Essay About Various Studies And Institutional Investors Perspective

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UNDER-PRICING AND LONG-RUN
PERFORMANCE OF INITIAL PUBLIC
OFFERINGS IN INDIAN STOCK MARKET
Dr. S. Janakiramanan
Associate professor
Singapore Management University
SINGAPORE MANAGEMENT UNIVERSITY
(LEE KONG CHIAN SCHOOL OF BUSINESS)
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 investors 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 developed 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