INVESTMENTS IN IPOS IN THE INDIAN CAPITAL MARKET

Arwah Arjun Madan

Lecturer, St. Miras College for Girls, Pune Research Scholar, NIA, Pune

The existence of the phenomenon of underpricing is a well-established fact for the common stock initial public offerings (IPOs). Research concerning the primary capital market is found to be unequivocal in its conclusion that initial public offerings are offered at a discount. It has been found that an average firm goes public with an offer price that is lower than the price that prevails in the immediate aftermarket. As a result, IPOs register significant excess returns on the first day of trading. Underpricing is a phenomenon that is largely restricted to the opening transaction. And hence, the underpricing is almost entirely corrected by the market at the opening transaction. A worldwide survey of literature on the phenomenon of Underpricing of IPOs exhibit three fundamental characteristics: (a) the initial price reaction phenomenon or in other words underpricing: the immediate after market price, on average is significantly higher than price at which the initial offer was made; (b) the Hot Issue Phenomenon: there are distinct cycles outlined, both in the number of issues that come to the market and the level of initial price reactions; (c) the long-run Underperformance phenomenon: initial offers are said to perform dismally in the long-run compared to the industry counterparts for the same period.

Extent of Underpricing: International Evidence

Country Australia Germany UK USA Malaysia Singapore Source: Aggarwal R, Leal R, & Leonardo H (1993) "The After Market Performance of Initial Public Offerings in Latin America" Financial Management, Spring PP 42-53 Period 1966-78 1977-87 1980-88 1975-84 1978-83 1978-83 Sample Size 93 97 712 1526 21 39 Performance(%) 29.2 21.5 14.3 14.3 166.7 39.4

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Studies on the Indian capital market also confirm the phenomenon of underpricing of IPOs. Most of the Studies on the Indian primary market concerning the phenomenon of underpricing are found to be in the post-liberalisation period i.e. after the abolition of the CCI. The initial excess return on IPOs in the Indian primary capital market are very high as compared to the experience of the capital markets of countries abroad.

Phenomenon of Underpricing: Indian Scene

Studies Narasimhan & Ramana (1995) S Uma (1995) Madhusoodon & Thiripalraju (1997) Baral & Obaidullah(1998) Ajay Shah (1995) Period 1993-94 1991-93 1992-95 1994-95 1991-95 Sample Size 103 495 1922 433 2056 Performance(%) 92.16* 80.79** 127.11 75.21 48.23* 85.75** 153.173 105.6

From Various Sources (See the references at the end)

Significant Developments in IPO Markets

The world financial markets (USA & UK) have come a long way. In the US markets, the IPO market has grown manifold in number and volume. The NYSE and the AMEX did not allow for transactions in equity securities of small companies. Smaller companies, that naturally imply smaller trading volumes, led to the development of a separate market to foster dealing of securities of these companies. The NASD, therefore, established the market for securities in the year 1971. There was demand for capital from the high growth-high risk medium sized companies. The expansion of the market for IPOs indicates that this expectation has, by and large, been fulfilled. In the UK capital market, the Big Bang (1985) constituted a fundamental revolution for the LSE. Post Big Bang, the daily turnover in equities almost doubled in value and in volume of transactions; the average rates of commission came down for almost all clients, particularly for institutional investors; though, for small deals, the small investor lost out. The Big Bang brought about fundamental changes on the securities market, changing every aspect of the market: the participants, the transactions, the competition factor and of course, the gains. The initiation of the process of reform in India also would not have been possible without changes in the regulatory framework. The New Economic policy (1991) led to a major change in the regulatory framework of the capital market in India. The Capital Issues (Control) Act 1947 was repealed and the Office of the Controller of Capital Issues (CCI)

