INITIAL PUBLIC OFFERINGS (IPOs)

LECTURER DEPARTMENT OF FINANCE AND ACCOUNTING

A FINANCIAL SEMINAR PAPER PRESENTED IN PARTIAL FULLFILLMENT

OF THE REQUIREMENTS FOR THE AWARD OF THE DEGREE OF MASTER
OF BUSINESS ADMINISTRATION SCHOOL OF BUSINESS, UNIVERSITY OF
NAIROBI

FEBRUARY 2015
 TABLE OF CONTENTS

CHAPTER ONE: INTRODUCTION......................................................................1

1.1 BACKGROUND...................................................................................................1
1.2 HISTORICAL DEVELOPMENT.............................................................................1
1.5 REVIEW OF IPO THEORIES...........................................................................4
1.5.1 Self Interest Theory.4
1.5.2 Book Building Theory.4
1.5.3 Lawsuit Avoidance Theory..5
1.5.4 Life Cycle Theory5
1.5.5 Signaling theory...5
CHAPTER TWO: EMPIRICAL REVIEW............................................................7
CHAPTER THREE: CONCLUSION, GAPS AND SUGGESTIONS FOR FURTHER
RESEARCH.................................................................................................................9
3.1 CONCLUSION.....................................................................................................9
3.2 RESEARCH GAPS...............................................................................................9
3.3 SUGGESTIONS FOR FURTHER RESEARCH..........................................................9

REFERENCES.........................................................................................................11

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 CHAPTER ONE: INTRODUCTION
1.1 Background
According to Draho (2004), Initial public offering (IPO) is a term used to denote the first time
that shares in a company are sold to public investors and subsequently traded on the stock
market. An initial public offering (IPO) is generally perceived as one of the most important
milestones in a firms lifecycle. It allows the firm to access the public equity markets for
additional capital necessary to fund future growth, while simultaneously providing an avenue
for the initial shareholders to sell their ownership stake (Brealy & Myers, 2003).

1.2 Historical Development

Wilmer, Cutler, Pickering, Hale and Dorr (2013) noted that the earliest form of a company which
issued public shares was the publicani during the Roman Republic. Like modern joint-stock
companies, the publicani were legal bodies independent of their members whose ownership
was divided into shares, or parties. There is evidence that these shares were sold to public
investors and traded in a type of over-the-counter market in the Forum, near the Temple of
Castor and Pollux. The shares fluctuated in value, encouraging the activity of speculators,
or quaestors. Mere evidence remains of the prices for which parties were sold, the nature of
initial public offerings, or a description of stock market behavior. Publicanis lost favor with the
fall of the Republic and the rise of the Empire.

In March 1602 the "Vereenigde Oost-Indische Compagnie" (VOC), or Dutch East India
Company was formed. The VOC was the first modern company to issue public shares, and it is
this issuance, at the beginning of the 17th century, that is considered the first modern IPO. The
company had an original paid-up share capital of 6,424,588 guilders. The ability to raise this
large sum is attributable to the decision taken by the owners to open up access to share
ownership to a wide public. Everyone living in the United Provinces had an opportunity to
participate in the Company. Each share was worth 3000 guilders (roughly equivalent to US$
1,500). All the shares were tradable, and the shareholders received receipts for the purchase. A
share certificate documenting payment and ownership such as we know today was not issued but
ownership was instead entered in the company's share register.
In the United States, the first IPO was the public offering of Bank of North America around
1783. Prior to 2009, the United States was the leading issuer of IPOs in terms of total value.
Since that time, however, China has been the leading issuer, raising $73 billion (almost double
the amount of money raised on the New York Stock Exchange) up to the end of November 2011.
The Hong Kong Stock Exchange raised $30.9 billion in 2011 as the top course for the third year
in a row, while New York raised $30.7 billion (www.wikipedia.org).

1.3 Seminal paper

Providing first insights to the anomaly of underpricing is the seminal paper by Ibbotson (1975).
The article sets the stage for subsequent studies to examine the underpricing puzzle in greater
detail. Ibbotson (1975), using one offering per month for the ten year period 1960 1969
computed excess returns on IPOs with an offer price of at least $3.00 per share. On a
sample of 120 IPOs, he found an average initial return of 11.4% from the date of issue to
the end of the offering month.

