Seshadev Sahoo

IMIS, Bhubaneswar

Prabina Rajib
IIT, Kharagpur

Investment Bank Prestige and IPO Underpricing: An Empirical Study

Abstract
Investigating the relationship between investment bank prestige and IPO underpricing, this study found an inverse relationship between the twoprestigious investment banks underprice less compared to their less prestigious counterparts. Further, prestigious investment banks are positively associated with syndicate size and structure, and other issue specific attributes like offer size, post issue promoter holding and age of the firm. The study was based on Indian IPO offerings during the period 200102 to 200405.
IIMB Management Review, September 2009

n initial public offering (IPO) issue process requires the active involvement of three key players: the issuing firm1, a single investment bank or group of investment banks (for underwriting and marketing the IPO), and the investors (institutional and non institutional) intending to buy shares. The issuing firm wants to obtain maximum price per share (issue price) while the investors want to buy shares at a minimum price. Investment banks acting as intermediaries help in matching the opposite expectations of both parties. Investment banks also perform various other functions like certifying the economic rationale of the issue to regulatory bodies like the Securities and Exchange Board of India (SEBI), book-building, deciding the issue price, allocating shares to investors and other issue specific responsibilities. As intermediaries between the issuing firms and the investors, investment banks need to act in balance, so that the objectives of both parties are fulfilled in making the IPO a success. Hence, the right selection of investment banks is a challenge for the company. Past research2 is unanimous that underpricing is less for IPOs managed by high ranking investment banks. In other words, issue price reflects the fundamentals of the company in a more rational manner if a prestigious investment bank is associated with the IPO issue.
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Though underpricing has been defined in many ways, one of the most accepted definitions is as follows: Underpricing is the difference between the price at which the firms stock was initially offered and the stocks closing price on the first day of trading3.

IPO Underpricing: Approach in Literature

ESOPs (Employee Stock Option Plan), day-of-the-week effect, auctions versus book-built approach, investment bank prestige, return and volatility of market, strength of analysts coverage, degree of venture capitalists involvement in the firms operations, and offer size of the IPO. Studies have taken either a single factor or multiple factors to substantiate their findings.

Underpricing of IPOs in the Indian market has been Worldwide, underpricing is one of the most observed researched considerably. The abolition of the Controller anomalies in the new issue market. In nearly every of Capital Issues (CCI)14 in 1992 and the opening up of country, IPO issues experience some sort of underpricing. new sectors to private investment as part of the The academic community is continuously exploring liberalisation programme led to significant growth in the various facets of the pricing mechanism to find suitable IPO market. explanations for the underpricing. Rocks winners curse Madhusoodanan and Thiripalraju15 model 4, information revelation conducted an extensive study on theory by Benveniste and Spindt5, Indian IPOs, covering 1922 IPOs 6 price stabilisation theory by Rudd , Worldwide, underpricing is one Ibbotson et als signalling model7, of the most observed anomalies for the period 1992 to 1995. They found that the winner s curse the ownership control model by in the new issue market. In hypothesis did not hold true. IPO Brennan and Franks 8, and the underpricing was higher for issues nearly every country, IPO agency model by Loughran and Ritter9 have tried to give reasons for issues experience some sort of where mutual funds and NRIs (Non Resident Indians)16 did not IPO underpricing. underpricing. The academic participate in firm allotments. They The major reasons for underpricing found that issues managed by community is continuously cited in the literature have been exploring various facets of the reputed investment banks produced summarised below: lower underpricing than others, pricing mechanism to find contradictory to what the agency Underpricing as the result of a explanations for the problem suggests. winners curse: Rock developed