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was abolished. The Securities and Exchange Board of India (SEBI), established in 1988 and armed with statutory powers in 1992, came to be established as the regulatory body with the necessary authority and powers to regulate and reform the capital market. The Controller of Capital Issues (CCI) has been the regulatory body for the Indian capital market for over fifty years. The CCI has had a strong control over the Indian capital market as a regulatory authority. Guidelines for issue of capital and pricing of securities has been rigid. SEBI came to be recognized as a regulatory body for the capital market after the abolition of the CCI. The control on pricing of capital issue has been abolished and easy access is provided to the capital market. The objectives of the SEBI are: (i) to protect the interest of the investors (ii) to promote and develop the capital market and (iii) to regulate the securities market. SEBI is set up on the lines of the SEC in the US and the SIB in the UK. The SEBI has taken over all the functions of the Office of the Controller of Capital Issues. This paper aims (1) To look at the behaviour of IPOs in the primary capital market in the pre and post Liberalization Era: (a) extent of underpricing during the CCI & SEBI times and (b) the influence on returns considering various factors such as Issue Size, Age, Foreign Equity, Issue Rating, and Issued Capital. (2) To assess the long-run performance of IPOs for a period of five years after listing & Performance of IPO vis--vis Stock Index & Industry Index. Phenomenon of Underpricing. A sample of 1597 companies having made an Initial Public Offer (IPOs) during 1989 to 1995 and listed at the Bombay Stock Exchange form the data set for the analysis. Out of the 1597 IPOs offered and listed for the period 19891995 considered here, 72 issues were fairly priced (zero returns on listing); 157 were overpriced (negative returns on listing) and a total of 1368 were under priced (positive returns on listing). Considering the Net Return (Em), 1268 out of the total 1597 IPOs registered positive return on the stock index whereas 259 IPOs registered negative returns. Initial returns on IPOs are found on an average to be quite high. Return on listing for the total sample (1597) is found to be 94%. Return on listing for the trimmed sample (2% of the highest and lowest observations) falls down to 81%. This is an attempt to limit the sensitivity of the extreme observations.

Performance Year-wise (1989-1995): a return on listing, as high as 287%, is registered for year 1991 and as low as 26.6% for the year 1995. Year 1992 and 1991 show higher returns on listing at 112.9% and 104.7%. For the years 1993, 1989 and 1994, the return on listing are 98.4%, 89.66% and 88.1% respectively, much on par with the one registered for the overall sample of 94%. For the years 1989, 1990, 1991, 1993 and 1994, the return on listing and issue price are found to be statistically independent. For the years 1992 and 1995, the relation between return on listing and issue price is found to be statistically significant (.05 level).

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Par v/s Premium Issues: Issues at par are seen to perform better than issues at premium. Return on listing is as high as 105% for issues at par as against 60.32% for premium issues. Issues at par outperform (Z-test) the issues offered at premium. The results are found to be statistically significant (.01level). Behaviour of IPOs in the pre and post Liberalization era The overall sample comprises of 187 IPOs for the period April 1989- April 1992 (CCI period) & 1410 IPOs for the period April 1992 to April 1995 (SEBI period). There is a significant fall in the initial excess return registered by IPOs during the CCI times and the SEBI regime now. IPOs during the CCI period registered a very high return on listing 202% as against 80.53% during the SEBI period. The level of underpricing has been very high during CCI times in comparison to the SEBI regime. The result is found to be statistically significant (.01 level).

Behaviour of IPOs
Issue Price: A negative relationship exists between return on listing and the issue price i.e. lower the issue price higher is the return accrued. The relationship is found to be statistically significant (0.01level). R2 is found to be low. Issue price is one of the factors to influence return, but it is not the only factor. Issue Size: There is a negative relation that exists between return on listing and the issue size. However, the relationship is found to be statistically significant at 10% level. Return is found to be higher in case of small-size issues in comparison to large-size issues. There is a gradual fall in the initial return on listing across issue-size. Initial return on listing is as high as 226.1% for issue-size of less than 1 crore and as low as 36.4% for issue-size more than 50 crores. Age of the Company: There is a negative relation that exists between return on listing and the age of the company at the time of issue. The relationship is found to be statistically significant (0.01 level). In both the cases: return on listing and daily return, a chi-square test indicates of a strong influence of age on the initial returns. The results are found to be significant (0.01 level). Foreign Equity: A positive relation is established between return on listing and the foreign equity holding present in the total equity of the company. The relationship is found to be statistically significant (0.03 level). Return are found to be higher for the companies with foreign equity holding of 26% & above; and very low in case of the companies with foreign equity holding of below 26%. Issue Rating: There is a positive relation that exists between return on listing and the issue rating for the said initial public offer made by the company. The relationship is found to be statistically significant (0.01 level). The issue rating assigned to the IPO is

