CHAPTER-1 INTRODUCTION Indian stock market had witnessed introduction of some important institutional mechanisms in the early part of this millennium in the realms of primary market and secondary market as well. These initiatives were aimed at bringing in the best practices and making the Indian stock market comparable to the global markets. An important reform in the primary market sphere is the introduction of Book building process of issuing shares. Book building involves soliciting from the professional investors how many shares they are willing to buy and at what price. On the basis of the resulting demand curve, the firm and its investment bankers determine the IPO offer price. IPO’s in India An Initial public offering (IPO) is the sale of a company’s stock to the public for the first time. The primary motive for an IPO is generally either to raise capital or to offer an exit strategy to some of the firms existing owners, but a number of other motivations and considerations also influence a firm’s decision to go 1
This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Transcript
CHAPTER-1
INTRODUCTION
Indian stock market had witnessed introduction of some important institutional
mechanisms in the early part of this millennium in the realms of primary market and
secondary market as well. These initiatives were aimed at bringing in the best
practices and making the Indian stock market comparable to the global markets. An
important reform in the primary market sphere is the introduction of Book building
process of issuing shares. Book building involves soliciting from the professional
investors how many shares they are willing to buy and at what price. On the basis of
the resulting demand curve, the firm and its investment bankers determine the IPO
offer price.
IPO’s in India
An Initial public offering (IPO) is the sale of a company’s stock to the public
for the first time. The primary motive for an IPO is generally either to raise capital or
to offer an exit strategy to some of the firms existing owners, but a number of other
motivations and considerations also influence a firm’s decision to go public. This
decision process illuminates a firm’s goals in issuing an IPO, which are important to
evaluate the potential reasons for the under pricing we observe.
Start-up companies rarely have the resources, history, or credibility to conduct
an IPO. In fact, firms in the most incipient stage of development generally rely
entirely on personal loans, savings, family, and friends for their initial financing. Even
as a company begins to develop and show some signs of promise, it will rarely
attempt a public offering; instead, it will look to angel investors or venture capital.
Angel investors are wealthy individuals, often prior entrepreneurs, who will provide
financing in exchange for equity in the company. Venture capital comes from firms
rather than individuals, but the principle is the same: investors offer financing in
1
return for a stake in the company. Both angel investors and venture capital firms
frequently take an active role in the company, advising management on the most of
issues it faces.
The initial investors are naturally hesitant to provide all the funding upfront,
and different private equity investors target companies at different stages of growth.
Thus, successful companies will typically undergo multiple rounds of financing and
will develop a base of investors that intend to eventually liquidate their stakes. When
an “IPO-ready” company requires additional financing, it has multiple options: pursue
further equity financing from the private market, issue debt, or conduct an IPO. So
what prompts investors and the company to go with the IPO option?
In addition to provide an immediate capital influx and mechanism through which
existing owners can cash in on their investment, there are other advantages of going
public. Since the expectation is that a liquid aftermarket will develop following the
offering, firms conducting an IPO can expect to be in a position to raise additional
capital relatively easily and on favorable terms following the initial offering. The
increased liquidity also makes it possible for public companies to offer stock-based
incentives and compensation, which can help them attract and retain top employees
and improve employee productivity.
1.1 IPO Process
The firm has to select an underwriter for selling its securities in primary market.
The company usually consults with an investment banker to determine how best to
structure the offering and how it should be distributed. Since most of the new issues
are too large for one underwriter to effectively manage, the investment banker, also
known as the underwriting manager, invites other investment bankers to participate in
a joint distribution of the offering. The group of investment bankers is known as the
syndicate. Members of the syndicate usually make a firm commitment to distribute a
certain percentage of the entire offering and are held financially responsible for any
unsold portions. The underwriter syndicate can choose either best effort method or
2
firm commitment method for selling of the securities. There exist two main
mechanisms in India for the sale of public issues.
1. Fixed Price Method.
2. Book Building Method
1.2.1 Fixed Price Method
In a fixed priced offer, an issuer company is allowed to freely price the issue.