underpricing. Underpricing of the winners curse model based Baral and Obaidullah17 analysed 433 on the information asymmetry IPOs in the Indian market has IPOs and found initial returns to be between informed and higher. In India, the fixed price been researched considerably. uninformed investors. To entice mechanism was used to price IPOs uninformed investors, companies till 1999. During this period IPOs underprice new issues so that after market price exceeds were underpriced substantially. Pandey and Kumar18 studied 1243 IPOs in the Indian market during 199395, the offer price10. and found that extent of underpricing, inside equity, and Companies deliberately underprice IPO issues so that firm reservations for institutional investors like mutual in future they can raise capital at better terms11. funds explained the oversubscription rate. Agarwal and Firms deliberately underprice where issuers/promoters Klapper19 studied the relation between IPO underpricing demand ownership dispersion. Underpricing of shares and investment preferences of institutional investors in helps to achieve a dispersed share ownership structure firms just prior to going public. This study reported no so as to provide for a liquid secondary market 12. significant relationship between investment by institutions 13 However Stoughton and Zechner suggest that IPO and underpricing. companies use underpricing to create a more Ranjan and Madhusoodanan20 studied 92 IPOs issued concentrated ownership structure. during 19992003, for the impact of book-building on Besides these factors, many other dimensions affecting IPO pricing. They found less underpricing in book-built underpricing have also been explored. These include issues than in fixed price issues. They also found that
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Investment Bank Prestige and IPO Underpricing: An Empirical Study

small size IPOs had more underpricing than bigger size IPOs. Ghosh 21 studied the boom and slump phases (popularly known as hot and cold periods) of the Indian IPO market during 19942004. He compared two key variables, namely IPO volume and initial returns and tried to find the interrelationship between them during the boom and slump phases. He found that IPO volume series were auto-correlated over the entire period and especially during the boom period. This indicates that in the last decade a firms decision to go public depended on the number of other companies getting listed over the previous months. He used a Granger Causality test and found no significant relation between IPO volume and initial returns during the hot and cold periods. As discussed above, most of the studies in the Indian context have focussed on IPO underpricing either on the listing date or over a long period of time, or compared underpricing dynamics before and after the introduction of the book-building pricing mechanism. In the international context, the underwriters prestige and IPO underpricing has been studied extensively, but this aspect has not been explored sufficiently in India. Hence the objective of this paper is to study underwriter prestige and its impact on IPO underpricing and whether syndicate size and structure influence underwriter prestige or not. This study explores cross sectional comparability of underwriter prestige with other issue specific attributes like offer size, post issue promoter holding and the age of the firm. The study is based on Indian IPO offerings during the period 200102 to 200405. The remainder of the paper is organised as follows: the second section focuses on the past studies on investment bank prestige and IPO underpricing including issue specific variables having a bearing on investment bank prestige. The third section provides a background on the Indian investment banking industry. Data source, data definition, sample selection procedure and analytical methodology are discussed in the fourth section. We document the empirical results in the fifth section, analysis and interpretation in the sixth and the seventh section concludes the paper.

1970s. Prior studies documented that the IPOs managed by prestigious investment banks resulted in less underpricing than the issues managed by their nonprestigious counterparts. Logue22 documented significant differences in the mean initial rate of return between the issues supported by prestigious and non-prestigious investment banks. Logue examined 250 IPOs offered during the period 19651969. He used investment bank prestige as a dummy variable along with other ten independent variables in the multiple regression models and found that investment bank prestige was significant in defining underpricing. The IPOs backed by prestigious underwriters reflect more rationality in valuation by leaving less on the table than their counterparts. Logue explained that association with prestigious banks sends signals to the market about the magnitude of risk of the issue. High ranking and reputed investment banks generally endorse quality issues, with strong fundamentals and a promising business story. He suggested that a small firm can bank on a high profile underwriter by paying more fees to maximise the issue price and to minimise the initial value difference. Neuberger and Hammond23 studied a sample of 816 IPOs issued during the period 19651969. They document that there is a significant difference in the magnitude of underpricing across different categories of investment banks. Their findings are a logical extension of McDonald and Fisher24 who concluded that the first week initial return differs statistically across investment banks. More precisely they documented that underprice is more pronounced for less prestigious, substandard underwriters. The Beatty and Ritter, and Carter and Manaster 25 studies are also consistent with Logues signalling hypothesis. Black and Stanley 26 used a prestige test similar to Logues and concluded that high profile investment banks are able to narrow down the spread between the issue price and the initial list price. Neuberger and LaChapelle27 posit a strong correlation between investment bank prestige and underpricing. They classified investment banks into three different categories based on the proxy for the prestige assessment. Their findings support the hypothesis that there is a significant difference in new issue underprice among the three underwriter groups examined. Johnson and Miller28 argue that the lower underpricing is the result of a clientele effect in which lower risk issues are associated with the most prestigious issuers. The
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IPO Underpricing, Investment Bank Prestige and Other Variables: Past Studies
The relationship between investment bank prestige and IPO underpricing came into focus in the early part of the
IIMB Management Review, September 2009