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found to significantly influence the initial return on the IPO. A high rating assigned to the initial public offer is found to be significantly influence the return on listing. Issued Capital: There is a negative relation that exists between return on listing and the issued capital of the company at the time of issue. The relationship is found to be statistically insignificant. List Delay: The average time taken for listing is 125 days; almost 68% of the IPOs got listed within this time frame. The minimum time taken for listing is 11 days while the maximum is 888 days. Listing delay and the return on listing exhibit a negative relation; i.e. less the amount of time taken to list at the stock exchange, higher is the initial return. The relationship is found to be statistically significant (0.01 level).

Subsequent events and the long-run Performance of IPOs

Long-Run Performance of IPOs: Return on IPOs decline with the passage of time (long-run). Raw return for a period from listing up to a period of one year after listing remains to be very high. A fall of almost 67% is registered between the two time periods: at listing and two years after listing. The fall in the return on listing is very drastic thereafter. Raw return for the fourth and the fifth year after listing after found to be negative. Daily return for the five-year period also shows a decrease with the passage of time. Daily returns are negative from the second year to the fifth year after listing. Long-Run Performance of IPOs-Par v/s Premium: The issues offered at par continue to outperform the issues at premium in the long run. Issues at par gave significantly high returns in comparison to issues at premium. Daily return is found to be higher for issues offered at par over those offered at premium in all time periods i.e. from listing to the fifth year of listing. The results are found to be highly significant (0.01 level). Long-Run Performance of IPOs- Bonus Offer: Issues with bonus register positive returns for all time periods; while issues without bonus offering register negative returns from the second to the fifth year of listing. One year after listing to the fifth year, those companies who went to make a bonus offer subsequently outperformed the rest. The results (Z-test) are statistically significant (0.01 level). Long-Run Performance of IPOs- Issue Rating: In the long run, IPOs assigned with a higher issue rating at the time of offer continue to perform better in comparison to IPOs with a lower issue rating. The results are found to be significant (at 0.05 level).

Long-Run Performance of IPOs- Issue Size: Return is found to be higher in case of small-size issues in comparison to large-size issues. However, returns do show a gradual fall over the period of time. Daily return is positive across all issue-sizes up to one year of listing; thereafter, daily return turns negative.

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Long-Run Performance of IPOs- Foreign Equity: Foreign equity holding in the company is found to influence the initial return on IPOs. Return falls with the passage of time in case of both the categories: (i) foreign equity upto 26% and (ii) foreign equity above 26%. Return turns negative from the second year after listing to the fifth year. Return is found to be higher for the companies with foreign equity holding of 26% & above and very low in case of companies with foreign equity holding of below 26%. The results (Z-test) are statistically significant (0.01level) Long-Run Performance of IPOs- Return on Stock Index: A positive relation exists between return on listing and return on the stock index. The relationship is found to be statistically significant (0.01 level). Return on the Stock Index also shows a fall as the time period increases. Return on the Stock Index however stands to be positive throughout the period under consideration. Long-Run Performance of IPOs- Return on Industry Index: There is a positive relation that exists between return on listing and return on the industry index. The relationship is found to be statistically significant (0.01 level). Returns across different industries show a fall with the passage of time. Returns are found to be negative for most industries from the second year after listing to the fifth year. Returns on Industry Index also show a fall with time. Return on Industry index is also negative in the second and the third year after listing.

