April 2005
SECTORAL

Why do IPOs Perform Well in the Short-run?

By Santosh Pandey

The popularity of Initial Public Offering (IPO) as a source of capital has increased over the years in both developed and emerging countries, thanks to the evolving capital markets. As per Ritter and Welch (2002), the number of companies going public from 1980 to 2001 in the United States exceeded one per day on average. An average IPO deal amounted to USD 78 million. In this regard, Nepal is no exception. We have seen a number of new issues in the recent past. However, it is necessary to see whether such IPOs perform well in the short-run and the long-run. Performance here is meant to be the returns on IPOs compared to the seasoned offerings of the similarly matched firms. In this article, the main focus will be on the short-run performance of IPOs. We will have a look at the theories explaining the short-run performance and some empirical evidences. This would probably be able to explain the long queues outside investment banks when there is an IPO announcement. Numerous studies have examined the short-run performance of IPOs and documented the existence of short-run excess returns. Ibbotson (1975) was among the first to report on the so-called “underpricing” of IPOs by documenting initial excess returns of 11.40 percent on US common stock IPOs (for more on this, see Smith, 1986). Studies on the long-run aftermarket price behaviour, such as Ritter (1991) and Aggarwal and Rivoli (1990), show that this initial out-performance appears to be a short-run phenomenon. The short-run performance of the IPOs is measured by the event returns the investors obtain in the initial days of trading activity (normally close price of day one). Most empirical evidences show positive short-run returns on IPOs. The main reason for the high short-run returns as pointed out by most researchers is the underpricing of IPOs. It has been observed that most of the initial public offerings are underpriced. There are various theories that try to explain the underpricing and thus the short-run abnormal returns of IPOs.

One of the theories suggested has been in line with the principal-agent problem. Under the underwriting contract, especially with the firm commitment contract, the underwriter is bound to buy all shares from the issuer and then sell them to the investors. Therefore, due to the fear of being left with unsold shares at the end of the offer date, the underwriters and advisors set the offer price below their actual value. This theory is consistent with Baron (1982) who points out that the underwriters underprice the issues to lower their selling efforts.

Another theory suggesting the underpricing is related to the issue of adverse selection. An information asymmetry occurs amongst the investors. Some of the investors are well informed than the others which mean that those well informed investors will put most of their funds only in “good” offerings and less in “bad” offerings. But, the uninformed investors will not be able to differentiate between the bad and the good IPOs and invest equally in both where they would be allotted less shares in good IPOs and more in bad IPOs thereby suffering a “winner’s curse” problem. (Winner’s curse is a danger that the winner of a contract may lose money). In order to protect and attract such uninformed investors and retain them in the market, the underwriters and issuers usually set prices below the actual value of stock. Rock (1986) explains this theory which was later supported by papers by Keloharju (1993) and Michaeley and Shaw (1994). The papers tested this theory for the US common stock market, and found strong support for the existence of a winner’s curse.

Also, it has been argued that IPOs are underpriced to signal the strong health of the firm. High quality firms set prices below the actual value to reflect their high quality such that prices go up in the trading floors and that they could raise capital in the future at higher prices. However, the same cannot be applied to low-quality issuers as their quality will be revealed once the IPOs start trading. In their study, Allen and Faulhaber (1989) who used their own model to support for this argument point out that it is indeed the firms’ desire to reflect their quality or let their quality be known to the investors for which they use underpricing. Besides, there is another theory which suggests that underpricing occurs due to high debt ratio and high growth potential of the firms. Firms with high growth potential will rely less on debt financing as they have high risk profile. This high risk will make these firms less accessible to the debt market and hence persuade them to go for equity issues. The investors will consider these firms more risky. It will therefore be important for the issuers to set the offer price below the actual firm value to attract the investors. Hence, underpricing occurs because of this. Smith and Watts (1992) support this hypothesis and argue that firms with lower debt ratios will tend to underprice more than the firms with high debt ratios. Also, there are findings that suggest that pricing methodology too affect the extent of underpricing of IPOs. The returns of IPOs tend to fluctuate on the basis of the pricing methodology of the IPOs. Loughran et al (1994), show that fixed price mechanism tend to result in a high level of underpricing leaving huge money on the table mainly due to the offer price being set relatively early, before much information about the state of demand is known. With book-building, however, the underwriters who organise road shows to find out the real demand of the IPO with a specific price range, the underpricing is lower as the underwriter and issuer more or less know what money the investors are keen to pay for the stock and readjust the offer price accordingly.