Ibbotson (1975) entailed studying the risk and performance (measured by risk adjustment
returns) on newly issued common stocks which were offered to the public for the first time. The
objectives of the study were to measure the initial returns from the offer date to the date when a
public market was first established and to examine the aftermarket performance to test for
departures from market efficiency. The distribution of returns was skewed so that the subscriber
of a single random new issue offering had equal chance for gain or loss.

Ibbotson (1975) found that although initial returns were not erased in the aftermarket, average
returns for one month holding periods were positive in the first year after the IPO, negative
during the following three years, and again positive in the fifth year. The results were generally
consistent with aftermarket efficiency. Positive initial return along with aftermarket efficiency
indicated that new issue offerings were underpriced.

Ibbotson (1975) suggested that part of the reason for the high levels of underpricing observed,
was the fact that compounding the low offer price, the first day closing prices were irrationally

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high. The reversion of the share price downwards towards its true economic value would result
in underperformance.

1.4 Subsequent key academic papers

Ibbotson and Jaffe (1975) defined a hot issue as one which rises to a higher than average
premium in the aftermarket. They describe hot issue markets as periods where the average
initial performance of new issues is abnormally high. Hot issue markets are characterized by
high volumes of IPOs and high levels of underpricing. Internationally there is overwhelming
evidence to support the existence of hot and cold issue periods. On the other hand, the cold
issue markets, with relatively low initial returns, tend to occur toward the end of the high IPO
volume periods.

Ritter (1991) criticized Ibbotson (1975) study on the sample size that he used. He argued that
even though Ibbotson conducted the most satisfactory formal statistics tests, the sample size of
only 120 issues resulted in large standard errors which made him not to be able to reject the
hypothesis of market efficiency after a stock had gone public. In his study, he comes up with a
third anomaly stating that in the long run IPOs appear to be overpriced. Using a sample of 1526
IPOs that went public in the U.S in the 1975 84 period, He finds that in the 3 years after going
public the firms significantly underperformed.

Ritter (1998) confirmed that while on average there were positive initial returns on IPOs, there is
a wide variation on individual issues. Using evidence from data collected he confirmed that one
in eleven IPOs had a negative initial return, and one in six closed on the first day at the offer
price. One in a hundred doubled on the first day. Ritter indicated that a number of reasons have
been advanced for the new issues underpricing phenomenon, with different theories focusing on
various aspects of the relations between investors, issuers, and the investment bankers taking the
firms public. In general, these theories are not mutually exclusive.

In summary Ritter (1998) noted that companies going public, especially young companies, face a
market that is subject to sharp swings in valuations. Pricing deals can be difficult, even in stable
market conditions, because insiders presumably have more information than potential outside

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investors. To deal with these potential problems, market participants and regulators insist on the
disclosure of material information.

Ritter (1998) observed that companies that went public during 1970-1993 produced an average
return of 7.9% per year for the five years after going public, while the market average annual
return was 13.1%, thus IPOs underperformed the market.

1.5 Review of IPO Theories

Much of the theoretical research in this field of study has mainly been focused on explaining the
empirical findings on IPO pricing that have been encountered over and over by multiple
researchers.

1.5.1 Self Interest Theory

A possible reason for underpricing may be the self-interest of investment bankers (Baron and
Holmstrm, 1980; Baron, 1982). According to Baron and Holmstrm (1980), most new security
issues are managed and distributed by investment banking syndicates that perform three basic
services for the issuers of the securities. First, they offer advice and counsel regarding the type of
security to be issued, coupon rates, maturity, offer price etc. Secondly, they provide an
underwriting function by bearing all the risks associated with the proceeds of the issue and
thirdly, they provide a distribution function by selling the securities to investors.

1.5.2 Book Building Theory

Benveniste and Spindt (1989) looked at how informational frictions affected the marketing of
IPOs in an attempt to explain the underpricing and long run underperformance anomalies. Their
analysis focused on the role an investment banker plays in eliciting information about the market
value of an IPO during the pre-selling period. They modeled the pre-market activity as an
auction, conducted by the investment banker, in which investors bid with indications of interest.

