Performance of IPO

“PERFORMANCE OF IPO AS COMPARED TO CRISIL GRADE"

NAME – DEEPAK BHATIA

BATCH – FALL WINTER 07-09
ALUMNI ID – DF-79-F -0357

EMAIL ID – DEEPAKBHATIA1093@GMAIL.COM

SUBMITTED TO:
MR. VIJAY BODDU

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 Performance of IPO

ACKNOWLEDGEMENT

I would like to extend our sincere thanks to Mr.PARAMJIT SINGH, our project guide

for his guidance and support throughout our study. His calm demeanor and willingness to

teach has been a great help in our successfully completing the project. Our learning has

been immeasurable and working under him was a great experience.

My heartfelt thanks are also towards our guides of our Institute faculty. Without their

continuous help and enthusiasm the project would not have been materialized in the

present form.

Finally, I also wish to thank Indian Institute Of Planning And Management for

making this experience of this project possible. The learning from this experience has

been immense and would be cherished throughout my life.

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 Performance of IPO

TO WHOM SO EVER IT MAY CONCERN

This is to certify that Mr. Deepak Bhatia, a student of Indian Institute Of

Planning And Management, New Delhi has completed his Thesis on
“Performance of IPO as per Crisil grades” under my guidance and all the
information in the thesis is authentic and acknowledged.

Paramjeet Singh

Head - Franchisee Business Unit (ROM)

IL & FS Investmart Securities Limited

33/15, Prashant Bunglow, Opp. Garware College,

Karve Road , Pune – 411 004

Tel: 020-66020000 Mobile: 09320979016

Email : Paramjeet.singh@hsbcinv.com

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TABLE OF CONTENT

S. No. Particulars Page No.

1 Cover Page I
2 Acknowledgement II
3 Executive Summary V
4 Synopsis VII
5 Introduction VIII
6 Abstract XI
7 CRISIL Background XIII
8 Financial Look at the topic XXI
9 Indian IPOs XIV
10 Empirical Findings XV
11 Methodology XVI
12 Explaining the topic XVII
13 Outcomes XLVIII
14 Description of variables LI
15 Findings LIII
16 Conclusion LVII
17 Final Outcome LVIII
18 Annexure LX
19 Bibliography LXII

Executive Summary

We propose that the long-run performance of IPOs is a function of pre-IPO factors,

including managerial decisions and the firm’s performance prior to going public and

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CRISIL’s contribution in evaluating and quantifying. We relate long-run performance to

a much richer set of explanatory factors than in the previous literature. Using a number of
variables, we provide empirical evidence in support of this proposition. The manner in
which a company is run before it is listed on the stock exchange gives a strong signal of
how its shares will perform in its first few years of coming to the market.

IPO grading is the grade assigned by a Credit Rating Agency registered with SEBI, to the
initial public offering (IPO) of equity shares or any other security which may be
converted into or exchanged with equity shares at a later date. The grade represents a
relative assessment of the fundamentals of that issue in relation to the other listed equity
securities in India. Such grading is generally assigned on a five-point point scale with a
higher score indicating stronger fundamentals and vice versa as below.

IPO grade 1: Poor fundamentals

IPO grade 2: Below-average fundamentals

IPO grade 3: Average fundamentals

IPO grade 4: Above-average fundamentals

IPO grade 5: Strong fundamentals

This paper attempts a detailed investigation of the boom and slump phases in the Indian
primary capital market. It concentrates on two key variables, namely, IPO volume and
initial returns and analyses their nature and interrelation during these two periods. This
study also analyses the firm-specific characteristics and their influence on the timing of a
company getting listed in the hot and cold market. The IPO volume series was auto
correlated over the entire period and especially during the boom period. This shows a
firm's decision to go public over the last decade depended on the number of other
companies that were getting listed over the previous months. Turning to the interrelation
of volume and initial return, the empirical exercise (Granger causality test) found no
significant relation between IPO volume and initial returns during the hot and cold
periods. This suggests that over the sample period, the Indian issuers' did not depend on
the information content of the initial returns while taking their decision to go public.

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Amongst the other characteristics that might have influenced the likelihood of IPOs
during hot and cold market (e.g. industry classification, age, size and under pricing of
new issues), this paper finds no significant influence of industry affiliation on the IPOs
during the boom period. The results also documented that more established firms have
greater likelihood to get listed on the capital market to raise large amounts and under
price more during the slump period.

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Synopsis

TITLE OF THESIS: Performance of IPOs as per CRISIL grades

WHY PERFORMANCE OF IPOs:

I propose that the long-run performance of IPOs is a function of pre-IPO factors,

including managerial decisions and the firm’s performance prior to going public. I would
like to relate long-run performance to a much richer set of explanatory factors than in the
previous literature. Using a number of variables, I will be providing a empirical evidence
in support of this proposition. The manner in which a company is run before it is listed
on the stock exchange gives a strong signal of how its shares will perform in its first
few years of coming to the market.

IPO grading has been introduced as an endeavor to make additional information available
for the investors in order to facilitate their assessment of equity issues offered through an
IPO.

Apart from that when a share is listed on the stock exchange what should be the
approximate first listed price of that share. I am trying to find and quantify those reasons
which decide the complete IPO journey. It includes little about IPO valuation then
prediction of listing price and then its long run performance.

I will explore the relationship between pre-IPO factors and its price performance in the
long-run believing that the pre-IPO performance of a firm taking a CRISIL grade as a
benchmark.

Research methodology…..

In terms of selecting the research methodology, I have thought of analyzing different

IPOs which came during the last 2 years with a CRISIL grades. Our sample will
include IPOs of three companies with three different grades.
Will various amount of allotment, different past performances and also in different
sectors to get an adequate coverage for the detailed study of the topic.

Primary Research
Data from companies.

Secondary research
Since the thesis is mainly based on secondary data only thus data required will be balance
sheet, profit and loss a/c and historical performances of other IPO's of the same company.

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Aim is to come out with some mathematical formula using various statistical tools to
quantify the various parameters on which the complete performance cycle of the
IPO depends from the IPO valuation to the first listing price and the long term
performance.

Methodology

The paper will be organized as follows:

Section I will include the introduction

Section II will include the previous literature on long-run IPO under-performance and the
various theoretical explanations for the anomaly.

Section III will describe the data

Section IV will include my methodology.

Section V will present the hypotheses I wish to test

Section VI will report my results.

Conclusions and recommendations for future research appear in section VII.

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Introduction

It has been empirically documented that the IPO market experiences cycles in terms of
volumes of new companies, which is referred to in the literature as “hot” and “cold”
periods. It is considered to be an empirical anomaly for which no unanimous explanation
is yet provided for. The most well known among the sighted explanations is technological
innovation or positive productivity shock that changes the prospects of IPOs from a
particular industry and an expectation of return associated with the CRISIL grade.
Empirical studies have found that small and young firms time their offers to use
investors’ optimism in their favor and get listed during the booming period may it be the
listing day or long term performance. There are evidences of high under pricing and
industry clustering during the hot periods, though their nature and extent have differed
from country to country.

The last decade is also important, since the Indian economy in general and primary
capital market, in particular, has undergone remarkable changes during this period. The
liberalization programmed initiated in 1992 along with other changes has enabled large
Foreign Direct Investment (FDI) and Foreign Institutional Investment (FII) inflows,
giving a ‘big push’ to the capital market.

The abolition of the Controller of Capital Issues (CCI) also had a major impact on the
activities in the Indian primary market. It witnessed a boom phase (1993-96) when more
than 50 companies got listed every month. And after 2006 when it was made mandatory
for the companies to get their IPOs get graded from any Credit Rating Agency. This
paper attempts a detailed investigation of the boom and slump phases in the Indian
primary market.

This paper attempts a detailed investigation of the boom and slump phases in the Indian
primary capital market. It concentrates on two key variables, namely, IPO volume and
initial returns and analyses their nature and interrelation during these two periods.

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This study also analyses the firm-specific characteristics and their influence on the timing
of a company getting listed in the hot and cold market for the listing gain as well as for
the long term return as per the expectation associated with the different grades of
CRISIL. The IPO volume series was auto correlated over the entire period and especially
during the boom period. This shows a firm's decision to go public over the last decade
depended on the number of other companies that were getting listed over the previous
months. Turning to the interrelation of volume and initial return, the empirical exercise
found no significant relation between IPO volume and initial returns during the hot and
cold periods. This suggests that over the sample period, the Indian issuers' did not depend
on the information content of the initial returns while taking their decision to go public.

Amongst the other characteristics that might have influenced the likelihood of IPOs
during hot and cold market (e.g. industry classification, age, size and under pricing of
new issues), this paper finds no significant influence of industry affiliation on the IPOs
during the boom period. The results also documented that more established firms have
greater likelihood to get listed on the capital market to raise large amounts and under
price more during the slump period.

