Initial Public Offerings
Initial Public Offerings
Underpricing of Initial Public Offerings (IPOs) is a historic norm in both developed and developing. Hiring of underwriters to place reasonable price for IPOs has been a custom of equity markets with average under pricing in between the range of 10-17%. However, during last decade, world view most unjustified under pricing ratios with the level rising to over 50%. From the 7% under pricing in 1980s to 15% ratio of under pricing during early 1990s, the ratio has raised to substantial levels during 2000s (Loughran and Ritter, 2004).
The increase in under pricing is mainly attributed to potential gains or returns that investors and even owners/issuers achieve on next few days or after lockup expiration. The key indicator for determining return achieved by investors is the intraday return which measures single day change in price and therefore, gains for investors. While the general assumption about motives of under pricing are often highlighted in several research works, it has been a controversial issue given the potential manipulation by IPO firms and underwriters.
According to Securities and Exchange Commission and National Association of Securities Dealers, the investment banks acting as managers of security listings, have artificially manipulated prices of IPOs to gain from inflated returns. Several unlawful commissions obtained by investment banks have been detected by lawsuit firms which were collected in return for illegal trading activities and artificial demand of IPOs.
While thorough research projects for developed and developing nations is easily available for investors’ references, particular attention is drawn towards Asian markets that have booming equity markets and attract investors around the world. Several researchers have investigated IPO process, their under pricing and associated factors in Hong Kong, however, there is very limited up to date data available for potential investors. Very limited number of authentic researchers has investigated the relationship between the rate of subscription and the underpricing of IPOs in Hong Kong from 2003 onwards.
During 2000s major structural and economic changes have taken place in the equity markets around the world including the Asian markets. One of the two major structural changes includes mergers between equity and derivative exchanges around the world and between Hong Kong Stock Exchange and Hong Kong Futures Exchange. Also Hong Kong since 1990s has seen several remarkable improvements in the market conditions due to capital inflows from China’s outstanding growth. The period after 2000s holds importance from a perspective of a boom in economy that has brought changes in analysis of factors affecting the IPO issues and their returns.
This project intends to investigate the trend of IPO under pricing in Hong Kong’s market and its effect on intraday returns of investors. The intraday return is measured on basis of rate of subscription and market price of IPO on listing day. Where developed countries like France, Germany and UK had under pricing ratios of 16. 5%, 40. 2% and 39. 6% during early 2000s, developing Asian countries had under pricing ratios in range of 18% to 50% (Chi, and Padgett, 2005).
Apart from intraday return and subscription rate, there are several cost related factors associated with IPO under pricing that will be considered in analysis of Hong Kong market. The IPO allocation process in Asian markets varies from developed countries as in Asian market non-discretionary allocation is done. In non-discretionary IPO allocation process, funds are taken from investors up front and are held until process of allocation ends. Such process involves certain amount of cost on investors’ behalf which must be subtracted from overall return for IPO.
Apart from this, underwriters’ compensation and listing costs are also included in IPO process. The intraday returns are analyzed on basis of first day return as well as financing and listing costs. IPOs and their underpricing is a norm in equity markets since it is a strategy used by firms through underwriters to attract new investors for a potential gain. The pricing of an IPO is determined on basis of several factors which include the book value of the shares being offered, its debt to equity ratios, asset-backing ratios and several other performance and composition based factors.
The investors of IPOs are normally keen on earning an intraday return for their investment in IPO. Intraday return is commonly used as a measure of initial public offering (IPO) underpricing (Chi & Padgett, 2005). The more underpricing of an IPO will provide more return for the investors but more opportunity loss for the previous shareholders or firm (Ross, Westerfield &Jordan, 2008). An equal important concept is that of subscription rate which refers to the number of applications that are received for subscription of the IPO that is being launched.
