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IPOUNDERPRICING:ALITERATUREREVIEW1

DeepakAgrawal
This paper covers a review of literature regarding IPO underpricing, defined as degree of difference in the closing price of an offer and closing price of listing day of that security on an exchange.Therearevariousfactors,suchasinformationasymmetry,underwritersintentionand reputation, firms characteristics, industry classification, regulatory environment, listing delay, marketing,postIPOownershipstructure,andintentionalunderpricingthatinfluencethelevelof underpricing, discussed in the paper. Apart from this few postIPO implications are presented which are well documented in the literature. In addition, one section is dedicated toward the scenario of Indian primary market, which has unique characteristics of its own to attract researcherstoexaminingtheevidencesabouttheIPOmarket.
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Intheareaoffinancetheconceptofgoingconcernofafirmandprofitabilityareimportanttermsand measuredtotakedecisionaboutanyinvestments.Hencetheobjectiveofanyfirmistosustainthrough its core operations and be profitable for the stakeholders (specifically to shareholders) to grow with time.Abusinessdecisionneedsmoneytoinvest,whichcanbegeneratedvarioussourcesoffundssuch asownerscapital,outsideequity,debt,ormanyotherforms.Apartfromownerscapitalandretained earnings firms usually raise money from outside market through different way such as private placements, venture capitalist, loan, issuing debt or equity. Sometimes traditional sources of finance (owners capital, debt, and retained earnings) are also not sufficient to finance the company due to rapid growth or higher cost. Rock (1986) states that one important motive of the firms behind going public is risk aversion of owners as risk is shared limitedly among distributed owners, and financial backers of publicly listed companies. Thus, in this paper our area of interest is fund raising through issuingequityi.e.InitialPublicOffer(IPO),wherefirmraisesmoneyfromtheoutsidemarketfirsttime throughIPO,atermusedwidelyandwelldocumentedintheliterature.ThemainobjectivesofIPOare to raise funds from the market to invest in a project, promoting a new company, or to expand by diffusingownershipthroughlistingonthestockexchange.Loughranetal(1994)foundthreedifferent mechanisms of such offerings across the countries: auctions, fixed price offers and book building. Sherman(2005)suggestedthatthebookbuildingissuperiormethodthanauctionsforIPOsellingandit is also less risky process as underwriter ensures the participation of minimum numbers of informed investors.
The paper is submitted as the term paper for subject Doctrol Seminar in FinanceI in PhD 200811 (Sem.1) during the course of Management Teacher Program leading to PhD degree at ICFAI Institute for Management Teacher(IIMT)tothefacultyguideDr.NupurPBang.
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DeepakAgrawal(08PFHY504),ResearchScholar,IIMT,Hyderabad(AP)India;a.deepak85@gmail.com

IPOUnderpricing:Aliteraturereview

Electronic copy available at: http://ssrn.com/abstract=1724762

This study reviews the literature regarding IPO underpricing described in next section, factors of IPO underpricing,postIPOimplications,andIndianscenarioofIPOmarket. INTRODUCTION ThetermIPOunderpricingreferstothedifferenceintheclosingofferpriceofasecurity(throughIPO), andtheclosingpriceofthesecurityonfirsttrading(listing)day,incaseiflistingpriceishigher.ThusIPO underpricingisconsideredasshortruninvestmentopportunitybytheinvestors. IPOunderpricingisaninterestingphenomenontostudyintheareaoffinance.Themotivationbehind this study is the observations that there is huge rush of firms towards listing on stock exchange and generatingfundsthroughIPO,largequeueofinvestorswaitingforIPOallotments,growthininvestment banking,anddevelopmentofregulatoryandtechnologicalchangescontinuouslytoeffectivelymonitor themarketandincreasethemarketinterest. A Firm announces the offer to issue equity to the market, termed as IPO, by disclosing necessary information about its background, prior financial performance, objective of raising funds and future prospectsalongwithrisk.Theriskinvolvedintheofferneedstobecompensatedinsomeway.Thisrisk maybeofnonallotmentofsharesduetooversubscriptionormaybeofriskyproject.Itisobservedthat most IPOs are traded on higher price on the listing day, which means that the firm could raise more money by higher offer price which actually they didnt. It shows that investors have different belief aboutthefutureprospectsofthecompanyi.e.thefirmhasvaluedwronglyanddeserveshigherprice.It leadstoincreaseindemandandpriceofthestocksinthesecondarymarket.Thehighertheamountof underpricingisconsideredasthegreaterthemoneythefirmcouldgeneratethroughhigherpriceoffer, and firmshavelostthatmoney.Thisphenomenonisnamedasmoneyleftonthetablebythefirms (PandeandVaidyanathan,2009). Thefirstprocessofgoingpublicisgenerallyfilingadraftprospectustotheregulatorybodyofthecapital market.Onapprovalandacceptanceoflistingagreements,thefirmhastocomplyandgetapprovalwith otherregulatorybodiesoftherespectivecountryandfulfillingregulatoryrequirements.Usuallyafirm hastofiledraft prospectusthroughan investmentbankerwhotake caresof alltheprocessesofIPO, from filing, pricing, marketing to distributing and providing analyst coverage. In the process, the investmentbankerchargestheiradvisingfeeaccordingtodifferenttypesofcontractdiscussedlater.In thestudyitisfoundthatIPOunderpricingisgoodforinvestorsasshortruninvestmentopportunitybut itisacostforissuerasitcouldraisemoremoneyaspremiumontheoffer,whileinvestmentbankeris alwaysoftenonprofitside.