Testing of Hypothesis: Return on IPOs

Factors Issue Price Issue Size Issue Rating Issued Capital Age of the Company Foreign Equity List Delay Long-run performance Bonus Offer Stock Index Industry Index Merchant Banker Other Studies Yes Yes Yes No No Yes Yes 3 yrs No Yes No Yes Relation/Results Negative/significant Negative/significant Positive/significant ----Negative Negative/significant Positive --Positive/significant --Not Significant My Study Yes Yes Yes Yes Yes Yes Yes 5 yrs Yes Yes Yes No Relation/Results Negative/significant Negative/significant Positive/significant Negative/ Insignificant Negative/significant Positive/significant Negative/significant Negative Significant Positive/significant Positive/significant ---

Return on IPOs is found to decline with the passage of time. The study by Madhusoodan & Thiripalraju (1997) analyzed the Indian IPO market and the phenomenon of

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underpricing, considering both, the short as well as the long term (three year after listing) view. The extent of underpricing of IPOs (short-run) in the capital market is reported to be higher than the experiences of other countries. However, in the long run, the study reports high as positive returns by Indian offerings. Another study by Chandra Shekara Rao & Chowdary (1999) also considered the long run (two years after listing) performance of 146 IPOs offered at a premium in the Indian Capital market during 199496. The returns were found to be very high in the short-run, whereas, in the long run, the returns were negative. This study also confirms that in the long run (five-year after listing), there is a drastic fall in the return on IPOs returns; returns are found to be negative from the second to the fifth year of listing. This is in confirmation with studies (Ritter, 1991), (Mario Levis, 1993), (Aggarwal & Rivoli, 1990) on the long-run performance of IPOs abroad. The initial public offerings have under performed in the subsequent years, showing negative returns during the three year to five-year period after issue.

Indian Primary Capital Market-Present Scenario

The year 2002 was to be the year of IPOs once again (Economic Times, May 28, 2002). Some of the high profile companies like Maruti, Tata Consultancy Services, Nalco were to tap the stock market. However, the Primary market is said to be dead at present. IPOs are no more in fashion. The recessionary trend worldwide, the slowdown of the Indian economy, excess liquidity situation for commercial banks, lack of demand for capital from corporates, no quality offerings currently available and so on are various reasons cited for the primary market bearing the desolate look. However, private placements are on a rise. Companies are all set to raise large amount of funds via the private placement route. The financial institutions and commercial banks are found to be catering to this demand. Private placement market has been witnessing the introduction of several debt instruments such as liquid income debentures subordinated bonds, etc. Unlike public or right issues, private placements are cost as well as time effective methods of raising funds. They can be structured to meet the needs of the entrepreneur. At the same time, private placements do not require detailed compliance of formalities as required in public or right issues. The private placement market in India can be called a highly informal market. It has not been covered under the guidelines for disclosure and investor protection as prescribed by SEBI. The secondary market for the privately placed issues is also said to have remained more-or-less illiquid. And hence, the healthy development of private placements market calls for regulatory norms and standards. The market has come to play a major role in mobilizing resources by the corporate sector. However, the recent growth of private placements has brought to fore the issue of regulation. The capital market scam (2001) involving Ketan Parekh bringing down the

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Madhavpura cooperative bank and the more recent gilt market fiasco with the involvement of numerous cooperative banks (Home Trade, CEO, Sanjay Agarwal) has drawn attention to the huge private placement market in India. This could be the next target of unscrupulous companies and financial operators. And the Government of India is waking up to this reality. The overall exposure of banks and FIs is considered to be very high in the unregulated private placement market. This is a cause for concern, for heavy investments have been made in the privately placed securities market by several provident funds, charitable funds along with banks and financial institutions. The Ministry of Finance, Government of India, has made the much-awaited decision to issue guidelines and bring all private placements under the control of SEBI. (The Economic Time June 4, 2002) With the primary market said to be dead and IPOs no longer in fashion, the merchant banker is left with no role to play, as the mainstay has been lead-managing public issues. In the early nineties, many institutions came in a big way to play the role of merchant bankers, especially after the abolition of the CCI. Easy norms and easy entry brought in may small and medium-sized operators. In the Indian context, the perception regarding the role of the merchant bankers has been a confusing one. Pure issue management and underwriting of issues is construed as the role of the merchant banker. Investment banking is not just issue management and underwriting; it is taking care of every financial need of the client. Merchant banking can be said to be in a primitive stage in India. There is a need for depth and sophistication in the manner in which the merchant banking business is carried out in India. The change in the regulatory environment has created new avenues for raising capital. Private placements are also on the rise. The merchant-banking scene is changing. The merchant bankers still in business and wanting to continue the same should tune themselves in providing an array of services-debt, commercial borrowings, GDRs, private placement of debt as well as equity, mergers and acquisitions, project appraisals, advisory services, loan syndication, etc. There is a need for ideas, innovation, initiative and creativity for keeping with the changing times and competition. Merchant banking began as an add-on activity at a non-banking finance or a manufacturing company. It is now important to look at merchant banking as service-based business.

