Trends and returns of initial public offerings in India With special reference to the period 2006-08.
The existence of the phenomenon of "underpricing" is a well-established phenomenon for the common stock initial public offerings (IPOs). Research concerning the primary capital market has unequivocally concluded initial public offerings are offered at a discount. It has been found that an average firm goes public with an offer price that is lower than the price that prevails in the immediate aftermarket. As a result, IPOs register significant excess returns on the first day of trading. The underpricing is thus corrected by the market on the listing day.
During the fiscal year 2000-01, the book-building route was made compulsory for companies, which do not have the track record of profitability and networth as specified in entry norms prescribed by SEBI. The book-building route has also been made compulsory for IPOs with issue size more than five times the pre-issue networth and for public issues by listed companies worth more than five times the pre-issue net worth. In these cases also, 60 percent of the 'offer should be allotted to Qualified Institutional Buyers(QIBs). While book building has become increasingly popular especially for large issues, smaller issues by relatively small firms continue to be offered on fixed price basis. Though other issuers can use fixed price offers also, most have been using book-building route ever since. The reason being that there are no restrictions on minimum asset size and profits incase it opts for the latter provided it is able to place at least 50 percent of the stocks offered to QIBs.
The existence of the phenomenon of "underpricing" is a well-established fact for the common stock initial public offerings (IPOs). Research concerning the primary capital market unequivocally concludes that the initial public offerings are offered at a discount. It has been found that an average firm goes public with an offer price that is lower than the price that prevails in the immediate aftermarket. As a result, IPOs register significant excess returns on the first day of trading. Underpricing is a phenomenon that is largely restricted to the opening transaction. And hence, the underpricing is almost entirely "corrected" by the market at the opening transaction.
This study aims to study the initial and long run returns of common stock initial public offerings made during the years 2006 and 2007 and understand the level of underpricing. It aims to understand the relationship between the performance of the index and the average returns of the IPOs of some important sectors. This paper is organized as follows: Section 2 gives the overview of trends and performance of IPO during 2006 and 2007; Section 3 reviews the empirical literature on the performance of IPOs in the short and long run; Section 4 describes the data sources and methodology of study; Section 5 presents the results and analysis and section 6 concludes the findings of the study.
Trend in the IPO Market
The number of issues during 2003 to 2007 grew at a good pace which peaked in 2007 due to high market sentiments, good economic growth, exceptional high FII activity, market friendly regulations etc. The period of study (years 2006 and 2007) was an important one since Indian companies raised Rs. 33,258 crores through 78 Initial public offerings in 2006. This was due to the fact that the Indian economy exhibited acceleration in growth, led by manufacturing and services sector activities, in this period, facilitated by financial market conditions, which remained orderly. Real gross domestic product growth accelerated from 9.0 per cent during 2005-06 to 9.4 per cent during 2006-07.
The year 2006, owing to the strong investment climate in the economy, was an exceptional year for the Indian IPOs, India being the eighth largest, the first being the United States, followed by Japan and China. The energy companies raised more than 59 percent share of funds raised. Real Estate and Energy sector dominated the surge in IPOs in 1997, too. This was due to the high growth in the corporate sector, a near double-digit economic growth, phenomenal growth in the sensex spurred by the heightened foreign institutional investors (FII) activity etc. Localization and qualified institutional placements also picked up. During 2006-07, cross-border activity and role of foreign capital grew and FIIs contributed three-fourth of new capital flowing into the market. The benchmark index, sensex gained over 44 percent between January'07 and December '07. The year 2007 will be remembered as one of the best years for stock investing as the domestic market more than doubled in value. The market capitalization during the year, increased by 110 percent. The period under study saw seven top infrastructure companies, such as Larsen and Toubro, Patel Engineering, Punj Lloyd, Nagarjuna Construction, IVRCL and Hindustan Construction growing by over 50 percent. This sector attracted total investment of over 2 crore between April 2005 and March 2007 including two mega hydro power, road and metro projects.
