Initial Public Offerings in Saudi Capital Market - Essay Example

Initial Public Offerings in Saudi Capital Market: Applicability of Under-Pricing and the Respective Model 1.0 Introduction: “High oil prices, substantial liquidity and a surging economy as well as self driven confidence are factors that continue to maintain a bull market and rapid development of the Saudi bourse.”- AME Info. As at the beginning of the year 2005 the Saudi Stock Market was witnessing a remarkable growth due to factors like high oil prices which contributed to the surge in the Saudi Economy. Apart from the increase in Oil prices there were other factors like the positive role played by the Saudi Capital Market Authority (CMA), liberalization of licences to trade in the Saudi Stock Market, surplus budget for the year 2005, other positive economic factors like growth in GDP and per capita income, political stability of the country, larger money supply due to oil price hike, full pledged privatization programmes undertaken by the Saudi government, high tech trading system introduced in the Stock Exchange that facilitated faster clearing and settlement system and higher investor confidence are some of the other factors which resulted in a phenomenal growth of the Saudi Sock Market. With the privatization move of the government there were a large number of companies that have resorted to Initial Public Offerings for raising capital for their setting up and expansion needs. Such IPOs were oversubscribed in the range of 3 to 12 times. This indicates either such oversubscriptions were due to excessive money supply or the IPOs were under-priced. This literature review, attempts to find out whether the IPOs were really under-priced and if so, what particular model of under-pricing can be attributed to such under-pricing. 1.1 What is an Initial Public Offering (IPO)? According to Experts Web site an Initial Public Offering (IPO) “is the first sale of a corporation’s common shares to public investors.” (Experts) While IPOs offer an attractive mode of raising capital for the companies, they also involve adhering to a number of regulations. The requirements for reporting also make them more complicated. The stock market, where the IPOs are generally made is known as the primary market and any subsequent public offering of shares by the companies will be made only in the secondary market. 1.2 Procedure for Issuing IPOs: The companies desirous of issuing IPOs usually enter into a contract for the sale of its shares with one or more investment banks known as ‘Underwriters’. The function of the underwriters is to approach the investors with offers to sell the shares of a particular company that wants to make an IPO. Such a contract may be entered into by a single investment bank or a syndicate of them comprising more than one, in which case there will be a ‘lead underwriter’. In consideration of selling the shares of the company to the public the underwriters get a percentage commission on the total value of the shares they sell. The sale of IPO may take several forms like Dutch Action or Firm Commitment to name a few which are common methods of marketing the IPOs. 1.3 Advantages of IPOs: The issue of IPOs by companies carries some advantages like: Lower cost of Capital: the company would be able to raise the capital required at a lower cost by issuing IPOs as compared to that of borrowing or any other form of raising capital The liquidity for the shares of the shareholders of the company is drastically increased as the shares in the IPOs are immediately traded in the stock exchanges By making the additional capital available cheaper and also quicker, the IPOs give the companies enough opportunities to expand their operations The issues of IPOs often increase the image of the company 1.4 Disadvantages of IPOs: The IPOs are not left without disadvantages. Some of them according to Amvest Financial Group are: The regulatory provisions and the reporting requirement make the IPOs incur additional expenses and make them cumbersome too IPOs lead to loss of confidentiality and management control due to dilution of share holding There is a continuous pressure from the shareholders to enhance the share value Sometimes there will be restrictions on the sale of stocks. 1.5 Pricing of IPOS: Usually the IPOs can be either under-priced or over-priced. The underlying idea to under-price the IPOs is to create an interest among the investing public to deal in the shares when they are first traded publicly in the stock market. The under-pricing leads to larger gains for the investors who enter the IPOs early. They can gain by selling the shares when their prices increase immediately following the IPO. However this practice reduces the money that the company otherwise could have risen by issuing the shares at a higher price. On the other hand the overpricing of the IPOs is also not advisable due to the fact that if a share is overpriced the underwriters may find it difficult to market the shares among the investors. Even if they sell if the prices come down after initial rounds of sale the shares may lose their marketability in the subsequent days. Hence with their experience the investment bankers always price the IPOs neither under nor over but fix them at a price what market will be able to take and pay for. 2.0 Literature Review: This section of the paper details the Under-pricing of the IPOs and the various models of under-pricing identified by the analysts. 