Perspective on Underpricing of IPOs in Emerging Economies

2.1 Factors Influencing Pricing of Initial Public Offerings

Literature on the pricing of IPOs in emerging markets in the recent past has identified a few factors that are relevant in this context. Three factors that merit attention are as follows:

Principal–principal (P–P) conflicts that reflect asymmetric information among the investors of the firm;

When formal institutions are not developed to the desired extent and when there is an allegiance of managers to controlling shareholders, P–P conflicts arise. As Lin and Chuang (2011) have stated, ‘… controlling shareholders engage in the expropriation of minority shareholders’. They have argued that increases in P–P conflicts are likely to accentuate IPO underpricing. As regards firms with high quality, they tend to underprice to a greater extent than firms of low quality in order to signal their superior status (Hameed & Lim, 1998; Zheng & Stangeland, 2007). As Shi, Pukthuanthong, and Walker (2015) have mentioned, ‘Regarding the agency cost arising from conflict of interest between minority and controlling shareholders, the new minority shareholders will likely price-protect themselves by demanding a deeper discount when they purchase new issues at the IPO’. They further state, at another point, in their article, ‘More stringent disclosure requirements are associated with lower IPO underpricing’.

Aspects relating to firm quality and market sentiment in influencing Indian IPO investors are discussed at length (Neupane, Paudyal, & Thapa, 2014). The authors argue that it is important to look at the two classes of investors, retail and institutional, separately in an emerging market such as India since each category is guided by a different set of factors. While institutional investors base their decisions on firm quality, retail investors are influenced by market sentiment (consisting of an active grey market).

2.2 Proposed Frameworks to Explain Underpricing in Emerging Markets

Drawing on the work cited in Section 2.1 and taking into account certain differences between developed and emerging markets, interactions relating to firm quality (that represent legitimacy of the top management), disclosure norms and P–P problems are discussed under two situations. The first framework presumes that institutional investors are the key players influencing IPO prices and the second framework is suggested in the backdrop of retail investors playing the dominant role in the pricing IPOs on the listing day and first few days of trading.

3.1 Understanding Underpricing When Institutional Investors Have a Significant Role

The relation between P–P conflicts and disclosure, firm quality and P–P conflicts and Firm quality and Disclosure when institutional investors are the dominant players on the listing day (or first few days of listing) is summarised in Table 1. This depicts the nature of underpricing resulting from the pair-wise interaction of characteristics and this is in line with most of the explanations advanced in the studies of underpricing undertaken in developed economies. Some of the emerging economies are likely to be moving into this status in the near future and the framework can help assess the expected level of underpricing based on the predominance of factors. This is captured in a three-dimensional diagram given in Appendix A.

What distinguishes these emerging markets at this juncture, however, is the role played by the secondary market in driving prices in the IPO market. It is conjectured that if the secondary market is on the upswing, then the P–P conflict and disclosure norms gain prominence (over firm quality) and accordingly one has to focus on the triangle RPD to understand the extent of underpricing. If the secondary market is range bound, then disclosure norms and P–P conflict gain importance (over firm quality), and the section RPD is relevant. However, when there is a downswing in the market, firm quality and disclosure norms are more important (than P–P conflicts) and the triangle RVD will be useful to understand the extent of underpricing.

The nature of relationship between the extent of underpricing under different degrees of P–P conflict and disclosure norms is as discussed in Section 3.1. The crucial difference in this case is the extent of underpricing that is linked to firm quality. The argument advanced is that in emerging markets, there could be occasions when retail investors are the significant players on the first day (or first few days) in the market for IPOs. Firms that are of high quality will not resort to the signalling mechanism through underpricing. On the contrary we expect high-quality firms to underprice to a lesser degree, since underpricing has a cost which these firms would not want to incur. The relation between P–P conflicts and disclosure, firm quality and P–P conflicts and firm quality and disclosure when retail investors are the dominant players on the listing day (or first few days of listing) is summarised in Table 2. This table depicts the nature of underpricing resulting from the pair-wise interaction of characteristics and is advanced owing to the unique nature surrounding businesses operating in emerging economies. The retail investors here may not act similar to institutional investors. This is a significant departure from the earlier framework and contribution to an understanding of the underpricing phenomenon in such economies. Most of the emerging economies are likely to be in this situation and the framework can help assess the expected level of underpricing, based on the predominance of factors. This is captured in a three-dimensional diagram given in Appendix B.

As in the earlier framework, the status of the secondary market is mapped to the various regions of the figure and using a similar analogy, we can understand the expected underpricing during an upswing and/or normal secondary market condition. The region of relevance is now ACD. The downswing in the market corresponds to the region ABD.