It concentrates on two key variables, namely IPO volume and initial returns series and
analyses their nature and interrelation during these two phases. This study also analyses
the firm-specific characteristics (i.e., age, industry type, size) and their influence on the
timing of a company getting listed during high volume period as compared to low volume
period. The remainder of the paper is organized as follows. This study contains a survey
of international literature, outlines the data sources for this study and then discusses the
methodology used and presents the results. Finally we summarize the main findings with
some concluding remarks.

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Abstract

We propose that the long-run as well as the listing performance of IPOs is a function of
pre-IPO factors, including managerial decisions and the firm’s performance prior to going
public. We relate long-run performance to a much richer set of explanatory factors than in
the previous literature. Using a number of variables, we provide empirical evidence in
support of this proposition. The manner in which a company is run before it is listed on
the stock exchange gives a strong signal of how its shares will perform in its first few
years of coming to the market. Using a UK data set, we find that the percentage of equity
issued and the degree of multinationality are key predictors of IPO performance.

It is well known that, on average, initial public offerings (IPOs) significantly

underperform the market over the long-run. Various explanations for this
underperformance (including the heterogeneous expectations of investors) have been
offered. In this paper, we focus on the evolution of financial analyst coverage and the
effect of the initiation of analyst coverage on the long-term performance of Initial Public
Offerings (IPOs). We find that IPOs followed by financial analysts significantly
outperform those that do not receive any coverage.
We also examine factors associated with financial analysts initiating coverage subsequent
to companies’ initial public offerings. Our results indicate that the original analyst
coverage decision is affected by: the extent of earnings history provided in the
prospectus; underwriter prestige; firm size; whether management included an earnings
forecast in the IPO prospectus and whether the post-IPO earnings indicate “good news”.

We also studied the initial and long-run performance of a unique sample of thrifts that
have recently converted from mutual to stock form. Because the market value of
converted thrifts equals the pre-conversion value plus all proceeds from the IPO, the
firms in our sample have a degree of under pricing automatically built into their offer
price. By simultaneously examining the initial return, long-run cumulative abnormal
returns, and returns over various post-issue sub periods, we are able to characterize
investor behavior in a way that is not possible with IPOs in other industries.

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We find that even after removing the large initial returns, cumulative excess returns for
the firms in our sample are significantly positive for up to five years post-issue. Excess
returns are significantly positive in all but one sub-period for five years post-issue. In
addition, these excess returns persist (as positive alphas) when performance is evaluated
using CAPM, 3-, 4- and 5-factor models. Our results are consistent with investor under
reaction in both the IPO and aftermarket. Thus, we find no evidence of investor
overreaction despite the large first-day returns and volume that would presumably attract
momentum investors.

We examine the effects of choice of underwriters, venture-capital support and industrial

classification, and the interactions of these effects on the long term performance of IPO’s.
We find significant underwriter and venture capital effect and that underwriter effect
subsumes industry effect. Short term price momentum and long term price reversal
pattern is most pronounced for IPOs that are underwritten by leading investment banks
and backed by venture capital. The beginning of price reversal coincides with the
expiration of IPO lockup period.
Although by the end of the first year, IPOs on average underperforms the market,
investors can earn above market returns by investing in IPOs that are underwritten by
leading investment banks and backed by venture capitalists and divest before the
expiration of the lockup period.

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CRISIL BACKGROUND

A Standard & Poor’s Company:

CRISIL is India’s leading Ratings, Research, Risk and Policy Advisory company.
CRISIL’s majority shareholder is Standard & Poor’s, a division of The McGraw-Hill
Companies and the world’s foremost provider of independent credit ratings, indices, risk
evaluation, investment research and data.

CRISIL’s Grading of Initial Public Offerings (IPO’s) is a service aimed at facilitating

assessment of equity issues offered to the public. The Grade assigned to any individual
IPO is a symbolic representation of CRISIL’s assessment of the “fundamentals” of the
issuer concerned on a relative grading scale. IPO Grades are assigned on a five-point
point scale, where IPO Grade 5 indicates the highest grading and IPO Grade 1 indicates
the lowest grading, i.e. a higher score indicates stronger fundamentals. An IPO Grade is
not an opinion on the price of the issue, pre- or post-listing.

The Grading Process:

CRISIL starts the IPO Grading process on receipt of a formal request from the issuer
company. CRISIL then sends a questionnaire seeking information on the company’s
existing operations as well as proposed project(s). This is followed by site visits and
discussions with the key operating personnel of the company concerned. Apart from
officials of the company, CRISIL also meets its bankers, auditors, merchant bankers, and
appraising authority (if any). If the case so merits, CRISIL also obtains the views of
independent expert agencies on critical issues like , for instance, the technology proposed
to be used . Once all the required information has been obtained, CRISIL’s team of
analysts presents a detailed Grading Report to CRISIL’s Rating Committee which then
assigns the Grade.

Usually, the assignment of Grade takes three to four weeks after all the necessary
information has been provided to CRISIL. Once the Grade is assigned, the issuer
company is required to disclose the same and also publish it in the Red Herring

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Prospectus (RHP), which is filed with the Securities and Exchange Board of India (SEBI)
and other statutory authorities. CRISIL does not carry out any unsolicited Grading; the
process involves the full co-operation of, and interaction with, the issuer company
concerned.

IPO Grading are a one-time exercise, not subject to subsequent surveillance.

Grading Methodology:

The emphasis of the IPO Grading exercise is on evaluating the prospects of the industry
in which the company operates , the company’s competitive strengths that would allow it
to address the risks inherent in the business(es) and effectively capitalise on the
opportunities available as well as the company’s financial position. In case the IPO
proceeds are planned to be used to set up projects, either Greenfield or Brownfield,
CRISIL evaluates the risks inherent in such projects, the capacity of the company’s
management to execute the same, and the likely benefits accruing from the successful
completion of the projects in terms of profitability and returns to shareholders. Due
weightage is given to the issuer company’s management strengths and weaknesses and
issues, if any, from the corporate governance perspective. Accordingly, CRISIL’s IPO
Grading methodology examines the following key variables:

Business and Competitive Position

:: Industry prospects

Typical factors which are assessed here includes the growth prospects of the industry, the
extent of cyclicality, competitive intensity, vulnerability to technological changes and
regulatory risks inherent in the business .

:: Market position

A company’s market position is indicated by its ability to increase/ protect market share,
command differential pricing and maintain margins at par with, or superior to its peers.

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Factors evaluated would include the sources of competitive advantages like brand equity,
distribution network , proximity to key markets and technological superiority.

:: Operating efficiency

The emphasis here is on evaluating the factors which could give rise to operational
efficiency, depending on the industry where the company is operating and typically
includes areas like access to raw material sources, superior technology, favourable cost
structure and so on.

New Projects Risks and Prospects

Key issues evaluated here are the company’s ability to successfully execute the project
that is being undertaken and the potential upside to the shareholders on completion and
commissioning of the project. CRISIL carries out a detailed risk assessment of the project
with respect to issues like availability of finances, technology tie-ups in place, ability to
execute the project without time or cost overrun , market risks arising from capacity
additions and the mitigates in place to counter those risks.

Financial Position and Prospects

Ability to generate sustained shareholders’ value as reflected by trends in profitability

margins , EPS growth, Return on Capital Employed (RoCE) and Return on Net Worth
(RoNW) are evaluated by CRISIL. While the absolute levels and the trends are important,
CRISIL also compares it with peers operating in the same industry to understand a
company’s relative position. Complementing this is an analysis of the company’s ability
to generate free cash flows in the long term. The capital structure of the company is
evaluated from a perspective of balance between the cost of capital for shareholders’ and
financial risks associated with higher leverage.

Management Quality

The assessment is designed to evaluate a company’s management depth, the profile of its
key operating personnel, the adequacy of the organization structure and systems in place

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as well as the management’s stated plans and policies towards earnings growth and
shareholder returns. CRISIL also evaluates t he management’s approach towards risk and
long term business plans in place.

Corporate Governance practices

While IPO grading is not intended to be a detailed evaluation of a company’s corporate

governance practices, broad issues like app arent quality of independent directors, quality
of accounting policies and type of transactions with subsidiaries and associates is looked
into.

Compliance and Litigation History

The IPO Grade assigned is the outcome of a detailed evaluation of each of the factors
listed, and is a comment on the fundamentals of the company concerned and its growth
prospects from a long -term perspective. The assessment involves combination of both
quantitative factors as reflected in financial numbers, market shares etc as well as
qualitative factors like risks associated with new projects, or the management’s ability to
deliver on the promises made.

A CRISIL IPO Grade does not comment on the valuation or pricing of the issue that has
been graded, nor does it seek to indicate the likely returns to shareholders from
subscribing to the IPO.

CRISIL’s IPO Grading Scale

• CRISIL’s five -point IPO Grading scale is as follows:

• CRISIL IPO Grade 5: Strong fundamentals
• CRISIL IPO Grade 4: Above-average fundamentals
• CRISIL IPO Grade 3: Average fundamentals
• CRISIL IPO Grade 2: Below-average fundamentals
• CRISIL IPO Grade 1: Poor fundamentals

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What a CRISIL IPO Grade Is Not:

• It is NOT a recommendation to buy sell or hold the securities Graded

• It is NOT a comment on the valuation or pricing of the IPO Graded
• It is NOT an indication of the likely listing price of the securities Graded
• It is NOT a certificate of statutory compliance

Why is IPO grading necessary?

