Short-run Underpricing of Initial Public Offerings in the Sri Lankan

Stock Market

Lalith Samarakoon

Department of FinanceOpus College of BusinessUniversity of St. Thomas

April 29, 2011

Short-run IPO Underpricing

Purpose of Research

Investigate the initial underpricing of IPOs in the Colombo Stock Exchange Initial Underpricing: positive first day return i.e.,

increase in price on the first day of trading relative to the offer price

Contribution Provide Sri Lankan IPO evidence to international

literature; no prior published work on IPOs in the Sri Lankan market

Examine the ability of investor sentiment and privatization to explain the asymmetry in underpricing between small and large issues in an emerging market

2

Short-run IPO Underpricing

Main Hypothesis Ex-ante uncertainty hypothesis [Ritter (1984), Beatty and Ritter (1986)]

Uncertainty about the value of the issue; risky issues must be more underpriced

Small issues are considered more risky than large issues; Smaller issues will be more underpriced [Ritter (1984), Beatty and Ritter (1986)]

Privatization issues are considered more risky than conventional issues; Privatization issues will be more underpriced [Jones et al. (1999), Perotti and Guney (1998)]

Investor sentiment hypothesis Sentiment about the short-term direction of the overall

market [Ritter (1984)] More positive sentiment will lead to more underpricing

3

Short-run IPO Underpricing

Table 1: The Sample

Year or Industry Number of IPOs Aggregate Proceeds

Conventional Issues

Privatization issues

Total Rs. Mn.

%

Panel A: By Year 1987 3 0 3 147 0.92 1988 7 1 8 132 0.83 1989 1 1 2 140 0.88 1990 1 0 1 7 0.04 1991 3 1 4 139 0.87 1992 7 2 9 1,765 11.05 1993 7 3 10 1,631 10.21 1994 12 3 15 3,248 20.34 1995 11 3 14 2,428 15.21 1996 2 7 9 1,573 9.85 1997 4 2 6 833 5.22 1998 1 4 5 330 2.07 1999 3 1 4 496 3.11 2000 1 2 3 100 0.63 2001 0 0 0 - - 2002 3 0 3 133 0.83 2003 5 0 5 1,170 7.33 2004 1 0 1 300 1.88 2005 1 0 1 600 3.76 2006 1 0 1 400 2.51 2007 0 0 0 - - 2008 1 0 1 396 2.48 Total 75 30 105 15,968 100.00

4

Short-run IPO Underpricing

Table 1: The Sample Continued

5

Year or Industry Number of IPOs Aggregate Proceeds

Conventional Issues

Privatization issues

Total Rs. Mn. %

Panel B: By Industry Bank, finance & insurance 18 2 20 3,747 23.46 Beverage, food & tobacco 6 1 7 1,040 6.51 Chemicals & pharmaceuticals 0 1 1 3 0.02 Diversified 2 0 2 1,225 7.67 Footwear & textiles 0 3 3 478 2.99 Health care 3 0 3 721 4.51 Hotels & travels 12 1 13 1,570 9.83 Information technology 1 0 1 100 0.63 Land & property 7 0 7 298 1.86 Manufacturing 17 5 22 4,129 25.86 Motors 0 2 2 226 1.42 Plantations 1 15 16 877 5.49 Power & energy 1 0 1 400 2.50 Services 1 0 1 113 0.71 Trading 6 0 6 1,042 6.53 Total 75 30 105 15,968 100.00

Short-run IPO Underpricing

Methodology

Calculating Initial Returns

Univariate Analysis of Underpricing: Issue year Issuer’s industry Issue size Investor sentiment Privatization vs. conventional issues.

i

iii PriceOffer

PriceOfferCloseDay -FirstIR

Where, i= ith issue

6

Short-run IPO Underpricing

Methodology Cross-sectional Analysis

ii8i7i654

i3i2i1i

εManuβPlanβFootβ rSizeUnderwriteβHotβ

PrivartizeβSentimentβSizeβαReturn Initial

Independent variables Size (-): natural logarithm of proceeds of the issue Sentiment (+): cumulative market return over the three-month period

before the first day of trading of the IPO Privatize (+): a dummy variable equal to 1 for privatization IPOs and 0

for conventional IPOs. Hot (+): a dummy variable, which is set equal to 1 for hot market years

