Fault lines have appeared in the primary market. These have been recurring, but recent actions taken by the regulator in some of the initial public offerings (IPOs) helped highlight the issue (see the previous column “Fault lines in the Indian IPO market,” January 9). A serious reparation effort of these fault lines would involve a careful analysis of the three primary factors that have largely influenced the behaviour of the market, and the pricing of issues, the participation in issues and the processes involved. Interlacing these factors is the behaviour of the investors.
The perfect pricing of an issue has been a challenge in every market. Finance literature over the past four decades is replete with examples of underpricing of IPOs. Underpricing is a term used when the issue price of shares of a company that is raising public equity capital and seeking to list itself on a stock exchange is below the closing price of the shares on the first day of listing. There is no single explanation for underpricing but, theoretically, underpricing should afford the investor an opportunity to make substantial first-day listing returns and this is known to the issuer and the underwriter. Alexander Ljungqvist of Stern Business School, Tim Jenkinson of Oxford University and Willliam Wilhelm of University of Virginia have worked extensively on IPO pricing, investor sentiment and IPO allocation. In one of their papers, they analyse the data from 65 countries between 1992 and 1999 to show, among other things, that book-built issues contrary to expectations do not necessarily lower underpricing in all countries. Other international evidence documents that subscribing investors in US, UK, Swiss and Italian IPOs of manufacturing companies, prior to the financial crisis, made double-digit gains and statistically significant positive first-day returns [see Review of Financial Studies (2003) and Journal of Financial Economics (2002)]. Of course, the IPO process is not similar in all these countries. In the US, book-building is the only method, while all others have a mix of fixed-price and book-built IPOs.
Since 1999, the Indian primary market has evolved from a mix of fixed-price, book-built and hybrid issues to only book-built issues. The available literature on Indian IPOs covering the entire decade (2000-10) is not extensive. But the existing works reach a somewhat confusing conclusion that book-built IPOs have greater oversubscription but lower underpricing.
Trading at a discount to the issue price, days and months after listing is common in many markets and it may occur for a host of reasons. In the US market, for example, according to data on the New York Stock Exchange, more than 50 per cent of IPOs were traded at a discount as on December 31, 2011. But what is perhaps unique to Indian markets is that IPOs with retail oversubscription, in particular, make positive returns in the first few days of listing and then rapidly trade at deeper and deeper discounts. The cases of IPOs against which regulatory action was taken fall in this category. There is, however, not enough literature on this trend that is not of a recent origin in India.
This uniqueness raises some policy concerns about the quality of issues that are permitted to be listed and the quality of intermediaries. It also begs the question as to why only the Indian primary market displays this unique phenomenon. Does it mean that the IPO entry-point norms – which have undergone frequent revisions in an attempt to capture all possible scenarios – are still inadequate in critical areas? And, thus, do these need a fresh look, strengthening and simplification because “other peoples’ money” is involved? Do pricing norms need to be re-examined so as to ensure compliance beyond just paper? Or, should the regulator review the responsibilities of lead managers and book runners and introduce some financial obligations on them to serve as economic deterrents. In any case, the unhealthy nexus that often develops between the issuer and lead managers and other intermediaries certainly needs to be broken. For solutions, it would be useful to look beyond the usual and the obvious. Common place and impractical resolutions to these questions should not include solutions like the end-use monitoring of funds, which in any case, after a while, is bound to remain only on paper. Sometime ago, experts of the Indian market hailed credit rating of issues as the ultimate protective talisman for the investor. It has not worked well so far. A study of many IPOs in the past year or so would show that there is no statistically-significant correlation between the rating and extent of oversubscription.
IPO processes have undergone several changes that have all gone down well with investors, issuers and intermediaries, and the issue costs for Indian IPOs should now be globally comparable. That leaves only a discussion on the IPO participation and for this an understanding of the investor psychology and behaviour is important. This can happen only if one is able to hear their voices and analyse them rationally.
We live in an age of Facebook and smartphones. In an age that seeks “instant gratification” and “quick-fix” solutions, it would be erroneous to expect all investors to always think of the long term. It would be their natural behavioural tendency to make a fast buck. This tendency drives oversubscription, selling immediately on listing and even day-trading. Unscrupulous issuers and intermediaries make the best use of this investor behaviour by entering into unholy alliances. Rather than attempting to curb the investor behaviour, regulatory policy interventions should focus on finding ways to make these “unholy alliances” economically unviable.
When fault lines appear in any system, a quick patchwork may be sufficient to mend them. But when these fault lines begin to appear frequently, it would be symptomatic of a deeper and perhaps malignant malaise. A “newthink” is necessary. What commonly stand in the way of such attempts are: the inability to overcome the fear of the unknown and the untried, the power of dominant logic embedded in the comfort zones of existing systems, lack of clarity of objectives and selfishness of the agents of the existing system. If the same “suspects” who helped build the existing system are given the task of the “newthink”, it is possible that their self-interest would lead them to do patchworks — larger patchworks at best. “Newthink” needs new and fresh minds, and a deep understanding of problems and issues predicated on unbiased research.
The author is former executive director of Sebi and is currently associated with the IFC’s Global Corporate Governance Forum of the International Finance Corporation and the World Bank. These views are personal.
