Underpricing & The Cost of Going Public : The Role of Private Equity Backing in Indonesia Stock Exchange IPOs

Chapter 1 Introduction 1.1 Background

The stock market grants companies to a large pool of capital. In order to do so a company must file for an initial public offering (IPO) which is a very critical component for a company when considering to go public. There are strong evidences that typically stock prices jump on the first day of trading. This is highly linked to a phenomenon in the stock market called underpricing. This underpricing phenomenon is a product of asymmetric information problems concerning initial public offerings. There have been significant amounts of researches concerning this IPO underpricing. Some of the best explanations for this underpricing phenomenon come from asymmetric information-based models. To name a few researches, these are Rocks ( 1986 ) winners curse model, Ritter ( 1984 ) and Beatty and Ritters ( 1986 ) ex-ante uncertainty theory, and the signaling model by Allen and Faulhaber ( 1989 ), Grinblatt and Hwang ( 1989 ) and Welch ( 1989 ). To a more conclusive extent, Barry et. Al ( 1990 ) and Megginson and Weiss ( 1991 ) concluded that a specific way to reduce information asymmetry is to have a Private Equity ( PE ) placement in the companys ownership structure. They also pointed out a considerable evidence from their research which capture the fact that companies which are backed by PE are less underpriced when they go public.

Private equity firms are firms that invest in private companies in form of equity. PE are of our concern due to several reasons. However, for the sake of simplicity it is suffice to say that PE firms have an extensive amount of capital to invest, hence enabling them to have a significant impact on the overall economy. In relation to current trend in Indonesia, existing private equity firms have committed significant and increasing amount of capital for Indonesia. Also, foreign private equity firms are taking interest in landing their reach to Indonesia. Ferretti and Meles ( 2010 ) stated that the debates in underpricing are closely related to wealth loss of pre-existing shareholders and the cost of going public for private firms. When firms typically go public, the issuance of new shares of the firms will dilute the number of shares already outstanding in the firm. Hence, pre-existing investors who do not sell their shares in the IPO will face a dilution in value below the level of underpricing. Barry ( 1989 ) also states that first-day ( on the day of IPO ) returns measure the indirect cost of going public, especially if the number of shares that are still held by pre-existing shareholders is high. Further research done by Habib and Ljungqvist ( 2001 ) and Bradley and Jordan ( 2002 ) explains that high rate of shares retention by pre-existing shareholders will reduce the opportunity cost of issuance ( OCI ) due to fewer shares are being placed at a discounted price. Dolvin and Pyles ( 2006 ) and Dolvin and Jordan ( 2008 ) found that companies backed by Venture Capitalists are negatively related to OCI. This paper is focused solely on Indonesia Stock Exchange. There are very little studies done on underpricing and cost of going public in Indonesia. Also, there are no studies done relating underpricing and cost of going public to PE-backed IPOs. The

Indonesian is of my concern due to two main reasons. First, with financial instability happening currently in more developed countries such like in Europe and North America, Asia region; particularly Indonesia; has become more of interest to global investors. To compound this fact, Indonesia has shown strong economic indicators. According to Ernst & Youngs publication on Private Equity Outlook in Asia, Indonesias consumption accounts for almost 60% of GDP in recent years insulating the economy from global pressures also market capitalization of Indonesia Stock Exchange has more than tripled since January 2009. All these indicate how Indonesia has become an important interest in the global economy map. Second, Indonesia as one of the most recent rapidly growing economy will subsequently attract more private equity investors looking for opportunities to exploit the potential growth of Indonesian economy. As private equity becomes more common progressively in Indonesia in the future, it will become an interest of financial studies and practices. Although it is indisputable that currently the number of PE firms and the transactions done by these firms are very limited in Indonesia, the author believes the prospect and potential impact of PE firms in the future outweighs the restriction that is constituted with current situation. Thus the author believes this research is necessary to certain extent.