Real estate companies were the foremost sector in mopping up huge amounts from the primary market through IPOs during 2007. Quoting the figures given by Assocham, property developers mobilized as much as 42.7 percent of the total funds through IPOs. Table 1 lists the amount mobilized during the last few years by initial public offerings.
Out of total Rs 34,119 crore raised in the primary market from January 1, 2007 till mid December, Rs. 14,591 crore was raised by realty firms. DLF mob ilized Rs. 9,1 87 crore, Housing development and Infrastructure Ltd Rs 1,707 crore and Purvankara Projects Rs 858.7 crore. Real estate companies namely IVR Prime Urban Developers (Rs 778 crore), Omaxe (Rs 650 crore), Brigade Enterprises (Rs 671 crore) and Akruti Nirman (Rs 361 crore) raised money through public issues. Power and telecom companies raised Rs. 4,519.18 crore and Rs 2,964.06 crore respectively. Even though interest rates were high to curb inflation and the RBI and the govt., curbed the real estate sector to access funds, they proved to be most aggressive in raising funds (refer to table II). The factors contributing to the growth was due to strong underlying demand, easy availability of home loans, easy repayment facilities, aggressive marketing, entry of new players and upsurge in retail and multiplexes.
Due to the US recession, prevailing slow-down and volatility in the Indian markets, IPOs are giving way to private equity route. The Indian realty sector which was earlier on a boom, witnessed a deluge of funds from investors and builders, despite the private equity deals picking up. Another trend was entity level partnerships in realty sector, such as that of Morgan Stanley acquiring a stake in Mantri developers. Overseas builders too perceive a huge opportunity in this market. The other sectors too faced slowdown due industrial slowdown, drying up of foreign funds and high oil prices, 2008 onwards. Due to supply constraints and sluggish increase in output, major infrastructure industries- crude petroleum, petroleum refining products, coal, electricity and finished carbon steel suffered major drop in growth.
By the third week of January 2008, the sensex was down by 10 percent. Banks were badly affected due to the US sub-prime losses and real estate and oil sector were also major casualties. Only 3 IPOs were issued in the first quarter of 2009. FIIs are waiting for a more stable environment to start investing again, a scenario which is expected to take a couple of more quarters.
Quoting a report by SMC Capitals in March 2009, out of 278 IPOs during 2005-2008, only 13 percent are in the green. This was when the sensex gained 51 percent during this period. The IPOs of 2006 traded at a loss of 19 percent whereas the IPOs of 2007 at a loss of 44percent. Only the infrastructure IPOs of 2006 were trading at a gain of almost 35percent. Table III gives the average returns for the last four years.
On studying the initial returns of IPOs, it was observed that underpricing has been the norm rather than the exception to compensate uninformed investors. Benveniste and Wilhelm 1990, Spatt and Srivastava (1991) and Benveniste and Busaba (1997), have proved by using theoretical models that book building as compared to fixed price option has shown lower underpricing. Benviniste and Spindt(1989) study showed that underpricing is a natural cost of compensating investors for giving truthful disclosure of private information. The early empirical studies on IPO markets in India focussed mainly on initial returns. A study by Krishnamurti and Kumar (1994) from 1992-93 for 98 IPOs revealed an average initial returns of 35.3 percent, Shah(1995) mean initial returns of 105.6 percent for the period Jan 1991-April 1995 on a data set of 2056 IPOs. The significant level of underpricing could be to compensate retail investors for their ignorance as reported by some studies done during the mid 1990s. The study conducted by Pandey and Arun Kumar (2001) found mean initial market adjusted returns of 69.8 percent on equally weighted basis. Though, most of the analysis was pertaining to initial returns rather than longrun returns, Shah (1995) reported that IPOs reported high average long run returns. This could be possibly due to the optimistic market sentiment and liberalization in the Indian economy post 1992.
Subsequently the long run returns started reducing and a large number of issuers are reported to vanish after mobilizing capital. A worldwide survey of literature on the phenomenon of underpricing of IPOs exhibit three fundamental characteristics: (a) the initial price reaction phenomenon or in other words 'underpricing': the immediate after market price, on average is significantly higher than price at which the initial offer was made; (b) the Hot Issue Phenomenon: there are distinct cycles outlined, both in the number of issues that come to the market and the level of initial price reactions; (c) the long-run "Underperformance" phenomenon: initial offers are said to perform dismally in the long-run compared to the industry counterparts for the same period.
