Section-I: Introduction

An Initial public offering (IPO) is the first issue of shares by a company to the general
public. IPOs have been an important source of corporate financing for a long time. The
IPO market provides an important infrastructure for the growth of new and emerging
companies by providing them an opportunity to raise necessary capital for future growth.
The investors also consider IPOs an attractive investment alternative as these are believed
to generate relatively higher returns in lesser time. Nevertheless, these new issues may
not be good investments in the long-run. Three empirical anomalies in the initial public
offerings market have been identified and duly tested by the financial economists across
world, these are IPO underpricing (i.e. positive excess returns in the short-run); strong
concentration of issue activity in certain periods (hot issue phenomenon); and
underperformance of IPOs in the long-run.

Over the past few decades, empirical studies have ubiquitously reported the frequent
incidence of high positive average returns of IPOs on the first day of trading. However,
such gains from early price appreciation have not been found to sustain in the long-run.
The after-market long-run price behaviour of IPOs has generated considerable interest
among the researchers, investors and the practitioners the world over. The incidence of
underperformance of IPOs is inconsistent with stock-market efficiency, which states that
two portfolios with same risk shall receive same returns. Moreover, the abnormal
performance of stocks after firm-specific events should be neutral, once the event-related
activities have been fully completed (Stehle et. al. (2000)).

For analyzing the long-run performance of IPOs, greater focus had been on stock price
performance with a few exceptions like Jain and Kini (1994), Loughran and Ritter
(1997), Mikkelson, et. al. (1997) and Teoh, et. al. (1998) who investigated the firms’
operating performance subsequent to issue. It would be interesting to analyze whether the
stock returns of issuing firms reflect their operating performance since the stock returns

1
have a direct implication on investors’ wealth. Furthermore, stock returns have been
found to be incapable of explaining the long-run underperformance. Various studies
documented a decline in the post-IPO operating performance of firms in various
countries. Jain and Kini (1994), Loughran and Ritter (1997), Mikkelson, et. al. (1997)
and Teoh, et. al. (1998) document long-run decline in companies’ post-IPO operating
performance for the USA, while Pagano et. al. (1998) for Italy and Cai and Wei (1997)
and Kutsuna, et. al. (2002) for Japan document such decline in operating performance for
issuing companies.

The IPOs have been found to underperform over the long-run as documented by Ritter
(1991) and this is confirmed by various studies in and outside US. Literature proposes an
array of hypotheses elucidating the post-issue underperformance: windows of opportunity
(managers time the offer when the stock market is overconfident or when the company is
performing well), window dressing (earnings management prior to the IPO), change of
ownership (agency problems), divergence of opinion (divergent expectations among
investors contribute to short term overreaction and long run underperformance) and over-
optimism (investors make over-optimistic valuations of issuers’ performance which does
not sustain in the long-run),.

1. Windows of Opportunity and Market Timing Hypothesis:

Ritter (1991) and Loughran and Ritter (1997) suggest that underperformance in the long-
run is the result of windows of opportunity or market timing hypothesis, according to
which managers select the timing that market overvalues their stock to issue new equity,
in order to take advantage of favourable market conditions to lower the cost of capital.
Thus, larger number of issues will be floated when market conditions are good and
possibly some issues may get overvalued resulting in underperformance in the long run
when these issues get correctly valued.

2. Window Dressing (Earnings Management) Hypothesis:

2
Underperformance of IPOs in the aftermarket period can also be attributed to the
management of discretionary accruals by the IPO firms prior to the offer. IPO firms
exhibit unusually good operating performance (strong fundamentals) prior to the IPO by
resorting to the practice of earnings management, thereby leading the investors to believe
in optimistic future prospects of the firm. In the long-run underperformance is caused
with revaluation of firm to its original value.1

3. Change of Ownership:

Divergence of interest between managers and shareholders also causes firms to

underperform in the long-run (Jensen (1986) and McLaughlin et. al. (1996)). Principal-
agent problems arise after a company becomes a public company (Jensen and Meckling
(1976)). There is an increase in the agency cost as the conflict between the managers and
the shareholders becomes worse because of decline in the entrepreneurs’ ownership and
dispersal of ownership subsequent to the IPOs.