IPOUnderpricing:Aliteraturereview

Electronic copy available at: http://ssrn.com/abstract=1724762

LITERATUREREVIEW TheinterestingphenomenonofIPOunderpricingislimitedtothestudyofliteraturearoundthetopicof IPOunderpricingfrom1970sto2009.Inthepaperthediscussionisrevolvingaroundhowthedifferent factors can influence the level of underpricing. Sherman and Titman (2002) stated that issuers are alwaysinterestedtoraisefundsatleastataccuratepriceofissueifnotmore.Theabilityofunderwriters topriceissueaccuratelyleadstomaintainandacquirehighqualityclients.Almostallstudiesacrossthe countries and time found the evidences of IPO underpricing. Pande and Vaidyanathan (2009) found averageunderpricingof22%onthedayoflistingwhichisdisappearedwithinthenext30days,intheir studyof55firmslistedonNationalStockExchange(hereafterNSE),aleadingstockexchangeinIndia. IPO underpricing is an important event for all investors, issuers, and investment bankers. Our area of interest is to find out the factors which may influence the level of underpricing through studying literature regarding the same. Throughout the study we have found some important factors such as information asymmetry among the investors, firms characteristics, underwriters intention and reputation,industryclassification,regulatoryenvironment,listingdelay,marketing,postIPOownership structure,andintentionalunderpricing.Theunderpricingresultsduetocertainmarketfactorssuchas theinitialuncertaintyofvalueofanIPO,demandforanewIPO,insecuritiesgeneratedduetopotential legalliabilitiesthatareassociatedwiththeissuerandtheunderwriter,andbythesignalingeffectofthe agents(Allietal,1994).Alltheabovefactorsarewelldocumentedintheliteratureandalsosupported by empirical evidences through various studies. In this study these are covered under the different headings. InformationAsymmetry Many investors apply in IPO with the positive expectation of firm valuation. The IPO may be undersubscribed, oversubscribed, or fully subscribed. If the IPO is oversubscribed, then each investor maynotnecessarilyreceiveasmuchsharesastheyhadappliedfor.Theymaygetfewsharesormaynot getevenasingleshare;hencetheywillnotbeabletogainthroughunderpricingbutwillbearariskof blocking his money for a period. Thus, it can be concluded that the investors, who apply for an IPO, suffersfromtwotypesofrisk:a)Riskofrationing,andb)ExanteUncertainty.Formerriskisuncertainty aboutthereceivingsharesintheprocessofallocation,whilelateristheriskofbadissue.Theallocation of shares depends on the number of applications. The number of applications is influenced by informationavailabletothemarket.Iftheofferisattractivetothemarket,measuredascostandbenefit ofbeingthefirstownerthroughofferissue,itmayoversubscribeotherwisenot. Theterminformationasymmetryreferstothedifferenceininformationavailabletovariousinvestorsin the market. Few investors may have additional information about the market or may generate such information through analysis which also carries a cost of information. Often large investors generate such information through the help of experts, which led to information asymmetry. The increase in informationasymmetryleadtotheissueofrationaldecisionbyinformedinvestorsandperceivedless IPOUnderpricing:Aliteraturereview 3

rationaldecisionofuninformedinvestorswhicharelargerthaninformedinrealeconomy.Henceafirm isalsoworriedaboutthisissueandtriestoreduceitthroughdisclosuresandannouncements. LelandandPyle(1977)werethefirstonetosuggestthatinformationasymmetrycanbereducedbythe introduction of financial intermediaries or by observing the postIPO ownership of issuers. In the literature the risk related with the information asymmetry is among the investors. Chemmanur and Fulghieri (1994) also supported that the important role of investment banker is producing more information resulted decrease in information asymmetry as issuers have more information about the futureprospectsofthefirmcomparedtoinvestmentbanker. Rock(1986)arguedthatfirmandunderwritermaybemoreinformedthanindividualinvestorbutallthe investorsinmarketcombinedaremoreinformedthanthem.Althoughunderwriterishavingexpertise alongwithbetterinformationaboutIPOmarket,issuer,butsomeinvestorsmayhaveaccesstoprivate information of competitors that may affect the firm value. Rock (1986) termed the winners curse problem in his study which says that since the informed investors have more information, they apply onlyforgoodissueswithlargeramountandwithdraw(nottoinvest)allmoneyfrombadissues,while retailuninformedinvestorsdonothaveaccesstoanysuchinformation,theyapplyforbothgoodand bad issues only on the basis of information available to whole market. Hence the good issues are oversubscribedasbothinformedanduninformedinvestorsapplyforthoseandduetorelativelysmall investment of uninformed investors, they carry greater risk of rationing (not receiving allotments) compare to informed investors, and at the same time uninformed investors receive all shares of bad issue (generating low return). Hence uninformed investors are not able to take advantage of higher underpricing of good issues, but bear both the risk of rationing and uncertainty. Hence to attract uninformedinvestors,firmshavetocompensatethembyunderpricingIPO.HoweverRock(1986)study islimitedtononavailabilityofsensitiveinformationofallocationfairnessofunderwriterandrationing methodtomeasureunderwritersability. Benveniste and Spindt (1989) suggested a model that the level of underpricing can be reduced, if the differentiationisdonepriortotheallocationofsharesbetweeninformedanduninformedinvestorsby theunderwriter.Saunders(1990)supportedthatunderpricingisacompetitiveoutcomeinIPOmarket resultedfromsmallnumberofinformedandlargenumberofuninformedinvestors.Chemmanur(1993) proposedthattheunderpricingispositivelyrelatedtotheincreaseinthenumberofinvestorsoftheIPO and the cost of information production, while negatively related to the probability of the being high valuefirmandthegrossproceedfromIPO. FirmCharacteristics The level of IPO underpricing is also influenced by the firms background, past performance, existing shareholdingpattern,presentperformance,etc. Reside et al (1994) found the evidence for negative correlation between firms age and level of underpricing, which is attributed to availability of more information of the older firm. In the study of IPOUnderpricing:Aliteraturereview 4