2.1 Under-pricing of IPOS: There have many studies in the filed of studying the characteristics of IPOs with respect to the efficiency of the process of raising capital through IPOs, the anomalies that exist in the process of issuing IPOs, the long-term performance of the IPOs, and also the volume of shares to be covered by the issuers of IPOs under different circumstances. The Studies also cover the under-pricing of the IPO issues. By ‘Under pricing’ we mean the process of offering the initial issue of shares to the public, at prices well below the market value. The under-pricing of the IPOs are often resorted to by the companies due to the fact there exist certain doubts or uncertainties about the level at which the IPOs can perform. In order to take the fullest advantage of the IPO, the firms under-price the shares. The firms expect that due to the under-pricing there will be maximum trading in the shares on the first day of the issue of the IPO. The level of under-pricing of the IPOs varies depending upon the predicted liquidity of the shares. The issuer decides on the levels of the under-pricing taking into account the participation expected from the prospective investors. It must be so priced that the investors are encouraged to invest more in the IPOs. This means that the firms knowingly are willing to realise the shares with a loss of their wealth which is technically described as ‘Leaving money on the table’. "Underpricing of Initial Public Offerings (IPOs) is referred to in the literature as one of the anomalies that is observed in the primary markets all over the world", (Ghosh, 2001). Certainly it depends on how much the company offers in the first place from its share, for instance offering a partial is not like offering the whole shares since loss will surely incurs, (Jenkinson and Ljungovist, 2001). Underpricing is defined as the percentage change between the offer price and the first day closing market price of the IPO There are many models that have been developed by the Economists for describing the cause and effects of under-pricing of IPOs. The purpose of these models is to explain the various reasons and circumstances for the different companies to resort to under-pricing of IPOs. 2.2 Under-pricing Models: There are certain anomalies that associate themselves with the IPOs. They are the first day under-pricing and the long-term underperformance of the IPOs. Despite several efforts and researches in this field any satisfactory explanation could be evolved for these anomalies associated with the IPOs. According to Ritter and Welch (2002) the initial under-pricing – the first day appreciation – of close to 20 percent on an average, during the period from 1980-2001, still remains out of any plausible explanation. Similarly the experts are unable to explain the anomaly of the long-term performance of certain IPOs which appears to be lag behind that of similar companies. Several theories have been developed to analyse and explain the possible causes for such anomalies; most of which point out the telling effect of asymmetry of information between the different parties connected with the IPO, namely the issuer, the investor and the institutions. All these asymmetric models postulate a prediction that the asymmetry is positively related to the under-pricing. The firm size, retained ownership or the reputation of the underwriters also adds up to the effect of asymmetry models on the under-pricing of IPOs. (Re-JinGuo, Baruch Lev and Charles Shi 2004) The other models explaining the under-pricing are identified with the investments by the institutions and the ownership and control of the entities. 2.3 Asymmetric Information Model: The under-pricing of the IPOs is generally correlated with the asymmetric information and risk which is associated with the new IPOs being floated in the stock markets. However theories have been developed which advocate that the after-market liquidity as backed by the asymmetry of the information about the IPO also go to determine how the IPOs perform after the initial euphoria in the market. If the asymmetric information points out that the after-market liquidity will be less or the after-market liquidity can not be predicted accurately, then the under-pricing will be larger. The Asymmetric information model assumes that: The underwriter is better informed than everyone else about the demand conditions. This situation leads to the rent extraction by banks or The issuer is better informed than everybody else which results in signaling arrangements or Some of the investors are better informed than everybody else and this leads to ‘Winner’s curse’ argument. According to Prof. Espen Eckbo (2005) the empirical prediction of asymmetric information models are: The uninformed investors can expect only zero initial returns. This is because of the adjustments made for rationing. But the informed investors may be able to just to cover their cost of becoming informed with the initial returns As the information becomes less heterogeneous across the different investor groups the under-pricing tends to get reduced. The expected under-pricing of the IPO will become more with a greater ex ante uncertainty about the true value of any IPO. The position of the underwriters is based on the under-pricing they do. If the underwriters under-price to a large extent they will lose the business from the issuers and alternatively if they under-price less then there is a possibility that the business from the investors may come down. 2.4 Model based on Institutional Investors: For IPOs from the issuers’ point of view, the allocation of ownership is crucial. However “A single institutional investor can afford to purchase an entire issue if permitted.” (James and Lena 2003) This is virtually not possible because of certain restrictions. Different countries have different forms of legislations restricting the percentage holding of the shares to determine the ownership. For example, in the United States any investor who holds more than 5 percent of the shares effectively becomes an insider. The other constraint is that if the IPOs are subscribed by less number of investors by taking large number of holdings, then there is a potential danger of the company getting de-listed due to the requirements of the stock exchanges. Therefore the institutions would not be willing to invest more than a certain percentage on the IPOs. Hence