IPO book building and penny stocks
Sunday, 22 March 2009
M. Imtiaz Mozumder
The Securities & Exchange Commission approved the book building method of pricing Initial Public Offerings (IPOs) for both domestic and foreign companies. However, this will not substitute the existing 'fixed-price' method of valuing IPOs. Some preconditions are set for companies willing to use the proposed book building method. These include, companies should (a) have at least Tk. 300 million of net worth, (b) have at least 10% share of the paid up capital or shares worth of Tk. 300 million, whichever is higher, (c) have at least three consecutive years of viable commercial operations of which at least two-years of profitable operations and no accumulated loss, (d) be audited independently and statutory by the SEC, (e) hold regular annual general meetings (AGMs), and (f) allocate IPO quota for both institutional and individual investors.
Interestingly, IPO quota is directly (inversely) proportional to the size of IPOs for institutional (individual) investors, for example, institutional (individual) investors will receive 20%, 30%, 40%, or 50% (60%, 50%, 40%, or 30%) if the size of IPO is in between Tk. 300 million and Tk 500 million, Tk. 500 million and Tk 1.0 billion, Tk. 1.0 billion and 8.0 billion, or above Tk. 5.0 billion respectively. However, mutual funds and non-resident Bangladeshis are rationed by a fixed 10 per cent irrespective of IPO sizes. The SEC officials and some investors believe that the book building method will lead to a price discovery and ensure fair stock prices which can not be attained by the current fixed-price; technique of pricing IPOs. Moreover, the executive director and other SEC officials expressed their positive opinions about the book building method enhancing market depth, volume and value turnover, market capitalization, supplies of IPOs etc. Some of these seem to be very promising sides of the situation but investors should be cautious about the myth (or illusion) of discovering fair IPO prices under the proposed book building method.
In a developed capital market, underwriters (either an investment bank or a syndicate of banks) play several key roles in the process of IPO book building such as origination, distribution, risk bearing, certification, price stabilization, financial analysis, auditing, advising, making the market, providing liquidity etc.
Under the fixed-price method, underwriters of issuing companies propose a fixed price for IPOs through companies' prospectuses. The SEC examines the prospectus and approves the fixed priced IPOs as long as the price is consistent with the company's financial and other economic fundamentals. However, both the SEC and underwriters are less able to determine the demand for IPOs and barely put efforts to verify whether the proposed fixed price represents a fair value. Moreover, underwriters discriminate in allocating IPOs because there is no hard and fast rule in distributing shares between individual and institutional investors.
Under the book building method, underwriters or book runners ask selective institutional investors (e.g. merchant banks, pension and provident funds, mutual funds, banks and non-banking financial institutions, stock dealers, insurance companies, registered venture capitalists, authorized foreign institutional investors etc.) to reveal their demand for IPOs and offer prices that they are willing to pay. This process is also known as IPO road-show i.e. issuing firms and underwriters host seminars; workshops etc. and try to explain and market their IPOs. The road-show allows underwriters and issuing companies to determine the demand for IPOs and their prices.
Based on expressions of interests by numerous institutional investors (the SEC set at least five from three different categories in Bangladesh), underwriters will set an indicative price; for IPOs and send it to the SEC and stock exchanges. All institutional investors are then allowed to participate in an automated but restrictive bidding (e.g. no more or less than 20% price variation from indicative price; no more than five bids; none can express to buy more than 10% of IPOs etc.). The weighted average of all bid prices (or the average of the highest and lowest bid prices) determines the final market price for an IPO to institutional investors. The cut-off price for individual investors will be determined by the closing bid price at which the last share was allocated to institutional investors. Notwithstanding this, individual investors may still feel like that they are paying a price similar to a fixed-price method. Due to conflict of interests, the underwriters cannot participate in IPO bidding process. In case of over-subscriptions, individual investors are unlikely to receive shares of oversubscribed offers in many developed markets including the USA but are guaranteed in many emerging markets including Bangladesh to receive shares through a lottery.