An investor in a hitherto unlisted company may either have limited access to information
on it, or may find it challenging to appropriately assess, on the basis of the information
available, its business prospects and risks. An IPO Grade provides an additional input to
investors, in arriving at an investment decision based on independent and objective
analysis.

In recent times, with the stock market participation of new and foreign investors
increasing, there is need for greater value-added information on companies tapping the
capital market and their intrinsic quality . In this context, IPO Grades, being simple,
objective indicators of the relative fundamental positions of the issuers concerned, could
help in both widening and deepening the market.

IPO Grading is NOT a recommendation to buy sell or hold the securities Graded.
Similarly, it is NOT a comment on the valuation or pricing of the IPO Graded nor is it an
indication of the likely listing price of the securities Graded.

What are the issues that are assessed while arriving at the grading?

The emphasis of the IPO Grading exercise is on evaluating the prospects of the industry
in which the company operates, its competitive strengths that would allow it to address
the risks inherent in the business(es) and effectively capitalize on the opportunities
available as well as the company’s financial position.

In case the IPO proceeds are planned to be used to set up projects, either Greenfield or
Brownfield, rating agency evaluates the risks inherent in such projects, the capacity of the

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company’s management to execute the same, and the likely benefits accruing from the
successful completion of the projects in terms of profitability and returns to shareholders.
Due weightage is given to the issuer company’s management strengths and weaknesses
and issues, if any, from the corporate governance perspective.

Accordingly, IPO Grading methodology examines the following key variables:

• Business and Competitive Position

• New Projects—Risks and Prospects
• Financial Position and Prospects
• Management Quality
• Corporate Governance practices
• Compliance and Litigation History

SEBI does not play any role in the assessment made by the grading agency. The
grading is intended to be an independent and unbiased opinion of a rating agency.

Validity of grading

The assigned grade would be a one time assessment done at the time of the IPO and
meant to aid investors who are interested in investing in the IPO. While the grading itself
is valid for a period of 6 months from the date of issuance, the grading letter will have a
validity of 2 months from the date of issue and would need to be revalidated
subsequently- there would not be any additional charges for the revalidation. Rating
agency however reserves the right to change the grading after the same has been assigned
should the circumstances so warrant.

Facilitating informed investment decisions

Continuing its tradition of pioneering and developing innovative products and services to
help its clients take better informed business decisions, CRISIL introduces its latest
product offering — CRISIL IPO grading.

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CRISIL, the originator of this concept, has been at the forefront of developing the IPO
grading model into a usable form. The views and feedback of the regulator, market
participants, investors and investor forums have been core inputs in the development of
this product. Therefore, CRISIL has a uniquely evolved understanding of this globally
revolutionary idea.
CRISIL believes that IPO grading provided by an independent agency would be free from
bias and add structure to the tools available at present for assessing the investment
attractiveness of an equity security.

The IPO grading will be based on CRISIL’s proprietary framework that has been
developed to help investors arrive at their own judgment on factors those drive
equities as an asset class. The debt market has benefited immensely from the available of
such an assessment in the form of credit rating - a representation of a relative assessment
of the fundamentals of the debt security, likelihood of timely repayment of interest and
principal. The IPO grading product of CRISIL is a relative assessment of the
fundamentals of the equity security. Investment decisions for IPO’s are at present based
on voluminous and complex disclosure documents, which pose a challenge to investors to
arrive at informed decisions. The focus, in these documents is meeting regulatory
guidelines on disclosures. Though seemingly there is a lot of information available on
IPO’s through free research on websites, media and other sources, investors often look
for structured, consistent and unbiased analysis to aid their investment decisions.
Moreover, information available on new companies varies with the size of the issue, the
market conditions and the industry that the issuing company belongs to. CRISIL IPO
grading aims to bridge this gap and facilitate more informed investment decisions.

CRISIL IPO grading brings value to issuer, merchant banker and investors

• It provides an independent, unbiased assessment of the fundamentals of the

company.
• The grade enables easy comparison between companies, irrespective of the size or
the industry they operate in.
• It is a collaborative initiative to widen and deepen market participation.

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• Increasing participation from new and foreign investors necessitates greater

‘awareness’ about the company and its fundamentals.
• It will help issuers to benchmark themselves and project their underlying strength
better.

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Financial Look: Long-Term Underperformance of New Issues?

Financial economists are still searching for appropriate answers to what explains the
long-term underperformance of new issues, both IPOs and SEOs. This section reviews
three major explanations proposed by academic research papers on this question.

A. The “Windows of Opportunity” Hypothesis or the “Fads” Hypothesis:

Given temporary overvaluation of a firm, two hypotheses have been proposed: (i) the
“windows of opportunity” hypothesis; and (ii) the “fads” hypothesis. Although they are
labeled with different titles, they are built on the same “overvaluation” phenomenon.
Depending on whose viewpoint we consider, it seems that two different titles have
evolved. From the managers’ viewpoint, propose the “windows of opportunity”
hypothesis which predicts that when a firm is substantially overvalued the managers are
likely to issue equity, taking advantage of the opportune time to lower the cost of capital.
Relying on the observation that equity issuing firms perform poorly following the issue
rather than a theoretical foundation justifying this hypothesis. From the viewpoint of
investors, that there are “fads” in the securities markets contrary to the assumption of the
rational expectations models in the literature and further that the IPO market overpricing
is a good case in point for the presence of fads. Using the market-to-book equity ratio as a
proxy for overvaluation, find that underperformance persists even after the market-to-
book equity ratio is controlled for, which is inconsistent with the hypothesis.
The size-adjusted long-term excess returns do not have any meaningful role in the log
regressions predicting whether a firm relies on equity or debt financing, which is also
inconsistent with the hypothesis.

On the average, it is true that IPO firms underperform the market or a matching control
group of non issuers, but the IPO literature often overlooks the fact that a large fraction of
new issues exhibit better performance than the matching control group of non issuers.
There is one exception that investigates long-term performance of over- and under-valued
IPOs.

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They find that overvalued IPOs become even more overvalued in the short-run exhibiting
momentum, but fall back in the long run exhibiting reversals; undervalued IPOs, on the
other hand, earn lower returns in the short run but earn higher returns in the long run.

Both “windows of opportunity” and the “fads” hypotheses are unable to explain why
there exist another group of IPO stocks that over perform the market or their counterpart
non issuers:
Over performance implies under pricing at the offer.

B. The Agency Cost Hypothesis:

Given divergence of interest between managers and shareholders, we believe that

managers prefer to divert the proceeds from new issues of equity or excess cash flows to
investments in projects with negative net present value at the expense of shareholders’
wealth. The selfish behavior undertaken by management in combination with the excess
cash on firm balance sheets points to Jensen's value-destroying hypothesis. Consistent
with this agency cost explanation, the long-term decline in operating performance is
greater for firms that have higher free cash flows.

The IPOs provide an interesting empirical setting in which another important hypothesis
related to agency costs emerges because the interests of managers and shareholders
become less closely aligned as managers’ stakes decrease and ownership becomes more
disperse. As a result, an issuing firm’s performance should suffer after going public.

In a similar line of logic, a negative relation exists between the level of agency costs prior
to new issues and subsequent changes in performance because new equity issues often
decrease the proportion of equity owned by managers thereby diminishing the managers’
incentives for value maximization.

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C. The Earnings Management Hypothesis:

One peculiar observation from various statistical data compiled by the past studies is that
both IPO and SEO firms exhibit unusually large and significant gains in operating
performance above and beyond the industry average or the control group of matched non
issuers one year prior to the offer date. We also observe that firms in the year prior to the
offering provide a higher return.
This observation leads us to suspect the presence of aggressive earnings management that
is intended to lead investors to be overly optimistic about the issuer’s prospects. When
initial high earnings cannot be sustained, disappointed investors revalue the firm down to
a level justified by the fundamentals. Decomposing net income into cash flow from
operations and accruals from accounting adjustments, post-issue underperformance in net
income is caused by accruals. When accruals are further decomposed into four categories
by time period (current and long-term) and manager control (discretionary and
nondiscretionary) discretionary current accruals drive the post-issue earnings
underperformance and predict underperformance in post-issue stock performance.

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Indian IPOs

Theoretically, a firm’s objective is to collect as much money as possible from the

investors for a given quantum of shares offered and thus firms are expected to go public
when initial returns are low. The empirically established positive relation between initial
return and IPO-volume poses a puzzle and underlines the signaling role (or information
content) of initial return series.
While the above-mentioned literature suggests concentration of IPOs during the hot
periods and change in the firms’ characteristics during hot and cold markets,
The IPO literature has frequently emphasized the role of investors’ optimism and the
consequent hot market. Ritter (1984) provided empirical evidence of investors’ over-
optimism in bidding up the aftermarket prices. Empirical literature has documented that
the underperformance is more for small and young companies that mostly go public
during the hot market period. Companies planning to go public try to predict the
investors’ sentiment on the basis of market behavior.
Against the above backdrop, the objective of this paper is to study the Indian IPO market
and to analyze the factors that influenced the volume, under pricing and timing of issues
during these two phases.