The data on IPOs for the years 2006 and 2007 was obtained from the official website of National Stock exchange, www.nseindia.com. A total of 168 public issues were issued in the calendar years 2006 and 2007, through the National Stock Exchange, out of which, 73 were issued in the calendar year 2006 and 95 in 2007. Out of the total, 34 IPOs could not be studied due to late listing, follow on shares, or non-availability of the continuous time-series of their prices on NSE. Thus a total of 134 IPOs were analysed for initial returns. The IPOs included in the sample had to be common stock only, be the company's first public issue, listed on NSE and those whose share price time series were available for 500 trading days since listing date.
Of the 134 IPOs, as many as 34 were from the infrastructure industry comprising of power, telecom, mining, cement, highways etc. and 14 were from the realty sector. The rest being from entertainment (12), Information technology (10), banking (10), pharmaceuticals (9) and textiles (8) industry. Thus out of 119 total IPOs in the period during study, a sample of 48 IPOs (34 from infrastructure and 14 from realty) were studied in detail regarding their initial and long run returns and compared with their respective indices namely CNX Infrastructure index and CNX realty index. The infrastructure sector picked-up, benefiting from strong growth in cement, basic metal and alloy industries.
The 25-stock CNX Infrastructure Index represents about 78.77 percent of the market capitalization and 77.07 percent of aggregate turnover of the companies forming part of the Infrastructure Sector Universe. Infrastructure Index constituents represent about 21.43 percent of the total market capitalization as on March 31, 2009. CNX Infrastructure Index includes companies belonging to Telecom, Power, Port, Air, Roads, Railways, shipping and other Utility Services providers.
The initial returns on the total sample of 134 IPO's were studied by finding their percentage return based on the first day of listing as given by-
Where, P= Closing price on the day of listing
O = Offer price
Long Run Returns
The long run performance of only 48 IPOs, 34 from the infrastructure and 14 from the realty sector IPOs were considered. These being the sectors, which mobilized the maximum funds during 2006 and 2007, exhibiting the robust growth of the economy. For analysing long run performance of the IPOs in the sample, the average daily returns for upto 500 trading days after listing were considered. This was done by computing the average daily return of 500 days after the day of listing.
Longrun performance was computed by: ([P.sub.t-] [P.sub.t-1])/ [P.sub.t-1] where Pt = Closing price of the stock on day
As 34 of the 134 IPOs in the sample are from infrastructure sector, the returns are compared with CNX Infrastructure index and the relationship between the two is judged by the Student t test for finding significance of difference of mean. For the realty sector (14 IPOs), CNX realty sector was used.
The standard deviation, which measures the risk of the asset, is also computed for realty and infrastructure IPOs under study.
The correlation of infrastructure companies and CNX Infrastructure index and correlation of realty companies and CNX Realty index was computed.
The sensitivity of the IPOs with the market movements, indicated by the beta value is also calculated to study the systematic risk of the IPOs under study. Beta for the security X is calculated by following formula: [beta] = cov([R.sub.x], [R.sub.w])/Var ([R.sub.w])
where return on IPOs which is dependent variable (Rx) and return on market index is the independent variable (Rm). Since the CNX infrastructure index and CNX realty index were formulated in February 2006 and December 2006 respectively, the average daily returns of the indices, the t-test for difference of mean daily returns, the correlation between the IPOs and the index and the beta value has been calculated from the average daily returns from February 2006 and December 2006 for the infrastructure and realty IPOs respectively. The study faced some limitations constraining the inference on long run performance. The market returns need to be adjusted with an index, which is representative of small capitalization stocks. The results otherwise, could be easily affected due to the presence of well known "size affect" in the capital markets. A further study could be made by considering the issue-size weighted initial returns and average cumulative adjusted returns for long run performance.