(1991 & 1998) and 0 otherwise UnderwriterSize (-/+): a dummy variable representing the size of the

underwriter and takes the value of 1 for large underwriters and 0 for small underwriters

Industry dummies (Foot, Plan, Manu)

7

Short-run IPO Underpricing

Table 2: Average Initial Returns by Issue Year

Year Average initial return Average initial return (%)

Aggregate amount left

on the table (Rs. Mn.)

Annual market return

(%) % t-stat Conventional issues

Privatization issues

1987 35.2 0.05 35.2 - 8.5 55.1

1988 5.6 -1.17 5.4 7.5 22.3 -23.0

1989 5.0 -0.61 0.0 10.0 9.0 6.4

1990 85.0 0.78 85.0 - 6.0 114.2

1991 106.9 2.12** 50.8 275.0 135.0 118.0

1992 46.0 0.54 54.5 16.3 267.0 -27.8

1993 38.2 0.22 23.0 73.7 502.8 61.7

1994 33.2 -0.01 13.4 112.4 1,102.3 0.8

1995 25.0 -0.44 22.9 32.8 42.3 -32.7

1996 21.1 -0.54 -33.0 36.5 -357.2 -9.2

1997 40.7 0.26 -11.9 145.8 163.6 16.5

1998 100.5 2.16** 9.1 123.3 312.0 -14.9

1999 -2.5 -1.08 11.7 -45.0 36.0 -4.2

2000 33.3 -0.00 20.0 40.0 36.0 -21.8

2001 - - - - - 38.8

2002 8.9 -0.64 8.9 - -21.7 31.3

2003 20.5 -0.43 20.5 - 590.3 30.3

2004 37.5 0.06 37.5 - 112.5 41.8

2005 25.0 -0.13 25.0 - 150.0 27.6

2006 -12.5 -0.69 -12.5 - -50.0 41.6

2007 - - - - - -6.7

2008 -10.4 -0.66 -10.4 - -41.3 -40.9

Overall 33.5 (66.2)

3,025.6 18.3 (43.2)

8

Short-run IPO Underpricing

Table 3: Average Initial Returns by IndustryIndustry Average initial return

Average

initial returns (%)

% t-stat Conventional issues

Privatization issues

Bank, finance & Insurance 5.5 -1.85* 5.8 2.5

Beverage, food & tobacco 11.4 -0.88 9.8 20.8

Chemicals & pharmaceuticals 7.5 -0.39 - 7.5

Diversified 44.8 0.24 44.8 -

Footwear & textiles 107.0 1.83* - 107.0

Health Care 19.2 -0.37 19.2 -

Hotels & travels 16.6 -0.88 6.5 137.5

Information technology -33.3 1.00 -33.3 -

Land & property 10.4 -0.91 10.4 -

Manufacturing 51.5 1.10 51.3 52.4

Motors 36.8 0.07 - 36.8

Plantations 76.9 2.39** 0.00 82.0

Power & energy -12.5 0.69 -12.5 -

Services 1.8 -0.48 1.8 -

Trading 27.7 -0.21 27.7 -

9

Short-run IPO Underpricing

Table 4: Initial Returns by Issue Size

Issue size Average

initial return (%)

Standard deviation

of initial returns (%)

Average size (Rs. Mn.)

Number of IPOs

Number %

Panel A: Size category (Rs. Mn.)