The basis of issue price is disclosed in the offer document where the issuer is closes in
detail about the qualitative and quantitative factors justifying the issue price. The
issuing firm (with the help of the underwriter) decides upon a selling price and offers
a set number of shares at that price. The underwriter does not build a book of potential
orders; instead, the price is based upon the underwriter’s judgment of the market
conditions and the intrinsic value of the company. The Issuer company can mention a
price band of 20% (cap in price band should not be more than 20% of the floor price)
in the Draft offer documents filed with SEBI and actual price can be determined at a
later date before filing of the final offer document with SEBI. In its offering materials,
the issuer will give both a qualitative and quantitative justification for the chosen
price. If the offering is oversubscribed, the shares are allocated on a pro rata basis.
This type of offering is commonly used in Singapore, Finland, India and the U.K.
1.2.2. Book Building Method
In the traditional IPO process, an investment bank is always hired to
“underwrite” an IPO. The issuing firm will choose a “lead underwriter” (book runner)
or “co managers” risk, the investment banks themselves almost always form a
syndicate, and each member of which will sell part of the issue .Deals can be
structured in a variety of ways. One major consideration is whether it is a "firm
commitment" or “best efforts” agreement. In a firm commitment, the underwriter
buys the entire offer and resells it to the public, thus guaranteeing the amount of
money that will be raised; under a best efforts agreement the underwriter sells as
much of the security to the public as it can sell at the offering price, but it does not
3
guarantee the quantity. Underwriting contracts will also specify he underwriter fee
(typically 5%) and the “green shoe” option (allows the underwriter to increase the
number of shares offered, typically by 15%).After the details of the deal have been
worked out, the underwriter files a registration statement with the SEBI. This
document provides details on the offering, as well as company information, such as
financial statements, management backgrounds, legal proceedings, and insider
holdings.
Next, the underwriter puts together a “red herring” (a preliminary prospectus
that obtains information on the company and offering), and goes on a “road show” in
which they present to potential investors and gauge demand. Most of these potential
investors are institutional investors, such as mutual funds, pension funds, and hedge
funds, and they give the underwriter feedback as to how much stock they intend to
buy and at what price. This is called the “book building process” since the underwriter
builds a book of potential orders. After the SEBI approves the registration and the
road show is complete, the underwriter and issuing firm decide on an offering price
range, which will depend upon the success of the road show, the current market
conditions, and the company’s goals.
After the offering range is decided upon, the underwriter will accept bids from
interested investors. If the orders exceed the value of the issuance, the IPO is
“oversubscribed.” When this is the case, the offering will price at the high end of (or
even a little above) the offering range, the underwriter will have partial discretion
over how to allocate the limited shares among the bidding institutional investors, and
the underwriter will exercise its green shoe option. When an offering is
undersubscribed, it will price at the low end of the range; or, if the offering is
extremely undersubscribed, the issuer may decide to postpone the deal. Since
institutional investors are their best clients, investment banks heavily favor them over
retail (individual) investors. Thus, there is a degree to which retail investors are
“excluded” from IPO’s. This is compounded by the fact that in many IPO’s, only
those individual investors who have a brokerage account with one of the underwriters
are even eligible to participate in the offering. The defining features of the book
4
building mechanism are: a price that is elastic to demand but ultimately set by the
underwriter, and a discretionary share allocation mechanism that has historically led
to the exclusion of most retail investors. This method is used in almost all domestic
IPO’s
1.3 Phenomenon of Underpricing.
A sample of 1597 companies having made an Initial Public Offer (IPO’s)
during 1989 to 1995 and listed at the Bombay Stock Exchange form the data set for
the analysis. Out of the 1597 IPO’s offered and listed for the period 1989-1995
considered here, 72 issues were fairly priced (zero returns on listing); 157 were
overpriced (negative returns on listing) and a total of 1368 were under priced (positive
returns on listing).
Considering the Net Return (Em), 1268 out of the total 1597 IPO’s registered
positive return on the stock index whereas 259 IPO’s registered negative returns.
Initial returns on IPO’s are found on an average to be quite high. Return on listing for
the total sample (1597) is found to be 94%. Return on listing for the trimmed sample
(2% of the highest and lowest observations) falls down to 81%. This is an attempt to
limit the sensitivity of the extreme observations.