Let us consider the situation where the secondary market is expected to be on the upswing or is range bound. When we compare the regions RPD and ACD, we notice that irrespective of the nature of investors (retail or institutional) who are expected to be the significant players in the aftermarket, the expected underpricing for the two scenarios, that is, high disclosure norms and low P–P conflict, and low disclosure norms and high P–P conflict, is similar. In the case when both disclosure norms and P–P conflicts are high, the expected underpricing is below average when institutional investors are the main players, while it is above average when retail investors are in the majority. The extent of the P–P conflict has to be probed to understand this better, even more than the nature of disclosure norms. Categorisation of P–P conflicts across emerging markets lends itself to being classified in buckets that can be mapped on to the amount of underpricing. Given that markets for corporate control are inactive (Luo, Chung, & Sobczak, 2009), and considering hypothesis 2 (Lin & Chuang, 2011), the amount of family ownership is proportional to the degree of IPO underpricing. In the other scenario wherein disclosure norms and P–P conflicts are low, Framework-A (with institutional investors) posits an above-average degree of underpricing compared to Framework-B (with retail investors). Since P–P conflicts are not significant, firms would like to take advantage of the prevailing regulatory setting to attract institutional investors who are expected to remain with them for a longer period.

When we expect the market to be on the downturn, the predominant factors that contribute to underpricing are firm quality and disclosure norms. The relevant regions to be compared are RVD in Framework-A and ABD in Framework-B. When disclosure norms and firm quality are high, markets dominated by retail investors are expected to have issues that are underpriced to a lower extent while the presence of institutional investors in such markets is likely to witness IPOs that are underpriced to an above-average extent. The decision of retail investors to participate is perhaps guided more by indicators of sentiment than indicators of firm quality (Neupane et al., 2014). Firms do not want to convey their quality through the signalling mechanism on the account of costs which they are unlikely to recoup through a seasoned offering subsequently. However, the same high-quality firms would want to signal their quality to institutional investors. The motive for this can partially be explained through hypothesis 4 (Neupane et al., 2014) that posits ‘Firm quality has limited influence on offer price and initial returns but has a positive influence on the long term performance of IPO firms’. When disclosure norms are high for low-quality firms, institutional investors show little interest on account of firm quality, and the high costs incurred by firms in meeting with disclosure requirements do not permit these firms to leave ‘money on the table’, resulting in a low degree of underpricing. However these firms do not mind underpricing to an above-average extent when confronted with uninformed investors (the retail segment). After having taken the decision of coming to the market at an inappropriate time (market downturn), they do not want to risk postponing the public offer since there may not be another opportunity to raise money after having made their intentions known to the market. High-quality firms confronting institutional investors, who operate in regulatory environments with low-disclosure norms, would want to signal their quality to these investors by underpricing their issues to a larger extent. However, these firms would want to sell their issue to uninformed investors by underpricing their issue to a below-average extent. When disclosure norms are less stiff for low-quality firms dealing with retail investors, they are very keen (bordering on desperation) to sell the IPO since there may not be another opportunity. In other secondary market environments (range bound or bullish), there could be IPOs of competitors that could make this issue less attractive. Hence they would like to underprice to a greater extent. These very firms when confronted with institutional investors would like their public issue to be lapped up since they would want to take advantage of the disclosure norms that they could hide behind and hence underprice their issues to an ‘above-average’ level. This is one notch lower than what would be witnessed if retail investors were to align with the firm.

Under what conditions would we expect firms to operate in the region CBD in Framework-A and PVD in Framework-B? Firms in countries that are making a transition from planned to market-based economies are likely to witness IPOs being offered under a quota system. In their study involving institutional investors, Wan, Yiu, and Wang (2010) found that in environments plagued by little or no knowledge of the quality of issuers and information about the issue, compounded with the absence of an established market mechanism, the amount of underpricing is difficult to establish. What the frameworks presented here suggest is that whenever transition is closer to completion, the anticipated level of underpricing can be gauged from the relevant section of the diagrams. For instance, in Framework-A, issuers offering IPOs to institutional investors are likely to underprice their offerings to a greater extent if they are of high quality and are beset by conflicts between controlling and minority shareholders. Firms with similar characteristics in Framework-B (with retail investors who are the predominant players) have something interesting to offer. They will not be underpriced to a great extent, unlike their counterparts in Framework-A. Instead they are likely to experience above-average levels of underpricing if there is a family CEO at the helm of affairs. If a professional outsider is appointed, then there would be a tendency to underprice to a below-average level. This is reflected by the coexistence of symbols * and □ in Framework-B. In their study of venture capital investment strategies, Khoury, Junkunc, and Mingo (2015) state that the ‘challenges faced by developing country ventures seeking VC funding at various stages of development are likely to face risks’. Such firms are likely to be confronted with certain sections of the regions CDB and PDV of the two frameworks.