Book building method is also known as two-stage price discovery process because it implicitly determines IPO prices by supply-demand interactions. Both the offer and indicative prices are somehow derived from using either a direct valuation method (e.g. Discounted Cash Flow or DCF approach where IPO values are estimated directly from issuing company's fundamentals) or relative valuation method (e.g. market multiples approach where IPO values are computed indirectly using comparable company's earnings, leverage, profitability, liquidity, asset and debt utilization ratios etc.). There are pros and cons for both valuation techniques. Some of the variables (e.g. future growth rate of a company and its terminal value, discount rate etc.) used in DCF technique are estimated using complex asset pricing models and different econometric techniques. There might be uncertainties associated with these forecasted values. Similarly, the identification of reasonable peer firms under relative valuation approach is also difficult for start-up companies.
Moreover, survivorship bias may exist if we exclude the performance of comparable firms which have already been wiped out. The timing (hot or cold market period) and contractual agreements between underwriters and issuing firms also play important roles in pricing IPOs.
It is worthy to mention about IPO underpricing (when prices of shares abnormally increase subsequent to the initial offerings and measured by the percentage increase of stock price from its initial offer price to the closing price at the end of first trading day) an adverse outcome of either a book building or fixed-price method.
Loughran, Ritter, and Rydqvist (Pacific Basin Finance Journal, Vol. 2, 1994) showed that the average IPO underpricing on the first day of IPO issuance was as high as 80% mostly in emerging markets of Asia and South America (think about making 80% returns per day for 365 days in a year if there is an IPO per day)! The average IPO underpricing on the first day of IPO issuance in developed countries is approximately 20-25%.
According to several research papers by Jay Ritter, Professor of Finance at University of Florida, the IPO underpricing in the USA was more than 22% during 1990-2008 suggesting that the issuers left approximately $120 billion on the table.
Moreover, the long-run underperformance of stocks (especially of small firms) is also observed under book-building method. Information asymmetry among investors, issuing firms, and underwriters may be a major driving force in IPO underpricing. There are also behaviourial explanations (overreactions by investors) of IPO underpricing.
Academic research shows that underwriters have different incentives than issuing firms which may lead underwriters to underprice IPOs. For example, underwriters may deliberately underprice IPOs (a) to provide their best clients with an opportunity to garner abnormal returns on the very first day; (b) to exercise the overallotment option (also known as green shoe option) in case of excess demand for IPOs to earn more fees and commissions; (c) to overcome adverse selection problem inducing uninformed investors to buy IPOs in near future; (d) to limit law suits by shareholders; (e) to generate excitements among investors; (f) to increase liquidity even at the expense of stock price dilution. Unfortunately, investors (both individual and institutional) and venture capitalists have limited ability and/or weak incentives to defend against IPO underpricing.
The Dutch auction method is an alternative (but still a dream for Bangladesh) process of pricing IPOs. The Dutch auction method challenges the traditional book building and fixed price methods because the role of underwriters in pricing IPOs is less significant here. Moreover, information asymmetries between underwriters and issuing firms are greatly reduced under the Dutch auction method. It should be noted here that the IPO underpricing is considerably less under the Dutch auction method.
The popular search engine and advertising company (Google) used a Dutch auction when they floated IPOs in 2004. Interestingly, the underpricing of Google was much less than comparable firms in the same industry. However, investors may still suffer from winners; curse (i.e. feel like paying overvalued price for IPOs)! In future, the SEC may consider permitting the Dutch auction process along with the proposed book building method. The SEC also imposes a 15-day lock-in period for institutional investors i.e. they cannot sell their shares within 15 trading days of initial purchase. The proposed lock-in period seems to have a very short window as opposed to a three or six-month lock-in period in many developed markets.