4. Divergence of Opinion:

Underperformance of IPOs in the long-run can also be due to divergence of opinion about
the value of firm at the time of IPO, which further declines with time (Miller (1977)). If
there is a great deal of uncertainty about the value of IPO the valuations of optimistic
investors will be much higher than those of pessimistic investors (Ritter (1997)). Greater
divergence of opinion exists for a company which is new as there is greater uncertainty
about its future, however the divergence of opinion reduces as the company develops an
operating history (as it becomes easier to forecast its future earnings and dividends).

1
Teoh et. al. (1998) find that issuers with very high accruals in the IPO year, experience poor stock
performance in the three years following the issue.

3
5. Impresario Hypothesis:

Overvaluation of IPOs by investors (or the presence of fads) in the early aftermarket
trading is also a possible cause of underperformance in the long-run (Aggarwal and
Rivoli (1990) and Ritter (1991)). Due to overoptimism, investors overreact to the signals
leading to high initial returns, but with release of public information, a price reversal is
expected in the long-run. In other words, the overreaction or fads hypothesis argues that
IPOs may be correctly priced but investors overvalue the new issues in the early
aftermarket. Therefore, under the assumption of efficient markets, the price of IPOs
should reach their equilibrium price leading to a negative correlation between initial
returns and long-term performance of IPOs (Shiller (1990)). Hansen and Crutchley
(1990), Jain and Kini (1994), Loughran and Ritter (1997) and Brav et. al. (2000) provide
evidence in support of role of investor overoptimism in explaining the long-run
underperformance.

The empirical evidence posits that the performance of IPO firms deteriorates over the
long-run. All the hypotheses pertaining to performance of IPOs have been formulated
and tested primarily in developed markets. Consequently, it is warranted to test the
applicability of these hypotheses in an emerging market like India. Despite the
importance for policy-makers, portfolio managers, shareholders and corporate managers,
no conclusive evidence exists on the long-run performance of IPOs in India. This study
aims to extend the IPOs literature on emerging markets geographically by investigating
the long run operating and share price performance of Indian IPOs.

Section-II: Review of Literature

Review of literature constitutes an important section in any research study, which

provides a critical overview of various dimensions of any subject, which have been
explored over different time frames and it helps us to identify the gaps in the literature,
which motivates for further research in the area so that such gaps in literature can be

4
 plugged. The following discussion is an attempt to provide an overview regarding
different dimensions of long-run performance of IPOs that have been critically examined
both in national as well as international context. On the basis of this critical review of
literature the objectives of current study will be decided. Literature review is organized in
two parts. Part A reviews different studies that examined the post-issue share price
performance of IPO stocks and Part B discusses the studies conducted to examine the
post-issue operating performance of IPO firms.

Part A: The Post-Issue Share Price Performance of IPOs

The academicians and practitioners across the world have documented the incidence of
underperformance of stocks of issuing firms in the aftermarket period. Underperformance
is where the difference between the long-run return of the new public company has a
lower performance than the benchmark. Following the findings of Ritter (1991), studies
in several countries have confirmed underperformance of IPOs in the years subsequent to
issue. As can be observed from Table 1 which summarizes some of the prior works that
have analysed the long-run performance of IPOs and their results, the low long-run
returns of IPOs is not a phenomenon unique to the United States, but is also applicable to
countries such as Australia, Canada, Chile, Great Britain, Japan, Mexico, etc., though the
magnitude of such underperformance varies across these countries. On the contrary, IPOs
in Korea and Sweden have been found to outperform the benchmarks in the long-run. In
case of India however, both underperformance and over-performance has been reported
in the long run.