Similarly, Boehmer and Fishe (2001) argue that underpricing is done by underwriters so that the trading volumes of IPOs immediately increase and that they generate huge trading revenues. Tinic (1988) and Hughes and Thakor (1992) on the other hand argue that the main incentive for issuers to underprice is reduction of legal liability. They point out that issuers underprice IPOs mainly to avoid being sued by investors. Habib and Ljungqvist (2001) in their paper explain the underpricing of IPOs for reduction of marketing cost. In their paper, with IPO data set from 1991 to 1995, they show that one dollar of underpricing reduces the marketing cost of such IPOs by one dollar. Loughran and Ritter (2003) argue that issuers placed more and more attention on favourable analyst coverage as valuations increased during the 1990s, which resulted in the IPO underwriting industry becoming less competitive (in the context of US IPOs). As a consequence, underpricing increased where underwriters profited by allocating hot IPOs in return to commission business offered by investors. Carter, Dark and Singh (1998) relate the initial returns or short-run performance of IPOs to the reputation of the underwriters. They use three alternative measures of underwriter prestige developed by Johnson and Miller (1988), Carter and Manaster (1990) and Megginson and Weiss (1991). All three measures show independently that they were significantly correlated to the initial IPO returns and that more reputed the underwriter the lower the underpricing and vice versa. This relationship between underpricing level and reputation can be explained on grounds of asymmetric information. Investors may be well informed about the actual value of stock by reputed underwriters thus the requirement for less underpricing. It may also be that reputed underwriters may have taken up only good IPOs to avoid any tarnishing of their image and that such IPOs, even though they are less underpriced, are subscribed by investors for “buy and hold” strategies. Loughran and Ritter (2002) argue that if underwriters are given the right to allocate IPOs, they would do so in such a way that more underpricing occurs and that favoured buy-side clients get these shares mainly so that the underwriters too gain business when such clients go for IPO issuance in the future. This is one reflection of the asymmetric information between the issuers and the underwriters. Tian (2002) points out that the underpricing in China is motivated not by any theories but from the regulatory ceiling of IPO pricing by the multiplier method (limiting it to 15) and mandatory delay of flotation on the stock exchange for public trading. The author reasons this out as political interests of the reformist government in developing a capitalist stock market and transforming the society.

In a nutshell, it can be seen that investors who buy stocks through IPOs benefit a lot from good amounts of capital gains if they decide to sell the stocks in the short-run. This normally results from underpricing of stocks in IPOs for various reasons ranging from asymmetric information to avoiding a winner’s curse for uninformed investors. The extent of underpricing, however, depends on many factors; some explained by the underwriters’ reputation and others by the pricing methodology used for IPOs. It can be concluded that the performance of IPOs in the short-run is normally very good from the investors’ point of view but from the issuers’ point of view, if there is too much money left on the table, it is a cost for them. A certain level of underpricing is, however, acceptable to attract uninformed investors on one hand and on the other hand, to maintain liquidity and make subsequent future issuance attractive and easy.

(Pandey is doing his MSc in International Banking and Finance, London Metropolitan University )

SMEs Why So High Mortality?

by Suresh Acharya

Small and Medium Enterprises (SMEs), irrespective of a country’s development level, form an integral part of the economy. For the last ten years, SMEs have been the dynamic source of growth, flexibility, innovation, competitiveness and job creation in the South East Asia as well as in the European Union. However, the case in Nepal is rather different though SME sector is the country’s single largest employer after agriculture and is one of the major sources of foreign exchange earning.

Nepali SMEs are mostly composed of the agro-industries (e.g. pulses, cardamom, and tea), handicrafts (e.g., pashmina, woollen carpets, woollen products, silver jewellery, and paper products, artisan works (e.g., wood, stone and metal carvings, paintings) and the readymade garment industries. Nepali SMEs are considered good at producing indigenous products, bringing about flexibility in manufacturing, producing smaller quantities but high quality products, especially in the handicrafts sector. However, they lack diversification and standardisation compared to that of small and medium enterprises of the industrialised world.

The development of SMEs in Nepal holds greater significance as the prospects for large industries are, for the time being, limited because of the low purchasing power of people, inadequate industrial infrastructure, underdeveloped transport and communication facilities, and the small size of the domestic market.

Contribution of SME sector:

Out of the total export earnings of Rs. 37,678.4 million in 2002/03, the share of the SME sector (including handicrafts) was around Rs. 18,000 million. This sector has a major share in the total number of industrial enterprises, as well as in employment and output. It provides employment to about 78 percent of the total industrial labour force and has seen an increment in its contribution to the GDP from 4.61 percent to 10 percent over the last decade. This clearly indicates that the contribution of the SME manufacturing sector to the national economy has been gradually increasing over time.

SMEs between 1991/92 and 2001/02:

The number of cottage and small industries registered increased during 1996/97 - 1999/2000. But in 2000/01 the registration decreased by about 8 percent, though in 2001/02 it increased by over 6 percent compared to the previous year. But again it went down by about 23 percent in 2002/03.

Moreover, out of the total registered small and medium scale industries, about 65 percent of them are estimated to be non-operational and more than 60 percent of the operating industries are characterised by under capacity utilisation and sickness.

Published data show that in 1991/92, about 98.8 percent of the manufacturing enterprises were in the small and medium category (see tables). This share has, however, declined over the years. Similar is the case in employment as well as investment. The decline in the number of establishments, workforce absorption capacity and fixed asset investments over the last decade indicate some serious problems in this sector that warrant urgent remedies.

