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IMPACT OF REGULATORY FRAMEWORK ON INITIAL PUBLIC OFFERING (IPO) UNDERPRICING IN INDIA
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IMPACT OF
REGULATORY FRAMEWORK ON INITIAL PUBLIC OFFERING (IPO) UNDERPRICING IN INDIA
AUTHORED BY
- AAYUSHI AGRAWAL
Introduction
A new company's decision to go public
is a significant turning point in its history. It makes public equity capital
accessible, which could reduce the cost of financing the business's operations
and investments. Additionally, it offers a platform for the company's share
trading, which helps current investors diversify their portfolios and capture
the cash gains they have made from supporting the business—a crucial factor for
venture capitalists. The simple process of going public draws attention to the
business, and the associated publicity may have unintended consequences like
drawing in managers of a higher level. Simultaneously, the business takes on additional
responsibilities in the shape of disclosure and transparency laws, and it is
held responsible for a bigger number of mostly anonymous shareholders who will
tend to “vote with their feet (by selling the shares) rather than assist the
company’s decision-makers in the way a venture capitalist might[1]”
The initial public offer, or IPO as
it is more often known, is the formal term for the company's initial public
offering of its shares to the general public. Either young businesses seeking
to raise funds to grow, or established major partnerships or private limited
companies wishing to become public limited companies, issue the IPOs. The most
well-known anomaly connected to this going public procedure is the underpricing
of initial public offerings (IPOs). The degree of underpricing differs between
markets, with emerging capital markets exhibiting higher levels of
underpricing. In a market like India where businesses go public to finance
their expansion despite paradoxical underpricing in the IPO, it is a riddle
that continues to be difficult to solve.
Underpricing is defined 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[2]”. When
an issue is priced below its actual value, this is known as underpricing. The
extent of underpricing differs between nations and within a single nation for
different issues. An undervalued initial public offering (IPO) results in money
left on the table for the company, which is a loss of capital. However, this
money also benefits the investors by providing them with positive early returns
on their undervalued shares. “Though underpricing is a cost for the issuing
company, the issuing company underprices the issue.[3]”
Specifically, it is expected that the
undervaluing of IPOs would gradually diminish as the vast majority of
investors identify and take advantage of the associated profit opportunities.
Nevertheless, it appears that most markets will always undervalue first public
offerings. These abnormalities are particularly harder to explain because they
are present in both industrialized and developing markets.
One important factor that can either
raise or decrease IPO underpricing is the regulatory framework that oversees
the offerings. In addition to exerting stringent control over the issuing
company, the regulatory framework serves as a guide for investors in making
just decisions. One of the primary regulatory guidelines influencing the
underpricing of the initial public offering (IPO) is the pricing mechanism used
to issue the shares. The two most popular pricing strategies for IPOs are fixed
price and book building. Although it is only available in some countries,
auction pricing is another option for issuing shares. It is not often used.
This paper aims to identify any significant modifications to the
regulatory framework pertaining to the issue of an IPO and study the impact of
legal framework on IPO underpricing.
Literature
Review
Initial Public Offerings (IPOs)
underpricing has drawn more attention than other financial market
irregularities. Without coming to a consensus, researchers have provided a
range of explanations as well as theoretical and empirical support. The
empirical literature that has grown over time demonstrates how difficult it is
for the market to value initial public offerings (IPOs) fairly. To be more
precise, the main characteristic of initial public offerings (IPOs) is their
systematic pricing at a lower price than their eventual market price. Five
primary theories can be used to classify the various conflicting
hypotheses and models put out to explain IPO underpricing:
1. Theories of asymmetric information
are seen to be the most applicable in explaining IPO underpricing. According to
the notion, one party to an IPO is presumed to know more than the rest.
According to Rock (1986)[4],
there are two types of investors: informed and ignorant. Only the informed
investor is aware of the actual worth of the share that is being offered.
Because of this imbalance, knowledgeable investors only place bids on IPOs
with appealing prices, while ignorant investors placed bids on any IPO. Due to
this, there is a significant risk of adverse selection where shares in
"bad" issues are distributed to ignorant investors. Another name for
this theory is "the winner's curse."
2. Three factors—legal culpability,
price stabilization, and taxation—are the foundation of the three
institutionally connected explanations for IPO underpricing. Companies
purposefully sell their stock at a discount, according to Ibbotson (1975)[5],
to lessen the possibility of lawsuits in the future from shareholders
dissatisfied with the performance of their shares after the first public
offering. Price stabilization is referred to by Benveniste and Busaba[6]
(1997) as "a mechanism that bonds underwriters and investors" since
the underwriter's dollar fees are based on the total amount raised.
Additionally, this naturally encourages the underwriter to increase the bid
price.
3. The division of ownership and control
is the foundation of the third group of theories. According to Brennnan and
Franks[7]
(1997), underpricing enables managers to maintain control over their operations
and the associated agency costs by evading scrutiny from a sizable number of
external shareholders. They speculate that in order to lessen the possibility
of being watched, IPO managers would like to discourage new block holdings.