Johnson and Miller study consists of 502 IPOs. They tested the clientele effect model on the basis of three hypotheses: (i) Underprice should be less for prestigious issues; (ii) Investment bank prestige should not explain risk adjusted underprice; and (iii) Prestigious investment banks tend to be a part of low risk IPOs than nonprestigious ones. Their theory is consistent with the fundamental investment principle of the risk return trade off i e high risk-high return and vice versa. However they observe that when the risk factor is taken into consideration, the association disappears. Tinic29 finds that risk is not an important issue in explaining IPO underprice once the underwriters prestige is taken into consideration. He concludes that prestigious underwriters certify issues better through more stringent adherence to the due diligence requirement. Though not directly related to IPO, there is some literature on merger and acquisition (M&A) valuation and investment banker prestige. Bowers and Miller30 found that when either the bidder or the target firm employs a prestigious tier one investment bank, the total wealth gained from the transaction is greater than when neither party takes the help of prestigious investment banks. They also argued that reputable advisors add value by detecting merger related synergies. Carter and Manaster31 document that low risk firms appoint highly prestigious investment banks and low profile investment banks are associated with high risk issues. This study indicated that investment banks also choose the kind of companies they would like to get associated with. Slovin et al32 posit that investment banks are used as external monitoring agencies and have a significant impact on the investors perception about new issues. They conclude that high ranked investment bankers provide more value addition during the process of due diligence certification and hence minimise the negative impact on the stock price as and when seasoned equity offerings are announced. Bae and Levy33 go one step further and say that prestigious investment banks undertake issues with low underwriting fees per share, provided the issues are associated with low risk and larger offer size. They document that even non prestigious investment banks do not assume the risk of an unsuccessful issue. They would rather transfer the risk to the issuer by underpricing the new issue substantially more than prestigious banks would. Puri34 develops a model for explaining the impact of the
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reputation of the financial intermediary on the pricing of the issue. She finds that highly reputed intermediaries have a higher incentive in maintaining their high standard and reputation in the industry, which leads to stricter norms for adherence to optimum quality standards. This results in rational valuation for the issue and minimises the chance of underpricing. Louge et al35 examine the interaction between underwriter reputation and market activities pre- and post-IPO. They find that underwriter reputation is a significant determinant of pre-market activities and a significant determinant of listing date return. However reputation is weakly related to after-market price stabilisation activities and is unrelated to long-run returns. In relation to M&A, Kale et al36 argue that target wealth gains are significantly related to advisors reputation, and conclude that reputable target advisors have superior abilities in creating value for their clients. In contrast to the majority of earlier studies, Loughran and Ritter 37 find investment banks have begun to underprice IPOs strategically in an effort to enrich themselves or their investment clients. Top banks have lowered their criteria for selecting IPOs to underwrite, resulting in a higher average risk profile for their IPOs. Kirkulak and Davis38 studied lead underwriters reputation, demand for shares of the Issuer Company and IPO underpricing in the Japanese market from 1998 to 2002. They found that when there is a high (low) demand there is a positive (negative) and significant relationship between underwriter reputation and the level of underpricing. In summary, most of the studies commonly agreed that there is a significant difference in the underprice of the IPOs managed by prestigious investment bankers and those managed by less-prestigious investment bankers. The literature is unanimous in concluding that prestigious banks tend to underprice less than their non-prestigious counterparts. In other words, the underwriters prestige contributes significantly to the listing day return. Not only do companies choose good investment banks to manage their IPOs, good investment banks are also choosy about the kind of issues they would like to be associated with. Prestigious investment banks would like to be associated with companies which have strong fundamentals. Past studies indicate that investment banks consider firm as well as issue specific signalling variables such as age of the firm going to public, offer size and post issue promoter holdings, syndicate size and issue price. Investment banks also consider the quality and
Investment Bank Prestige and IPO Underpricing: An Empirical Study