Loughran and Ritter (2004) reported that underpricing in the US ranged from 7% in the 1980s to 15% in the 1990s before declining to 12% in the post-bubble period. The underpricing practices differ in different states based on their underwriting practices in each country as well as the information available to and demanded by the investors regarding factors that formulate the pricing for IPOs. A study by Chen, Firth and Kim (2004) provided an insight into the Chinese stock market and their techniques of IPO underpricing.
Similarly, Kucukkocaoglu (2008) presented a paper on comparison between international practices of IPO underpricing and the one being followed in Turkey. Hong Kong stock exchange (HKEx) is relatively a volatile market given the developing stage of its economy and financial industry and therefore, has attracted several researchers towards studying the performance of its IPO market and considering the underpricing techniques used. Information about the ratio of the adjusted net tangible assets per share to the offering price (the assets-backing ratio) and the rate of subscription is publicly available to investors.
However, the importance of these factors in determining the underpricing of IPOs and its outcomes is unclear for many economies where the research is either incomplete or prior the major economic changes in that state. For instance, the studies on IPO underpricing in Hong Kong and the major factors associated with it are dated back to late 1990s and therefore, provide less discerning and valid information for investors who are looking for investment opportunities today.
Lack of information regarding Hong Kong’s market during 2000s is a hindrance to knowledge of international investors who are in search of factors related to IPOs that affects their initial returns and therefore, returns for investors’ money. For instance, the severe under pricing of IPOs witnessed during 2000s with its first day return reaching to level of 65% is unexplainable to common investors and even to some analysts.
The motive of this paper is firstly to understand the reasons for under pricing of IPOs in Hong Kong and study of various factors that directly or in directly affect IPO underpricing as well as intraday returns. These factors include rate of subscription of an IPO which again is related to asset value of firm that is ready to be listed on stock exchange as well as information asymmetry that is present in markets. Apart from this, factors like subscription rate and asset-backing ratio are then tested against underpricing levels and intraday return to determine the extent of direct or indirect relationship between these factors.
The main objective of this study is to determine the relationship between various factors that lead to under pricing tactics by organizations and the relationship between rate of subscription and asset-backing ratio to IPO underpricing based on their initial returns. The relationships will also be determined interchangeably for instance, relationship between rate of subscription and intraday return will also be determined. The study contains several sections contributing to the analysis of the paper.
The statement of research will provide a detailed description of what the paper investigates in this research and what are the main questions to be answered. The purpose of conducting a research of this sort is also explained along with its significance to various groups of readers including investors and analysts. The sample for this study consists of databases related to around 284 IPOs that have been listed on HKEx during the period of 2003 to 2008. Since there are no recent studies conducted on similar area in Hong Kong market, the data used in this study provides fresh information and analysis.
The project is divided into several sections that provide overview of Hong Kong’s IPO market as well as selection of IPOs to be analyzed. Secondly, the major explanations offered for the underpricing of IPOs by major researchers and scholars are provided. This also gives a way to further analysis of factors and hypotheses that are needed to be developed in this research. The next section will proceed to discussion of measurement of variables and determination of relationships between various elements related to IPOs and methods that will contribute towards establishment of that relationship.
Finally, the measurement methods will be applied to test hypotheses presented above and results will be presented along with discussions. Further explanation of chapters is given below. The literature review provides a summary of past and current trends in empirical research on IPO underpricing. The section will review contributions of several researchers in the field of studying Initial Public offerings and its underpricing in various countries and specifically Hong Kong. Then the methodology will include different sections providing information pertaining to the research methods that have been employed in this paper.
Several models and hypotheses have been developed to explain this phenomenon. Finally the data collection and analysis will summarize the whole research into tangible and valid conclusions based on results gathered from using the research methods chosen earlier. Statement of the Research Problem Several researchers after 1980s have shown immense interest in the initial public offerings, its price calculation, initial returns and the impact of various factors like subscription rate, asset-backing ratios and company performance on underpricing of these IPOs.