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Empirical Findings

Table 1 reports the average of the key variables over the entire 1990s. It shows that the
average amount raised over the years has increased in the second half of 1990s. The
number of new issues that got listed on the BSE went up considerably during 1993-96.
These three years were followed by a slump when the number of IPOs went down
substantially.
A close inspection of the monthly volume of IPOs shows that there were two distinct
phases in 1990s.

Table 1: Averages of Key Variables for Indian IPOs

Size: Money raised by the issuers from public at constant prices;

Under pricing (U_D): percentage difference between listing and offer price.
A_UD: Under pricing adjusted for the market return over the issue-listing period;
Volume: The average of the ‘number of IPOs getting listed on BSE in a month’ over the
financial years considered here.
Note: All averages reported in the Table are significantly different from zero at 1 per cent
level.

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 Performance of IPO

Empirically the timing of this structural break has also been confirmed by the Markov
Switching process. Chart 1 shows the number of IPOs over the months and the
probability of the structural break (switching regression model) in the Indian primary
market. There was a boom phase when (on average) more than fifty IPOs got listed on
BSE per month (1993:01 to 1996:09) and subsequently a slump when only a handful of
companies raised money from the stock market.

It is evident from the literature survey that the IPO volume and the under pricing series
follow a certain time pattern. The periods of large number of IPOs and the high initial
return are followed by periods when only a handful of companies get listed in the market.
Empirical evidence suggests that the firms’ decision to go public could also depend on
the behaviour/decision of the other companies and on the observed initial returns. The
decision to get listed and its timing are also found to depend on firm-specific
characteristics (e.g. industry affiliation, size of the issue, age). Having identified the
boom and slump periods, and in light of the above observations, the subsequent sections
of this paper analyze the pattern and characteristics of the key variables over different
phases in the Indian IPOs market.

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 Performance of IPO

Time Pattern of IPO Volume and Initial Returns

In this section we analyze the IPO volume and under pricing series individually taking
into account different phases in the Indian IPO market during 1993-2001. Earlier
researchers argued that the fluctuation in IPO volume series could be related to three
factors. These are changes in private firm’s aggregate demand for capital, changes in cost
of issuing equity (under pricing) and variation in investor optimism. In face of cyclical
pattern in the IPO market, empirical evidence from the developed countries suggests that
the volume and under pricing series depend considerably on their past behaviour.

Table-2 reports the autocorrelation in the monthly volume, under pricing and index
adjusted under pricing series for the Indian IPO market. Empirical results show that the
monthly volume of IPOs has a large autocorrelation (first lag coefficient being 0.62) that
dampens slowly over the increasing lags.
However, the other two series, namely, under pricing (U_D) and market adjusted under
pricing (A_UD) did not show signs of any strong autocorrelation or uniform damping
pattern over the sampling period. The inertia or time dependence is indicative of the
information content of the IPO volume (number of IPOs in a month) which could have
signaled the issuers about the buoyant market conditions or the new profit prospects.

Table2: Autocorrelation in Volume and under pricing Series

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 Performance of IPO

From Table 2, the differences in the pattern of the autocorrelation coefficients over
different phases become quite evident. For the boom period, the coefficients display a
high initial autocorrelation coefficient and a slower damping pattern over the lags while
during the cold period, the same show a weak and mixed pattern. So, it appears that
during the boom period, a company’s decision to go public depended more on past IPO
volume as compared to the slump periods. The above analysis suggests that the nature
and pattern of autocorrelation over the entire period of time and over the sub periods
differ considerably. The high autocorrelation in the monthly IPO volume during the hot
market might be indicative of the investors’ optimism resulting from the array of
liberalization measures announced during the first half of 1990s. The under pricing series
also illustrated considerable autocorrelation and slow damping pattern over the increasing
lags during the boom period. The similarity in the autocorrelation pattern of the IPO
volume series and under pricing series might be indicative of one influencing the other
during the hot market period as observed in the developed markets. We investigate the
interrelation between the volume and under pricing series in greater detail below.

Interrelation of IPO Volume and under pricing Series

Besides the observed autocorrelation, the other question that needs due attention is the
relation between the IPO volume and under pricing. This is important since the existence
of such a relation would imply that the issuers’ time their offers in response to the ‘value-
relevant information available from the under pricing series and vice-versa.
For empirical investigation of the IPO volume and under pricing relation, this paper
attempts Granger causality tests to examine the presence of any causal relation between
IPO volume and past under pricing.
Granger causality test assumes that ‘X causes Y’ if the past values of X help in predicting
Y in addition to past values of Y. The causality test is generally done by running
regression of the following form:

XXVIII
 Performance of IPO

If the  i coefficients (∀i=1…m) are jointly and significantly different from zero (the F-
test statistics is greater than its critical value) then the null hypothesis “X does not cause
Y” is rejected. In order to determine the optimal lag length (m) this paper uses the
Schwarz information criterion.
Before proceeding to test the causal relation between monthly volume of IPOs and the
monthly average under pricing one must ensure that the two series considered are either
stationary or have 'same statistical property'. By 'same statistical property' it is meant that
the series have to be differenced or de-trended the same number of times to render them
stationary. To test for the stationarity of the series, Augmented Dickey Fuller (ADF) test
was performed. The ADF test found the presence of unit root (at one per cent level) for
the three series considered during the whole period and for the hot period. However, all
the three series were stationary during the cold period. The causality test this paper
considers the hot and cold periods separately and not the entire period. To take care of the
non-stationary problem during 1993-96, IPO volume and under pricing series were
difference for the hot period. However, the series in levels were used for the cold phase.
Table 3 reports the coefficients and Granger-F statistics for volume and under pricing for
the periods considered, the lags being selected on the basis of Schwarz information
criterion as mentioned above. The coefficients of under pricing over different lags in the
causality test (for whether under pricing caused the IPO volume) reported low values and
none of them were significant at 10 per cent level (Table 3, Column 2 and 3). The value
of the Granger F-Statistics (0.29) and its P-value (0.96) also confirm the joint
insignificance of the estimated under pricing coefficients and reject the hypothesis that
monthly IPO volume was Granger caused by past values of the under pricing series.
The causality analysis for the cold period (that used the above mentioned variables in the
levels) supported the finding for the hot period. The coefficients of under pricing (as
indicated in Table 3, Column 7 and 8) took low values.

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 Performance of IPO

Table 3: Causal Relation between Volume and Under pricing

Note: Hot Period (Jan 1993 to Sep 1996): more than fifty IPOs in a month; Cold Period
(Oct 1996 to March 2001): less than fifty IPOs in a month; Granger F test for causal
relation of volume of IPO and initial returns and vice versa; Under pricing (U_D):
percentage difference of listing and offer price; Vol: No. of IPOs getting listed on BSE in
a particular month; and, Vol1 (volume) and U_D1 (Under pricing) reported here refer to
the first differenced series vol and U_D for the hot market.

These results reveal that the issuers’ decision to go public during the boom and the slump
periods did not depend on the past values of the under pricing series. They also show that,
unlike the international experience, the Indian issuers’ decision to go public was not
directly dependent on the information content (investors’ optimism or the cost of rising
funds) of under pricing series. This might be because; the time consumed by a company
for getting listed in a stock exchange in India was very high over the study period.

XXX
 Performance of IPO

The average time lapsed in between the offer date and listing date being 4 months, the
company deciding to go public was able to get listed only after six months (two months
are considered for registration and other official formalities prior to the offer). Under
pricing being the percentage difference of the offer price from the listing price (the
former being decided six months before the latter) might have recorded the breaking
news over this long time lag rather than the investor’s optimism perse. Given such an
institutional structure, it might have created considerable uncertainty on the issuers’ part
to decide about the investors’ sentiments and/or cost of raising funds after a considerable
period of time from the observed under pricing.

We also test the existence of any reverse causality (under pricing is caused by IPO
volume) in the Indian IPO market which was argued that the under pricing might increase
during the hot market period with the increases in the number of listing, since the hot
market is often a result of technological innovation or positive productivity shock that
increases the number of companies getting listed from new and high risk industries. The
high risk factor pulls up the initial returns during the hot periods. Empirical results for
India reject this reverse causality hypothesis for both hot and cold periods (Table 3,
columns 4 and 5, 9 and 10). These findings apparently question the hypothesis of positive
technological shock resulting in industry clustering - an argument that is often forwarded
to explain hot market. The industry clustering issues are discussed in more detail later.
The above empirical analysis might be summarized by saying that the issuers in India
during the 1990s did not base their decision to go public on the past values of under
pricing series. The boom during the first half of 1990s was perhaps a result of the
investors’ optimism and business conditions rather than the information content of the
under pricing series. While the above analysis concentrated on the time pattern and the
information content of the under pricing and IPO volume series, it remained silent about
the firm-specific characteristics and their influence on the timing of a firm going public
during hot and cold periods. The next sub-section is devoted to a detailed study of these
factors influencing the companies’ decision to go public during the hot and cold periods.

