lower offering prices on behalf of the influential clients. As a result, in the Hot market, the first day closing are higher due to bullish investors and the offering prices are lower due to a high bargaining power of investment bankers.

FAD Hypothesis

Aggarwal and Rivoli (1990) and Ritter (1991) based on the long term underperformance of the market reported that excess initial returns are caused by overvaluation of IPOs by investors and the presence of fads in the early aftermarket. The Fad Hypothesis explained that IPOs were priced well but it was the investor's high interest that overvalued the IPOs. Aggarwal (1993) and Levis (1993) provide international evidence, which supported the Fad Hypothesis.

The above literature focuses in the initial underpricing of IPOs. There are several studies which shed light on the long run performance of IPOs is of interest. From investor's point of view, the existence of price patters may present opportunities for active trading strategies to produce superior returns. The volume of IPOs displays large variations over time. If high volume periods are associated with poor long run performance, then this would indicate that issuers are successfully timing new issues to take advantages. The cost of external equity capital for companies going public depends not only upon the transaction cost incurred in going public but also upon the returns that investors receive in the aftermarket. If low returns are earned in the after market, the cost of external equity capital is lowered for the firms.

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