Loughran, Ritter, and Rydqvist (1994) completed a comprehensive survey of companies going public in 25 countries from 1980 to 1089. They found that the average initial return in Hong Kong was 17. 6%. Chong, Yuan, and Yan (2006) mentioned that the average IPO underpricing level for H shares—shares of companies incorporated in mainland China that are traded on the Hong Kong Stock Exchange (HKEx)—from 1993 to 2003 was about 16. 8%. This figure is similar to the level of underpricing found in developed countries. Prior studies have presented various models to explain the underpricing of IPOs.
Kiymaz (1998) presented a paper on review of performance of Turkish IPOs through assessment of underwriting techniques and methods used by underwriters in Turkey. The study analyzed IPOs launched during 1990 and 1996 on Istanbul Stock Exchange (ISE). Similarly various researchers (Chen, Firth & Kim, 2004; Kucukkocaoglu, 2008) have conducted empirical research on establishing relationship between valuation methods and under pricing of IPOs in different countries including Turkey, China and Bangladesh, using listed IPOs for a specific time period.
Kucukkocaoglu (2008) in his study analyzed the IPO underpricing methods in Asia and recommended methods to control the volatility in these markets. Umutlu (2008) also focused on factors like pecking order and timing that can affect performance of IPOs. Prior studies have presented various models to explain the underpricing of IPOs. Burgstaher and Divhev (1997), during their research on IPOs inferred that asset value of firms present a curve function which means that they are relative to values of firm’s earnings as well as its book value.
Among these factors book value factor is the most important factor affecting value of firm. Based on the book value of firm, underwriters deduce firm’s IPO initial price offer. Therefore, it can be concluded that underpricing of IPOs is somehow related to net asset value of firms. Similarly, rate of subscription is another important factor that is based on demand for IPO of a firm. The more demand is created for a specific firm’s IPO; the greater will be its subscription rate. Studies by Vong, conducted in 2006 as well as in 2009, consider IPOs in Hong Kong that went public during late 1980s and early 1990s.
However, no research has been conducted on the relationship between the assets-backing ratio and the underpricing of IPOs in Hong Kong from 2003 to 2008. No research based on this time frame tests the relationship between the assets-backing ratio and the underpricing of IPOs in Hong Kong. This study attempts to fill that gap. This study also seeks to address the idea that the subscription rates of offerings provide valuable information about how the intraday returns affect the first day of trading for a company’s stock shares on the HKEx.
Given the importance of these factors, it can be said that this study has two main objectives. Firstly, this study intends to record extend the IPO data for Hong Kong’s stock market and present the level of underpricing that took place during more recent period i. e. during 2000s. Given this objective the period of 2003-2008 is chosen to incorporate latest changes that have taken place on world’s economic platform. This period enables a relatively large sample of issues to be examined by considering a substantial number of Hong Kong IPOs following economic inflation and then bubble burst in 2003 and economic deterioration in 2008.
After examination of level of underpricing in Hong Kong, the project will evaluate the main area of research which includes understanding of factors that positively and negatively affect intraday returns of IPOs. These include the level of subscriptions and asset-backing ratio which incorporates a firm’s asset value. This area of study draws largely upon the existing models for levels of underpricing (Baron, 1982; and Rock, 1986) and the related theoretical and empirical literature derived from these models.
From this literature, a number of hypotheses are formulated and tested. Despite various studies conducted on IPOs in Hong Kong and the factors affecting them, there is a need for information upgrading for the investors and analysts. During 2000s major structural and economic changes have taken place in the equity markets around the world including the Asian and European markets. Hong Kong has been given tremendous attention by investors around the world for its continuous progress and investment products.
The performance of IPOs and their underwritings methods, therefore, have also seen changes that have affected their performance. This study attempts to fill the gap between the previous studies that have attempted to analyze Hong Kong market’s performance during early 2000s and the current performance of Hong Kong markets, before and after the market downfall worldwide. This study extends the body of research presented by Vong (2006), who used 251 samples to conclude that there was a relationship between the rate of subscription and IPO underpricing in Hong Kong from 1988 to 1995.
University/College: University of Chicago
Type of paper: Thesis/Dissertation Chapter
Date: 10 October 2016
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