1.4 Concept of underpricing
Generally, it has been found that investors, who purchase IPO’s on the
offering day, experience high returns on the first trading day, indicating that these
shares may have been priced at the time of their offering to the public at values much
below their intrinsic value. The phenomenon is known as Underpricing.
Underpricing of issue represents the first day returns generated by the firm,
Calculated as: (Closing Price on listing day – Offer price) X 100
Offer price
5
An issue is under (over) priced if the price received by the issuer in the
primary market is lower (higher) than the price of the same securities in the secondary
market on the first day of trading.
The existence of the phenomenon of “underpricing” is a well-established fact
for the IPO’s issued all over the world. It has been found that an average firm goes
public with an offer price that is lower than the price that prevails in the immediate
aftermarket. As a result, IPO’s register significant excess returns on the first day of
trading. Underpricing is a phenomenon that is largely restricted to the opening
transaction. And hence, the under pricing is almost entirely “corrected” by the market
at the opening transaction.
A worldwide survey of literature on the phenomenon of Underpricing of IPO’s
exhibit three fundamental characteristics:
(a) The initial price reaction phenomenon or in other words ‘underpricing’: the
immediate after market price, on average is significantly higher than price at which
the initial offer was made;
(b) The Hot Issue Phenomenon: there are distinct cycles outlined, both in the number
of issues that come to the market and the level of initial price reactions;
c) The long-run “Underperformance” phenomenon: initial offers are said to perform
dismally in the long-run compared to the industry counterparts for the same period.
1.5 Extent of Underpricing: International Evidence
The table below shows the number companies which underpriced their shares
in different countries at the respective time duration and the sample size of the
observation made.
Table 1.5.1 showing the extent of underpricing in other countries
Country Period Sample Size Performance (%)
6
Australia 1966-78 93 29.2
Germany 1977-87 97 21.5
U.K 1980-88 712 14.3
U.S.A 1975-84 1526 14.7
Malaysia 1978-83 21 166.7
Singapore 1978-83 39 39.4
Source: Handbook of Statistics on the Securities Market 2006, Table 12
Studies on the Indian capital market also confirm the phenomenon of
underpricing of IPO’s. Most of the Studies on the Indian primary market concerning
the phenomenon of ‘underpricing’ are found to be in the post-liberalization period i.e.
after the abolition of the CCI. The initial excess return on IPO’s in the Indian primary
capital market is very high as compared to the experience of the capital markets of
countries abroad.
1.6 Company profile of Kotak Securities Limited
Kotak Securities Limited is a subsidiary of Kotak Mahindra Bank, is the stock
broking and distribution arm of the kotak Mahindra Group. The company was set up
in 1994. Kotak Securities Limited is a corporate member of both the Bombay Stock
Exchange and the National Stock Exchange of India Limited. Its operations include
stock broking and distribution of various financial products – including private and
secondary placement of debt and equity and mutual funds. Currently, Kotak Securities
Limited is one of the largest broking houses in India with wide geographical reach.
The company has four main areas of businesses:
1. Institutional Equities,
2. Portfolio Management,
3. Retail (equities and other financial products) and
7
4. Depository Services.
Institutional Business
This division primarily covers secondary market broking. It caters the needs of
foreign and Indian institutional investors in Indian equities (both local shares and
GDR’s). The division also incorporates a comprehensive research cell with sectoral
analysis which covers all the major areas of the Indian economy.
Client Money Management
This division provides professional portfolio management services to all high
net-worth individuals and corporates. Its expertise in research and stock broking gives
the company the right perspective form which to provide its clients with investment
advisory services.
Retail distribution of financial products
Kotak Securities has a comprehensive retail distribution network, comprising
approximately 7000 agents 73 branches and over 200 franchisees across India. This
network is used for the distribution and placement of arrange of financial products
that includes company fixed deposits, mutual funds, Initial Public Offerings,
secondary debt and equity and small savings schemes.