According to this theory, initial public offerings (IPOs) are underpriced to encourage
ownership dispersion, which boosts the IPO stocks' aftermarket liquidity. Many
scholars look at behavioural explanations for IPO underpricing because they are
dissatisfied with the rational theories' explanations, which do not support
underpricing on large scale.
4. Behavioural theories presuppose that
issuers are prone to behavioural biases or that there exist
"irrational" investors that drive up the price of IPO shares above
their genuine value. Ljungqvist, Nanda, and Singh[8]
(2003) make the assumption that sentimental investors have high hopes for the
IPO Company's future. The issuer wants to seize as much of the excess as it can
from the downward-sloping demand curve caused by sentimental investors. This
analysis is improved by taking into account both hot and cold markets. They
discover that only in a thriving market do IPO firms trade at a greater
valuation.
5. Signalling theory provides an
explanation for the extent of IPO underpricing. According to this hypothesis,
the issuer wants to induce a certain level of IPO underpricing in order to
"leave good taste" in the minds of investors and guarantee the
success of subsequent public offerings. Welch[9]
(1992) replicated the signalling theory argument, which states that companies
purposefully undervalue the issue in order to ensure a positive response and
raise money through future seasoned equity offerings. According to the model,
high-quality firms indicate their firm quality by inducing a certain degree of
underpricing.
Regulatory
Framework In India
1992 was a pivotal year for the
Indian economy, both historically and economically. The federal government
initiated the reform process, which served as the foundation for all policy
matters and established India's economy as one of the fastest-growing in the world.
The process began with the Securities and Exchange Board of India (SEBI) being
incorporated and the Capital Issues (Control) Act being repealed. The
Controller of Capital offerings (CCI) had complete control over the price of
new offerings under the Capital Issue (Control) Act of 1947, and the disclosure
standards were appalling. Issuers have the freedom to choose the issue price in
accordance with SEBI regulations. Prior to 1995, the fixed price system was the
only allowed method of pricing. Protecting investor interests and growing and
regulating the primary and secondary markets were SEBI's principal goals upon
incorporation. SEBI streamlined the share issuance process and instituted
stricter disclosure guidelines and prudential standards. Many regulations have
been developed, and further laws have been passed (such as the Prevention of
Money Laundering Act of 2002, the Securities Contracts (Regulation) Act of
1956, and the Depositories Act of 1996). SEBI imposed further rules on IPO
pricing and other limitations on promoters, like a lock-in period for their
ownership, between 1995 and 1996. By corporatizing and demutualizing stock
exchanges, the government made the historic decision in 2001 to separate
ownership and operation of stock exchanges from trading rights.
The Securities and Exchange Board of
India and other regulatory bodies have focused on protecting investors and
increasing market competitiveness in the global marketplace over the last few
years. The employment of different pricing systems to issue shares in the
primary market has been one of the main regulatory challenges. The three
different pricing strategies that are utilized globally are (a) auction
pricing, (b) book building, and (c) fixed price. There have been three distinct
regimes, with respect to regulatory framework, in the Indian market namely the
immediate post-liberalization regime (1992-1995), the initial regulated regime
(1996-2000), and the reformed regulated regime (2001 onwards).
Following the economy's opening up,
there was a sharp spike in demand for shares, which raised their underpricing.
Throughout the various regimes, the average underpricing for fixed priced
issues has been declining. The average underpricing for fixed priced initial
public offerings (IPOs) was cut in half during the first regulated regime, and
it was further decreased during the reformed regulated.
Considering the two distinct pricing
methods, the impact of regulatory changes can be examined. In the first
mechanism (fixed pricing), the issue price and total number of shares that the
company can issue are strictly regulated. In contrast, in the second mechanism
(book building), companies are more free to choose how much to charge for their
initial public offerings (IPOs), can provide investors with variable pricing,
and can even change the total number of shares that are sold to investors.
Allowing the issuance of shares through the book building process was one of
the main modifications made to the primary market's regulatory framework in 1998.In
2004, the corporations began using this procedure to issue shares. The primary
benefit of the book-building method over the fixed price mechanism for pricing
initial public offerings (IPOs) is that it incorporates market perception of
the firm value into the pricing process. Thus, the book-building process of
pricing is used to issue initial public offerings (IPOs) in the majority of
countries. “Through book-building, the IPOs are issued in a price band of not
more than 20 per cent (as per SEBI guidelines) and for a period (maximum 13
days) in which the applicants bid for the issue and after closing of the issue,
a final price (called as the market clearing price) is determined on the basis
of the demand received through the applicants’ bids.[10]”
The issue's offer price is represented by this ultimate cost.
As per a research conducted by Bhalla
and Kaushal[11] (2014)
average underpricing of all the issues through fixed pricing mechanism was way
less than shares issued through book building process. The results are in
conformity with the literature that fixed price offer can lead to higher
underpricing as compared to book building offer as the market perception and
mood of the investors will be considered while fixing the final issue price.
In comparison to fixed pricing
and the auction method, the book building process is thought to be a superior
share issuance mechanism. When using the auction pricing method, investors may
experience the winner's curse because they won't know the share price that is fair.