it becomes necessary that a larger number of institutions are attracted towards investing in the IPOs. This may sometimes influence the issuer to under-price the IPOs just to lure more number of institutional investors to participate in the IPO. The reaction of the Institutional investor model depends on factors like legal liability arising out of subscribing to the IPO, the share price stabilization factor and the incidence of taxes payable on the gains of sale of shares after the IPO in the secondary markets 2.5 Ownership and Control Considerations: The models emphasizing the corporate control and ownership motives explain the concern of the managers about the possible changes in the shareholder base which will have a direct impact on the monitoring and control of the activities of the company. Brennan and Franks (1997) explain the mechanism of the under-pricing of the IPO in allowing the managers to achieve ownership dispersion through Model fixed price offerings totally unconnected with the market demand based on a pro-rata share allocations and Under-pricing usually creates excess demand which gives the leverage to the managers to allocate shares to smaller and passive shareholders so that there will not be any dilution in the ownership and control. Moreover ownership dispersions create greater market liquidity which is highly beneficial to the firms. If the IPOs are valued on the basis of the assumption that there is no wealth or ownership constraints, then the IPO price will be fixed at a level which bears a higher valuation that the investor would be willing to pay for the IPOs and also that the entire issue will be subscribed by the public. But this is an ideal situation that will not happen in the real market. In order that the firms raise the required capital and also meet the listing requirement that there should be a wide distribution of the shareholders, the IPO prices are to be fixed at a price at or below the market clearing prices. Hence in the secondary market when ownership constraint is relaxed optimistic investors who are willing to acquire more shares will bid at higher prices and as a result the IPOs will fetch a real price run up. Thus this model explains why under-pricing is resorted to by different firms. 3.0 Under-Pricing of IPOs in Saudi Stock Market: There has been no indication as to the under-pricing of IPOs in the Saudi Stock Exchange as there were other factors which mainly led to the over subscription of the IPOs. As per the AME Info website there had been numerous other reasons for the stock market to surge. Apart from high oil prices, large cash availability, positive economic indicators, the stock market, more than substantiated by the privatization of the Saudi Government has encouraged more private companies to go in for IPOs. As a result of the high confidence level of the investors the IPOs of the companies were oversubscribed for some 10 to 12 times. This move was more than assisted by the Tadawul Electronic trading system which enables a faster settlement and clearing system. The Saudi Arabian Information Resource on Saudi Stock Market also suggests that the growth in equity market had been boosted by the government’s ongoing privatization programme as well as the increase in the number of private companies looking for capital. There had been instances that a single IPO has attracted more than 8.7 million subscribers which is more than approximately half of the population of Saudi Arabia. On the other hand the different models that explain the under-pricing of IPOs may also be applied to Saudi stock Market conditions with respect to the various IPOs that were made through the Saudi market. Considering the different models that describe the under-pricing of IPOs in general, as applied to the Saudi Stock Market, the following points emerge: The asymmetric information model doesn’t apply to the prevailing stock market situation in Saudi Arabia. On an analysis of the knowledge base of different groups of investing public in Saudi it can be observed that for a major proportion of the investors the investment in the stocks is a way to double the money in their possession just as gambling. Apart from this objective, the investors could not assimilate any considered opinions or feedbacks either on the under-pricing or after-liquidity of the stock market. There are no major institutional investors who can react to the market information and affect the investments in the IPOs drastically. As outlined above the majority of the investors represent the common people who undertook the stock trading options as a way of gambling. Since there are no major institutional investors who play a dominant role in the stock market dealings the model based on institutional investments for under-pricing also doesn’t apply in Saudi Stock Market situations. The ownership and control model for under-pricing of IPOs may have some relevance to the stock market situations in Saudi, as most of the private firms who followed IPO route are privately held. However, the listing requirements of the stock exchange for a wider distribution of the shareholders might have affected the pricing of IPOs to have a wider distribution of the shareholders, as the investing public is highly scattered and the ability for larger investments in IPOs is comparatively lower. Hence it may be concluded that the huge oversubscriptions that the IPOs in Saudi Stock Market witnessed may partially due to the ownership and control model as a basic requirement for increasing the number of shareholdings. 4.0 Research Methodology This Chapter details the research methodology adopted for the preparation of this dissertation paper. 