1.2 Research Question The problems that are addressed in this research can be structured as listed below : 1. Is the role of PE certification will adjust the underpricing phenomena in Indonesia Stock Exchange IPOs? 2. Does the PE certification role reduce the opportunity cost of issuance ( OCI )?

1.3 Objectives of Research Generally this research has the objective to identify whether private equity firms have significant impact on the companys IPO ( exit strategy of private equity firms ). Specifically the author through this research aims to detect two main issues: 1. To test the role of private equity firms in underpricing and asymmetric information related to IPO in Indonesia. 2. To test whether the role of private equity firms role certification will reduce the opportunity cost of issuance

1.4 Significance of Research The author hopes this research will be informative and provide benefits to various parties as listed below : 1. For entrepreneurs, practitioners, and investors. It is a great hope that this research will provide insight on how entrepreneurs or practitioners should proceed when considering to access capital from private equity firms, especially due to increasing growth of Indonesias economy the probability of growing private equity investments is very likely.

2. For academics. The author hopes this research will provide a fresh insight on a issue that is still uncommon in Indonesia. Hopefully as private equity becomes a common issue in Indonesias financial industry, academics can refer to or build upon this research to seek more insight in related topics in the future.

1.5 Research Restriction Mainly there are two restrictions that are inherent in this research. First is the limited knowledge, time, and experience of the author in relation to the topic of the research. Second and perhaps more concerning restriction is the data sample used in the research. This research is specifically focused to Indonesias economy and Indonesia Stock Exchange and as mentioned before, private equity transaction in Indonesia is still in its infant stage where the number of transactions and IPOs backed by private equity firms are very limited in numbers. It is important to also point out that the total number of IPOs in 2011 is 25 IPOs( which is the largest number of IPO in the last decade). The number of IPOs itself is very limited. There are several private equity firms investing their capital in Indonesia. However amongst these firms, there are only two private equity firms that focus entirely on Indonesia. Not coincidentally, these two private equity firms are the only private equity firms responsible in IPOs that are backed by private equity.

1.6 Systematic of the Study This research is constructed as shown below : Chapter I : Introduction

In this chapter the author elaborates the background of the topic covered in the research, the research questions, the objectives of the research, the significance of the research, and lastly the systematic outline of the research.

Chapter II

Literature Review

This section presents recent literature related to IPO underpricing and the cost of going public to issuers, underlying private equity firms role in reducing underpricing and cost of going public. Also, the author discusses previous literatures of the same topic which the author use as a building ground for this research. Finally the hypothesis of the research is presented in this chapter.

Chapter III

Research Methodology

This chapter provides explanation of the variables used in the research, the sampling method, the model used in the research, and finally the data processing method.

Chapter IV

Empirical Result

The author will explain the results from the regression done in the research using descriptive statistic approach and test the hypothesis of the research with the findings.

Chapter V

Conclusion and Recommendation

In this chapter conclusion is drawn upon and will be elaborated. Furthermore the author will provide recommendations that will be hopeful in conducting further research.

CHAPTER II LITERATURE REVIEW

Related theories and previous literatures that are relevant to the topic of the research will be discussed in this chapter. At the end of the chapter the hypothesis proposed by the author will be given. 2.1 IPO Underpricing IPO underpricing has been extensively reviewed by academics. Many empirical studies find that the phenomenon of IPO underpricing exist significantly both in terms of frequency and the value of the discount. IPO underpricing is generally defined as the spread between the initial public offering price and the closing stock price at the first day of the trading ( Ferretti and Meles 2010 ). Implied in this definition is the fact that this initial public offering price is undervalued from the perspective of the market. In other words, the stock price is valued at discount price. To further understand this underpricing phenomenon it is crucial to look for reasons that lead firms to go public at a discount price. There have been man empirical studies in explaining these reasons.

