Doctoral thesis of philosophy underwriter allocation discretion, investor participation and ipo pricing evidence from the indian ipo market

Underwriter Allocation Discretion, Investor Participation and IPO Pricing: Evidence from the Indian IPO market A thesis submitted in fulfilment of the requirements for the degree of Doctor of Philosophy Nirav Parikh Masters of Finance School of Economics, Finance and Marketing College of Business RMIT University June 2017 Declaration I certify that except where due acknowledgement has been made, the work is that of the author alone; the work has not been submitted previously, in whole or in part, to qualify for any other academic award; the content of this thesis is the result of work which has been carried out since the official commencement date of the approved research program; and, any editorial work, paid or unpaid, carried out by a third party is acknowledged Nirav Parikh 01/06/2017 ii Dedicated to the dear memory of my late father and to my gracious mother and a wonderful wife iii Acknowledgements I should begin by expressing gratitude to my supervisors, Dr Vijaya Marisetty and Dr Monica Tan for their guidance and advice throughout my PhD journey My discussions and shared ideas with Dr Marisetty have provided the framework for my thesis Right to the end, Dr Tan continued to monitor and encourage my efforts and was always available with valuable suggestions, critical direction and sound advice For this, I will always be grateful to her My supervisors’ intellect and passion for excellence have motivated me to discover my potential as a researcher and as an independent thinker I would like to thank Prof Michael Dempsey for critical comments on my draft thesis I would also like to express my gratitude to Dr Meg Elkins and Dr Trevor Kollmann with whom I had important discussions on research methods I wish to acknowledge the managing editor of Smart Investment, Mr Dilip K Shah for providing the grey market data for my thesis I am grateful to Dr Michael Gangemi, Dr Silvia Islam, Dr Kaleel Rehman and Dr Sivagowry Sriananthakumar for offering me additional research and teaching opportunities A special thanks to my fellow PhD student Gaurangi Laud with whom I shared many, many insightful and invigorating discussions I am also thankful to my HDR friends Vineet Tawani, Girija Chowk and Jeff Fang, who were always a great source of positive energy and enthusiasm through the years of my endeavour I would like to thank my wife Avani for her patience and support through this journey I would also like to thank my brother Brijal, and uncle Nailesh Kadakia, for also being the source of my strength and endurance And in this, I must also take this opportunity to express my gratitude to my mother for so many things Finally, I acknowledge the support I have received for my research through the provision of an Australian Government Research Training Program Scholarship I extend my gratefulness to RMIT University for providing financial support for my doctoral study and also Ms Rilke Muir who offered her copy editing services iv Table of Contents Declaration ii Acknowledgements iv Table of Contents v List of Tables ix List of Figures x List of Thesis Related Definitions xi Abstract Chapter Introduction 1.1 Research Context 1.2 The Setting: Indian IPO Market 1.3 Motivation and Aim for Thesis 1.3.1 Study 1-Conceptual Framework (Chapter 3) 14 1.3.2 Study 2-Underwriter Signaling (Chapter 4) 15 1.3.3 Study 3-Underwriter Syndication (Chapter 5) .16 1.4 Outline of the Thesis 17 Chapter Institutional Features 2.1 Introduction 19 2.2 Indian IPO Market 19 2.2.1 Investor Classification and Allocation Proportion 20 2.2.2 Allocation Mechanisms 21 2.2.3 Transparency in the Indian IPO Market 23 2.3 Institutional Features of the Grey Market 25 2.3.1 Grey Market Timeline 25 2.3.2 Grey Market Instruments and Pricing 27 2.3.3 Settlement of Grey Market Trades 29 2.3.4 Grey Market Information 29 2.3.5 Indian Grey Market versus the American and European Markets 30 2.4 IPO Underwriting Market in India 30 2.4.1 Example of an Underwriting Syndicate 31 2.5 Conclusion 35 v Chapter (Study 1) Conceptual Framework of Information Sharing in the Presence and Absence of Allocation Discretion Abstract 37 3.1 Introduction 39 3.2 Introduction to Conceptual Framework 42 3.3 Allocation Discretion, Information Sharing and IPO Pricing 50 3.3.1 Allocation Discretion and Information Sharing .51 3.3.2 Positive Effect of Allocation Discretion on IPO Pricing 52 3.3.3 Negative Effect of Allocation Discretion on IPO pricing 54 3.3.4 Allocation Discretion and IPO Underpricing 56 3.4 Allocation Discretion, Quality of Information Sharing and Signaling 57 3.4.1 Information Asymmetry between IPO Investors 57 3.4.2 Effect of Information Asymmetry on IPOs: Signaling Theory Perspective 61 3.4.3 Effect of the Grey Market Signal on Retail Subscription and Underpricing 63 3.4.4 Effect of Allocation Discretion on Underwriter Signaling .65 3.5 Regulating Allocation Discretion and Underwriter Syndication 67 3.5.1 Regulating Allocation Discretion 68 3.5.2 Reputation-based Syndication and IPO Pricing 70 3.5.3 Regulating Discretion, Reputation-based Syndication and IPO Pricing 74 3.6 Conclusion 77 Chapter (Study 2) Allocation Discretion, Quality of Information Sharing and Signaling Theory Abstract 81 4.1 Introduction 82 4.2 Key Institutional features of the Indian