The SEC should also ask the issuing firms to have multiple book runners (i.e. underwriters) to reduce information asymmetries and discover share prices more efficiently. Academic finance research was able to show that the IPO underpricing declines as the number of book runners increases. The SEC should also put appropriate regulations on dual structure of IPOs (which may differ in terms of voting rights or prices) as it has important implications on corporate governance and market transparencies. Amazingly, on the same day (March 5, 2009), the DSE decided not to list any company with an IPO face value of Tk. 1.0 or less (these are known as penny stocks). The DSE officials mentioned that the revised rule will bring to a halt of any bet or gambling in the stock market because individual investors more often wrongly evaluate a penny stock which creates high volatilities in the market. Penny stocks are risky by nature: think about a 10-cent price decline for a 1.0 stock or $10 price decline for a $100 stock (both are equivalent to a 10% decline)! The US securities exchange act also put some bars on issuing penny stocks.
Interestingly, the revised regulation on penny stocks postpones the proposed IPOs (with a Tk. 1.0-face value) of Grameen Phone. Grameen phone's decision to float penny stocks in the market is still not well understood. As a leading telecom sector, Grameen phone should avoid offering a penny stock and using a fixed price IPO method. It has been alleged that numerous DSE high officials were not able to manage Grameen Phone's share in pre-IPO placement and are now putting artificial obstacles to its IPO issuance. This requires further investigation by the government.
However, it should be reported here that the Telenor (owner of Grameen Phone's 62% equity share) was recently asked by a Russian Court to pay $1.7 billion in damages to Vimpelcom (Russia's second largest cell phone company and approximately 1/3rd of which is owned by Telenor) due to corruption, corporate fraud and poor governance system imposed by Telenor. Telenor also had to delist its shares from NASDAQ in mid-2007. The poor corporate governance of Telenor, employing child labour in Grameen Phone and several accident-related deaths in its plants make it less credible that Grameen's IPO is based on its so-called social businesses. The SEC and other regulatory agencies should watch the documentary, Flip the Coin - A Tower of Promises and use it along with Grameen Phone's prospectus to ensure better and ethical corporate governance and behaviour from a public company aspiring to issue IPOs and be listed in stock exchanges.
The writer is an Assistant Professor of Finance at the School of Business of State University of New York Institute of Technology (SUNYIT) in New York.
He may be reached at
e-mail: mazumdm@sunyit.edu
The Securities & Exchange Commission approved the book building method of pricing Initial Public Offerings (IPOs) for both domestic and foreign companies. However, this will not substitute the existing 'fixed-price' method of valuing IPOs. Some preconditions are set for companies willing to use the proposed book building method. These include, companies should (a) have at least Tk. 300 million of net worth, (b) have at least 10% share of the paid up capital or shares worth of Tk. 300 million, whichever is higher, (c) have at least three consecutive years of viable commercial operations of which at least two-years of profitable operations and no accumulated loss, (d) be audited independently and statutory by the SEC, (e) hold regular annual general meetings (AGMs), and (f) allocate IPO quota for both institutional and individual investors.
Interestingly, IPO quota is directly (inversely) proportional to the size of IPOs for institutional (individual) investors, for example, institutional (individual) investors will receive 20%, 30%, 40%, or 50% (60%, 50%, 40%, or 30%) if the size of IPO is in between Tk. 300 million and Tk 500 million, Tk. 500 million and Tk 1.0 billion, Tk. 1.0 billion and 8.0 billion, or above Tk. 5.0 billion respectively. However, mutual funds and non-resident Bangladeshis are rationed by a fixed 10 per cent irrespective of IPO sizes. The SEC officials and some investors believe that the book building method will lead to a price discovery and ensure fair stock prices which can not be attained by the current fixed-price; technique of pricing IPOs. Moreover, the executive director and other SEC officials expressed their positive opinions about the book building method enhancing market depth, volume and value turnover, market capitalization, supplies of IPOs etc. Some of these seem to be very promising sides of the situation but investors should be cautious about the myth (or illusion) of discovering fair IPO prices under the proposed book building method.
In a developed capital market, underwriters (either an investment bank or a syndicate of banks) play several key roles in the process of IPO book building such as origination, distribution, risk bearing, certification, price stabilization, financial analysis, auditing, advising, making the market, providing liquidity etc.