2.2 Conflict of Interest Baron and Holmstorm ( 1980 ) and Baron ( 1982 ) on their research present underpricing model where the issuers delegate the stock price valuation to underwriters. These underwriters use their knowledge of the market and demand of investors to purposely undervalue the price of the issuers stocks. The underwriters do this to save some marketing costs ( cheap stock price will sell itself ) and favor their customers. Inherently

this is a problem of conflict of interest where the underwriters are not acting upon the good of the issuers. They are acting based on their own interests.

2.3 Asymmetric Information Another research done by Rock ( 1986 ) approach underpricing from the perspective of asymmetric information. He argued that there are informed and uninformed investors. Informed investors will invest only based on the information they have and predict that the equilibrium price will be higher than the offering price. Investors of the latter kind may subscribe to every stock IPO due to their lack of information. Often times the asymmetric information are related to the information available only to insiders ( management ) and investors.

2.4 Signaling Theory Allen and Faulhaber ( 1989 ), Grinblatt and Hwang ( 1989 ), and Welch ( 1989 ) argue that underpricing comes from signaling of the issuers ( signaling theory ). Signaling theory assumes that only great companies can sustain the upfront cost of the underpricing signal from subsequent issues. One of the signals the issuers can give out to investors is the share retention rate. High share retention rate means the owner still owns a large amount of shares of the company implying that the owners are not willing to let go large amount of their ownership due to profitable potential of the company.

So far, there are three perspectives to explaining why underpricing occurs. Amongst these three, the most influential perspective is the asymmetric information. Academics

view asymmetric information between investors and managers of the company as a moral hazard issue. If moral hazard creates the problem of underpricing then theoretically the discount inherent in underpricing can be reduced by having a PE firm in the ownership structure. This is due to the fact that PE firm tries to eliminate the discount price. By eliminating the discount price, they will gain more return on their initial investments in the company. Thats why research done by Barry et. Al ( 1990 ) and Megginson and Weiss ( 1991 ) both indicates that PE-backed companies have lower first-day returns compared to non PE-backed companies. However Barry concludes that this is due to the fact PE firms when first determining what companies to invest screen only for better companies relative to non PE-backed companies. Hence, when the company goes public the market realizes this value and lowers the price discount. While Megginson and Weiss ( 1991 ) concludes the certification role of PE lowers the underpricing effect. There have been several studies that derive into further what role certification these PE firms hold. Many studies relate this role certification based on the PE firms quality reputation, the age of the PE firms, the relation of the PE firms with banks, etc. However since in Indonesia the PE firms are very limited, the role that is discussed in here is merely that existence of the PE firms ownership in the company. Ferretti and Meles ( 2010 ) argues that if PE-backed IPOs should face lower losses due to underpricing effect, thus these IPOs will have a lower retention rate and a higher proportion of shares sold in the IPO.

2.5 Opportunity Cost of Issuance Dolvin and Jordan ( 2008 ) quantifies OCI as the money left on the table from preexisting shareholder wealth . They find that in the US PE-backed IPOs have lower OCI due to the effect of role certification.

2.6 Research Hypothesis Mainly the research is trying to find the relation of the PE-backed IPOs with underpricing phenomenon. There are two hypothesis that will be tested in this research : Hypothesis 1 : PE-backed IPOs will have lower effect of underpricing Hypothesis 2 : PE-backed IPOs will have lower opportunity cost of issuance.

CHAPTER III RESEARCH METHODOLOGY

3.1 Sample The sample necessary to conduct this research comes from the Indonesia Stock Exchange. We take the total number of PE-backed IPOs in the Indonesia Stock Exchange since 2008 - 2011. We specifically chose 2008 as starting year due to the fact that 2008 was the year in which the first ever PE-backed IPO occurred in Indonesia. Departing upon this, five IPOs are the only IPOs in which private equity is part of the ownership since 2008. Also, the number of IPOs that are not backed by PE firms from 2008 - 2011 is necessary in this research since we want to detect and compare the severity of underpricing effect. 3.2 Research Data The data that we compile as an input for this research comes absolutely from the Indonesia Stock Exchange. Since this research covers underpricing phenomenon and the opportunity cost of issuance, below are the data inputs to be used in the research : 1. Opening and closing price of first year listing of PE-backed stocks and non PE-backed stocks. 2. The offering price of PE-backed stocks and non PE-backed stocks 3. Market index return. 4. Beta of the stocks 5. Prospectus of IPOs