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 Performance of IPO

Firm-Specific Characteristics of IPOs during Hot and Cold Phases

In order to test as to how the firm-specific characteristics influence likelihood of listing

across two periods, the analysis in this sub-section following Helwege and Liang
( examines the likelihood of an IPO in hot phase vis-à-vis a cold phase, conditional upon
the companies that actually went public during these phases.
This is done by employing a log it model where the dependent variable is a coding for a
discrete qualitative outcome [e.g. whether a particular company is going public in high
volume (hot phase, Y=1) or low volume (cold phase, Y=0)].
The general specification of the model is as follows:

where the set of parameters _ reflect the impact of changes in X on the probability. The
logistic distribution used here is given by:

Like other non-linear distributions, the coefficients do not represent the marginal effect
of the change in a particular variable. The marginal effect in such case is given by

Where f (.) is the density function to the corresponding cumulative distribution F (.).
In an attempt to examine whether the likelihood of IPOs getting listed from a particular
industry is more during the hot period, all industries were broadly classified as Primary,
Manufacturing (MNF), Services (SER) and computer related industry (SOFT) and were
included as explanatory variables in the logit model. It is documented in the IPO
literature that small and young companies are likely to go public during the hot period to
take advantage of investors’ enthusiasm.

XXXII
 Performance of IPO

To examine the validity of this argument the issue amount (SIZE) and the age of the IPO
companies are included in the model to evaluate their influence on the likelihood of the
Indian companies getting listed in the hot market. The other factor of interest is the under
pricing of the IPO firms. Signaling theory claims that the good firms would get listed
during the hot market and under price more to win investors confidence. The IPO
underperformance school, on the other hand, believes that new firms would try to collect
as much money as possible from the enthusiastic investors during the hot market. So, the
above mentioned model includes under pricing as an explanatory variable and evaluates
companies’ pricing decision during the hot and cold periods. The constant term was not
included in the model in order to avoid the dummy variable trap problem. The ‘’
coefficient of the logit model estimated using maximum likelihood estimation technique
is reported in the Table 4.

Table 4 shows that the primary, manufacturing and services sector considered here have
similar positive coefficients. The value of the -coefficient for the software sector is
however considerably less (1.4) than that of other sectors. All the sector-specific
coefficients were significant at one per cent level. This might be interpreted as the non-
existence of industry clustering in India during hot market, since companies from
primary, manufacturing and service sector got listed in the market during this period.

Table4: Factors Influencing the Likelihood of IPOs

Note: *ME is Marginal Effect of the logit model

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 Performance of IPO

PRI is the dummy variable which takes value one if the company is from Primary Sector,
otherwise zero. Similarly, MNF, SER and SOFT are the dummies for Manufacturing,
Service and Software sector respectively. SIZE is issue amount adjusted by GDP deflator;
U_D is under pricing: percentage difference of listing and offer price [Pl-Po/ Po]; Age is
the difference between the incorporation year and the listing year.

The marginal effect (ME) reported in Table 4 confirms this finding as the ME figure for
the software sector was lower than the other three sectors. Table 4 however, shows that
the coefficients of size, age, and under pricing have negative signs and were significant at
1 per cent level. The negative signs of the size, age and under pricing coefficients suggest
that the large and well-established firms got listed in the cold period and under pricing
were more. It might be because investors being less enthusiastic during the cold period,
only the well-established firms could convince them about their prospective investments
and raise funds through IPOs. It is generally believed that firms raising large amounts of
money are scrutinized more by the market than their small size counterparts.

So a larger size might have acted as a signal to the market and helped the issuers to raise
more money during the cold period. The IPO firms during the cold period might have
used under pricing as a signaling device (as suggested by the signaling theory) to
persuade the investors about their good quality and raise large amounts of money from
the market.
The results thus do not support the industry-clustering hypothesis explaining hot period
for the Indian IPO market in 1990s. Firms from all the existing sectors of the economy
took advantage of the booming primary market and investors’ optimism and raised funds
from investors in the first half of 1990s. The evidence presented in this paper suggests
that the likelihood of established companies raising large amount from the primary
market and under pricing considerably is more during the cold phase whereas the small
and young companies time their issues during boom phase.

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 Performance of IPO

Methodology:

For the initial after market (close of the first day of trading), we computed the market
adjusted abnormal returns (MAAR0) for each firm. For simplicity, we describe the
methodology below.
The total return for stock ‘i’ at the end of the first trading day is calculated as:

Ri , 1 = ln(Pi , 1 / Pi , 0)

where Pi , 1 is the price of stock ‘i’ at the close of the first trading day, Pi , 0 is the offer
price and Ri , 1 is the total first-day return on the stock.
The return on the market index during the same time period is:

Rm , 1 = ln(Im , 1 / Im , 0)

where Im , 1 is the market index value at the close of first trading and Im , 0 is the market
index value on the offer day of the appropriate stock, while Rm , 1 is the first day’s
comparable market return.
Using these two returns, the market adjusted abnormal return for each IPO on the first
day of trading is computed as:

MAARi, 0 = 100  { [( 1 + Ri , 1 ) / ( 1 + Rm , 1 )] 1}

Table 2 gives the average first day returns for the IPOs for the entire sample and for
offers and placements separately.
For the sample the average MAAR0 was found to be 9.74% with an associated tstatistic
of 8.54 (the t-statistics on initial returns must be interpreted with caution since the
distribution of initial returns is positively skewed). The MAAR0 has a median of 6.30 and
a standard deviation of 17.21. However, it is still rather surprising, since placements are
usually available to institutional investors who are more likely to be better informed
about the true value of an issue.

XXXV
 Performance of IPO

It is not clear why institutional investors need a higher first day return incentive to
encourage them to participate in the new issues’ market. The differences in average initial
returns between offers and placements might be related to the degree of uncertainty about
the true value of an issue.
Since the placement is usually the method of issuance used by smaller companies, we can
argue that the differences in initial returns between the two methods are related to the
market value of the offerings.

Using gross proceeds for the issue as a proxy for the size of the company that in turn can
be used as a proxy for the uncertainty about the true value of an issue, i.e., the smaller the
size of the company the higher the uncertainty. We did not find any significant
relationship between the gross proceeds from the issue and the initial returns (the Pearson
product moment correlation coefficient was found to be -0.03). Only 11% of the total
number of placements started trading below their offer price as compared to 19% of the
offers for sale. This provides further evidence for the asymmetric information model in
that the placements are usually available to institutional investors who are believed to be
better informed about the true value of the issue. Though the presence of some
overpricing is surprising. The market adjusted long-run after-market returns were
calculated following the first month of trading using the LSPD, which reports the
monthly return, measured on the last day of the month on which the stock is traded. These
returns incorporate dividend payments and are adjusted for rights and scrip issues.
Allowing for the initial under pricing and the possibility of price support in the first few
trading days, the first month of trading was excluded from the study of long run returns. It
is expected that this month would allow prices to adjust downwards towards the true
market equilibrium after the support has been withdrawn. The following methodology is
used to calculate the long-run returns:

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 Performance of IPO

where MABHRi denotes the market adjusted buy and hold return for a firm i over a 37
month period (for the purpose of the study this constitutes only monthly readings since
the first month of trading is excluded from the data) and Pi, t and Im, t denote the end of
the t month share price for the firm i and the corresponding end of the month index
respectively. These returns exclude initial under pricing. Buy and hold returns were
preferred to Cumulative Average Abnormal Returns (CAARs). Conrad and Kaul showed
that cumulative abnormal returns are biased because they not only process true returns
but also the upward bias in single period returns induced by errors in measurement. In
contrast buy and hold returns do not suffer from this bias. Moreover CAARs implicitly
assume frequent and thus costly portfolio rebalancing. Barber and Lyon also argued that
the abnormal returns should be calculated as the simple buy and hold return on the
sample firm less the simple buy and hold return on the benchmark.

In this study, we have not adjusted the monthly abnormal returns for systematic risk. The
previous studies demonstrated that the average betas decline with the length of time after
the IPO and the average difference in betas between the IPOs and matching firms
becomes too small to have any significant effect on the results.

The average monthly MABHR returns with the associated t-statistics for the 37 months
after going public. Many IPOs were delisted in their first year of trading because of
acquisition/takeover/merger while another 11 were delisted in the second year (one
company was declared bankrupt while the other 10 were delisted due to
acquisition/takeover/merger). The third year saw a similar fall with only 10 firms getting
delisted (all of them were delisted because of acquisition/takeover/merger). So over the
three-year period 23 firms were delisted which is about 10% of the total sample. 25 of the
36 monthly average market adjusted returns were found to be negative with 7 of them
having t-statistics lower than -2.0.