reputation of the IPO firms management before deciding whether they would like to be associated with the issue or not39. (However, this variable has not been considered in this study.) Age of the firm (Ag), defined in terms of years, is one of the most popular proxies on company characteristics. High rank investment banks normally choose companies with a longer operational history40. Age of the IPO firm signals the level of maturity of the company. In this study, age has been measured by the difference between the date of incorporation and the date at which the company goes public. The data collected is rounded to a whole number in years. The relationship between post issue promoters holding (PIPH) and underprice has been the focus of several studies41. Quality companies use ownership concentration as a signal to potential investors about the quality of the firm. PIPH is defined as the percentage of shares being owned and retained by the promoter in the post issue scenario. It is an important signalling variable indicating the prospects of the company to the investors. Offer size (OS) as a signalling variable has been explored by many studies42 which found that underpricing is more severe in the case of smaller issue sizes. Offer size is the amount of capital the company wants to raise through the IPO. The offer size conveys the magnitude of the capital expenditure involved with the planned business proposition. Syndicate size (SS), another signalling variable, is defined in terms of the number of investment banks in the syndicate. Corwin and Schultz 43 found that a large syndicate, particularly more co-managers, leads to increased analysts coverage resulting in more accurate offer prices and less underpricing. Barzel et al44 found that the investment banking syndicate is an institutional arrangement designed to avoid wealth transfer from the issuing company to the investors.

The investment banking industry in India is primarily dominated by privately owned domestic players or joint ventures with foreign players like Morgan Stanley and Merrill Lynch. Exhibits 1 and 2 list the top ten investment banks in terms of the number of issues managed and deal value respectively. DSP Merril Lynch leads the pack and has managed a total of 50 IPOs during the period 2001-05, followed by Enam Financial Consultants (49 IPOs) and Kotak Mahindra Capital Company Ltd (48 IPOs). However, in terms of deal value, JM Morgan Stanley garnered the maximum business (Rs 47,100 crore/Rs 471 billion) followed by DSP Merril Lynch (Rs 46,700 crore/Rs 467 billion) and Kotak Mahindra Capital (Rs 43,527 crore/Rs 435.27 billion) during the period 200105. Exhibit 3 highlights the growth of the Indian investment banking industry during 2001 to 2005. During a short span of four years the number of investment banks

Exhibit 1

Top Ten Investment Banks in Terms of Number of Issues Managed

2004- 2003- 2002- 2001- Total 2005 2004 2003 2002

Sl No Investment Bank

DSP Merrill Lynch Ltd 11 13 11 15 50

Enam Financial Consultants Pvt Ltd 14 14 9 12 49

Kotak Mahindra Capital Co Ltd 9 15 10 14 48

JM Morgan Stanley Retail Serv 12 14 12 15 43

. 5

SBI Capital Markets Ltd 7 1 10 6 8 9 15 12 40 28

6 7

Bajaj Capital ICICI Securities & Finance Co.Ltd

12

27

Indian Investment Banking Industry: An Overview

The Indian investment banking industry came into existence in the early 1980s when a large number of companies came out with public issues. An entire industry of investment banks, brokers, agents, registrars and publicity managers flourished around the primary issue market.
IIMB Management Review, September 2009

RR Financial Consultants 5 6 8 7 26

KJMC Global (India) Ltd 5 8 8 3 24

10

Karvy Investor Services Ltd 8 7 5 3 23

Source: Prime Database annual reports for the period 200102 to 200405.