IndianmarketbyShellyandSingh(2008),itisfoundthattheincreaseinfirmageispositivelycorrelated totheoversubscriptionduetohigherconfidenceinfirmprospectsresultinginhigherunderpricing. UnderwritersReputationandIntention Often it is observed that IPO underpricing is used as a mechanism by investment bankers for various purposes along with extraordinary gain. Underpricing may be due to the reputation of underwriter amongtheinvestors.AreputedunderwriterinvolvedinanIPOmayincreasevalueoftheissueresulting inunderpricing. Chemmanur and Fulghieri (1994) suggested that issuers have more information about the future prospectsofthefirmcomparedtoinvestmentbanker.Hencetheimportantroleofinvestmentbankeris producingmoreinformationresulteddecreaseininformationasymmetry.Theyarguedforthekeyissue of measuring the credibility of such information. The role of the investment banker is information producerintheequitymarket,andtheordinaryinvestorstaketheburdenoffixingthemarketvalueof equities. As a common measure of the credibility of the recommendation given by the investment banks,investorslookintothepastperformanceoftheinvestmentbanksandaccordinglysetthevalue oftheequity.Theconsiderationforreputationbuildingofinvestmentbanksplaysanimportantrolein shapingthewayinwhichinvestmentbanksinteractwiththeinvestors.Theempiricalimplicationsthat can be derived from their model are that investment banks, having better reputation, can be more effectiveinresolvingtheinformationalasymmetryintheequitymarket.Thesecondimplicationthatcan bedrawnis that greaterthereputationofinvestmentbank,thelower is thevariableofpossiblefirm values of the firms it markets. Thus the level of information asymmetry again related to the level of underpricing of an IPO. Shelly and Singh (2008) studied the effect of reputation ofunderwriter in the Indianmarketandfoundthatithaspositiveeffectonoversubscriptionresultinginhigherunderpricing. Baron(1982)suggestedthatinvestmentbankerhasmoreinformationabouttheIPOmarketcompareto issuer.Duetothereputationoftheinvestmentbanktheoriginalvalueoftheissuemaygethypedmore thanusualHenceitcanbeinterpretedthattheissuersincentivizetheinvestmentbankersbyallowing him to underprice the issue rather than bearing high monitory cost (optimal delegation). Tinic (1988) found that the Underwriters deliberately underprice IPOs due to the risk of the reputation of underwriterandinstitutionalarrangements. Saunders (1990) examined the impact of GlassSteagall Act (1933) on the level of underpricing. Glass Steagall Act restricted the commercial banks from providing corporate equity underwriting services (hence separating the commercial and investment banks), though the foreign banks was allowed till 1978 as per International Banking Act (1978). This act increased the monopoly power of investment bankers.Although,themonopolypowerofinvestmentbankersoffsetbyprocompetitiveeffectamong themselves (Saunders, 1990). Hence the study is motivated to examine the impact on level of underpricingduetochangeinregulation,monopolyofinvestmentbanks,andinformationasymmetry. Saunders (1990) argued that underwriter increase level of underpricing to reduce their risk of under subscription.Beattyand Ritter(1986)was consistentwithSaunders(1990)thatif investment bankers IPOUnderpricing:Aliteraturereview 5

used monopoly power and highly underpriced the IPO during a period then they lose the business in longrunasthefirmschangedtheunderwriter. Marchand and Roufagalas (1996) suggested in their study that underpricing is a better way for the underwriter to gain in any mechanism, such as in firm commitment offer main loss of proceed is afforded by the issuer while underwriter gains due to full subscription at lower price. Under the best effortscontracttheunderwriterisincentivizedonthenumberofsharessold,whichcanbeincreasedby sellingatlowercost,thusagainissuerissufferedfromunderpricing.ButRitter(1987)foundthehigher level of underpricing in best effort contract compared to firm commitment offering. Marchand and Roufagalas (1996) found that underpricing will be minimized in three cases where underwriters are forced to price equally as per owners expectation, i.e. a) if demand uncertainty is minimal, b) if full informationoffutureprospectsandprofitabilityisavailabletomarket,andc)iftheoptimalsolutionis the corner solution. Cliff and Denis (2004) found that underwriters with higher reputations will be compensatedforanalystcoveragewithgreaterunderpricingofIPO. IndustryClassification ThephenomenonofIPOunderpricingisstudiedacrosstheindustriesbymanyresearcherstoexamine the implicationofindustry classification. Themostimportantdifferenceis consideredasdifferenceof financialindustryversusnonfinancialindustrybyresearchers(Allietal,1994;CagleandPorter,1996; Tinic, 1988). Since financial institutions are controlled by regulatory bodies, there is less initial uncertainty about the firm value compared to nonregulated industrial firms when they try to launch theirIPOs.Evenduetohigherrestriction,thereislessinformationasymmetryinthemarket. Ritter(1984)foundthesignificantdifferencebetweenunderpricinglevelofofferingsofnaturalresource firmandnonnaturalresourcesfirmsusingthedataduring19771982intheUnitedStates. Alli et al (1994) examined the difference using two samples (185 financial and 1361 nonfinancial institutions) which went public during January 1983December 1987. The banks, bankholding companies,Savingsandloanassociationsweredefinedas185financialinstitutions,whichwerefurther dividedin99saving&loanconversionsand86nonsaving&loanconversionstoextendthestudy.They testedtheexanteuncertaintyandlevelofunderpricingforthedifferentsamplebyusingnonfinancial institutionsascontrolsample.TheirstudyfoundthatIPOsoffinancialinstitutionsarelessunderpriced thannonfinancial institutions IPOs because of less uncertaintyaboutthe valueof issuing firm due to greater regulatory disclosures requirements. Also, the results showed that there is a significant difference between the under pricing of saving & loan conversion IPOs, and nonsaving & loan conversion IPOs. The results further revealed that difference of exante uncertainty was not much betweenthesavingsandloanconversionIPOs,andnonsavingandloanconversionIPOsbuttherewasa significantdifferenceinthelevelofuncertaintiesbetweenthefinancialIPOsandnonfinancialIPOs. Cagle and Porter (1996) also supported the lower underpricing (4.8% less) of financial institutions (thrifts, commercial banks, utilities, and insurance companies as financial institutions) compared to IPOUnderpricing:Aliteraturereview 6