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References 1. Aggarwal R, Leal R, & Leonardo H (1993) The After Market Performance of Initial Public Offerings in Latin America Financial Management, Spring PP 42-53 2. Allen Franklin & Faulhaber G.R. (1989) Signalling by Underpricing in the IPO Market Journal of Financial Economics, 23, 303-323 3. Baral Susant Kumar & Obaidullah Mohmmed (1998) Short-run Price Behaviour of IPOs in India: Some Empirical Findings UTI Institute of Capital Markets
4. Barua S K & Raghunathan V & Varma J R (1994) Research on the Indian Capital Market: A Review Vikalpa, Vol. 19, No.1, Jan-Mar 5. Barua S K & Raghunathan V (1986) Inefficiency of the Indian Capital Market Vikalpa, Vol 11, No.3, Jul-Sept. 6. Barua S K & Raghunathan V (1987) Inefficiency and Speculation in the Indian Capital Market Vol 12, No. 3, Jul-Sept. 7. Gupta Ramesh (1987) Is the Indian Capital Market Inefficient or excessively Speculative Vikalpa, Vol. 12, No.2, Apr-Jun 8. Gujarathi M (1987) Do Equity Issues fetch extranormal return? Vikalpa, Vol. 12, No. 4, Oct-Dec. 9. Madhusoodanan T.P (ed.) (1998) Indian Capital Markets: Theories & Empirical Evidence UTI Institute of Capital Market 10. Madhusoodanan T.P & Thiripalraju M. (1997) Underpricing in Initial Public Offerings: The Indian Experience Vikalpa, Vol. 22, No.4, Oct-Dec 11. Narasimhan M.S. & Ramana L.V. (1995) Pricing of Initial Public Offerings: Indian Experience with Equity Issues The ICFAI Journal of Applied Finance, Vol.1, No.1,Jan

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12. Shah Ajay (1995) The Indian IPO Market: Empirical Facts Centre for Monitoring Indian Economy 13. Uma S. (1995) Study of Equity Issues in the Primary Market National Insurance Academy, Pune

Newspaper Articles 1. Barua Samir K (2001) Stock market crisis and the need for regulatory reforms Economic Times, April 25 2. Bhat U. R (2001) The Index Constraint Economic Times, Jan 15 3. Bhat U. R (2001) Who needs IPOs? Economic Times, July 9 4. Ghosh Sugata (2001) Financial Regulation: the more the merrier Economic Times, Aug. 1 5. Gupta L C (2001) Why stock market crises recur in India Economic Times, March 14 6. Gupta L C (2001) The missing part of Indian stock market refirms Economic Times, April 24 7. Gupta L C (2001) Dont prevent speculation; dont encourage speculation Economic Times, May 5 8. Mehrotra Anuj (2001) Investing in IPOs Economic Times, July 2 9. Mythili Bhusnurmath (2001) Unexpected respite for finanicial sector regulators Economic Times, March 19 10. Pani Narendar (2001) Treating the symptom Economic Times, Jul 20 11. Pani Narendar (2001) Smallcap market Economic Times, May 16 12. Rao S. L (2001) Boost investor confidence to shore up savings Economic Times, Apr 9 13. Sachs Jeffery D (2001) When capital markets fail Economic Times, Sept. 7 14. Sharma Ruchir (2001) Nothing Local about it Economic Times, Dec 11 15. Stiglitz Joseph (2001) Info-asymmetry & policy Economic Times, Dec 7

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16. Verma Deeksha (2000) Is this after all a saga of failed promises? Economic Times, Oct 20 17. Vijay P N (2000) Small investor friendly steps on anvil Hindustan Times, Dec 18 18. Vittal N (2001) JPC can catalyse reforms Economic Times. Aug 11 19. The Economist (2001) The Financial Services Authority: Too big for its suits? Economic Times, Nov 2

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