Table 1: International Evidence of Long-Run Performance of IPOs

Window
Sample Return
Country Author(s) Period (No. of
Size (%)
Years)
Australia Lee, Taylor and Walter (1994) 1976-89 266 3 -46.5
Brazil Aggarwal, Leal and Hernandez (1993) 1980-90 62 3 -47.0
Canada Kooli and Suret (2003) 1991-98 445 3 -16.86

5
Canada Jog (1997) 1971-92 130 3 -35.15
Chile Aggarwal, Leal and Hernandez (1993) 1982-90 28 3 -23.7
Finland Keloharju (1993) 1984-89 79 3 -21.1
Germany Uhlir (1988) 1977-87 97 1 -7.4
Germany Ljungqvist (1997) 1970-90 145 3 -12.1
Hong Kong McGuinness (1993) 1980-90 72 3 -18.3
India Madhusoodan and Thiripalraju (1997) 1992-95 1922 3 16.3
India Pandey (2004) 1999-02 84 2 -.85
India Singh and Mittal (2005) 1992-96 500 3 -65.5
Japan Cai and Wei (1997) 1971-90 172 3 -27.0
Korea Kim, Krinsky and Lee (1995) 1985-88 99 3 91.6
New Zealand Firth (1997) 1979-87 143 3 -10.00
Singapore Hin and Mahmood (1993) 1976-84 45 3 -9.2
Sweden Loughran, Ritter and Rydqvist (1994) 1980-90 162 3 1.2
Switzerland Kunz and Aggarwal (1994) 1983-89 42 3 -6.1
Tunisia Naceur and Ghanem (2001) 1990-99 40 3 -21.74
U.K. Levis (1993) 1980-88 712 3 -8.1
U.S. Loughran (1993) 1967-87 3656 6 -33.3
U.S. Loughran and Ritter (1995) 1970-90 4753 5 -20.0
U.S. Ritter (1991) 1975-84 1526 3 -29.1
Source: Compiled from various studies.

Ibbotson (1975) reported a negative relation between initial returns at the offering and
long-term share price performance. He found that the average returns for one month
holding periods were positive in the first year after the IPO; however returns turned
negative during the following three years, and again became positive in the fifth year.
The distribution of returns was found to be highly skewed (most returns negative, but a
few very high), indicating that these investments were individually very risky.

Aggarwal and Rivoli (1990) attributed underperformance to a temporary overvaluation of

the IPO firm at the offering date, the so-called ‘fads’ theory. The value of the new shares
got downwardly adjusted when the over optimism disappeared. Ritter (1991) had further
advanced the fads theory and showed that IPO firms with a high risk profile (i.e. younger,
smaller and active in certain sectors) were sooner subject to shareholder sentiment; the so
called fads of the stock market.

6
Ritter (1991) analyzed 1526 IPOs in the US offered during 1967-87. He documented that
newly listed companies substantially underperformed a set of seasoned firms matched by
size and industry in stock returns for the first three years subsequent to listing. He was the
first to document the long-run underperformance anomaly in IPO literature. Following
Ritter (1991), Loughran (1993) examined the returns from 3,556 IPOs during 1967-1987
and found an average six year total return of 17.29% compared with 76.23% for the
NASDAQ index during an identical period. The results were however worse than those
of Ritter for his three year tests.

Loughran and Ritter (1995) examined the stock returns of 4,753 initial public offerings
and 3,702 seasoned equity offerings offered during 1970 to 1990. They reported that the
3 and 5 year buy-and-hold returns for IPOs in the post-issue period were 26.9% and
50.7% less than size-matched non-issuing firm respectively. Consistent with Loughran
and Ritter (1995), Spiess and Affleck-Graves (1995) also reported that seasoned issuers
underperform their industry peers matched by size. Servaes and Rajan (1997) examined
initial public offerings from 1975-1987 and found a five year raw return of 24%. This
represented a 47% underperformance when compared against NYSE/AMEX index, a
17% underperformance against the smallest decile from the NYSE/AMEX, and a 41%
underperformance against firms matched by size and industry.

The underperformance phenomenon is not limited to the United States only. In the UK,
Levis (1993) examined the long-run performance of a sample of 712 UK IPOs issued
during 1980-88. He reported that underperformance varied between 8.3% and 23.0%,
depending on the benchmark chosen. Aggarwal, Leal, and Hernandez (1993) reported
three-year market-adjusted returns of -47.0%, -19.6% and -23.7% for Brazil, Mexico, and
Chile, respectively. Kunz and Aggarwal (1994) examined 42 Swiss IPOs between 1983
and 1989 and reported underperformance to the extent of 6.1%. Keloharju (1993) found
that the average Finnish IPO lost 22.4% from the first market trading to subsequent three
years, in comparison to 1.6% average decline for the market index. Underperformance of
IPOs was also confirmed in Australia. Lee, Taylor and Walter (1996) analyzed both

7
initial under-pricing and post-listing returns for Australian new issues. The results
showed that Australian new issues significantly under-performed market movements in
the three-year period subsequent to listing.