Benveniste and Spindt (1989) also came up with a possible explanation for the long run under
performance phenomenon in their book building model. They argued that subsequent
performance is positively correlated with the initial price revision that was undertaken during the

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book building process. If there was more disclosure of negative than of positive information
performance may be negative in the future.

1.5.3 Lawsuit Avoidance Theory

Another possible reason for underpricing that has been put forward is lawsuit avoidance (Hughes
and Thakor, 1992; Tinic, 1998). This is because some underwriters may stand to face legal action
if the market price of a new share issue significantly drops below the offer price. This was
empirically tested by Lin (2004). She specifically tested the insurance effect of the lawsuit
avoidance hypothesis which states that firms that are subject to higher litigation risks underprice
their issues more to reduce the likelihood of being sued in connection with their IPO.

1.5.4 Life Cycle Theory

Zingales (1995) observed that it is much easier for a potential acquirer to spot a potential
takeover target when it is public. He noted that entrepreneurs realize that acquirers can pressure
targets on pricing concessions more than they can pressure outside investors. By going public,
entrepreneurs thus help facilitate the acquisition of their company for a higher value than what
they would get from an outright sale.

Chemmanur and Fulghieri (1999) argue that IPOs allow more dispersion of ownership. They
assert that early in its life cycle, a firm will be private, but if it grows sufficiently large, it
becomes optimal to go public. Public trading has both cost and benefit. Maksimovic and Pichler
(2001) pointed out that a high public price can attract product market competition.

1.5.5 Signaling theory

Ross (1976) argued that due to asymmetric information between IPO insiders and potential
investors, signaling theory continues to be an important component of IPO research. Early
papers, such as Leland and Pyle (1977), argue that selling insider shares and selling a large
portion of the firm in the IPO served as negative signals to would be potential investors.

According to Modigiliani and Miller (1959) the signaling hypothesis is based on the assumption
that the firm knows about its prospects better than the investors. The disparity of information is
referred to as asymmetric information. Other things being equal, because of asymmetric

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information, managers will issue debt when they are positive about their firms future prospects
and will issue equity when they are unsure. A commitment to pay to fixed amount of interest and
principal to debt-holders implies that the company expects steady cash flows. On the hand, an
equity issue would indicate that the current share price is overvalued. Because of this, it has been
found that the announcement of new issue of shares generally causes share price to fall.
Therefore, the manner in which managers raise capital gives a signal of their belief in their firms
prospects to investors.

1.5.6 Random walk Theory

The central idea behind the random walk theory is that the randomness of stock prices renders
attempts to find price patterns or take advantage of new information futile. The theory claims
that day-to-day stock prices are independent of each other, meaning that momentum does not
generally exist and calculations of past earnings growth does not predict future growth. The
random walk theory also states that all methods of predicting stock prices are futile in the long
run. Malkiel (1973) calls the notion of intrinsic value undependable because it relies on
subjective estimates of future earnings using factors like expected growth rates, expected
dividend payouts, estimated risk, and interest rates.

There are two forms of the random walk theory. The semi-strong form states that public
information will not help an investor or analyst select undervalued securities because the market
has already incorporated the information into the stock price. The strong form states that no
information, public or private, will benefit an investor or analyst because even inside information
is reflected in the current stock price.

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 CHAPTER TWO: EMPIRICAL REVIEW

The relationship between the offer price of an initial public offer and its corresponding
fundamental value has been the subject of a lot of research in many of the jurisdictions with
developed capital markets.

Ritter (1991) found a significant long run under performance at the end of three year following
the offering for a sample of 1526 IPOs over the period 1975- 1984. He found that the result
appeared to be time sensitive. He observed a positive mean for the period 1975-1980 and
negative mean performance for the period 1981-1984. This suggested that IPOs performed well
in certain periods than in others.

Levis (1993) in a study of 712 UK firms during the period 1980 1988 reported an under
performance three years after going public. He noted that the average underperformance in the
UK sample appeared to be less excessive than in the Ritters (1991) US sample. Loughran and
Ritter (1995) studied companies that had issued stock between 1970 and 1990 whether in an
initial public offering (IPO) or a seasoned equity offering (SEO). It emerged that average annual
returns during the five years after the issue was only 5 percent for firms conducting IPOs and 7
percent for firms conducting SEOs.