others industrial institutions, but no significant difference is found between the underpricing of commercial banks and other financial institutions. They also examined the difference between underpricing level of these financial institutions individually and other industrial firm, and found the differenceasThrifts(4.2%),commercialbanks(5.8%),insurancecompanies(8.4%),andutilities(2.7%). ContrarytothisTinic(1988)foundthattheunderpricingofregulatedfinancialinstitutionsislargerthan those of nonregulated firms because underwriters and issuers would tend to underprice the IPOs to avoidfuturelegalliabilitiesformisrepresentingthefirmstruevalue. RegulatoryEnvironment IPOunderpricingisalsoinfluencedbyregulationsprevalentintherespectedcountry,ortimewhichis alsosupportedinempiricalstudies.Withtimeandlocation,thereischangeintheruleofthemarketby regulatorybodiestoattractinvestorsandimprovetheefficiencyofthemarket,whichaffectthedegree ofunderpricing. ComparingtwodifferentstudyofIndianprimarymarket,PandeandVaidyanathan(2009)fortheperiod of2004to2006andShah(1995)fortheperiodof1991to1995,itisobservedthataverageunderpricing has significantly decreased from 105.6% to 22.62%, which is attributed to the change in regulation of discontinuing theallocation to informedindividuals.Pande andVaidyanathan(2009)alsoshowedthe finding of different level of underpricing in different countries such as Malaysian firms showed 80% averagelevelunderpricing,followedbyBrazil(79%),SouthKorea(78%),Thailand(58%),Portugal(54%), Taiwan (45%), US (15%), UK (12%), Australia (12%), Canada (5%), and France (4%) with samples of differentsizeanddifferentperiodsbetween1971and1992. Benveniste and Spindt (1989) supports that the level of underpricing can be reduced, if the differentiation is done prior to allocation shares between informed and uninformed investors by underwriterwhichwasallowedduringoldregulatoryregimesuchasduringCCIinIndia. Prasadetal(2006)triedtofindtheeffectofdifferentregulationbyexaminingthelevelofunderpricing at pre and postimplementation period of Bumiputera Public Policy, 1976 (hereafter 1976 policy) in MalaysianIPOmarketusingthedataof208IPOsduringtheperiod19681992.MalaysianIPOmarketis uniqueinthesensethatnewIPOoffersarerequiredtofixaninitialpriceatthetimeofapplication,and thefinalapprovedfixpriceofthenewsharesisdeterminedbystateregulatorybody.Anotherunique featureofMalaysianIPOmarketisthatthemarketwassubjecttoadditionalregulationwhichmandated that30%ofallnewsharesonanIPOissuemustbegiventotheeconomicallydisadvantagesegmentof the population or to mutual funds owned by them (1976 policy). The study also investigated the differentimplicationsofshortandlongrun.Prasadetal(2006)foundthatnewissuesaresignificantly underpriced during pre and postpolicy implementation period in the short run as well as in the long run,howeverinlongruntheunderpricingpersistsforashorterperiodduringtheprepolicyperiod.In the short run, the level of underpricing is higher compared to the long run for both pre and post

IPOUnderpricing:Aliteraturereview

implementation period. Higher level of underpricing is found for the postpolicy implementation comparedtoprepolicyimplementationforbothshortandlongrun. Saunders (1990) examined the effects of change in regulation i.e. introduction of GlassSteagall Act, 1933(hereafter1933act),whichrestrictedthecommercialbanksfromprovidingunderwritingservices toitsclientsresultinginincreasedmonopolypowerofinvestmentbankers.Tinic(1988)studyprovided theevidencethatlevelofunderpricingincreasedduring196671comparedtotheperiodof19231930 which may be attributed to 1933 act. Saunders (1990) found that IPOs of investment banks are underpricedonlyby8%whichislessthanthemedianormeanunderpricingfoundinmajorityofstudies. Thusthestudysuggestedthattheimplementationof1933actledtoincreaseinlevelofunderpricing which may be controlled through spreading information, encouraging competition among investment bankers. AstudybyDandapanietal(1992)onrelationshipbetweenunderpricingandpersonaltaxratesshowed that the level of underpricing decreased due to change in regulation regarding the capital gain tax treatment. Prior to 1987 (Tax reform 1986), capital gain income was taxed at lower rate compare to ordinaryincome,henceownerswereinterestedinunrealizedcapitalgainorrealizedcapitalgainwith lowertaxes.AnotherextendedstudyofResideetal(1994)supportedthenegativecorrelationoflevelof underpricingandchangeincapitalgainstaxrateassumingceterisparibus. ProtectionagainstLegalLiabilities Undertheregulatoryenvironment,ProtectionagainstLegalLiabilitiesisaspecialinfluencingfactorof underpricing. Any legal liability regarding the IPO may damage the reputation of both issuer and underwriter, therefore underpricing is also used as a technique to protect the firm from any legal liability. By studying thedata of 134 IPOs in the Post1933 Securities and Exchange Commission (SEC) regulationsand70IPOsinthepreregulationperiod,Tinic(1988)foundtheevidencetosupportthatIPO Underpricingisusedasamechanismofinsuranceagainstlegalliability.Tinics(1988)studyismotivated duetoincreaseinstringentcontrolandhigherlegalliabilitiesrequiredasperthesecuritiesact.Hughes andThakor(1992)statedthatalthoughprotectionagainstlegalliabilitiesisonemotiveofunderpricing andalsosupportedtheoreticallybutitisnottheonlycauseofunderpricing,asthecountrieswithweak legalsystemalsoprovideevidencesofunderpricing.Saunders(1990)alsostatedthatunderwritermay useunderpricingtosafeguardtheirreputationamonginvestorsandkeepthemhappy. ListingDelay Thetermlistingdelayreferstothenumberofdaysbetweentheclosingdayofofferandlistingday.In differentcountriesthesenumberofdaysdiffersbasedonregulations,marketefficiency,etc.Thelisting delay blocks the investors money for a time period and leads to illiquidity of investors, and risk of rationing, hence investors ask for the higher premium on the listing day (Shah, 1995). Shah (1995) studiedtherelationshipbetweenlistingdelayandlevelofunderpricingusingthedataofBSE,wherethe listing delay of three weeks is observed. Due to listing delay different opinions are formed among IPOUnderpricing:Aliteraturereview 8