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 Performance of IPO

The average MABHR for the sample period as a whole was found to be -17.81% with a t-
statistic of -3.68. The under-performance of the IPOs is both statistically and
economically significant. We believe that our results are free from any significant
survivorship bias because only 23 firms were delisted in the 36 month period.
We also calculated the long-run performance for small and large firms, profitable and
loss-making firms, firms with assets and liabilities and firms with different turnovers.
Table gives the average MABHR returns of the cross sectional study. Our results confirm
that under-performance is largely concentrated in the smallest issuing firms. The large
firms in the sample, in fact, do not show a statistically significant underperformance. The
cross sectional study also exhibits some interesting results. Firms which earned profits in
the last three years before they were listed show more underperformance than the firms
that were running losses before their listing (for three years before listing). This indicates
that listing provides an efficient monitoring for badly performing firms while firms with
healthy profits in the pre IPO period suffer from a management slack. As expected, firms
with net liabilities perform worse than firms with net assets before the IPO. Firms with
large turnover in the year before flotation perform better than small turnover firms.
The plot of market adjusted monthly returns for the sample. The returns vary between 1%
and -2.7% over the study period. The returns peak at 1% in the 18th month of trading. A
minimum return of -2.7% is recorded in the 36th month.

The plot for the cumulative raw returns and also the cumulative Index adjusted monthly
returns. The cumulative raw returns are positive and are stable around 2.5% for the first
15 months and peak at 16.28% in the 28th month. They fall to 10.07% by the 37th month.
The cumulative Adjusted monthly returns are negative and suffer a continuous decline. A
sharp fall starts after the 28th month and continues till the end of our period of study
(37th month). At the end of the 37th month the cumulative adjusted monthly returns were
-24.57%.

XXXVIII
 Performance of IPO

First day market adjusted returns (in %) for the IPOs

The average monthly MABHR returns after going public.

XXXIX
Performance of IPO

XL
 Performance of IPO

Explaining the topic

Hypothesis 1: There is a positive relationship between the size of a firm at the time
of its going public and it’s listing share price performance after the IPO.

As a proxy for quality of a firm, the variable COST has been used. It represents the total
direct costs of going public expressed as a percentage of the funds raised by an IPO. The
costs of flotation include under-writer commissions, legal, printing and auditing. Table 7
reports the average direct costs of going public as well as the costs of flotation as a
percentage of the funds raise at the time of offer.
Of all the elements that add up to make the costs of flotation, the underwriter’s
commission component is expected to vary according to the quality of the firm. The other
components are expected to depend on the size of the offer. By dividing the total cost by
the size of the offer, we eliminated the components which vary with the offer size but
retain the ones that vary with the quality of the firm whose shares are on offer. We make
the following four assumptions before formulating a hypothesis on COST.
(1) Bigger firms are better quality firms
(2) Bigger firms raise larger amounts of capital from their listing
(3) Bad quality firms are bad long term performers
(4) Assumption (3) is known to the underwriter and hence this information is reflected in
the cost of underwriting.
Based on these assumptions, we hypothesize that as the size of the funds raised increases,
the quality of the firm becomes better (because larger IPOs are often made by more
established firms and so there is less risk about the true quality of the firm) and hence the
proportion of costs of the funds raised decreases (underwriters charge a relatively smaller
commission for underwriting bigger firms). So we expect a negative coefficient for
COST. The following hypothesis is considered for COST:

Hypothesis 2: The higher the cost of flotation expressed as a percentage of the fund
raised, the worse is the quality of the firm and the worse is the listing and long run
performance.

XLI
 Performance of IPO

The other variables used as a proxy for quality, risk and reputation of a firm are:
DURATION, PROFLOAT and MSHARE. While the variable DURATION gives the age
of a firm (in days) from the date of incorporation to the day of listing, the variable
PROFLOAT gives the average profits (or losses) for the last three years before the firm’s
listing. The market share of the underwriter is expressed as variable MSHARE.
The mean age of the firm in the sample was around 9 years. Some companies were 20
formed to takeover others and hence the DURATION for some of them is as less as 50
days.
The age of the firm has been suggested as a proxy for the risk (i.e. quality) of the IPO
firm and interpreted his evidence as being consistent with the over-optimism explanation.
We anticipate the coefficient for age (DURATION) and underwriter reputation
(MSHARE) to be positive for the long-run return analysis. A firm which is profitable
before flotation should continue to be so after the IPO. The profit in period t is normally
highly correlated with profit in t-1 period. This suggests that the more profitable a
company is before its listing, the better is its long-run performance. So we expect a
positive coefficient for PROFLOAT. We consider the following hypotheses for the
variables used as a proxy for quality and reputation of a firm.

Hypothesis 3:

(i) Underwriter Effect

The major benefit associated with IPOs is the cost saving of the underwriter spread,
which is typically about 7% Therefore, from an investor’s viewpoint, if the firm passes
through the full amount of cost savings to investors, holding other things equal, IPO
shares might be relatively cheaper compared to their counterparts in IPO market.
Another often cited reason for these firms to raise capital through IPOs is that the size of
the issue is too small to attract an interested underwriter. Instead of allowing for the
business to grow to a size suitable for IPO, these firms choose not to wait. However, the
choice of not undergoing underwriting process (i.e. a lack of validation from a third
party) may send out negative signals to market investors.

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 Performance of IPO

Beside the size of IPO issue, we argue that investment banks are selective in underwriting
IPOs. In order not to tarnish their reputation which in turn will have an impact on their
future earnings, the top investment banks will only underwrite IPOs which they believe
will have a strong showing in the aftermarket. A strong showing in the aftermarket will
not only allow the underwriters to profit further by exercising their over allotment options
but also strengthen their position in the IPO market. Premarket activities undertaken by
underwriters can signal to public the strength of the demand for the IPOs.
Previous Studies show that an upward adjustment of the offer price is positively related to
the degree of under pricing which is an indication of a strong demand for the IPOs.
Investors’ overreaction to the signal of strong demand on issue date will lead to undue
self attribution bias which further induces overreaction to continue in the short-run.
However, eventually, prices will revert to the fundamental value. It is usually argued that
underwriters offer to buy back stock in the aftermarket is equivalent to giving a put
option to investors to compensate for the potential adverse selection bias due to the
presence of information asymmetry. They further assert that only reputable investment
banks are in the position to convince investors that they will carry out such a promise in
the aftermarket. Therefore, we argue that the more reputable the underwriters are, the
higher will be the perceived quality of the signal.
The selectiveness of underwriters and the signaling effect of underwriter premarket and
aftermarket activities have lead us to formulate the following hypotheses:

H3 (i) H1: Stock prices of firms which have undergone direct public offering will under
perform those of firms whose IPOs are underwritten by investment banks.

H4 (i) H2: Aftermarket patterns (positive short run price momentum and long run price
reversal) as predicted by DHS will be more pronounced for IPOs underwritten by more
reputable investment banks.

(ii) Venture-Capital Effect

XLIII
 Performance of IPO

Conflicting theories has been forwarded by researchers on the role played by venture
capitalists in certifying the quality of an IPO. On one hand, we argue that the backing by
venture capitalists is a signal of quality and thus help in alleviating the problem of
information asymmetry existed between management and investors. On the other hand
the backing by venture capitalists will result in adverse selection in that only lower
quality enterprises will be willing to sell part of the company to venture capitalists at a
discount.
The empirical evidence on the relationship between issue-date return and pre-IPO venture
funding is inconclusive. Some studies find that venture capital backing is associated with
lower initial returns, others with higher initial returns Francis and
The evidence show that a venture capital financed IPO has better long-term aftermarket
performance, especially in the case of smaller companies. The better long-term
performance can be attributed to the fact that reputable venture capitalists would
effectively screen the companies they back and thus signaling the quality of their IPOs.
In addition, the expiration of IPO lockup period, the heavier selling by venture capitalists
results in a larger negative abnormal return and a higher trading volume.
To evaluate the impact of Venture-Capital financing on stock performance, two
hypotheses are formulated:

H3(ii)H1: If venture capitalists play a certification role, the aftermarket patterns (positive
short run price momentum and long run price reversal) will be more pronounced for
venture capital backed IPOs.

H3(ii)H2: The exit by venture capitalists on the expiration of the lockup period will
hasten the price reversal.

(iii) Interaction of Underwriter and Venture-Capital Effects

Specifically, lower initial pricing and underwriting spread are observed for IPOs backed
by highly reputable venture capitalists. Since the reputation of underwriter as well as the
reputation of venture capitalist can have an effect on the performance of IPOs, one could

XLIV
 Performance of IPO

argue that because well-established venture capitalists may have a strong business
relationship with some of the leading underwriters, there is a possibility that any venture
capital effect observed may be an underwriter effect in disguise.

On the other hand, if investors perceive the backing by venture capitalists as an extra-
layer of assurance for high quality in addition to the positive signal provided by reputable
underwriters, IPOs underwritten by leading investment banks and backed by venture
capitalists will have the best aftermarket performance.
In order to examine if there is an interaction between the effects of types of underwriters
and the method of financing, we first subdivide the sample by underwriter market
leadership and then by venture capital financing.