The exception to the globally observed underperformance was reported by Kim, Krinsky
and Lee (1995), who investigated Korean initial public offerings (IPOs). They analysed
169 firms listed on the Korean Stock Exchange during 1985-1989. Unlike previous
international evidence, their results revealed that the Korean IPOs outperform seasoned
firms with similar characteristics. For Malaysia, Paudyal et al. (1998) found that the
performance of IPOs is not different from that of the market portfolio.

The empirical studies on Indian IPO markets primarily focused on the initial returns.
Unlike the underpricing issue, the long-run performance of IPOs in India is less explored
and has so far mixed results have been depicted. Madhusoodan et al. (1997) documented
a positive return of 16.33% for 1922 IPOs after three years from issue. Pandey (2004)
analysed 84 fixed priced and book build Indian IPOs from 1999 to 2002 for a period of
500 trading days. It was found that fixed price IT IPOs performed the worst and all types
of IPOs, on an average underperformed till about two years subsequent to listing.
However, Singh and Mittal (2005) analysed the long-run performance of 500 Indian IPOs
offered during 1992 to 1996 up to three years. The Indian IPOs earned excess returns up
to six months from the date of listing and thereafter the returns declined sharply, though
remained positive at the end of first year. However, the investors who held their
investments for a period of 2-3 year experienced negative returns.

Part B: The Post-Issue Operating Performance of IPO Firms

Corresponding to the stock underperformance, operating performance has been found to

decline in the years after issue. Extant literature on IPOs documents the existence of
underpricing and subsequent underperformance of issuing firms. The reasons for the
underperformance of IPO firms in the long-run are less explored. In this context, Jain and

8
Kini (1994) reported a significant decline in the operating performance of IPO firms
subsequent to the offering. Loughran and Ritter (1997), Mikkelson et al. (1997) and Cai
and Wei (1998) corroborated the evidence provided by Jain and Kini (1994) that decline
in operating performance of issuing firms is in line with their stock underperformance in
the long run. Rangan (1998) and Teoh et al. (1998) attributed such underperformance to
the practices of earnings management prior to a seasoned equity offering.

Hansen and Crutchley (1990) reported that the operating returns of issuing firms
experience substantial decline in the years subsequent to the issue, whereas the capital
expenditures have been found to rise substantially. Moreover, they found that the size of
decline in operating returns had a positive correlation with the size of the issue. They
argued that managers expect the operating underperformance and thus time their issues to
raise new capital.

Jain and Kini (1994) reported the decline in post-issue operating performance of IPO
firms as compared to their pre-issue levels They examined 682 U.S. IPOs from 1976 to
1988 and observed that the median changes in industry-adjusted operating return on
assets are -2.98%, -6.24%, -8.12%, and -6.81% (all are significantly different from zero
at 1% level) for years 0, +1, +2, and +3 relative to the year prior to that of issue. They
also observed that the median change in asset decreased by 23.44% over four-years from
year -1 to +3, while net sales and capital expenditures grew faster than matched industry
firms. In spite of the high growth in sales and capital expenditure, they reported a decline
in asset turnover which indicates that IPO firms increase their assets faster as compared
to the growth of sales.

McLaughlin, Safieddine and Vasudevan (1996) examined the operating performance of

1,296 seasoned equity offerings listed on the New York Stock Exchange (NYSE),
American Stock Exchange (AMEX), and NASDAQ during the period 1980-1991. They
revealed that SEO firms had a significant increase in operating performance prior to the

9
issue however such firms registered a considerable decline in profitability in the post-
issue period.