IPO market 88 4.2.1 Regulation Change 88 4.2.2 The Grey Market 89 4.3 Background Literature and Hypothesis Development 89 4.3.1 Allocation Discretion and Information Sharing .90 4.3.2 Allocation Discretion and Quality of Information Sharing 92 4.3.3 Signaling Theory and the Key constructs for an IPO market .94 4.3.4 Grey Market Price Signal, Retail Subscription and Underpricing 97 4.3.5 Allocation Discretion and Underwriter Signaling 100 4.4 Data Sources and Summary Statistics 102 4.4.1 Data Sources .102 4.4.2 Description of Variables used in the Study 104 4.4.3 Descriptive Statistics 105 vi 4.5 Empirical Results and Discussion 113 4.5.1 Grey Market Price Signal and Retail Subscription .113 4.5.2 Allocation Discretion and Effect on Grey Market Premium 119 4.5.3 Allocation Discretion, Retail Investor Participation and IPO Underpricing 123 4.5.4 Discussion 129 4.6 Conclusion 131 Appendix 135 Chapter (Study 3) Allocation Discretion, Information Sharing and Underwriter Syndication Abstract 138 5.1 Introduction 139 5.2 Information Sharing Hypothesis and Related Literature 145 5.2.1 Allocation Discretion, Information Sharing and IPO Pricing .146 5.3 Regulatory Intervention in Allocation Discretion 148 5.4 Underwriter Syndication and Related Literature 149 5.4.1 Regulating Allocation Discretion and Underwriter Syndication 150 5.4.2 Determinants of Underwriting Syndicate 152 5.4.3 Motivation for Syndication: Risk Mitigation or Price Manipulation 154 5.4.4 Reputation-based Syndication and IPO Pricing 156 5.4.5 Regulating Discretion, Reputation-based Syndication and IPO Pricing 160 5.5 Data Sources and Description of Variables 163 5.5.1 Data Sources .163 5.5.2 Description of Variables used in the Study 164 5.6 Summary Statistics 168 5.6.1 Annual Descriptive Statistics .168 5.6.2 Low-High UW Syndicate Effort and Pre-Post Regulation sample .172 5.6.3 Underwriter Syndication Matrix and Participation Characteristics 174 5.7 Empirical Results and Discussion 181 5.7.1 Determinants of Underwriting Syndicate and Syndication Hypothesis 181 5.7.2 Reputation-based Syndication and Institutional Participation 188 5.7.3 Information Sharing, Underwriter Syndication and IPO Underpricing .193 5.7.4 Discussion 200 5.8 Conclusion 202 Appendix 206 vii Chapter Overall Conclusion 6.1 Summary of Findings 208 6.1.1 Study Conceptual Framework 209 6.1.2 Study Underwriter Signaling 210 6.1.3 Study Underwriter Syndication 211 6.2 Overall Summary 212 6.3 Limitations and Avenues for Future Research 214 References viii List of Tables Table 2.1: List of Qualified Institutional Buyers (QIBs) 20 Table 2.2: Allocation Proportion 21 Table 2.3: The US versus Indian IPO Bookbuilding mechanisms 24 Table 2.4 : Underwriting Syndicate members for GMR Infrastructure Ltd 32 Table 2.5: Inter Se Allocation of Responsibilities of the Underwriting Syndicate Members for GMR Infrastructure Ltd 34 Table 4.1: Description of Variables used in Study 104 Table 4.2: Descriptive Statistics by Year of IPO 108 Table 4.3: Correlation Matrix 109 Table 4.4: IPO details as per Regulation Period and Grey Market Premium 112 Table 4.5: Grey Market Price Signal and Retail Investor Participation 115 Table 4.6: Allocation Discretion and Grey Market Price Signal 120 Table 4.7: Allocation Discretion, Retail Participation and IPO Underpricing 126 Table 4.8: List of Underwriters and Underwriter Reputation (Study 2) 135 Table 5.1: Description of Variables used in Study 164 Table 5.2 Part 1: IPO Details for the Year 2001 166 Table 5.3: Year-wise IPO details 170 Table 5.4: Low-High UW Syndicate Effort and Pre-Post Regulation sample 171 Table 5.5: Underwriter Syndication Matrix 175 Table 5.6: Year-wise Concentration Ratios and Ranking of Top 10 Underwriters 177 Table 5.7: List of most Active Underwriters 179 Table 5.8: No of IPOs managed by Underwriters 180 Table 5.9: Underwriting Syndicate Determinants and Syndication Hypothesis 183 Table 5.10: Reputation-based Syndication and Institutional Subscription 190 Table 5.11: Reputation-based Syndication and IPO Underpricing 196 Table 5.12: List of Underwriters and Underwriter Reputation (Study 3) 206 ix List of Figures Figure 1.1: IPO Underpricing and Money left on the table in the US Figure 1.2: Initial IPO returns in European IPOs 10 Figure 1.3: Initial IPO returns in non-European IPOs 11 Figure 2.1: Allocation Mechanisms 22 Figure 2.2: Pre- and Post-Regulation period 23 Figure 2.3: Timeline of events for an IPO 26 Figure 3.1: An Integrated Conceptual Framework of Information Sharing with and without Allocation Discretion to Underwriters 44 Figure 4.1: Information Sharing and Signaling Hypotheses 84 Figure 4.2: Indian Mobile Subscribers 134 Figure 5.1: Information Sharing and Syndication Hypotheses 142 Figure 5.2: Year Wise Concentration Ratios 178 x Chapter Overall Conclusion 6.1 Summary of Findings This thesis contributes to an active and ongoing debate in the literature on the benefits of granting discretionary power to underwriters to allocate shares to IPO investors in a bookbuilding mechanism I conclude that by granting allocation discretion to underwriters, pricing efficiency in the IPO process is improved This is because underwriters can obtain private information related to the IPO pricing from informed institutional investors This assists underwriters to price an IPO at the fair price, and hence benefits the issuing firm through lower underpricing