H3(iii)H1: Underwriter effect subsumes venture capital effect. Once we factor out the
underwriter effect, there will be no significant venture capital effect.

H3(iii)H2: If venture capitalists play a certification role, the aftermarket patterns

(positive short run price momentum and long run price reversal) will be most pronounced
for IPOs underwritten by more reputable investment banks and backed by venture
capitalists.

(iv)Industry Effect

The investors are more likely to be affected by overconfidence when dealing with vague
and subjective information. Since it is more difficult to value growth stocks, self
attribution bias will have a stronger influence in the valuation of these stocks. The
eventual correction of the mispricing will result in a stronger short term price momentum
for growth stocks and the momentum effect is strong for growth stocks but weak or
nonexistent for value stocks.
We also examined whether the long-term performance of IPOs is different between high-
tech IPOs and non-high-tech IPOs, and this may allow us to determine if the market
overreacts to high-tech IPOs.

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 Performance of IPO

H3(iv)H1: The aftermarket patterns (positive short run price momentum and long run
price reversal) as predicted by DHS will be more pronounced for IPOs by firms in the
high-tech industry.

(v) Interaction of Underwriter and Industry Effect

Lastly, we also examine the interaction between the underwriters and industry effects.
The sample is first subdivided by underwriter’s market leadership and then by firm’s
industry classification. It is our contention that the initial mispricing of high-tech IPOs
together with the signaling effect of underwriter reputation will result in a stronger short-
run price momentum.

The following two hypotheses are tested:

H3(v)H1: Underwriter effect subsumes industry effect. Once we factor out the
underwriter effect, there will be no significant industry effect.

H3(v)H2: The aftermarket patterns (positive short run price momentum and long run
price reversal will be most pronounced for high-tech IPOs underwritten by more
reputable investment banks.

Hypothesis 4: The more profitable a company is before its listing, the better is its
long-run performance after the IPO.

We use industry based on the industry groups the sample firms belong to. These codes are
the primary research has shown that there are marked differences in the long-run
performance of individual industries.
Industry classification has been used to capture this difference. Indirectly, they also help
to adjust for differences in business cycles between industries. Year classification are also
added which correspond to the year of the IPO. 4 yearly classifications are used for the

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 Performance of IPO

sample period and they adjust for business cycles in that they allow for the fact that the
IPOs are taking place at different stages of a business cycle.
Proxies for multi-nationality and diversity of products for a firm have also been used.
This study is the first attempt to address long-run under-performance using the nature of a
firm. DIVERPRD gives the number of two digit standard industrial classification for the
firm. This is used to show how diverse the company is in its products shows the
multinational character of a firm.

Hypothesis 5: The higher the dilution of the original share holding (the higher the
percentage of equity sold) in the IPO, the worse is the long-run performance.

The estimation method is ordinary least squares. We use the market-adjusted buy and
hold return after three years as the dependent variable in the regression analysis. 6 The
minimum equity issued was 7% while the maximum was 100%. Expecting the presence
of outliers we indorsed the data on equity issued. Examination of the data showed that
there was a gradual increase in the percentage of equity issued.

The empirical model is displayed as follows:

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 Performance of IPO

Outcomes

An examination of the distribution of the long-run returns and the independent variables
shows that most of them are positively skewed but are not significantly non-normal. Only
MABHR and FLOAT are negatively skewed but are also not significantly non-normal.
The results are presented for small firms, large firms and the full sample. As shown
earlier, the small firms drive the long-run under-pricing where as the share price
performance of large firms is driven by the managerial decisions and the firm’s financial
performance before the IPO.
As expected, we find a positive relationship between the size of a firm and its long run
performance. The larger the size of a firm in terms of the assets at the time of floatation
the better is the long run performance.

The results on the size variables suggest that hypothesis1cannot be rejected.

The size of a firm prior to its going public has a positive impact on the long-run
performance of the firm in the post-IPO period. Of the quality, risk and reputation
variables used COST and PROFLOAT show significance. The underwriter’s reputation
and the age of the firm fail to explain the long-run under-performance. For small firms
the higher the costs (as a percentage of funds rose) of flotation, the more is the under-
performance. This lends support our earlier proposition that underwriters know of the risk
involved with an IPO firm (especially if it is a small firm) and hence charge higher
underwriting costs to risky firms. For large firms this effect is absent thereby indicating
the underwriters’ perception of firms. They categorize small firms as risky and large
firms comparatively less risky though it is difficult to comment on an underwriter’s
definition of small and large firms.

These findings validate hypothesis 2 and signal that the ratio of the cost of flotation to
the funds raised explains the long-run performance of an IPO firm.

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 Performance of IPO

We do not find any significant relationship between the age of the firm and its long-term
performance. These results were arrived at, after an exhaustive model building exercise,
where we tested a range of non-liner models along with linear ones. The non-linear
models did not improve the regression results.

In order to account for general market conditions, market-adjusted returns are used to
evaluate the aftermarket performance of initial public offerings

where Ri,t is the monthly return of firm i on month t, Rm,t is the monthly return of market
index in month t, and ARi,t is the monthly abnormal return of firm i in month t.

The market-adjusted Cumulative Abnormal Return (CAR) is calculated as follows:

where Ri, l is the monthly return of firm i in month l, Rm,l is the monthly return of market
index in month l, and CARi,t is the cumulative market-adjusted abnormal return for firm i
from month 1

Hypothesis 3 thus stands valid.

We document three other variables that have an effect on the long-run performance of
IPO firms. One of these is a performance variable (PROFLOAT) and the other two are
nature of the firm variables (GSCOPE and DIVERPRD). Ownership structure
(EQUISSUE) and initial under pricing (MAAR0) also explain long-run under-pricing.
We find a negative relationship between the profitability of a firm prior to going public
and its long-run performance. The result is stronger for larger firms. The more profitable
a firm is prior to going public; the worse is the long-run performance.

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 Performance of IPO

This result is surprising and contradicts our hypothesis 4.

It suggests that firms go public at the height of their performance thus seizing their
window of opportunity. Similar conclusions were reported by others researchers who
showed that long-run share price performance and the change in operating performance
from before to after flotation are negatively related: when operating performance fails to
sustain pre-listing levels of profitability, share prices fall, indicating that investors were
surprised by the change in operating performance.

We also find a significant relationship between the degree of multi-nationality of a firm

and its long-run performance. This effect was strong for both the small and large firms
alike. The more multinational a firm (in terms of subsidiaries in different countries) the
better is the long-run performance. This could be the result of diversification of the risk of
a firm and the positive effect this has on investors’ sentiments.

This result validates hypothesis 5 and suggests that investors value multinational firms’
more than domestic firms. Multi-nationality signals quality and reputation of a firm.

We also document a relationship between ownership change at the time of IPO and long-
run performance. We find that the higher the proportion of equity sold at the time of
offering (i.e. the higher the dilution of original share holdings) the worse is the long-run
performance.
The result is stronger for large firms. These results are consistent with the predictions of
previous researchers who argued that incentives of an owner/manager change when
shares are issued to another party.

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 Performance of IPO

Description of the variables used in the study

Industry Dummies: The dummies are based on different industry categories.

Year Dummies: These are based on the 5 different years of the initial public offering.

AR = Market adjusted Abnormal Return

CAR = the market-adjusted Cumulative Abnormal Return

Proxies for quality, risk and reputation of the firm

DURATION: The age of the issuing firm. The age has been calculated as the difference
between the date of registration and the date of listing.

MSHARE: Gives the % share for an underwriter of the total underwriting (by value) in
the year of flotation.

PROFLOAT: The average pre tax profits (or losses) for the last three years before the
listing.

COST: The total direct costs (expressed as a percentage of the total funds raised),
incurred for listing- for example underwriting fees, legal expenses, accountancy and audit
fees. This variable acts as a proxy for quality of a firm.

Proxy for size of the firm

ASSFLOAT: The net assets of the firm in the year before the listing.

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 Performance of IPO

MCAPFLOT: Gives the market capitalization of the firm at the time of the prospectus.

FUNDS: The money rose from the public offering. It is used as a proxy to measure the
size of the offering.

Proxies for multinationality and diversity of products

DIVERPRD: Gives the number of two digit standard industrial classification codes for
the firm. This is used to show how diverse the company is in its products.
GSCOPE: Shows how multinational a firm is. The digit 1 is assigned if at least 1
subsidiary of the firm is present in a particular continent (the subsidiaries have been
assigned a continent depending upon their location) and 0 if there are none. The score is
then summed to give GSCOPE. The higher the GSCOPE the more multinational the firm
is. The minimum value of GSCOPE is one has no subsidiaries

Proxy for Agency Costs after the IPO

EQUISSUE: Gives the percentage of equity issued at the offering, thus gives the extent of
original shareholders’ dilution of ownership due to the offering.