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Exhibit 2
Sl No

Top Ten Investment Banks in Terms of Deal Value in Rupees Crore

200405 200305 200205 200102 Total

Investment Bank

1 2 3 4 5 6 7 8 9 10

JM Morgan Stanley Retail Services DSP Merrill Lynch Ltd Kotak Mahindra Capital Co Ltd Enam Financial Consultants Pvt Ltd ICICI Securities & Finance Co Ltd Bajaj Capital SBI Capital Markets Ltd RR Financial Consultants KJMC Global (India) Ltd Karvy Investor Services Ltd

17012.14 18062.14 16576.92 13437.00 14676.64 4094.85 2903.39 4094.85 4094.85 4165.88

18263.36 16723.06 18067.39 5942.34 4879.72 4323.54 5609.46 4323.54 4432 4333.54

5575.85 5575.85 3378.29 4980.88 1893.81 4792.88 3123.46 4692.88 4692.88 2350.46

6249.03 6339.02 5505.00 4990.52 998.50 4990.52 5579.50 3596.01 972.90 972.90

47100.38 46700.07 43527.60 29350.74 22448.67 18201.79 17215.81 16707.28 14192.63 11822.78

Source: Prime Database annual reports for the period 200102 to 200405.

increased to 40 from 24. The total amount of IPO capital raised by them stands at Rs 25,526 crore (Rs 255.26 billion), with a CAGR of 31% during 200105. In the overall process of issue management, investment banks play a variety of rolesadvisor to the issuer, performing of due diligence, interfacing with SEBI, stock exchanges and regulatory bodies, coordinator, event manager and in a fiduciary capacity to protect the interests of the investors. This multifaceted role places a tremendous responsibility on the investment bankers. In practice, IPOs are normally managed by a syndicate or a group of investment banks. The syndicate members provide a host of services to the issue house which includes marketing and distribution, underwriting, analyst coverage and post issue market stabilisation activity. The key element of the syndicate is the book running lead manager. The lead manager runs the book and allocates shares to investors after the book building process closes.

Other members of the syndicate support the lead manager in the successful completion of the IPO process. As the success of the IPO greatly hinges upon the efforts of investment banks associated with the issue, companies take great care in choosing them. Investment banks are evaluated based on factors such as research capability, underwriting commitments, distribution capacity, sector expertise, track record and credentials, client relationship and after market commitments, and so on. It is a common practice not only in India but also in the world market that large size issuers demand a large syndicate and the small issues bank upon small syndicate size. Exhibit 4 shows the number of participating banks in syndicates during 200105. Syndicate size (column 1) indicates the number of investment banks grouped as a syndicate associated with a specific issue. For example, in 2004 05, two investment banks worked as a syndicate for 13 IPO issues. A majority of Indian IPOs were managed through a syndicate, rather than through a single investment bank. In the year 200405, out of 34 issues, a total of 27 issues (about 79.41%) were managed through syndicates.