Depository Services
Kotak Securities is a depository participant with the National Securities
Depository Limited and Central Depository Services (India) limited for trading and
settlement of dematerialized shares. Since it is also in the broking business, investors
who use its depository services get dual benefit. They are able to use its brokerage
services to execute transactions and its depository services to settle these.
8
Kotak Securities with volume, width and quality of offerings regularly earned
many accolades from industry monitors. In recent times, these have included:
i. The “Best Brokerage Firm in India” by Asia money for four consecutive years
2006, 2007, 2008 and 2009.
ii. Best Performing Equity Broker in India - CNBC Financial advisor Awards 2008
iii. Euro money Award (2006 & 2007) – Best provider of Portfolio Management
iv. Finance Asia award (2004 & 2005) – Best Equities House in India
v. Asia money Award (2005) – Best Equity House in India
Vi. Prime Ranking Award (2003-04) – Largest Distributor of IPO’s
Kotak Institutional Equities
Kodak Institutional Equities is among the top institutional brokers in India. It
mainly covers secondary market broking and the marketing of equity offerings,
including IPO’s to domestic and Foreign Institutional Investors (FII’s). Its full-
pledged research division comprises many analysts engaged in micro-economic
studies, industry and company specific equity research. It has full financial service
capability, which includes derivatives, facilitating market access through affiliates and
the distinctive offering of corporate access to investors. The division serves over 250
clients including FII’s, pension and mutual funds. The division has sales desks in
Mumbai London and New York, with the India desk also serving clients in Hong
Kong, Singapore, Japan and Australia.
The group has a net worth of over RS 5824 cores, employees around 20,000
people in its various businesses and has a distribution network of branches,
franchisees, representative offices across 370 cities in India and offices in Network,
9
London, San Francisco, Dubai, Mauritius and Singapore. The group services around 5
million customer accounts.
Value statement of the company: whether you are a customer with small or large
investment you can expect us to bring value to you in every form.
Quality research,
Quick trade execution,
Low brokerages,
Accounts that suit your investment profile and
Risk profile
Service: The Company believes in high standards of service and that’s precisely what
they offer. It’s an honor to be awarded the most customer responsive company award
in the financial institution sector by AVAYA global connect award both in 2006 and
2007.
Robust Technology: The company have developed their own proprietary trading plat
form which is robust and among the best in the industry. It has more than 150
technology professionals constantly working on upgrading and speeding up all their
systems.
Centralized Risk Management System: Unlike many other players Kotak Securities
have centralized risk management systems which allow them to offer the same levels
of service to customers across all locations.
Exceptional Research: Unlike most other competitors Kotak Securities have their
own in-house research team. The in-house research team is among the best in the
10
industry and they have many years of experience in the financial markets. They scan
through the group of stocks and find the scripts that have a high potential of providing
a good returns to the investors. The investors get research results of technical and
fundamental analysis, derivatives analysis, macro economic and mutual fund research.
Large presence: Kotak Securities is present in 321 cities with 877 offices allover the
country. Their employee strength extends beyond 5100.
Background of the study
This study is carried out in order to know the effect of Underpricing on the price
performance of IPO’s in the short and long run period. Short run period ranges from
listing day to first six months. The long run period means more than one year and
above after the IPO’s listing in the stock market. this study was conducted during Jan-
2007 to Mar-2010. The main aim of this study was to identify the factors which
influence the investor’s decision of investing in IPO’s, and to know how they affect
the price performance of the IPO’s.
1.7 Significance of the study
Making a firm public is significant turning point in the life of a firm with
serious wealth implications for the existing shareholders. The success of the public
listing depends, among other factors, on the ability to determine an offer price. This is
a difficult process. Thus, if the firm’s shares are overvalued, their sale to the public
will fail; if it succeeds, it will entail a transfer of wealth from the new shareholders to
the old ones.
In case the new shares are undervalued the old shares will relinquish a claim
on the firm’s cash flows at a price below its fair value. To avoid certain uncertainties
involved in the public sale of their securities, firms retain underwriters who undertake
the risk of pricing and selling the new securities. The conditions under which new
11
securities are offered to the public and the role of underwriter are both affected by the
regulatory and institutional environment of local IPO market.