investorsbasedontheinformationaddedduringtheperiod,whichinfluencesthelevelofunderpricing oftheIPO. MarketingInvestment With the positive change in regulation, the numbers of companies going to public are increasing. Primarymarketismoreattractivechoiceofraisingfundcomparedtotraditionalmethodoffinancing. HencewiththeincreaseinnumberofIPOsthereisnewareadiscoveredi.e.marketingofanissue.IPOs aremarketedtoattractthelargenumberofinvestorsascustomers.Hencetheincreaseinnumberof investors mayleadtooversubscriptionordecreaseininformationasymmetry, inturnshigherlevelof underpricing. Marketing may also lead to serve as a signal about the quality of the firm as it reduces underpricingbydecrease inthe adverseselection.Habiband Ljungqvist(2001)foundtheevidenceto supportthehypothesisthatmarketingexpensesandunderpricingaresubstitutecosts.Theysaid,every 1$of promotion costs seekstoreducethepromoterswealthlossesby 98%,sothemarginal costs of promotionequalthemarginalbenefits. FriederandSubrahmanyam(2005)foundintheirstudythatinvestorsretainhighlyvisiblefirms,where visibilityisanoutcomeofinvestmentsinmarketingofIPO.AnotherstudybyCooketal(2006)suggested thatinvestmentbankersinvestinmarketingtopromoteIPOamongsttheretailinvestorsfortheissuers toretainandattractclients.Studieshavefoundevidencesthatincaseofinsufficientpreofferpublicity byinvestmentbanker,issuerschangeinvestmentbankers. IntentionalUnderpricing IPOUnderpricingisusedasasignalaboutthefirmvaluetotheinvestors.Therearemanyotherreasons tointentionallyunderpricetheissue.FirmsunderpricetheIPOhighlywithexpectationofhighergainin secondIPObyleavinggoodtasteforinvestors.Theremaybesomeinterestofownersassociatedwith underpricingofanIPO.Fewarediscussedbelow: Signalinghypothesis(AllenandFaulhaber,1989)withtheassumptionofgreaterinformationwithfirm, suggestedthatIPOunderpricingisusedasasignalaboutthefutureprospectsofthefirmtoinvestorsby thefirms.AstudybyIbbotson(1975)supportsthatIPOsaredeliberatelyunderpricedbythefirmswith theexpectationofhighergaininfutureseasonedequities. Contrarytootherstudies,Jain(1996)didnotfoundsignificantdifferenceinreissuingandnonreissuing firmsonthebasisofvariablessuchasriskoftheissue,IPOoffersize,andunderwriterreputation.There isnoevidencefoundfortherelationshipbetweenthelevelofunderpricingofIPOandthetendencyof reissuing. CliffandDenis(2004)studyindicatethatunderwritersandfirmsshareamutuallybeneficialagreement inwhichthefirmsoptfordeliberatelyunderpricingtheirIPOstomeetthehighercompensationcharges ofexpertanalyst. IPOUnderpricing:Aliteraturereview 9

Allen and Faulhaber (1989) states that firms have more information regarding their future prospects comparedtoinvestmentbankers.Inthisstudyauthorsconsideredinvestmentbankersjustasarational administrator of IPO. Since underpricing is considered as good signal about the firm value, firms intentionally underprice their IPOs. Incase of no information asymmetry, there isnoneed to provide anysignaltotheinvestorsandsimilarlynounderpricingisrequired. Dandapanietal(1992)examinedtherelationshipbetweenunderpricingandpersonaltaxesofowners. Theysuggestedthatownersretainlargenumberofsharestoearnthroughcapitalgainasitwillbetaxed when realized, that is also at lower rates due to capital gains income, which, prior to 1987, were typically lower than ordinary income tax rates. Results showed that underpricing is a better way, if ownersretain66.7%or100%,atanyordinarytaxrateirrespectiveofdurationofdeferredcapitalgains. Resultsalsoshowedthatunderpricingwashigherduringthefirstthreequartersof1985comparedto thefirstthreequartersof1987whichisattributedtochangeinCapitalGainTaxTreatment(1987). OwnershipStructure PostIPO ownership structure serves as a signal for the future prospects (Leland and Pyle, 1977). Prospecttheory(LoughranandRitter,2003)statedthathighunderpricingofIPOsresultsintheincrease inwealthoftheissuersduetotheirownshareholding.Insupport,CorruptionHypothesis(Loughranand Ritter,2003)statedthatmanagementisnotconcernedaboutthemoneyleftonthetablewhilethey use it as a mechanism to increase their own wealth. Grinblat and Hwang (1989) also supported that underpricing and shareholding of issuer after IPO serves as a signal of quality of IPO. Lelandand Pyle (1977)supportthepositiverelationshipbetweenoriginalownersstakeafterIPOandthequalityoffirm. Ljungqvist, Wilhelm (2003) study investigates the relationship between postIPO decrease in shareholdingofpreIPOownersandDotcombubbleusingthedataof2178IPOsbetweenJanuary1996 and December 2000. They found that widely use of newly Directed Share Programs (hereafter DSP), whichprovidedthefamilies,friends,employeesetc.theopportunitytopurchasesharesatIPOprice,led to a motivation to deliberately underprice IPOs. These were the unique characteristics which were associatedwiththefirmduringtheboomoftheITandITESindustrywhichledtotheDotcomBubble. TheresultsfoundthatDotcomfirmsaccountedfor21.7%ofthetotalvariationinmeanrevenues,and meanbookvalueofassets,whichmeansspecificcharacteristicsofanindustry.Itwasfoundthatin1999 internet firms represented 57.4% of the total IPOs. The average gross proceeds from the IPO transactionshaveincreasedthreetimesfrom$57.4mnin1996to$164.9mnin2000.Asarepercussion oftheeventtheproportionofpreIPOsharesoutstandingdeclinedfrom4.9%in1996to0.7%in2000. TherewasasharpdeclineinthepreIPOinsiderownershipstakesfrom63.9%in1996to51.8%in2000. DuringthesametimeCEOstakesalsodeclinedfrom22.7%to11.6%.Samewasthestoryfortheventure capitalistandinvestmentbanksaswellasothercompanies.Theresultwasanincreasinglyfragmented ownership structure. To complement with these changes in ownership structure, the year 19992000 alsowitnessedarapiddeclineinboththefrequencyandmagnitudeofsecondarysalesofexistingshares byallcategoriesofpreIPOowners. IPOUnderpricing:Aliteraturereview 10