In contrast, when using fixed pricing, issuers will typically price the share
at a lower value in order to attract buyers and increase demand for the shares.
Investors will have more information by setting a price range for the shares
through the book building process, and the company will also be able to set a
price by assessing the investor base's sentiment. When determining the price
range, consideration is given to the price range of shares held by rival firms
as well as the anticipated value based on investor expectations of what the
company can sell for. Because they are more adaptable, issuers and
intermediaries are better equipped to meet individual demands. Additionally,
they are able to distinguish between investors, forging a lasting relationship in
the process.
“Maximum underpricing has been
1620.50 per cent for fixed priced IPO in 1999 whereas in case of IPOs issued
through book building process, the maximum underpricing has been found to be
relatively very less at 230.26 per cent in 2006”[12].The
fact that some of the largest initial public offerings (IPOs) to date have only
been made through the book building method indicates that this IPO process
has become more popular in India.
Underpricing in initial public
offerings (IPOs) can be caused by or reduced by the regulatory framework. Due
to increased government intervention, a stringent and restricted regulatory
framework will cause more underpricing, whereas a reformed and free regulatory
regime will assist issuers in pricing their initial public offerings (IPOs)
fairly, resulting in less underpricing. The aforementioned data unequivocally
demonstrates that underpricing has decreased over time in India as well, as the
country's securities market transitioned from a post-liberalization one to an initial regulated
one and then to a reformed one. In
addition, IPOs issued through the book building process often have far lower
average underpricing than IPOs issued under the fixed pricing method. Since
over 80% of IPOs since 2001 have been issued through the book building process[13],
this is the reason why more businesses have begun to choose it as their
preferred IPO issuance technique since 2004.
Conclusion
A nation's regulatory framework has a
big impact on how much underpricing occurs in initial public offerings (IPOs).
Issuers, investors, and intermediaries have better opportunity to capitalize on
market conditions in a more reformed market. By lowering information asymmetry,
the regulatory framework aids investors in making well-informed decisions.
Since 1992, there have been significant modifications to India's primary market
regulatory framework. The primary market in India has been able to develop and
become more competitive with other developed markets worldwide because to the
reform process. The aforementioned study unequivocally demonstrates that
underpricing is a widespread occurrence in IPOs across nearly every nation.
There are several reasons why initial public offerings (IPOs) are underpriced.
To lessen underpricing in initial public offerings (IPOs), SEBI and other
regulatory organizations have implemented a number of initiatives, some of
which have also produced the expected outcomes.
It has also been noted that
regulatory actions taken by SEBI to protect the interests of retail investors,
such as IPO grading and the anchor investor, are not very successful. In the
Indian IPO market, investor sentiment is a significant factor, as seen by
variations in initial returns based on market phases and IPO pricing at higher
or lower price points.
Although the number of companies
going public in India has increased recently, we are still far behind other
developed economies in this regard. As a result, IPOs are sometimes viewed more
as opportunities for speculation than as ways to diversify portfolios.
Furthermore, the efficiency of the Indian IPO market has not increased with the
transition of the putting process from fixed price offerings to book building.
It is unfortunate that intermediaries' activism in India lacks transparency
following listing. A list of comprehensive details that the intermediaries must
furnish and publicize when trading shares following listing should be arranged
by SEBI as soon as practicable.
The correct actions being taken by
SEBI to uphold and sustain investor confidence and enhance corporate governance
standards in companies will play a crucial role in the future in lowering IPO
underpricing.
[1] Eckbo BE, ‘IPO Underpricing’, Handbook
of Corporate Finance: Empirical Corporate Finance. Volume 1 (Elsevier 2008)
[2] Ibid.
[3] Jain N, ‘Underpricing of Initial
Public Offerings in the Indian Capital Market’ [2009] SSRN Electronic Journal
[4] Rock K, ‘Why New Issues Are
Underpriced’ (1986) 15 Journal of Financial Economics 187
[5] Ibbotson RG and Jaffe JF, ‘“hot
Issue” Markets’ (1975) 30 The Journal of Finance 1027
[6] Benveniste LM and Busaba WY,
‘Bookbuilding vs. Fixed Price: An Analysis of Competing Strategies for
Marketing Ipos’ (1997) 32 The Journal of Financial and Quantitative Analysis
383
[7] Brennan MJ and Franks J,
‘Underpricing, Ownership and Control in Initial Public Offerings of Equity
Securities in the UK’ (1997) 45 Journal of Financial Economics 391
[8] Ljungqvist A, Nanda V and Singh R,
‘Hot Markets, Investor Sentiment, and IPO Pricing’ (2003) SSRN Electronic
Journal
[11] ibid
[13] Bhalla,
Lalit, and Vijay K. ‘IPO Underpricing.’ (2014) Sch. J. Econ. Bus. Manag 1,
no. 4.
Article Information
IMPACT OF REGULATORY FRAMEWORK ON INITIAL PUBLIC OFFERING (IPO) UNDERPRICING IN INDIA
Authors: AAYUSHI AGRAWAL
- Journal IJLRA
- ISSN 2582-6433
- Published 2024/01/23
- Issue 7
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International Journal for Legal Research and Analysis
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