Findings and Analysis
In line with the evidence on initial returns from IPOs worldwide, IPOs included in the sample also provided positive and significant initial returns on an average. The average initial returns were positive and significant. It was 28.34 percent on an average for the years 2006 and 2007, based on the opening offer price and the closing price of listing day. This was 24.95 percent for the year 2006 and 30.63 percent for the year 2007. The median returns on these IPOs were 15.67 percent, even though the variance of the initial returns was at 52.25 percent. Out of the total sample of 134 which were studied for initial returns, 45 IPOs were underpriced whereas 89 were overpriced (refer table IV). The equity markets were very volatile during the second-half of August 2007 and second-half of December, in tandem with trends in international equity markets.
The 34 IPOs of infrastructure industry gave average initial daily returns of 37.32 percent ranging from -30 percent to 235 percent. The median returns of this sample were 27.34 percent. The issue size of this sector ranged from approximately 24 crore to 5261 crore, the average issue size being 502 crore.
The 14 IPOs of realty sector gave initial average daily returns of 20.95 percent ranging from -24 percent to 75 percent. The median returns were 14.62 percent. The issue size of realty sector was much higher, ranging from 51 crore to 9187 crore, the average issue size being 1073 crore. While the standard deviation of the realty sector was 30.86 percent, it was as high as 55.2 percent for the infrastructure IPOs.
The cross-sectional differences in initial returns arises due to various factors like quality of underwriters, institutional and venture capital stake in the firms, proportion of the issuing firm's capital being offered in the IPO, financial competence, reputation, size of the issue, age of the issuer etc.
Long-run Performance of the IPOs
Return on IPOs decline with the passage of time (long-run). Daily return for the 500 days period also shows a decrease with the passage of time. Whereas the average daily return for the 500 days after listing is -.11 percent for the realty sector, it is -.03 percent for the infrastructure sector. The positive returns of both have been wiped out by the third day.
Whereas the infrastructure initial public offerings have negligibly underperformed the index, the realty offerings have shown almost similar performance as the CNX realty index. The standard deviation for the realty sector IPOs was 1.56 percent whereas for the infrastructure companies, it was .90 percent, which is insignificant. These sectors have thus not shown much volatility and risk during the years under study. Infact, infrastructure sector during 200607 showed highest growth since 1999.
While 19 of these 33 infrastructure IPOs ended 500 days with positive average daily returns, remaining 14 had negative average daily returns. For realty IPOs, only 4 showed positive average daily returns for 500 days, and the rest 10 negative returns. There was insignificant correlation between infrastructure companies and index at .12. (The CNX infrastructure index has been taken from 17th Feb '06 post its formation upto 500 days).
Between realty companies and its index, there was no correlation. (The CNX realty index average returns have been taken from 2nd Jan '07 post its formation upto 500 days).
Graph 1 traces the changes in average daily returns of realty and infrastructure IPOs from month 1 to month 17 starting from January 2006.
The correlation between infrastructure IPOs is 0.76 and for the realty IPOs 0.99, which is very strong.
The beta value for the realty IPOs is computed to be 0.92 whereas it is 0.46 for infrastructure IPOs. Since, these are less than 1; it indicates that the IPOs under study are less volatile than the market. ([beta]<1) indicates that the security has less systematic risk or is less volatile than market.
Overall the results are consistent with evidence of relatively poor long run performance of IPOs reported across countries. The findings do not agree with the analysis of Shah (1995) which shows excess returns on IPOs even after listing. According to this study, most of the excess initial returns on an average are wiped out in the first year after listing. The study however has informational constraints. The excluded IPOs from the sample were the ones for which time series data was not available.
The gains made by the IPO investors soon turned to losses due to underpricing and spillover effects of the US sub-prime mortgage crisis seen in India too by the mid of 2009 but the adverse impact could be felt much earlier. The banking and the realty sector were most prominently adversely affected since the RBI raised CRR, SLR and the interest rates to reign in inflation. The housing sector, heavily dependent on loans are facing a demand slowdown and falling prices which is expected to continue for the next two years. Developers who are specialized in building homes and offices are planning to expand their scope of work by building warehouses due to the high growth in Indian retail sectors and slowdown in realty sector.