Under the fixed-price method, underwriters of issuing companies propose a fixed price for IPOs through companies' prospectuses. The SEC examines the prospectus and approves the fixed priced IPOs as long as the price is consistent with the company's financial and other economic fundamentals. However, both the SEC and underwriters are less able to determine the demand for IPOs and barely put efforts to verify whether the proposed fixed price represents a fair value. Moreover, underwriters discriminate in allocating IPOs because there is no hard and fast rule in distributing shares between individual and institutional investors.
Under the book building method, underwriters or book runners ask selective institutional investors (e.g. merchant banks, pension and provident funds, mutual funds, banks and non-banking financial institutions, stock dealers, insurance companies, registered venture capitalists, authorized foreign institutional investors etc.) to reveal their demand for IPOs and offer prices that they are willing to pay. This process is also known as IPO road-show i.e. issuing firms and underwriters host seminars; workshops etc. and try to explain and market their IPOs. The road-show allows underwriters and issuing companies to determine the demand for IPOs and their prices.
Based on expressions of interests by numerous institutional investors (the SEC set at least five from three different categories in Bangladesh), underwriters will set an indicative price; for IPOs and send it to the SEC and stock exchanges. All institutional investors are then allowed to participate in an automated but restrictive bidding (e.g. no more or less than 20% price variation from indicative price; no more than five bids; none can express to buy more than 10% of IPOs etc.). The weighted average of all bid prices (or the average of the highest and lowest bid prices) determines the final market price for an IPO to institutional investors. The cut-off price for individual investors will be determined by the closing bid price at which the last share was allocated to institutional investors. Notwithstanding this, individual investors may still feel like that they are paying a price similar to a fixed-price method. Due to conflict of interests, the underwriters cannot participate in IPO bidding process. In case of over-subscriptions, individual investors are unlikely to receive shares of oversubscribed offers in many developed markets including the USA but are guaranteed in many emerging markets including Bangladesh to receive shares through a lottery.
Book building method is also known as two-stage price discovery process because it implicitly determines IPO prices by supply-demand interactions. Both the offer and indicative prices are somehow derived from using either a direct valuation method (e.g. Discounted Cash Flow or DCF approach where IPO values are estimated directly from issuing company's fundamentals) or relative valuation method (e.g. market multiples approach where IPO values are computed indirectly using comparable company's earnings, leverage, profitability, liquidity, asset and debt utilization ratios etc.). There are pros and cons for both valuation techniques. Some of the variables (e.g. future growth rate of a company and its terminal value, discount rate etc.) used in DCF technique are estimated using complex asset pricing models and different econometric techniques. There might be uncertainties associated with these forecasted values. Similarly, the identification of reasonable peer firms under relative valuation approach is also difficult for start-up companies.
Moreover, survivorship bias may exist if we exclude the performance of comparable firms which have already been wiped out. The timing (hot or cold market period) and contractual agreements between underwriters and issuing firms also play important roles in pricing IPOs.
It is worthy to mention about IPO underpricing (when prices of shares abnormally increase subsequent to the initial offerings and measured by the percentage increase of stock price from its initial offer price to the closing price at the end of first trading day) an adverse outcome of either a book building or fixed-price method.
Loughran, Ritter, and Rydqvist (Pacific Basin Finance Journal, Vol. 2, 1994) showed that the average IPO underpricing on the first day of IPO issuance was as high as 80% mostly in emerging markets of Asia and South America (think about making 80% returns per day for 365 days in a year if there is an IPO per day)! The average IPO underpricing on the first day of IPO issuance in developed countries is approximately 20-25%.
According to several research papers by Jay Ritter, Professor of Finance at University of Florida, the IPO underpricing in the USA was more than 22% during 1990-2008 suggesting that the issuers left approximately $120 billion on the table.
Moreover, the long-run underperformance of stocks (especially of small firms) is also observed under book-building method. Information asymmetry among investors, issuing firms, and underwriters may be a major driving force in IPO underpricing. There are also behaviourial explanations (overreactions by investors) of IPO underpricing.