Purnanandam and Swaminatham (2004) carried out a study to find out whether initial public
offers were really underpriced. They sampled more than 2000 IPOs from 1980 to 1997 using
comparable firm multiples such as price-to-EBITDA, price-to-sales and price-to-earnings of
industry peers as the mode of valuation. They found that from this sample of 2000 relatively
large capitalized IPOs, the average IPO is overpriced by 50%. Their results revealed systematic
overpricing despite the positive initial returns that were an indication of underpricing.

Jumba (2002) studied the performance of IPOs in Kenya for the period 1992-2000 and concluded
that in the short run IPOs over perform the market while in the long run IPOs underperformed
the market using three year holding period. Njoroge (2004) analyzed initial and long run

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performance of IPOs at the NSE during the period 1984-2001 and concluded that all IPOs
underperformed the market in the long run using three year holding period.
Moko (1995) looked at the relationship between offering price at the subscription rate of initial
public offering at the NSE. He found out that there was a significantly large return for the initial
subscribers, adjusted for market effects in the short-run following the offering. The result of his
study showed that discount on new issues had an association with the rate of subscription.

Mwathi (2013) analyzed the relationship between on the subscription rate of IPOs and long term
performance of IPOs at the NSE. Subscription rate was measured in monetary terms. He
analyzed twelve IPOs that happened at the NSE between the years 1992 and 2009 and used a
regression model to determine the relationship between IPO performance and IPO subscription.
The study established a weak positive relationship between IPO subscription rate and the long
term performance.

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 CHAPTER THREE: CONCLUSION, GAPS AND SUGGESTIONS FOR
FURTHER RESEARCH

3.1 Conclusion
Going public is an important event in the life of a company and is commonly motivated by the
desire to enlarge the set of potential investors to meet the firms increasing capital needs,
potentially at a lower cost. Initial Public Offerings (IPOs) also give the opportunity to
shareholders to realize capital gains from backing the firms operations at its early stages. A large
number of papers studied IPOs characteristics and highlighted stylized facts in the stock
behavior of firms that go public. In particular, two puzzling anomalies were reported in the stock
behavior of these companies positive initial return commonly referred to as underpricing and
long-term underperformance.

3.2 Research Gaps

The prior studies which are on equity issuances - IPOs and SEOs mainly examine one particular
aspect. Most of the studies which examine the long-run performance of IPOs conclude that the
issuing firms underperform in the long-run relative to benchmarks because managers time the
market and sell their overvalued equity. These studies do not examine the direct impact of market
timing on equity issuance. Similarly, the studies which analyze the direct impact of market
timing on equity issuance do not evaluate the long-run performance of issuing firms. In order to
arrive at the conclusion that managers time the market and take the advantage of firms
mispriced equity by issuing equity when it is overvalued, both the evidences are necessary
positive relation of market timing with equity issuance and long run underperformance of issuing
firms. Moreover, even if these issues have been examined independently, they are done only in
developed countries. No study on either market timing or on investment based motives has been
conducted in emerging economies.

3.3 Suggestions for Further Research

Since various factors play a role in determining IPO pricing, it is important that investors be very
keen in ascertaining all the possible variables that may play a significant role in the pricing of IPOs

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to establish whether the IPO is underpriced or overpriced. This will be helpful in ascertaining which
IPOs will be profitable especially for those investors interested in short term goals (speculators)
rather than the long term investors. More studies need to be done in this area especially to establish
what other factors may be significant determinants of IPO underpricing in Kenya.

Further studies can be done on the stock splits effects on stock prices of firms quoted in the
Nairobi Securities Exchange. This owes to the fact that splits would increase the number of
shares without a consequent increase in market capitalization. Research is recommended to find
out the extent to which investors hold on to IPO shares and the reasons for holding the shares. A
further research may be done to unveil the reasons that hinder private companies from raising
IPOs at the NSE. In future, a study can be done to test the performance with long run period
being five and ten years. A further research can also be done to investigate whether IPOs of
certain segments perform better than others.

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