The bullish trend in the capital market was seen in the IPO volume of 2007, as a record volume of USD 8.18 billion was raised. This was due to the accelerated growth in the Indian economy led by manufacturing and services sector activities. However, the value of the amounts raised has heavily eroded by Oct 2008 across all industry segments.
* This study investigates the initial and long run (up to 500 days) returns of common stock initial public offerings in the years 2006 and 2007. The average initial returns made on the first day of listing on the offer price are quite high at 28.34 percent. Only 44 out of the 134 IPOs that were made after 1 January 2006 till 31 December 2007 were listed at a discount, the rest at a premium.
* The long run performance of 48 IPOs under study belonging to the infrastructure and realty sector, the hot sectors under the period of study, showed insignificantly negative, long run average daily returns (up to 500 days). The SandP CNX Nifty index gave a positive but average daily return of .17 percent.
* The long run average returns of the realty and infrastructure IPOs were found to be consistent with that of their respective indices.
* The standard deviation of both the sectors, realty and infrastructure, is negligible, As such, investing in these sectors in 2006 and 2007 were not risky for the investors. Infact, the IPOs of infrastructure sector which came in the market in 2006 were still trading at a profit in March 2009. The growth of core infrastructure industries at 8.6 per cent during 2006-07 has been the highest since 1999-2000 (9.1 per cent).
* There was insignificant difference of means of average returns of IPOs and the respective index, as verified by t-test.
* There was high correlation and thus high degree of relationship between realty and infrastructure IPOs and their respective indices.
* The IPOs of realty and infrastructure IPOs have shown less systematic risk than their respective indices. Thus their returns were less volatile than the returns on their respective indices. The reason could be attributed to the favourable economic scenario in these years.
* The infrastructure and realty sectors were good sectors to have invested in the period 2006 and 2007.
* Acceleration in the growth rate during 2006-07 was attributable to buoyancy in the industrial and services sectors, which exhibited double-digit growth (11.0 percent). This favourably affected the performance of IPOs. (see chart 2)
Going forward, pricing of the forthcoming issues in the bear market will be a major challenge for the issuers as the fundamentals and technicals of the issue prices are not being considered by the market. The forthcoming IPOs may witness an underpricing in their share values in order to get their issues subscribed. Another interesting area of further research would be the impact of share allocations, which is decided by a variety of means, on the IPO's performance on the first day.
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Table--I Resources Mobilsed from the Primary Market Rs. No. of (Crore) IPOs 2000-01 2,722 114 2001-02 1,202 7 2002-03 1,039 6 2003-04 3,434 21 2004-05 13,749 23 200506 10,936 79 2006-07 28,504 77 2007-08 42,595 85 2008-09 (as on 31/01/09) 2,010 20 Source: handbook of statistics on the Indian securities market 2006, www.sebi.gov.in Table--II Distribution of IPOs during Jan'06-Dec'07 IPO amt (Rs % crore) share Construction & real estate 18641.7 21.17 Construction (excluding DLF) 9454.2 10.74 Banking & Finance 16261.6 18.47 Oil & Gas 14243.1 16.17 Manufacturing 21854.45 24.82 IT, telecom and other services 7604.6 8.64 Total 88059.65 100 Source: ETintelligence.com Table--III Trends of returns No. of IPOs Returns as on March 17,2009 2005 -25.19% 2006 -19.03% 2007 -44.39% 2008 -56.27% Table--IV Initial returns of IPOs under study Returns greater No. of issues than 99% 9 75% 17 60% 27 50% 34 40% 47 30% 54 Table--V Findings Infrastructure Average daily returns-. -.03 Standard deviation. 90 Average daily .15 returns of SNP infra index t-test for difference insignificant of means between average returns of index and IPOs Correlation between .76 IPOs and index. Beta(index and IPOs) .46 Realty Average daily returns-. 11 Standard deviation 1.56 Average daily -.20 returns of SNP realty index t-test for difference insignificant of means between average returns of index and IPOs Correlation between .99 IPOs and index Beta (index and IPOs) .92