Academic research shows that underwriters have different incentives than issuing firms which may lead underwriters to underprice IPOs. For example, underwriters may deliberately underprice IPOs (a) to provide their best clients with an opportunity to garner abnormal returns on the very first day; (b) to exercise the overallotment option (also known as green shoe option) in case of excess demand for IPOs to earn more fees and commissions; (c) to overcome adverse selection problem inducing uninformed investors to buy IPOs in near future; (d) to limit law suits by shareholders; (e) to generate excitements among investors; (f) to increase liquidity even at the expense of stock price dilution. Unfortunately, investors (both individual and institutional) and venture capitalists have limited ability and/or weak incentives to defend against IPO underpricing.
The Dutch auction method is an alternative (but still a dream for Bangladesh) process of pricing IPOs. The Dutch auction method challenges the traditional book building and fixed price methods because the role of underwriters in pricing IPOs is less significant here. Moreover, information asymmetries between underwriters and issuing firms are greatly reduced under the Dutch auction method. It should be noted here that the IPO underpricing is considerably less under the Dutch auction method.
The popular search engine and advertising company (Google) used a Dutch auction when they floated IPOs in 2004. Interestingly, the underpricing of Google was much less than comparable firms in the same industry. However, investors may still suffer from winners; curse (i.e. feel like paying overvalued price for IPOs)! In future, the SEC may consider permitting the Dutch auction process along with the proposed book building method. The SEC also imposes a 15-day lock-in period for institutional investors i.e. they cannot sell their shares within 15 trading days of initial purchase. The proposed lock-in period seems to have a very short window as opposed to a three or six-month lock-in period in many developed markets.
The SEC should also ask the issuing firms to have multiple book runners (i.e. underwriters) to reduce information asymmetries and discover share prices more efficiently. Academic finance research was able to show that the IPO underpricing declines as the number of book runners increases. The SEC should also put appropriate regulations on dual structure of IPOs (which may differ in terms of voting rights or prices) as it has important implications on corporate governance and market transparencies. Amazingly, on the same day (March 5, 2009), the DSE decided not to list any company with an IPO face value of Tk. 1.0 or less (these are known as penny stocks). The DSE officials mentioned that the revised rule will bring to a halt of any bet or gambling in the stock market because individual investors more often wrongly evaluate a penny stock which creates high volatilities in the market. Penny stocks are risky by nature: think about a 10-cent price decline for a 1.0 stock or $10 price decline for a $100 stock (both are equivalent to a 10% decline)! The US securities exchange act also put some bars on issuing penny stocks.
Interestingly, the revised regulation on penny stocks postpones the proposed IPOs (with a Tk. 1.0-face value) of Grameen Phone. Grameen phone's decision to float penny stocks in the market is still not well understood. As a leading telecom sector, Grameen phone should avoid offering a penny stock and using a fixed price IPO method. It has been alleged that numerous DSE high officials were not able to manage Grameen Phone's share in pre-IPO placement and are now putting artificial obstacles to its IPO issuance. This requires further investigation by the government.
However, it should be reported here that the Telenor (owner of Grameen Phone's 62% equity share) was recently asked by a Russian Court to pay $1.7 billion in damages to Vimpelcom (Russia's second largest cell phone company and approximately 1/3rd of which is owned by Telenor) due to corruption, corporate fraud and poor governance system imposed by Telenor. Telenor also had to delist its shares from NASDAQ in mid-2007. The poor corporate governance of Telenor, employing child labour in Grameen Phone and several accident-related deaths in its plants make it less credible that Grameen's IPO is based on its so-called social businesses. The SEC and other regulatory agencies should watch the documentary, Flip the Coin - A Tower of Promises and use it along with Grameen Phone's prospectus to ensure better and ethical corporate governance and behaviour from a public company aspiring to issue IPOs and be listed in stock exchanges.
The writer is an Assistant Professor of Finance at the School of Business of State University of New York Institute of Technology (SUNYIT) in New York.
He may be reached at
e-mail: mazumdm@sunyit.edu