3.2 Theoritical Model 3.2.1 Measuring IPO Underpricing :

Variables : 1. Pi,1 2. Pi,0 3. Ii,0 4. Ii,1 = Closing price of company at the end of first trading day = Offering price of company = Market index on offering beginning = Market index on first day of trading.

3.2.2 Measuring OCI We follow the Dolvin and Jordan ( 2008 ) measurement of OCI by using OCI adjusted for the gross spread

Variables : 1. N0 2. N0,p = Number of shares offered in the IPO = Number of primary shares offered

3. Na 4.

= Number of shares after the offering

= One minus

the gross spread percentage

3.3 Empirical Model The empirical model that we use in this research is shown below :

The variables or determinants in this regression model are: 1. Log_Age 2. Log_Asset 3. Log_Size 4. Share retention 5. Sell 6. Institutional Ratio 7. Market Index 8. Market Volatility 9. SD 4_days 10. D_SPE 11. D_NSPE = the firms age = the firms size = logarithm of total offer size = Proportion of shares kept by Pre-existing shareholders = Fraction of shares sold in IPO represented by secondary shares = Percentage of shares reserved for institutional investors = Market index performance over 100 days before offering = Market volatility over 60 days prior to offering = Standard deviation of stocks up to 4 days since its IPO = Dummy variable of involvement of syndication of PE firms = Dummy variable of involvement of single PE firms

We can see from the variable above that this regression takes into accounts five dimensions. First is firm specific factors. Second, it also takes into account the IPO specific variables. Third, market condition is also considered since it is argued in previous researches that IPO market timing is very crucial. Fourth, we take into account the proxy of risk for the stock by using standard deviation and finally we also take into account the role of private equity firms in the IPO by using dummy variable.

*The base journal used for this proposal is : Underpricing, Wealth Loss, Cost of Going Public : The Role of Private Equity Backing in Italian IPOs by Riccardo Ferretti and Antonio Meles ( 2010 ). References : Ljungqvist, A.P., and W.J. Wilhelm. 2003. IPO pricing in the dot-com bubble. Journal of Finance 58: 72352. Ljungqvist, A.P.. 1999. IPO underpricing, wealth losses and the curious role of venture capitalists in the creation of public companies. Working Paper, Oxford University, CEPR Jensen, M.C., and W.H. Meckling. 1976. The theory of the firm: Managerial behaviour, agency costs and ownership structure. Journal of Financial Economics 3: 30560. Grinblatt, M., and C. Hwang. 1989. Signalling and the underpricing and of new issues. Journal of Finance 24: 1331. Habib, M.A., and A.P. Ljungqvist. 2001. Underpricing and entrepreneurial wealth losses in IPOs: Theory and evidence. Review of Financial Studies 14: 43358. Francis, B.B., and I. Hasan. 2001. The underpricing of venture and nonventure capital IPOs: An empirical investigation. Journal of Financial Services Research 19: 99113. Bradley, D., and B.D. Jordan. 2002. Partial adjustment to public information and IPO underpricing. Journal of Financial and Quantitative Analysis 37: 595616. Barry, C. 1989. Initial public offering underpricing: The issuers view a comment. Journal of Finance 44: 10991103 Baron, D.P., and B. Holmstrom. 1980. The investment banking contract for new issues under asymmetric information: Delegation and the incentive problem. Journal of Finance 35: 111538. Allen, F., and G.R. Faulhaber. 1989. Signalling by underpricing in the IPO market. Journal of Financial Economics 23: 30323. Rock, K. 1986. Why new issues are underpriced. Journal of Financial Economics 15: 187212.