Exhibit 3

Growth of Investment Banks in India

2004 2005 40 25526 2003 2004 26 22145 2002 2003 24 5732 2001 2002 24 6423

Year

Data and Methodology of Study

The data for this study was collected from the Prime Database annual reports from 2001 to 2005 and the capital markets database Capitaline.com45. Data was also collected
Investment Bank Prestige and IPO Underpricing: An Empirical Study

No of investment banks Amount raised (Rs Crore)

Source: Prime Database annual reports for the year 20012005

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Exhibit 4

Syndicate Structure of IPOs (Number of Issues)

2004 2005 7 13 3 2 2 7 34 2003 2004 8 8 7 1 5 6 35 2002 2003 1 1 0 1 2 9 14 2001 2002 2 1 0 3 1 12 19

Syndicate Size One Two Three Four Five More than five Total

of personal judgement of the researcher or the opinion of the market professionals. The Carter and Manaster model rates investment banks on the basis of their position and appearance in the tombstone advertisement of the IPOs47. Investment banks placed on the top of the tombstone are assigned highest rank of value 9 in a scale of 10, the rest follow accordingly with the non-prestigious banks being credited with zero points. Megginson and Weiss48 apply the most objective method of ranking i e the market share approach, where prestige is calculated based on the relative market share of the investment banks. Underwriters with more market share are credited with high prestige value and vice versa. In this paper, the prestige of investment banks was quantified in three steps: First the ratings of investment banks were collected from the Prime Database annual reports for the period 20012005. (The Prime Database rates investment banks based on their annual market share.) This methodology is consistent with the Megginson-Weiss model. This approach is superior as it does not assume the reputation of an investment bank to be constant over time. Additionally the market share provides a cardinal value of reputation than ordinal value. In the second step, rank value points to each investment bank from the ratings given by the Prime Database were assigned. Rank value points correspond to the Prime Database rating but in reverse order. For example, a bank with Prime Database rating of 1 got a rank value point of 10 while one with a rating of 2 got a rank value point of 9. The rank value point declines with the increased ratings of the bank. As there were more than 10 investment banks, a bank with a rating value range of 1115 was given a rank value point of 0.50. Similarly ratings from 1620 were given rank value point of 0.25 and ratings with >20 were given rank value of 0.125. Exhibit 5 lists the Prime Database ratings and the corresponding rank value points. Finally the prestige value of a syndicate associated with an IPO was calculated by totalling rank value points of each investment bank belonging to the syndicate. For example, a syndicate with three members with Prime

Source: Prime Database annual reports for the period 200102 to 200405

from the National Stock Exchange (NSE, Mumbai) and SEBI websites (sebi.gov.in) and was cross-referred with the CMIE Prowess database.

Measurement of Investment Banker Prestige

Quantifying investment bank prestige (IBP) is one of the most important aspects of this study. The literature reveals that researchers have used three different kinds of methodologies for assigning a proxy for underwriter prestige, drawing from the work of Carter and Manaster, Hayes, and Johnson and Miller46. These are (i) binary measurement, which classifies special bracket banks as prestigious (Prestige=1) and all other banks as nonprestigious (Prestige=0). (ii) The second system, after Hayes, follows a three point scale of ranking of investment bankers. The top rated banks are assigned the rank value of 3 followed by 2 for the middle group and 1 for the third category. (iii) The third system, after Carter and Manaster, follows a 10 point scale, starting from 0 to non-prestigious investment banks and 9 to most prestigious banks. Johnson and Miller used the subjective approach for ranking investment banks according to which investment banks are assigned ranks or classified either on the basis

Exhibit 5
PDR RVP 1 10

Rank Value Points for Investment Banks in a Syndicate

2 9 3 8 4 7 5 6 6 5 7 4 8 3 9 2 10 1 1115 0.5 1620 0.25 > 20 0.125

PDR: Prime Database ratings; RVP: Rank value points assigned IIMB Management Review, September 2009

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Database rating of two, three, and six was assigned a cumulative rank value point of 22 (= 9+8+5). Similarly a syndicate with four members with Prime Database rating of 8, 15, 18 and 27 was assigned a cumulative rank value point of 3.875 (= 3+0.5+0.25 + 0.125). On the basis of the cumulative rank value points, syndicates were classified into three different categories i e Tier 1: Super group, Tier 2: Major group, Tier 3: Least group. Syndicates with total rank value points higher than 15 were categorised as Super group while between 6.5 and 15 as Major group. The following box contains the issue specific characteristics of the Initial Public Offerings floated by Tata Consultancy Ltd (TCS) along with cumulative rank value points of all of the investment banks participating in the syndicate.