4.1 Methodology: Different research methods are to be used to complete the dissertation project. It is important to use both secondary and primary sources of information to achieve the goal and objectives of the study. Overall, the inductive research method is to be used because it is more appropriate for the purpose of the dissertation. Jill and Johnson (2002) write that induction is the ‘construction of explanations and theories about what has been observed… learning by reflecting upon particular past experiences and through the formulation of abstract concepts, theories and generalisations that explain past and predict future, experience’. Due to the practical nature of the topic, induction is more suitable since the author will first collect data, observe, analyse and only then present his findings and conclusions. Additionally, qualitative rather than quantitative research methods will be used because the aim of the project is not to analyse figures or statistics but to observe, interpret and make recommendations. The general belief of business research is often thought of as collecting data, constructing questionnaires and analysing data. But it also includes identifying the problem and how to proceed solving it (Ghauri et al., 1995) Data sources can be described as the carriers of data (information). There are to types of data sources (Ghauri et al., 1995) 1. Primary data (field) is collected specifically for the research project. This will be in form observations and interviews. 2. Secondary data (desk) is collected by others. These include academic and non-academic sources. 4.2 Research Methods: As mentioned earlier, several methods of collection of data for this research were considered. It was necessary to arrive at a specific method that will be appropriate to attain the objectives of the research; which depended on the subject under study. For that, the researcher collected the available information about research methods and carefully analysed the difference between the two major data collection approaches (i.e. the qualitative and quantitative research methods). 4.3 Qualitative Methods: The qualitative method is ‘one of the two major approaches to research methodology in social science’, which involves ‘investigating participant’s opinions, behaviours and experiences from the informants' points of view’. In contrast with the quantitative research method, the qualitative research method ‘does not rely on quantitative measurement and mathematical models, but instead uses logical deductions to decipher gathered data dealing with the human element’. In qualitative research method non-quantitative’ methods of data collection and analysis are being used (Lofland & Lofland;1984) 4.4 Quantitative Method: Quantitative method is a research method which depends less on subjective methods but is more focused on the collection and analysis of numerical data. Quantitative research involves analysis of numerical data. According to Burns and Grove, Quantitative research is: "a formal, objective, systematic process in which numerical data are utilised to obtain information about the research question" (Burns and Grove cited by Cormack 1991 p 140). Quantitative research uses the methods which are designed to ensure objectivity and reliability. In this method the researcher is considered external to the actual research and results are expected to be the same, no matter who conducts the research. William Trochim (2001) defines, that ‘some methods are more quantitative (like surveys, automated counting), and other methods are more qualitative (like in-depth interviews and group discussions)’. On the other hand, ‘there can be qualitative surveys - using mostly open-ended questions’ and quantitative group discussions by using the consensus group technique. William Trochim (2005) point out, that there's little difference between the qualitative and quantitative approaches. He gives two reasons for that, the first reason that every research can be quantitative, because any response can be counted - even if, purely verbal. The second reason is that every research is qualitative, because answer to even the most numeric questions may reveal a significant meaning. For that, ‘the real difference between qualitative and quantitative method is approach of the researcher. References: 1. AME Info Will the Saudi stock market boom continue? http://www.ameinfo.com/78125.html 2. Amvest Financial Group Inc. Initial Public Offering Advisory http://www.amvest.com/Initial%20Public%20Offering%20Advisory.htm 3. Brennan, M. J., and J. Franks, 1997, Underpricing, ownership and control in initial public offerings of equity securities in the uk, Journal of Financial Economics 45, 391–413. 4. Burns and Grove cited by Cormack (1991), p.140, taken form ‘Ways of Approaching Research: Quantitative Design’ in December 2003. 5. Experts Initial Public Offering http://en.allexperts.com/e/i/in/initial_public_offering.htm 6. Ghauri, P., Gronhaug K and Kristianslund I., (1995) “Research methods in business studies – a practical guide” Hempstead, Prentice Hall 7. James R.Booth and Lena R.Booth Agreeing to Disagree: Why IPOs are Underpriced? www2.hawaii.edu/~fima/PDF/Finance_Seminar/Summer_2003/Booth&Booth03.doc 8. Jill, J. and Johnson, P. (2002). Research methods for managers. 3d ed. London: Sage Publications 9. Lofland, John and Lyn H. Lofland. (1984). Analyzing Social Settings: A Guide to Qualitative Observation and Analysis. Belmont, CA: Wadsworth. 10. Prof. B.Espen Eckbo (2005) Initial Underpricing of IPOs http://www.nhh.no/for/courses/spring/fin501/FIN501-S5-IPO_Underpricing.pdf 11. Ritter, J., and I. Welch, 2002, A review of IPO activity, pricing, and allocations, Journal of Finance 57, 1795-1828. 12. Re-JinGuo, Baruch Lev and Charles Shi (2004) Explaining the Short and Long-Term IPO Anomalies by R&D http://pages.stern.nyu.edu/~blev/docs/Explaining%20the%20Short%20and%20Long%20Term%20IPO%20Anomalies.pdf 13. Saudi Arabian Information Resource on Saudi Stock Market http://saudinf.com/main/y8194.htm 14. William Trochim (2001) The Research Methods Knowledge Base, Second Edition 15. William Trochim (2005) Research Methods: The Concise Knowledge Base, First Edition Read More