However, the negative side of granting allocation discretion is that underwriters can use it to pursue self-interest, by engaging in rent-seeking activity This is possible by favouring regular institutional investors with the allocation of a higher quantity of underpriced shares These institutional investors are in turn willing to offer reciprocal benefits to the underwriters by sharing a percentage of the higher profits they receive This can adversely affect market efficiency due to higher underpricing of IPOs The regulation of the discretionary allocation power of underwriters in favour of proportionate allocation by a regulator can cause significant contrary consequences on the feedback expected from informed institutional investors related to IPO pricing This is because underwriters experience difficulty in maintaining information sharing relationships with informed institutional investors This can result in the IPO being either highly overpriced or underpriced and can negatively impact the efficiency of the IPO market mechanism In addition, we find that regulating allocation discretion increases the uncertainty associated with the successful subscription of IPOs from regular institutional investors For this reason, enforcing constraints on underwriter allocation 208 discretion can result in a negative impact on IPO success Such restrictions consequently increase the overall risk for underwriters managing an IPO For regulators, the question is whether to grant allocation discretion to underwriters or, alternatively, to enforce regulation Prior research has investigated underwriters’ allocation discretion and its outcome on information sharing with informed institutional investors Nevertheless, there remains the question of whether allocation discretion is used by underwriters to enhance the welfare of IPO market participants generally, or whether it works to benefit rent-seeking activities Thus, the central theme of this doctoral thesis is an examination of granting allocation discretion to underwriters as opposed to regulating allocation I concentrate on how different allocation mechanisms influence underwriters’ behaviour in the IPO market and their impact on their relationship with IPO investors The aim is to contribute to a better understanding of the IPO market mechanism from the welfare perspective of market participants The research project is in the form of seven research questions that are addressed in three individual studies The first one is a conceptual study, and the other two are empirical studies 6.1.1 Study Conceptual Framework In the first study, I introduce an integrated conceptual framework to understand the effect of two different allocation mechanisms, discretion and no discretion, on the information sharing relationship between underwriters and informed institutional investors Based on an extensive literature review, I advance the information sharing literature by debating the benefits of each allocation mechanism on underwriters’ behaviour in the IPO market and investigating their relationship with IPO investors I contribute to the literature by addressing the debate in the literature on regulating the allocation power of underwriters in relation to the efficacy of discretionary and proportionate policy regimes on the welfare of market participants 209 Further, in the presence of a grey market for IPOs, I apply signaling theory in an IPO market setting to understand the impact of information asymmetry on IPO investors Moreover, I contribute to the academic literature about underwriting syndicates by discussing the determinants of an IPO syndicate Finally, I conceptualise the usefulness of syndication as an indirect medium of discretion for underwriters when their discretionary allocation power is regulated Thus, the focus of the conceptual framework is that it jointly links signaling and syndication theories with information sharing theory to develop associated hypotheses, which are empirically tested using data from the Indian IPO market The institutional framework in the Indian IPO market has two unique features First, when bookbuilding was introduced, the regulatory authority, the Securities and Exchange Board of India (SEBI), granted discretionary power to underwriters to allocate shares to institutional investors However, recently, regulatory intervention has curtailed the previously held discretionary allocation power of underwriters In the new regime, allocation of shares to institutional investors is made on a proportionate basis Second, and more importantly, there is the presence of an active grey market for IPOs This particular market setting influences the behaviour of underwriters during the IPO process and has stimulated an environment that allows for an empirical testing of the hypotheses developed in the conceptual framework 6.1.2 Study Underwriter Signaling In the second study, the main focus is the implications of signaling theory in the Indian IPO market setting, in the context of an active grey market for IPOs I examine how underwriters can reduce the information asymmetry for uninformed retail investors by using the grey market as a signaling environment to signal IPO quality to them Further, I examine the effect of allocation discretion on underwriters’ motives in the grey market and thus their choices in regard to sharing information with IPO investors I also examine how the