Ljungqvist, Wilhelm (2003) found that this unusual pricing behavior experienced during the Dotcom bubble may be partially accounted for the radical changes that took place in the preIPO ownership structureandtheinsidersellingbehaviorofthefirmsoverthesameperiod. Derrien(2005)investigatedthereasonsfortheattachmentofinsideinvestorstowardstheirshareinthe IPOandtheresultinbehaviorofnotsellingtheirshareinthemarketandfoundthatinsiderspreferto keeptheirfundsintheformofsharesbecausetheyexpecttheirsharestoincreaseinvalueinthelong run.ThestudyfoundthemostimportantfactorsthatinfluenceanunderwriterdeterminationofanIPO price,aretheinformationabouttheintrinsicvalueoftheissuer,andnoisetradersentiment.Theresults provided evidence that noise traders participate in the aftermarket only when they are bullish, otherwise the dominant players in aftermarket trading are the institutional investors. The study also providesevidencethatIPOprice,initialreturn,andaftermarketturnoverareallpositiverelatedwiththe demandsoftheindividualinvestors. RelationshipwiththeBank Schenone(2004)examinedwhetherapriorrelationshipofafirmwithabanki.e.proficientinhandling IPO activities has an impact on the firms IPO underpricing. The assumption behind the study is that havingapriorgoodrelationshipwithafinancialinstitutionorabankmayhelpinreducinginformation asymmetry i.e. the difference in information between all investors, hence decreases the level of underpricing. Schenone (2004) supported that if there is a previously established relationship (only limitedtotheunderwritingactivityofthebank)ofafirmwithabankwhichcanmanageIPOs,thereis no decrease in the firms IPO underpricing. However the firms, in a borrowing relationship with the bank, require higher disclosures hence there is decrease in level of underpricing due to decrease in information asymmetry. In case, there is no prior relationship between the bank and the firm then underpricing is higher for firms compare to those firms which have a relationship with the bank. Schenone (2004) also found that firms, which had a preIPO underwriting relationship with the bank, showlowerunderpricingcomparetofirms,whichhavenosuchpriorrelationshipwiththebank. PostIPOImplications TherearedifferentresearchesdonetoexaminethepostIPOscenarioofthefirmandthemarket.The levelofIPOunderpricingmaygeneratesomenewinformationaboutthefirm.Also,therearemanypre andpostIPOservicesofferedbyinvestmentbankerssuchaspreIPOservices,relatedtothevaluation or pricing, marketing, and IPO distribution, and postIPO services such as price stabilization, market making,andanalystresearchcoverage. Jain(1996)measuredthefirmqualitybystudyingpostIPOeffectontwoperformancevariableoffirm performancei.e.operatingreturnonassets,andoperatingcashflowdeflatedbytotalassetsusingthe dataduringJanuary1980December1988andfoundthatIPOunderpricingdoesnotserveasasignalof firmquality.IPOunderpricing,thelogofIPOoffersize,thepostIPOmanagementstakeinfirm,andthe riskoftheissuewereusedasexplanatoryvariablesinthestudyoveratimeperiodfromoneyearprior IPOUnderpricing:Aliteraturereview 11

tothreeyearspostIPO.Inthestudy,IPOoffersizewasconsideredasproxyofinformationasymmetry. TheresultssuggestedthatpostIPOoperatingperformanceisindependentoflevelofunderpricing,even afterconsideringindustryeffectalso.ThusthereisnosignalprovidedthroughunderpricedIPOabout thepostIPOfirmquality. Cliff and Denis (2004) examined the relationship between a firms use of postIPO analyst coverage service and underpricing of that firms IPO. They tried to measure the impact of analyst coverage compensation on underpricing of the IPO using the data of 1050 firms, who have issued IPO during 19932000andfoundthattherewasstrongcorrelationbetweenthefrequencyandperceivedbeliefof recommendation (buy or strong buy by underwriters) with the underpricing of IPOs. This analyst coverageservicehelpsthefirmstopublicizeofferingsandinturnsattractinglargenumberofinvestors. Many researches support that analyst recommendations boost the share prices and influence insider selling(ChenandRitter,2000;Aggarwaletal,2002). CliffandDenis(2004)foundasignificantpositiverelationbetweenunderpricingandanalystcoverageby the lead underwriters. Similarly they found that underwriters with higher reputations will be compensated for analyst coverage with greater underpricing of IPO. And it was also found that the probability of switching underwriters between the IPO and SEO was negatively related to amount of postIPOanalystcoverage. INDIANSCENARIO ThissectioncoversthereviewofliteratureregardingIPOunderpricingbutrelatedtoIndianMarketonly. ItincludesthegrowthofIndianprimarymarketwhichprovidedtheopportunitytomillionsofinvestors. Indian market is more interesting compare to other markets to study about IPO underpricing due to variousunique characteristics asthere is huge rush towards the market tobe listed onexchange and generating funds through public, Indian market is comparatively efficient and well equipped with technologynowasothermarketsare,Indiaisthefirstcountryintheworldtointroducetheconceptof equity rating (Pande and Vaidyanathan, 2009). Indian primary market is having a different regulation history,aspecialkindofinstitutionalinvestments,thesheersize,largenumberoffirmsgoingforlisting, andthelargenumberofretailsparticipantsapplyingdirectly.InIndia,anIPOisalsoratedpriortolisting onthebasisofthedisclosuresmadeintheirprospectus,notonthebasisofqualityorvaluationofthe issue.Althoughthisratingdoesnottellanythingabouttheissueandthefirmbutitservesasasignalto the retailinvestorsinthemarket.Theonly limitationof Indianmarket isthe data availabilityofshort spanoftimei.e.twodecadesonlywhileinothermarketsdataisavailableformanydecades. IndianIPOmarkethasgrownrapidlywitheconomicliberalizationof1990s.Theregulatorybodynamed the Controller of Capital Issues (CCI) was abolished and after some time in 1992, the Securities and Exchange Board of India (SEBI) was established as monitoring body of capital market in India, which graduallybecomespowerfulwiththetime.Priorto1990swhenCCIwasexisting,companiesonlywith substantial reserves could issue shares on premium. This rule has changed by SEBI in 1992 and IPOUnderpricing:Aliteraturereview 12

