IPO UNDERPRICING

By:Shivam Singh (FPM11011) Parvathi Ganesh (FPM11012)

WHAT IS UNDERPRICING

Underpricing is estimated as the percentage difference between the price at which the IPO shares were sold to investors (the offer price) and the price at which the shares subsequently trade in the market. Usually measured as the percentage difference between the offer price and the end of day closing price for the first trading day.

THEORIES OF UNDERPRICING

Theory based on Asymmetric Information

According to Rock, Informed investors bid only for attractively priced IPOs, whereas the uninformed bid indiscriminately. This imposes a winners curse on uninformed investors. When conditional expected returns are negative, uniformed investors will be unwilling to bid for IPO allocations, so the IPO market will be populated only with informed investors. To make uninformed investors to participate in IPO, conditional expected returns should be non negative so that the uninformed at least break even.

Beatty and Ritter (1986) argue that as repeat players, investment banks have an incentive to ensure that new issues are underpriced by enough lest they lose underwriting commissions in the future. Investment banks thus coerce issuers into underpricing. Underpricing can be reduced by reducing the information asymmetry between informed and uninformed investors. ( A specific way to reduce the informational asymmetry is to hire a prestigious underwriter or a reputable auditor)

INFORMATION REVELATION THEORIES

Bookbuilding involves underwriters eliciting indications of interest from investors which are then used in setting the price. After collecting investors indications of interest, the bank allocates no (or only a few) shares to any investor who bid conservatively. This mitigates the incentive to misrepresent positive information. Even though their IPOs are underpriced, Issuers benefit because bookbuilding allows them to extract positive information and raise the offer price in response even though the price will rise further in the after market because some money has to be left on the table.

PRINCIPLE AGENT THEORIES (BARON (1982))

Theories of bookbuilding stress the important role of investment banks in eliciting information that is valuable in price setting. Underwriting fees are typically proportional to IPO proceeds, and thus inversely related to underpricing. This provides a countervailing incentive to keep underpricing low. But at times, it is conceivable that the banks private benefits of underpricing greatly exceed this implied loss of underwriting fees To induce optimal use of the underwriters superior information about investor demand, the issuer delegates the pricing decision to the bank. The more uncertain the value of the firm, the greater the asymmetry of information between issuer and underwriter, and thus the more valuable the latters services become, resulting in greater underpricing.

SIGNALING THEORY (ALLEN AND FAULHABER (1989)

If companies have better information about the present value or risk of their future cash flows than do investors, underpricing may be used to signal the companys true high value. Though it is costly, if successful, signaling may allow the issuer to return to the market to sell equity on better terms at a later date. High-quality firms have incentive to credibly signal their higher quality, in order to raise capital on more advantageous terms. Low-quality firms have incentive to mimic whatever highquality firms do. With some positive probability, a firms true type is revealed to investors before the post-IPO financing stage. This exposes low-quality issuers to the risk that any cheating on their part will be detected before they can reap the benefit from imitating the high-quality issuers signal. This makes separation between the two types possible.

LITIGATION THEORY (TINI (1988))

Investors may sue the issuers if the IPO return is lower than the expectation. Issuers thus underprice to reduce their legal liability.

INFORMATIONAL CASCADES (WELCH (1992))

An investor is looking at whether other investors are buying the shares. If there are sufficiently many others buying, he concludes that the stock is worth buying. If the initial price is too high, the firm risks that nobody will start buying the shares, hence no cascade will start

INDIAN UNDERPRICING

STUDIES

Shah (1995)

Documented the evidence of persistent underpricing in the primary market and proposed improvement in the quality of the information disclosure at the time of a public issue.
provided evidence that listing delay and the size of the issue were major determinants in the IPO pricing.

Madhusoodanan and Thirpalraju (1997)

Ranjan and Madhusoodanan (2004)

found that small size issues are more likely to be underpriced as compared to their larger counterpart.

INDIAN UNDERPRICING

STUDIES

Khurshed, Arif, Pande, Alok and Singh, Ajai K (2009)

study timing and subscription pattern of different investor groups dissect underpricing into two distinct components: one relating to pre-listing, set by the underwriter and the other from the post-listing period, which is determined by the market. The transparency of the bookbuilding process in the Indian IPOs helps alleviate the winner's curse problem for the non-institutional and retail investors. show that market underpricing is primarily driven by the unmet demand of the non-institutional investor groups. This insight is unprecedented in the IPO literature

NON-APPLICABILITY OF FOREIGN THEORIES IN INDIAN CONTEXT

Litigation Theory is probably not as applicable in the Indian context as the investor protection laws are not as stringent in India as in some other economies

Winners curse In India, the Institutional investors (informed) and the retail investors (uninformed) bid for different pool of shares. Thus the Winners curse problem will be curbed to some extent here.

THANK YOU