Cai and Wei (1997) investigated 180 initial public offerings listed on the Tokyo Stock
Exchange during the period 1971-1992. They reported that Japanese IPO firms
experienced a downward drift in post-offering performance which was confirmed by the
deterioration in operating performance. However, they did not find any significant
difference between the changes in the operating returns of low and high director-
ownership firms, which is against the agency cost hypothesis. Moreover, they
documented that the post-issue deterioration in operating performance cannot be
attributed to the reduced managerial ownership.

Loughran and Ritter (1997) analysed the post-issue operating performance of 1,338
seasoned equity offerings, issued during the period of 1979 to 1989. They reported that
the issuing firms’ profitability as measured by profit margin, return on assets and
operating income to assets ratio, declined significantly subsequent to the issue, compared
with the non-issuing firms (matched by assets size, industry and profitability). They also
found a substantial increase in profitability of the issuing firms prior to the offerings.

Mikkelson, et. al. (1997) examined 283 IPOs from 1980 to 1983 and documented that
median operating income of issuing firms after adjustment for the industry-matched firms
was nine per cent of assets in the year before going public which declined to minus two
per cent of assets by first year after going public. They found that the post-issue operating
performance was not related to the decline of managerial ownership. The ownership stake
of officers and directors declined substantially after the offering but the operating
performance exhibited a substantial decline only in the first year subsequent to the issue.

Teoh, et. al. (1998) examined the post-issue operating performance and earnings
management for a sample of 1,265 seasoned equity offerings of firms listed on Securities

10
Data Corporation from January 1970 to September 1989. They found that the
discretionary current accruals of the seasoned issuers increased significantly prior to the
offering which however decreased to normal levels in the post-issue period. Such
reported increase in accruals in the pre-IPO period and their subsequent decline in the
post-issue could be a result of earnings management.

The finding of Teoh et al. (1998) was confirmed by Rangan (1998). In his study on the
quarterly data of 230 seasoned issuers offered during 1987-1990, Rangan reported that
the discretionary accruals in his sample increased substantially in the four quarters
preceding the offering and then declined significantly in the following eight quarters. He
found evidence of earnings management around the offering date and reported that
earnings management influenced the underperformance and stock returns in the
subsequent years. It implies that market overvalues firms because of increase in
discretionary earnings and due to poor earnings there is a negative reaction of stock
prices.

Chan, et. al. (2003) examined the long run performance of 570 A-share and 39 B-share
IPOs issued in China. After three years from listing, A-share IPOs were found to
underperform their non-IPO benchmarks while B-share IPOs outperformed their non-IPO
benchmarks. They found that the post-issue stock returns for A-share IPOs had a positive
relation with changes in operating return on assets, changes in operating cash flows on
total assets and changes in growth rate of sales. This finding implies that in the long run,
stock price performance exhibits a reflection of a firm’s operating performance.

Kim et. al. (2004) examined the ownership and operating performance of 133 IPOs in
Thailand. They found a decline in operating performance of issuing firms and reported
that the magnitude of decrease in performance after the issue is much greater in Thailand
than in the US. They suggested that a curvilinear relationship exists between post-IPO
managerial ownership and post-IPO operating performance.

11
The literature on the IPO is vast and expanding. The empirical evidence shows that the
IPO firms’ stock return performance and operating performance deteriorates in the
consequent years after going public. Although no unanimous explanations yet exist for
underperformance, literature suggests earnings management, timing of the offer and
agency problems after going public as the major reasons causing such underperformance.
This study aims to extend the IPOs literature on emerging markets geographically by
investigating the share price and operating performances of the Indian IPOs in after-
market period.

Section – III: Need of the Study

There are several strands in the literature about stock offerings, among which the most
controversial one is the stock underperformance in the post-issue period. A vast number
of empirical studies on long-run performance of IPOs in various international markets
document substantial underperformance. Stock market efficiency implies that market
prices correctly express the "true value" of the firm from the first days of listing.
Moreover, offered stock is not expected to offer, during the first weeks, or at least in the
long-run, a return significantly different from the market performance. Yet, the literature
shows that in several markets, particularly in the U.S., the market return of IPOs-backed
stocks is significantly lower than the market portfolio performance.