companies can issue shares on premium if generating a profit for last 35 years or if the promoting companyhaving50%postIPOownershiphasthesamerecord.DuringCCI,theCCIFormulawasused tocalculatethefairpriceofequityonthebasisofaccountinginformationwhichoftenledtoextreme lowpricesduetoconsiderationofbookvalue;hencethedebtwasmorepreferredchoicethanequity (Shah, 1995). SEBI changed listing guidelines time to time during the decade to compete with world marketresultingintransformationofIndianIPOmarket.TheprocessofgoingpublicinIndiaisalmost similar to other developed countries, i.e. filing draft prospectus first with SEBI through with eligible investment banker and then filing to Registrar of Companies. The change in regulatory environment reformedtheIndianprimarymarketwhichresultedinhugerushtowardgoingpublic.Someofthemajor implicationsare: 1. Theofferpriceischosenbyfirmandmerchantbanker,notusinganyfixedformula. 2. ApprovedofferpricebySEBIcanbeincreasedby20%toadjustlistingdelayeffect. 3. MarketingofIPOisincreasedwidelytoappeallargenumberofinvestors. 4. Theissueusuallycloseswith410daysandlistingdelayisalsoreducinggradually. PandeandVaidyanathan(2009)foundtheimprovementinvaluationofIPOsasthelevelofunderpricing hasdecreasedoverthetimeinthestudyof55firmslistedonNationalStockExchange(NSE)duringthe periodMarch2004October2006.Theyalsoobservedthatifthefinalpriceofofferisfixedatcloserto highersideofthebandthenitservesasasignalforgoodqualityandleadstohigherunderpricing,which supportsthestudybyBenvenisteandSpindt(1989).Theirstudysupportedthatlistingdelayispositively relatedtotheunderpricingwhiletheyfoundnegativepostIPOperformanceofthefirminonemonth period.TherelationshipbetweenmarketexpensesonIPOandunderpricingarenegativelyrelated,but the study could not provide any significant reduction in level of underpricing. Their study has the limitationofnotconsideringtheallocationpatternbetweenretailandinstitutionalinvestorsthatmay influencetheresultsoflevelofunderpricing. AnotherstudybyShah(1995),usingthedataof2056offeringslistedonBSEduring19911995,stated thatthelistingdelayispositivelyrelatedtotheunderpricingtotheextentthatthatthethattheissuing firmearnstheinterestratefloatontheapplicationmoney,andtotheextentthatinvestorsloseliquidity ontheirapplicationmoney,theymustbecompensatedforitbyenhancedunderpricing.Shah(1995) found the evidence of underpricing of both larger and smaller issue, which is contrary to results of studiesinothercountrieswhereonlysmallercompaniesareassociatedwithunderpricing. Ghosh(2005)studiedthe1,842offeringslistedonBSEbetween1993and2001bydividingsampleinto two sub periods: boom period during January 1993August 1996 and slump from end1996 to 2001. Ghosh (2005) found the contrary results to the international markets, that in Indian market the underpricing is lower during the hot period compared to slump period as stated that during boom, offers with premium are considered less risky by Indian investors. Ghosh (2005) also studied the differencesinbusinessgroups,smallissues,andgovernmentownedcompanieswhicharenotdiscussed in this paper. Ghosh (2005) foundevidence that large issue were less underpriced than smaller issue. IPOUnderpricing:Aliteraturereview 13

Ghoshs(2005)studydidnotfindsignificantimpactoffirmageandindustryonthelevelofunderpricing. Ghosh(2004,2005)foundthatsuccessfullargeissuesandfirmswithhigherunderpricingagainoffered newIPOstotaketheadvantageofthegoodtasteofmarket. ShellyandSingh(2008)studiedthe1,963offeringslistedonBSEbetweenJuly1992andAugust2006,to studythesignalingvariablesandfoundthatleadmanagerreputation,firmage,andcertificationtoissue providedbyunderpricingledtooversubscriptionwhilemarketissuesizeandindustrydidnothaveany significanteffectonoversubscriptioninIndianMarket.Theyalsofoundtheevidencethattherelation between the degree IPO subscription and underpricing and found positive correlation above full subscription.ShellyandSingh(2008)statedthatnumberofuninformedinvestorsparticipatinginIndian IPOmarketissignificantlyverylargeasagainstinstitutionalinvestorscomparedtoothermarkets. SUMMARY In the paper, we started with the understanding the phenomenon of IPO underpricing. The area of interestinthisstudyistofindingtheinfluencingfactoroflevelofunderpricing,supportedbyliterature. ThestudyalsocoverssomepostIPOimplicationsofunderpricing,andthenadedicatedsectionpresents the scenario of Indian primary market. We studied that these factors independently and jointly influencing the level of underpricing. Few of them are correlated themselves such as regulations and listing delay, etc. The study can be extended to compare the impact of such influencing factor in the context of specific country such as India, which is having a unique characteristics compared to world market.Suchfuturestudymayprovideinterestingresultstocomparewiththeworldprimarymarket. Withthegrowinglistofnewcompaniesgoingpublictheempiricalstudycanprovidesomemoreresults throughtimeseriesandcrosssectionalanalysis. *****