issue price (IP). List price (LP) is the listing day closing price of the stock. Issue price (IP) is the final offer price at which the shares were sold to institutional investors. The following method has been used to calculate the magnitude of underprice:
UP = LP IP 100 IP

Calculation of Initial Return (Underprice) of the IPO

To define the various terms/concepts connected with underprice, Magnitude of Underprice (UP) refers to initial return and is calculated as difference between list price (LP) (closing price on the maiden trading day), and the

The above formula conforms to Miller and Reillys49 for calculating initial return. Initial return computed as above is unadjusted market rate of return. Market adjusted return using Sensex was also computed. The difference between the market adjusted and unadjusted return was found to be 1.23% which was statistically insignificant. Insignificant difference between the unadjusted return and market adjusted return conforms to the findings of Beatty and Ritter50. They concluded that there is no significant deviation between the unadjusted initial return and the market adjusted return if cross section data is used. Since this study is also based on cross section of returns (IPOs dispersed across industries issued during the period of 20012005), the unadjusted initial return does not deviate significantly from the market adjusted return.

IPO of Tata Consultancy Services Ltd

(Issue Specific Characteristics and Rank Value Points of Investment Banks)

Tata Consultancy Ltd issued shares through the IPO on 29th July 2004 with face value of Re 1 per share.
Price band (in Rs) : Rs 775Rs 900 Rs 850 Rs 987.95 (first day closing price) Rs 5428.90 crores 3 JM Morgan Stanley Pvt Ltd, DSP Merril Lynch Ltd, JP Morgan India Pvt Ltd

Final offer price per share (in Rs) : List price (in Rs) Offer size (OS) Syndicate size (SS) Book running lead managers : : : :

Prime Database Ranks for Lead Managers JM Morgan Stanely Pvt Ltd DSP Merril Lynch Ltd JP Morgan India Pvt Ltd = = = 1 3 7

Rank value points of the syndicate : 10 + 8 + 4 = 22*, which is far more than the average rank value points of 9.64 for all syndicates for all IPOs. *on a scale of 10 the value points for rank 1 is 10 points, rank 3 is 8 points, and rank 7 is 4 points. Source: Public issue offer document; http://www.nseindia.com

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Investment Bank Prestige and IPO Underpricing: An Empirical Study

Exhibit 6 Sample Selection Criteria for IPO Issues

Universe of Total Number of Public Issues Offered Total number of IPO offered during the period Exclusion number of IPO missing offer price Remaining Exclusion number of IPO missing age proof Remaining Exclusion number of IPO missing list price Remaining total number of IPO eligible for study Percentage of eligible companies in the sample for study 79.62 102 54 04 50 03 47 04 43

Exhibit 7 Descriptive Statistics of the Selected Sample

Variables OS (Rs Cr) Ag (Years) PIPH (%) SS (No) IBPP UP (%) Mean Median Minimum Maximum Standard Deviation 482.18 132.81 22.73 59.67 2.84 13.57 46.63 16.0 57.7 2.00 13.50 25.53 7.5 2.0 29.94 1 0.13 -50.55 5428 57.0 89.5 6 42 367 1117.62 18.94 14.80 1.43 10.71 78.65