Indian securities market had witnessed introduction of some important
institutional mechanisms in the early part of this millennium in the realms of primary
market, secondary market as well. These initiatives were aimed at bringing in the best
practices and making the Indian capital market comparable to the global markets. An
important reform in the primary market sphere is the introduction of Book Building
process of issuing shares. Book Building involves soliciting from the professional
Investors how many shares they are willing to buy and at what price. On the basis of
the resulting demand curve, the firm and its investment bankers determine the IPO
offer price. Book building is an established process of public issue of securities in
many markets Argentina, Brazil, China, Finland, France, Germany, New Zealand,
Japan, and the U.S. Book building process helps the issuer not only to determine the
demand but also aids the process of 'price discovery' i.e., the price at which shares
shall be issued will be determined by the demand and supply forces of the market. In
this paper we attempt to see short and long run price performance of the book-built
IPO’s.
1.8 Purpose of the Study
The study intends to examine the performance of the Indian IPO’s listed on
NSE, using a sample of IPO’s that tapped the NSE market during 2007-2010 by
taking in consideration of their prices. The short run as well as long run analysis of
their price performance has to be done by taking the gap of time intervals of one
weak, one month, three month, six month and one year, two years, respectively. In
addition to that an analysis to be conducted to know the influence of the factors such
as Issue size, Lead time, Age, Subscription level and Market timing on the price
performance of the IPO’s. these factors are explained below.7
Issue size
12
Total amount of money the company wants to rise through issuing IPO’s. This
is equal to the product of total no of shares and the price per share.
Lead time
Lead time is the time gap between the date of allotment of shares of IPO’s and
the listing of the shares the first day in the stock market.
Age of the company
Age of the company is the time from when the company is in the business,
what is the reputation of the company in the market. How the company was
performed in the past years.
Subscription level
The percentage level of the shares the investors are willing to buy. It is a
measure of demand for the shares in the market. Usually measured in terms of how
many times the shares are subscribed before the allotment day.
Market timing
Market timing is the time when the company issued the IPO’s, and gives
information about what was the market condition at that time. It is mainly related to
the ‘Opportunity Window’, that is the choices available for the investors.
The primary objective of the study is to determine how the market timing at the time
of issue of IPO’s going to affect on the price performance of IPO’s in short and long
run. It may affect on the systematic over-optimism of the market investors and
managers at the time of IPO events. The performance measures being used are post-
issue long-run holding period stock returns, Along with return obtained for potential
earnings growth.
13
1.9 Objectives of the study
More specifically, the study has been designed to achieve the following objectives:
1. To measure the initial under-pricing of IPO’s in India issued between Jan-2007 to
Mar-2010.
2. To study the underpricing on the short run performance of IPO’s in India up to six
months.
3. To study the underpricing for the long run for more than one year till Mar-2010.
4. To study the factors influencing Investors decision of investing in IPO’s.
14
1.10 Limitations of the study:
1. The important limitation of the study is that due to non availability of ‘one size
fits all’ model for studying IPO under-pricing phenomenon.
2. The time horizon taken is considered short for the analysis of long run
performance.
CHAPTER 2
LITERATURE REVIEW
The literature review examines recent and important research studies,
company data, or industry reports that act as a basis for the proposed study. It is a
critical summary and an assessment of the current state of knowledge or current state
of the art in a particular field. The literature review provides evidence that a certain
15
amount of relevant literature in the topic has been read and understood prior to the
start of the proposed study. Literatures on sales management are vast. However, a few
literatures have been highlighted here for the project.
2.1 Literatures on IPO’s in International perspective
A survey of literature on the phenomenon of Underpricing of IPO’s exhibit
three fundamental characteristics:
(a) The initial price reaction phenomenon or in other words ‘underpricing’: the
immediate after market price, on average is significantly higher than price at which
the initial offer was made;
(b) The Hot Issue Phenomenon: there are distinct cycles outlined, both in the number
of issues that come to the market and the level of initial price reactions;
(c) The long-run “Underperformance” phenomenon: initial offers are said to perform
dismally in the long-run compared to the industry counterparts for the same period.
Source: "The After Market Performance of Initial Public Offerings in Latin America"