UNDER-PRICING AND LONG-RUN PERFORMANCE OF INITIAL PUBLIC OFFERINGS IN INDIAN STOCK MARKET
Dr. S. Janakiramanan Associate professor Singapore Management University SINGAPORE
INTRODUCTION
The transition from being a private company to a public one is one of the most
important events in the life of a firm. It is also one of particular interest to institutional investors, and the transition is facilitated through the initial public offering (IPO) process. The IPO provides a fresh source of capital that is critical to the growth of the firm and provides the founder and other shareholders such as venture capitalists a liquid market for their shares. From an institutional investor's perspective, the IPO provides an opportunity to share in the rewards of the growth of the firm. When a firm issues equity to the public for the first time, it makes an initial public offering consisting of two kinds of issues – the primary issue and the follow-on issue. In a primary, the firm raises capital for itself by selling stock to the public, whereas in the followon issue, existing large shareholders sell to the public a substantial number of shares they currently own. It is a well documented fact that IPOs tend to be generally under-priced, though some issues tend to be overpriced. From the viewpoint of financial research, IPO under-pricing in the sense of abnormal short-term returns on IPOs has been found in nearly every country in the world. This suggests that IPO under-pricing may be the outcome of basic problems of information and uncertainty in the IPO process, and is unlikely to be a figment of institutional peculiarities of any one market. There have also been various studies made to suggest the reasons for such underpricing. From the investors’ point of view, this under-pricing appear to provide the sure and quick profit that most dream about. Though first day return could vary, few of the issues tend to provide a very high return over the first day. One of the examples is VA Linux which had a first day return of 700%. It is also seen that for some of the issues, the first day return could also be negative. It then becomes inevitable for most investors to measure the performance of IPOs by the short term (usually within one week of issue), as the general scheme is to buy the shares at a low initial offering price and sell it the next day when the price increases. Pricing of the IPOs are done by the issuers with guidance from underwriters from investment banks. There are various ways to price the stocks but what is commonly used now is a process called book building. It is basically a capital issuance process used in an Initial Public Offer which aids price and demand discovery. It is also a process used for marketing a public offer of equity shares of a company. During the period for which the book for the IPO is open, bids are collected from investors at various prices, which are above or equal to the floor price. The offer/issue price is then determined by the issuing company after the bid closing date based on the various bids that have been collected. For a more detailed discussion of book building, one can visit any of the many stock exchanges. An example of the book building process can be seen from the National Stock Exchange. This Initial Public Offering can also be made through the fixed price method or a combination of both book building and the fixed price method. There have been various studies conducted on the price changes of the shares after prolonged periods (six months to five years). These studies show that while the short-run performance of IPOs is often quite impressive, the long-run performance over the subsequent three to five years is not as impressive. Excluding the initial-day return, IPOs tend to underperform various benchmarks. However, these studies focus mainly on eveloped economies and tend to neglect the developing counterparts. A study by Madhusoodanan and Thiripalraju studies the performance of Indian IPOs prior to 1996. It is in the hope that the long term performance of IPOs in developing economies can also be a useful indicator to the potential investor that this study is to be undertaken. The purpose of this paper is to examine the long-run performance of IPOs in Indian stock market which were issued during 2000-2001. The IPO literature has shown that the IPO issues and performance is based on a cycle. In some years there are a large number of IPOs while in some years, there are only a few IPOs. When it is a vintage year with a large number of IPOs, most IPOs tend to do well on the first day but tend to do poorly over a long term whereas in years when there are only a few IPOs, the results tend to be mixed. The long run performance is likely to be affected while we include IPOs from different time periods because the market movements in different market conditions are likely to be different. In order to see that results are not confounded by the time period when IPO was issued, it was decided to include IPOs that were issued within a one-year period. This has resulted in a sample of 116 companies which had IPOs in this period from various industries. This study is important mainly because the Indian stock market has been performing very well from the year 2001 and our research wants to show whether this performance is due to the established firms or the performance also gets to the newly issued shares through IPOs. The study uses various methods to ascertain the significance of the over or underperformance of IPOs. Among the many reasons for the performance which we see, one of them could be the sensitivity of the results to the choice of benchmarks. Dimson and Marsh, Ritter, Gregory et al, Fama and French and Fama have successively demonstrated the sensitivity of the long-run performance of the IPOs the benchmark used in the study. For this reason, the effect of various benchmarks on the return measurements will be studied so as to elucidate the possibility that the magnitude of the performance is benchmark dependent.
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