outcomes of retail investor participation and IPO underpricing can be different, depending on the signaling behaviour of underwriters in the grey market 210 I find that granting allocation discretion to underwriters does not result in lower underpricing in an IPO I also find that the grey market price signal has a positive effect on retail investors’ participation and results in a reduced level of information asymmetry I conclude that the grey market price signal can be a dominant signal for retail investors to gain information about IPO quality, and hence influence them to actively participate in an offer, leading to IPO success However, a significant finding that emerges is that the granting of allocation discretion to underwriters, combined with the presence of an unregulated grey market, motivates underwriters to manipulate the grey market by giving a false signal of IPO quality for their own benefit The evidence is that regulating the allocation power of underwriters reduces their incentive to participate in the grey market, thereby restricting manipulation in the grey market This represents a positive outcome for market welfare as the cost of the false signal in the grey market is borne by uninformed retail investors, whose investment decision is influenced by the grey market price signal I find that greater retail investor participation results in higher underpricing However, regulatory intervention makes this relationship insignificant This represents a positive sign for IPO markets, allowing that underpricing in the period is not expected to be the outcome of overenthusiasm by retail investors Further, contrary to existing research on the grey market, the evidence from this study finds no significant relationship between the grey market price and underpricing in an IPO This evidence supports my earlier finding that there is a possibility that the grey market price does not represent the fundamental value of the IPO 6.1.3 Study Underwriter Syndication In the third study, the main focus is the examination of underwriting syndicates I examine the determinants of an underwriting syndicate and investigate the critical question of why underwriters form an IPO syndicate I examine the effectiveness of syndication as an indirect mechanism of information and risk sharing 211 for underwriters when regulators enforce constraints on allocation discretion Finally, I explore the motivation for syndication by highly reputed underwriters and investigate whether, in the absence of allocation discretion, reputation-based syndication results in either higher information sharing or, alternatively, price manipulation in an IPO The evidence is that granting allocation discretion to underwriters does not result in higher information production from institutional investors Further examination indicates that the underwriting market in India is highly concentrated and dominated by a few large underwriters who have established reputations and relationships amongst themselves to manage IPOs For this reason, it is difficult for new and small underwriters to enter and survive in the IPO market Moreover, I find that the underwriters who form large syndicates generally not have a high reputation and that the IPOs they manage are large in size, and participation from investors is weak I find no support for the argument that motivation of syndication is risk mitigation or price manipulation However, I find that underwriters form syndicates to reduce the risk of IPO failure by sharing inventory risk, which, in effect, is indirect risk mitigation When the discretionary allocation power of underwriters is regulated, with an attendant increase in the overall risk of managing the IPO, underwriters are less likely to form a syndicate Finally, in the absence of allocation discretion, reputation-based syndication positively influences participation from institutional investors and also results in lower underpricing in an IPO 6.2 Overall Summary Overall, the results not support the information sharing hypothesis that granting allocation discretion to underwriters results in better price discovery in the IPO process The conclusion is that in a setting which has the presence of a grey market, and for which underwriters have allocation discretion, such a market encourages the underwriters to engage in rent-seeking activity for higher income This 212 is made possible by manipulating the grey market price signal that positively influences the participation of uninformed retail investors, which in turn results in higher underpricing in the IPO The inference is that when allocation discretion is regulated, all IPO investors have similar information about the quality of the IPO firm, which thereby works to lower underpricing and increase market welfare The conclusion is that in the Indian IPO market, underwriters syndicate to reduce the risk of IPO failure by sharing inventory risk In the absence of allocation discretion, reputable underwriters, if they not have active participation from institutional investors, are reluctant to operate in the market because of higher risk This allows institutional investors to act as a mediating factor for reputable underwriters to syndicate by sharing risk Thus, I conclude that syndication by a reputable underwriter is an effective mechanism for higher information and risk sharing as it creates an indirect medium of discretion for