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REFERENCES Allen, F.; Faulhaber, G. (1989), Signaling by Underpricing in the IPO Market, Journal of Financial Economics,Vol.23,No.2,pp.303323. Alli,K.;Yau,J.;Yung,K.(1994),TheUnderpricingofIPOsofFinancialInstitutions,JournalofBusiness Finance&Accounting,Vol.21,No.7,October1,pp.10131030. Cagle, J.; Porter, G.E. (1996), IPO Underpricing in Regulated Industries, Journal of Economics and Finance,Vol.4,No.20,SupplementIssue,pp.2737. Chemmanur, Thomas ; Fulghieri, Paolo (1994), Investment Bank Reputation, Information Production, andFinancialIntermediation,TheJournalOfFinance,Vol.49,No.1,March,pp.5779. Cliff, M.T.; Denis, D.J. (2004), Do Initial Public Offering Firms Purchase Analysts Coverage with Underpricing?,TheJournalofFinance,Vol.59,No.6,December,pp.28712901. Dandapani,K.;Dossani,R.;Prakash,A.J.;Reside,M.A.(1992),PersonalTaxesandtheUnderpricingof InitialPublicOfferings,ManagerialandDecisionEconomics,Vol.13,pp.279286. Derrien,Francois(2005),IPOPricinginHotMarketConditionsWhoLeavesMoneyontheTable,The JournalofFinance,Vol.60,No.1,February,pp.487521. Ghosh, S. (2005), Underpricing of Initial Public Offerings: The Indian Experience, Emerging Markets FinanceandTrade,Vol.41,No.6,Nov/Dec,pp.4557. Jain,BharatA.(1996),IsUnderpricingaSignalofFirmQuality,AmericanBusinessReview,January,pp 3845. Ljungqvist,A.;Wilhelm,W.J.Jr.(2003),IPOPricingintheDotcomBubble,TheJournalOfFinance,Vol. 58,No.2,April,pp.723752. Marchand,J.;RoufagalasJ.(1996),SearchandUncertaintyDeterminantsoftheDegreeofUnderpricing ofInitialPublicOfferings,JournalofEconomicsandFinance,Vol.20,No.1,spring,pp.4764. Pande,Alok;Vaidyanathan,R.(2009),DeterminantsofIPOUnderpricingintheNationalStockExchange inIndia,TheICFAIJournalofAppliedFinance,Vol.15,No.1,2009,pp.1430. Prasad,D.;Vozikis,G.S.;Ariff,M.(2006),GovernmentPublicPolicy,RegulatoryIntervention,andTheir ImpactonIPOUnderpricing:TheCaseofMalaysianIPOs,JournalofSmallBusinessManagement, Vol.44,No.1,pp.8198. Reside, M.A.; Robinson, R.M.; Prakash, A.J.; Dandapani, K. (1994), A TaxBased Motive for the UnderpricingofInitialPublicOfferings,ManagerialandDecisionEconomics,Vol.15,pp.553561. Rock,K.(1986),WhyNewIssuesareUnderPriced?,JournalofFinancialEconomics,Vol.15,Nos.12, pp.187212. IPOUnderpricing:Aliteraturereview 15

Saunders, Anthony (1990), Why Are So Many New Stock Issues Underpriced?, Business Review FederalReserveBankofPhiladelphia,Mar/Apr,pp.312. Schenone, Carola (2004), The Effect of Banking Relationships on the Firm's IPO Underpricing, The JournalofFinance,Vol.59,No.6,December,pp.29032958. Shah, A. (1995), The Indian IPO Market: Empirical Facts, Centre for Monitoring Indian Economy, Mumbai,May. Shelly; Singh, Balwinder (2008), Oversubscription and IPO Underpricing: Evidence from India, The ICFAIJournalofAppliedFinance,Vol.14,No.12,pp.6573. Tinic, S.M.(1988),AnatomyofInitialPublicOfferingofCommonStocks,JournalofFinance,Vol.43, No.4,pp.789822.

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OTHERCITEDREFERENCES Baron,D.P.(1982),AModeloftheDemandforInvestmentBankingAdvisingandDistributionServices forNewIssues,JournalofFinance,Vol.37,No.4,pp.955976. Benveniste, L.M.; Spindt, P.A. (1989), How Investment Bankers Determine the Offer Price and AllocationofNewIssues,JournalofFinancialEconomics,Vol.24,No.2,pp.343361. Cook, D.O.; Kieschnick, R.; Van Ness, R.A. (2006), On the Marketing of IPOs, Journal of Financial Economics,Vol.82,No.1,pp.3561. Frieder,L.;Subrahmanyam,A.(2005),BrandPerceptionsandtheMarketforCommonStock,Journal ofFinancialandQuantitativeAnalysis,Vol.40,No.1,pp.5785. Grinblat,M.;Hwang,C.Y.(1989),SignalingandthePricingofNewIssues,JournalofFinance,Vol.44, No.2,pp.393420. Habib,M.;Ljungqvist,A.(2001),UnderpricingandEntrepreneurialWealthLossesinIPOs:Theoryand Evidence,ReviewofFinancialStudies,Vol.14,No.2,pp.433458. Hughes,P.J.;Thakor,A.V.(1992),LitigationRisk,IntermediationandtheUnderpricingofInitialPublic Offerings,ReviewofFinancialStudies,Vol.5,No.4,pp.709742. Ibbotson, R.G. (1975), Price Performance of Common Stock New Issues, Journal of Financial Economics,Vol.2,No.3,pp.235272. Kim,M.;Ritter,J.R.(1999),ValuingIPOs,JournalofFinancialEconomics,Vol.53,No.3,pp.409437. Leland, H.E.; Pyle, D.H. (1977), Informational Asymmetries, Financial Structure and Financial Intermediation,JournalofFinance,Vol.32,No.2,pp.371387. Loughran, T., Ritter, J.R.; Rydqvist (1994), Initial Public Offerings: International Insights, PacificBasin FinanceJournal,Vol.2,No.2,pp.165199. Loughran, T.; Ritter, J.R. (2003), Why has IPO Under Pricing Changed Over Time?, Working paper, UniversityofNotreDameandUniversityofFlorida. Pagano, M.; Panetta; Zingales, L. (1998), Why Do Firms Go Public? An Empirical Analysis, Journal of Finance,Vol.53,No.1,pp.2764. Sherman,A.E.(2005),GlobalTrendsinIPOMethodsBookBuildingversusAuctionswithEndogenous Entry,JournalofFinancialEconomics,Vol.78,No.3,pp.615649. Sherman,A.E.;Titman, S.(2002),BuildingtheIPOOrderBookUnderpricingandParticipationLimits withCostlyInformation,JournalofFinancialEconomics,Vol.65,No.1,pp.329.

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