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 Performance of IPO

Findings

ANALYSTS’ COVERAGE AND LONG-TERM PERFORMANCE OF INITIAL

PUBLIC OFFERINGS

The intent of this paper is two fold: to investigate whether there is any systematic pattern
in the initiation of analysts’ coverage. Our results show that analysts’ coverage is
generally restricted to a subset of firms that are large, are managed by those willing to
provide future guidance, and have an independent quality check by a prestigious
underwriter. Our results also show that analysts’ coverage positively related to firms
showing good earnings performance in the post-issue period, and that it tended to
increase over time.

We also show that analyst coverage provides a key indication of the long-run stock
market performance of IPO. Analyst coverage is significant in addition to established
factors from prior research, such as the extent of earnings history provided in the IPO
prospectus, and the use of a prestigious underwriter.

EFFECTS OF UNDERWRITERS, VENTURE CAPITAL AND INDUSTRY ON

IPO PERFORMANCE

Our empirical results suggest that short-run price momentum and long-run price reversal
is only observed for the IPOs underwritten by the leading investment banks. On the other
hand, direct public offerings and IPOs underwritten by less active underwriters tend to
under perform the market in almost every month for the first year after IPOs.

IPO by itself does not transmit any information regarding the quality of the firm to
investors. Therefore, it is not unexpected that we do not observe the behavior pattern for
direct public offerings and IPOs underwritten by less active underwriters since such IPOs
will not reaffirm investors’ confidence. On the other hand, for IPOs underwritten by
leading investment bank, the participation by top underwriters is a signal of quality which

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 Performance of IPO

can reinforce the investors’ belief and hence may lead to investors’ overconfidence due to
biased self-attribution.
We also observed a venture capital effect and industry effect. The results present in this
paper show that ventured capital-backed IPOs perform better than those that are not
backed by venture capital.

When we test underwriter effect against venture capital effect and industry effect, our
results indicate that both underwriter and venture capital effects are distinct effects.
However, our results show that underwriter effect subsumes industry effect. That is, once
the underwriter effect is removed, there is no significant difference in aftermarket
performance between firms in high-tech and non-tech industry. The industry effect,
which we observe previously, is implicitly an underwriter effect.

Since venture capital backing and reputation of underwriter are both signals for quality,
we would expect IPOs backed by venture capitalists and underwritten by leading
underwriters to exhibit a more pronounced performance.

Industry analysis reveals that only the high-technology sector exhibits a significant
return differential between hot and normal markets for the full sample and non-
venture IPOs. This result stems from the large proportion of high-technology firms
issued during hot markets with the pervasive presence of exuberant noise traders.
Cross-sectional regressions support the claim of significant underperformance by
high-technology firms in hot markets for the full sample and non-venture IPOs.
Venture-backed IPOs issued during hot markets underperforms more severely
although while their non-venture counterparts also suffer substantial negative returns
year’s.
In addition, we find that VC backed IPOs significantly underperforms the market because
the sale of shares by venture capitalists following the expiration of the lookup period is
more intense as compared to those by insiders. The sale of shares by venture capitalist
immediately after the expiration of the lockup period is more pronounced for IPOs
underwritten by leading investment bankers. Although, by the end of the first year, IPOs,

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 Performance of IPO

on average, underperforms the market regardless of the choice of underwriters, investor

can still benefit from investing in IPOs underwritten by highly reputable investment bank
if they divest before the expiration of the lockup period. The returns will be even higher if
these IPOs are financed by venture capitalists.

EXPLAINING THE SHORT- AND LONG-TERM IPO ANOMALIES BY R&D

In this study, we identify a major source of the information asymmetries affecting IPO
short- and long-term performance: the R&D activities of issuers. The issuers’ R&D
intensity is positively associated with the initial IPO under pricing and also positively
associated with the long-term performance of IPOs, thus singling out R&D as a major
contributor to both the short and long-term performance of IPOs.

In the process of our analysis we found out that R&D subsumes various factors, such as
venture capital backing and underwriter reputation, which were discussed earlier. We also
found out that R&D intensity affects analysts’ forecasts of IPO long-term earnings.

The importance of identifying R&D as a major factor that affects both the short- and
long-term performance of IPOs is that it provides both investors and managers with
actionable knowledge. Investors can increase their information search about the nature of
the R&D conducted by IPO issuers, such as examining the intellectual property
protection of R&D outcomes (patents) and the results of feasibility tests, thereby reducing
information asymmetry. Managers can achieve the same effect with enhanced
information disclosure. Market efficiency and investor welfare will improve with such
information enhancement about the R&D activities of IPOs.

LIQUIDITY RISK, LEVERAGE AND IPO RETURNS

According to our finding the IPO stocks have significantly lower leverage ratios and
exhibit greater liquidity than other small growth stocks. Since leverage “turbo charges”
equity returns by increasing factor loadings, reducing leverage also reduces the stock’s

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 Performance of IPO

exposure to leverage-related risk factors. So the market beta of IPO stocks is greater than
for matched firms. On the other hand we found that IPO stocks have somewhat lower
exposures than matched firms to leverage-related factors such as the default spread, the
term spread and unexpected inflation.
While the contribution of the non-market risk factors to overall portfolio expected return
is small, the evidence does indicate that the attenuating effect on average returns of the
non-market risk factors help set the greater market risk exposure of IPO stocks.
The liquidity factor is constructed as the return differential between a portfolio of low-
liquidity stocks and a portfolio of high-liquidity stocks. There is theoretical reason to
suspect that such a factor is priced, and we show that the factor indeed produces factor
loadings of a magnitude and significance comparable to that produced by the momentum
factor. When applied to the IPO portfolio, the liquidity factor reduces expected portfolio
return, as predicted.

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 Performance of IPO

Conclusions

This paper attempted a detailed analysis of the Indian IPO market over the boom and
slump phases. It documented that (like the developed market) the Indian IPO market
experienced a dramatic swing in terms of volume of new IPOs. The IPO volume series
was auto correlated over the entire period and especially during the hot period. This
shows a firm’s decision to go public over the last decade depended on the number of
other companies that were getting listed over the previous months. The autocorrelation in
the under pricing series was weak as compared to the IPO volume series. Turning to the
interrelation of volume and initial return, the empirical exercise (Granger causality test)
found no significant relation between IPO volume and initial returns during the hot and
cold period. This suggests that Indian issuers’ did not depend on the information content
of the initial returns while taking their decision to go public. A key reason for these
findings could be that, unlike the developed countries, it took a long time (more than six
months on an average) for Indian companies to get actually listed on the stock market
after the promoters decided to go public.
Under pricing derived from the price changes over the six months (or more) perhaps also
captured the changing investors’ expectation with the availability of new information
rather than investors’ optimism per se. So Indian corporate bodies might have depended
more on long lasting market sentiments to decide on the timing of their IPOs. Turning to
the other characteristics that might have influenced the likelihood of IPOs during hot and
cold market (e.g., industry classification, age, size and under pricing of new issues) the
evidence in this paper suggests no significant influence of industry affiliation on the IPOs
during the hot period. It is generally observed that hot market is triggered off by positive
productivity shock in some sectors and companies from such sectors mostly go public
during the hot period.
However, the empirical exercise in this paper did not support the hypothesis that
companies’ from any particular sector timed their issues to take advantage of the hot
phase in Indian primary market. The results also documented that more established firms
came to the capital market to raise large amounts and under price more to signal their
better quality during the cold phase.

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 Performance of IPO

Final Outcome

IPO valuation gives an idea to the investor whether the price band offered by the
company is over priced or under priced. But the investor is still in dilemma whether to
invest in that IPO or not. This is because he is expecting the returns from capital
appreciation in the secondary market. So always one question is there in the mind of the
investor that what will be the issue and what should be the open price of that IPO on the
first trading day in the secondary market.
This study is an attempt to answer that question of many primary market investors who
invest in the primary markets in an expectation to earn through capital appreciation from
the secondary market as per the grades given by CRISIL.
We hare have tried to give mathematical formula which will give them the approximate
opening price of that particular IPO

P = E(x) = E (MABHRi) =

Here MABHR is the expected return the investor is looking for looking at the company
management, company profile, size of the company, ownership of the company, future
plans and accordingly projections and the reputation of the merchant banker involved.
This is because when the company is not public the investors do not adequate information
to judge the company on their investment profile. So the reputation of the merchant
banker involved affects the investor behavior and final decision.

LVIII
 Performance of IPO

In the above formula the return expected is not for the short term investor. We here
looking at a long term perspective and that is why we have taken MABHR i.e. monthly
average buy and hold return. The standard deviation covers the parameters like risk,
business profile, size, reputation of the company and the merchant banker involved etc.
Then beta is the coefficient of all the deviation discussed above. This will cover any other
qualitative risk involved due to the lack of the information.
The returns here the expected which carry a probability that the returns expected will
there or not. So here according to the risk appetite of the investor we take the probability
from the bell shaped symmetric curve and calculate the final price to somewhere around

Ui + beta.
Here Ui is the mean of the returns from the past records before becoming public.

After taking the probability we can take the value of the expected return in the long term
and the coefficient of all the deviation because of different factors discussed in the study
above.

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 Performance of IPO

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