underwriters when allocation discretion is regulated Issuers benefit when a syndicate manages their IPO, when at least one of the syndicate members is an underwriter with a good reputation as this can maximise the amount raised for the same number of shares offered The outcome is that regulating allocation discretion of underwriters is positive from the welfare perspective of market participants through lower underpricing However, for regulatory intervention to be efficient, the grey market must also be regulated because the price signal in the grey market positively affects the participation of small retail investors For regulatory authorities in other IPO markets, the evidence from this study is that when allocation discretion is regulated, underwriters can overcome the regulation hurdle by creating an indirect discretion through reputation-based syndication Thus, the combination of findings supports regulatory intervention as it results in increased market welfare while allowing syndication to act as a substitution mechanism for IPO success 213 6.3 Limitations and Avenues for Future Research Although the study makes an effort to address all important issues, it is subject to certain limitations The first limitation relates to data The unavailability of day-to-day grey market premium data obliges us to use weekly data for the grey market premium, although I have data on the day-to-day participation in each individual investor category Access to daily grey market price data during the period when the IPO opens for subscription would have allowed me to examine the effect of the change in grey market premium depending on the day-to-day subscription from each investor category Care must be taken in applying the findings of this study to IPOs more generally This is because I have only considered IPOs that had a positive grey market premium (which led to a few firms being eliminated) Nevertheless, the data period is the largest to date, compared with data samples of other published reports, since the introduction of the bookbuilding mechanism in the Indian IPO market My analysis is also constrained by the unavailability of data on the number of shares applied in the subcategory of institutional investors This data would have allowed me to understand which institutional investors are more informed and, more importantly, whether foreign institutional investors (with better skills and modelling techniques compared to local Indian institutions) are able to identify IPOs that give higher returns Compared to syndication in the American IPO market, the syndicate size of an Indian IPO does not vary substantially Controlling for the number of underwriters in a syndicate does not provide any significant findings For this reason, I have used the calculated measure of underwriter syndicate effort as a proxy to represent the size of an underwriting syndicate in the Indian IPO setting 214 The data for this research has been mostly hand-collected from publicly available sources such as websites or from prospectuses Moreover, to understand the operations of the grey market, I interviewed participants active in the grey market in India (market operators, brokers, investors and a newspaper editor) over a period of months The interviews did not provide direct data for the thesis but contributed invaluably to a realistic recognition and understanding of the mechanism at work in the IPO market in India The data on the grey market prices/premiums were available only from public announcements (No databanks exist) During my visit to India, I contacted six newspaper publishers to obtain data on the grey market but without success Ultimately, the data for the period of my study (2000-2013) was made available by the financial newspaper Smart Investment that granted me access to their archives (permission to visit their storage of past issues and hand-collect the data) Smart Investment is published in a regional language, namely Gujrathi 56, in Ahmedabad, Gujarat It was, therefore, necessary to translate the data into English so that I could use the data for my research Thus, I invested considerable time and effort in gathering the data necessary for my empirical analysis Human error has, however, been eliminated as far as possible The rich information available from the Indian IPO market presents a number of interesting directions for future research Future research could explore more on the role of the grey market in influencing market participants and how regulators can deal with the potential welfare costs associated with grey market manipulation Also, in the Indian market, many IPOs are backed by venture capital firms When an investor is prepared to enter with prior commitment, this enhances the issuing firm's ability to sell the IPO and generate more confidence in the minds of other 56 http://www.smartinvestment.in/ This newspaper, more recently, is published in an English version and the publisher have developed an online portal 215 investors I plan to use a propensity score methodology to conduct a relative study of IPOs with and without venture capital backing to understand whether the participation of venture capital investors acts as a signaling tool for uninformed retail investors When investors are prepared to enter with prior commitment, this enhances the issuer firm’s ability to sell the 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