Incidence of mortality of Nepali SMEs:

The incidence of mortality is identified as a severe problem in the development of the SME sector in Nepal . This sector is characterised by a very high degree of volatility both in terms of new start-up and closure. It has been estimated that up to 50 percent of SME start-ups in most economies do not survive the first five years of operation. In Nepal , it is not mandatory to register micro-enterprises with fixed capitals of Rs. 100,000 or less. Generally, very few of these micro-enterprises are found to be in operation. It is estimated that each year 25 percent of the registered SMEs die before they actually start operations. Of the remaining, half close down in the initial stage of operation. According to a survey conducted by the Department of Cottage and Small Industries (DCSI), the Ministry of Industry, Commerce and Supplies, only 25 percent of the total registered industries are estimated to be in operation and commercially sound.

According to a separate study, SME mortality rate is estimated at 63.07 percent of the total registered small and medium enterprises in Nepal . It is significantly higher than the world's average of 40 percent. This obviously has implications for designing effective support and rehabilitation programmes as well as to start new projects.

Causes for high mortality:

The major problems and constraints faced by Nepali SMEs are in the field of policy and legal framework, finance, entrepreneurship, management, socio-cultural values and technology. Nepali SMEs are troubled at every stage of their development, but the pre-start up and start-up phases are the most crucial ones. The causes identified include shortcomings in managerial capabilities, problems concerning availability, reliability and price stability of raw materials, lack of marketing skills, deficiency in marketing networks and clusters, technology, product development, product diversification and quality control, shortage of qualified technical manpower and lack of access to long term and low interest fund. In fact, the problems relate to every aspects of development in this sector. Thus, there is an urgent need to mitigate these tribulations to make the SME sector more vibrant, so as to convert it to an engine of economic growth.

In developed countries, SMEs derive their strength and comparative advantage either from specialising in niche markets or from linking up with large, often transnational corporations through integration into their supply chain. In many developing countries including Nepal , SMEs compete "head-on" with large companies and the same type of imported products in the same markets.

The causes of demise may be attributed to many other factors as well as the launching of SMEs without strategic planning, proper knowledge of industrial processes, marketing potentialities and the lack of accumulated business experience. In this context, the main factor for the high mortality rate of SMEs in Nepal is none other than the dearth of a business incubation environment. It has been proved from the experience of other countries that the survival chances of a company, which has been inside an incubator, is generally three or four times greater than of those which have not. The business incubator imparts idea, information, technological support, capacity building as well as seed capital and working capital to prospective entrepreneurs and helps them prepare business plans so that they become capable of operating professional and self-reliant business houses. Without it, the development of SMEs cannot really "take-off."

In most LDCs, the problems faced by SMEs are more or less similar in nature. Only a small percentage of the surviving SMEs turn into reasonably high-growth firms. Awareness and knowledge about business planning, dynamics and intricacies of production, operation and marketing management, and modern computer-based techniques for better management information are imperative in the competitive and changed global context for minimising the incidence of pre-mature mortality and for the sustainability of SMEs.

Projected loss caused by high SME mortality in Nepal :

The combined 68,296 cottage as well as the small and medium scale businesses in Nepal had an overall projected pre-start and start-up losses of Rs. 51.26 billion in a 12 year interval between 1991/1992 and 2003/2004. This shows that the country's scarce capital resource has been depleting or evaporating each year by an average of Rs 3.94 billion, which could have been otherwise utilised in a more productive and sustainable manner in growth augmenting sectors of the economy. It is more worrying to find that the loss is about 4 percent of the annual total national budget. This is a sheer waste of the scarce resources. There is, however, a lack of official data regarding the industrial mortality factors. Hence, this area needs special attention and a study has to be undertaken to ascertain the gravity of the situation.

According to a 1996 OECD report Technology, Productivity and Job Creation, less than one half of SME start-ups survive for five years. The report has underlined that only a small percentage of the surviving SMEs turn into high-growth firms citing an example of Canada , an industrialised nation. However, these high-growth firms make significant contributions to job creation and productivity growth in Canada . The report says that this is the reason why Canada is helping more of its SMEs get past the critical survival phase and into the growth phase. Considering the huge premature demise of Nepali SMEs, it is imperative for Nepal to revisit its support and rehabilitation programmes to make this sector commercially sound and turn it into a high growth sector.

SMEs can play pivotal roles in creating dynamic and market-oriented economic growth, employment for the growing workforce in the rural areas and the reduction of poverty. The changes that have been taking place in the international economic scenario have definitely brought challenges for the Nepali SMEs. However, these changes have also opened up tremendous business and market opportunities for this sector. It is a time to focus on the prevention of pervasive mortality in the SME sector.

(Acharya writes on contemporary issues and economics. He can be reached at sacharya@info.com.np)

Source: Compiled from Census of Manufacturing Establishments 2001/2002, Central Bureau of Statistics, National Planning Commission