0 < Size ≤ 50 50.0 72.7 27 36

34

50 < Size ≤ 150 37.4 68.7 93 35

33

150 < Size ≤ 750 11.9 50.4 345 34

33

Panel B: Small vs. large issues

Small 50.8

76.6 43 56

53 Large 13.6

44.9 277 49

47

Small – Large

37.2

(3.08)***

10

Short-run IPO Underpricing

Table 5: Initial Returns by Investor Sentiment

11

Investor sentiment (Market return %)

Average initial return

(%)

Standard deviation

of initial returns (%)

Average sentiment (Market return)

( %)

Number of IPOs

Number %

-27% < Market return ≤ -6% 26.0 60.0 -13.7 36

34

-6% < Market return ≤ 5% 34.6 72.3 -0.8 35

33

5% < Market return ≤ 42% 40.3 67.0 17.6 34

33

Short-run IPO Underpricing

Table 6: Initial Returns by Privatization vs. Conventional Issues

Issue type Average initial return

(%)

Standard deviation

of initial returns (%)

Number of IPOs

Number %

Privatization 68.5 85.3 30 29 Conventional 19.4 51.0 75 71

Privatization - Conventional

49.1

(2.95)***

12

Short-run IPO Underpricing

Table 7: Cross-sectional Regression of Initial Returns

Model 1 2 3 4 5 6 7 8 9 Constant 0.87

(3.51)*** 0.33

(5.31)*** 0.19

(3.32)*** 0.27

(4.50)*** 0.22

(2.45)** 0.31

(5.07)*** 0.26

(3.97)*** 0.29

(4.43)*** 0.52

(2.03)** Size -0.12

(-2.46)** -0.10

(-1.91)* Sentiment 1.06

(2.12)** 1.17

(2.50)** Privatize 0.49

(3.00)*** 0.33

(2.04)** Hot 0.76

(2.42)** 0.57

(2.27)** UnderwriterSize 0.32

(2.21)** 0.23

(1.95)* Foot 0.75

(1.10)

Plan 0.51 (2.59)**

0.04 (0.20)

Manu 0.23 (1.19)

Adj-R2

0.04

0.05

0.11

0.11

0.06

0.03

0.07

0.01

0.31

13

ii8i7i654

i3i2i1i

εManuβPlanβFootβ rSizeUnderwriteβHotβ

PrivartizeβSentimentβSizeβαReturn Initial

Short-run IPO Underpricing

Table 8: Analysis of Small vs. Large Issues by Investor Sentiment, and Privatizaion vs. Conventional Issues

Sentiment Initial returns (%) Standard deviation of initial returns

(%)

Number of IPOs

Small Large Small- Large

Small Large Small Large Total

Panel A: Small vs. large issues by investor sentiment Positive

59.2

21.7

37.5

(1.85)*

80.5

60.5

25

24

49

Negative

44.0

5.9

38.1

(2.75)***

73.9

20.0

31

25

56

Positive – Negative

15.4

(0.73)

15.8

(1.21)

Panel B: Small vs. large issues by privatization vs. conventional issues Privatization

82.6

35.7

46.9

(1.39)

83.3

85.4

21

9

30

Conventional

31.7

8.7

23.0

(1.90)*

66.3

29.1

35

40

75

Privatization - Conventional

50.9 (2.39)**

27.0 (0.94)

14

Short-run IPO Underpricing

Summary and Implications

15

IPOs in Sri Lanka are underpriced by about 34%. Small issues are more underpriced than large issues by about

37%, and issue size is negatively related related with underpricing.

Investor sentiment is positively related with underpricing Investor sentiment affects both small and large issues

similarly and does not explain the difference in underpricing between small and large issues.

Privatization issues are more underpriced than conventional issues by a large 49%, and privatization is positively related with underpricing. Difference in underpricing between small vs large issues is

much larger in privatization issues than in conventional issues.

This partially explains the difference in initial returns between small vs. large issues.

Short-run IPO Underpricing

Summary and Implications

16

There exists a privatization effect: Although small privatization issues are more underpriced than large privatization issues, the risks of the two groups are similar.

However, even after controlling for investor sentiment, privatization, hot markets, underwriter size and industry, small issues are reliably more underpriced than large issues.

Overall, the results provide strong support to the uncertainty hypothesis as an explanation for larger underpricing of small issues and privatization issues.

International Evidence

Short-run IPO Underpricing 17

Loughran, T., Ritter, J. R., Rydqvist, K., 2010. Initial public offerings: International insights, http://bear.warrington.ufl.edu/ritter/Int.pdf.