The purpose of this study is to investigate the long run stock price behaviour of
unseasoned new issues (IPOs) in India. It aims to fill the void by providing evidence on
the long-run share price and operating performance of IPOs in India. It will contribute to
the literature in several aspects. Most research in the literature is focused on developed
market, where regulatory system is well established and sophisticated institutional
investors accounts for the majority. A study on the stock market in India will provide
evidence from a transitional economy with insufficient supervision and a majority of
unsophisticated individual investors.

12
A study on the long-term performance of issuers has practical importance also. Investors
regard tradable shares as lucrative investment due to scarcity of alternative investment
opportunities. It is very confusing that why IPO initial returns are significantly positive
while long-run returns are negative. Typically, if all the investors expect that the long-run
returns of IPO shares will be negative, then no one will invest in IPOs in the initial
markets. Therefore, the long-run underperformance of IPOs is an anomaly that needs
further examination. As compared to underpricing, evidence on the long-run performance
of IPOs in India is limited. There is no conclusive evidence on the determinants of this
phenomenon in India, despite its importance for policy-makers, portfolio managers,
shareholders and corporate managers. This study aims to extend the IPOs literature on
emerging markets geographically by investigating the long run performance of the Indian
IPOs in the post-listing period. As the IPO market is an important channel for resource
allocation, it is important to have definitive results on the positive economics of the IPO
market.

13
Section – IV: Objectives

The overall objective of the study is to examine the long-run performance of Initial
Public Offerings in India. The specific objectives of the study will be:

1. To study the extent and determinants of the subsequent market performance of

Initial Public Offerings in India.
2. To analyze the post-issue operating performance of Initial Public Offerings in
India.
3. To examine the relationship between long-run stock returns and operating
performance of Initial Public Offerings in India.

Section – V: Data Base and Research Methodology

The sample of the study consists of all the companies, which raised capital for the first
time since their inception and have been listed on BSE between June 1992 and March 31,
2002. The study has been restricted to the companies, which raised capital during the
period under study because new regulatory regime became functional from 1992 onwards
with Securities and Exchanges Board of India (SEBI) replacing the Controller of Capital
Issues (CCI).

Data base and research methodology for current study will be as follows:

1. To achieve the first objective, share prices of all IPO firms in the sample will be
collected for a period of five years from their respective date of listing. For
evaluation of long-run stock performance, stock returns over five years will be
calculated and suitable benchmarks like BSE-Sensex, etc., will be applied to
compare the performance. Furthermore, various issue-specific, firm-specific, and
other relevant factors that may affect performance of IPOs in the long-run will be
analysed to find out the determinants of long-run performance of Indian IPOs.

14
 2. To achieve the second objective, data relating to operating performance of the
IPO firms will be collected for five years from the date of the listing of IPO.
3. To achieve the third objective, both the share price and operating performance
data of IPO companies will be used. The long-run stock price performance of
sample firms will be regressed on their operating performance to find out whether
information on changes in operating performance is important in adjusting the
stock prices.

All the IPOs occurring during the sample period will not be included in the sample. Of
the total IPOs, the sample firms will be selected on the basis of the following criteria:

(i) The firm is listed on the Bombay Stock Exchange (BSE);

(ii) The initial public offering is of common stock;
(iii) The initial public offering is from post-SEBI period and offered under free
pricing era;
(iv) The firm has atleast five years trading history from the date of its listing.

For the purpose of collection of data, Capitaline and Capitacharts 2000 databases
(maintained by Capital Markets) will be used. In order to make an analysis of the
collected data, suitable statistical and econometrical techniques will be used. All possible
efforts will be made to use those advanced econometrical techniques, which have been
employed by different researchers in their studies and accepted as most sophisticated and
apposite for the study.

15
Tentative Chapter Scheme

1. Introduction
2. Developments in Indian IPO Market
3. Review of Literature
4. Data Base & Research Methodology
5. The Determinants of Stock-Price Performance of Indian IPOs
6. The Post-issue Operating Performance of IPOs
7. The Relationship Between Post-Issue Stock price and Operating Performance of
IPOs
8. Summary and Conclusions
Bibliography
Appendices

16
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