Sample Selection Procedure

The sample used in this study comprises 43 initial public offerings out of 102 public issues (for both equity and debt) during 2001-2005 available on the Prime Database. Only IPOs for equity shares have been considered. As this study focuses on the initial public offerings of unlisted companies only, follow on public offerings (FPOs) as well as debt issues have been excluded. Fifty-four companies qualified, using the above criteria, and 11 companies were excluded from the sample because of non-availability of data. Exhibit 6 highlights the sample size and selection methodology in detail. Exhibit 7 reports the sample mean, median, minimum, maximum, and standard deviation for the whole sample of 43 IPOs issued and listed during period of 2001-02 to December 2004-05. The standard deviation for the underprice for the entire sample was 78.65, reflecting a high degree of variation in initial day return for Indian IPOs. We find that underprice persists in the Indian IPO market during the period 2001-05. The mean percentage of under valuation of 46.63% implies that the issuer leaves too much on the table in order to attract more subscription for the issue. The median undervaluation is 25.53%, standard deviation is 78.65% implying high degree of variations in initial return for the sample, which can also be shown in the spread between maximum value and minimum value.

Definition of variables: OS: offer size; Ag: age of the firm; PIPH: post issue promoter holdings; SS: syndicate size; IBPP: investment banks prestige points; UP: underprice. IBPP is cumulative rank value for the syndicate. UP percentage is calculated as unadjusted rate of return for the IPO. Age (Ag) has been measured by the difference between the date of incorporation and the date at which the company goes public.

(IBPP) and underprices has been modelled in the Ordinary Least Square (OLS) framework. Underprice has been used as the predicting variable (dependent variable) and IBPP as the predictor (independent variable). Hence the test hypothesis is Hypothesis 1: H0: No linear relationship exists between underprice and investment bank prestige. H1: There exists a linear relationship between underprice and investment bank prestige The regression model is as follows: UPi = + (IBPP)i + i Eq (1)

UPi: underprice value for security, IBP: investment banker prestige value points for the security, : the standard error term, : the intercept and : regression coefficient The degree of underprice varying across different tiers (Super group, Major group and Least group) of investment banks has also been explored. Hypothesis 2: H0: T1 = T2 = T3 All three tiers of investment banks (Super group, Major group and Least group) exhibit equal underpricing. H1: T1 T2 T3 All three tiers exhibit different underpricing.
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Empirical Methodology
The relationship between investment banks prestige points
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Test for investment bank prestige as endogenous construct: To identify various proxies influencing prestige of an investment bank, multiple regression (enter estimator technique-under sequential search method) was undertaken. Bhagat and Ranjan51 test the usefulness of investment bank prestige as endogenous (dependent variable) construct along with insider retention, while modelling for offer value. To account for the endogeneity of insider retention and investment bank prestige, Bhagat and Ranjan use the three-stage least squares (3SLS) procedure. They use three simultaneous equations. The dependent variables for the three equations are offer value, insider retention, and investment bank prestige. They document that in accounting for endogeneity of insider retention and investment bank prestige, their findings do not change regarding the predictive power of the income, sales, book equity and growth opportunities in valuing IPOs. In this study, to identify the degree of contribution of each issue specific signalling variable i e offer size, age of the firm, post issue promoter holding, issue price, and syndicate size in predicting the magnitude of the prestige (dependent variable) for the investment bank, the following model was used.

(IBPP)i = 0 + 1(OS) + 2(Ag) + 3(PIPH) + 4(IP) + 5(SS) + i Eq (2) where 0: intercept, 1: degree of regression coefficient between (IBPP)i and (OS)i, 2: degree of regression coefficient between (IBPP)i and (Ag)i, 3: degree of regression coefficient between (IBPP)i and (PIPH)i, 4: degree of regression coefficient between (IBPP)i and (IP)i, 5: degree of regression coefficient between (IBPP)i and (SS)i while i: error term. The data for each variable is tested using Levene Test for meeting the required assumptions of simple linear regression model i e linearity, constant variance (homoscedasticity) and normality. All these tests were conducted using SPSS 13.0 version. Empirical methodology applied the F test for 95% level of confidence for the above mentioned hypotheses. The following box lists the variables mentioned in Equations (1) and (2) for Tata Consultancy Services Ltd (TCS)s initial public offerings.

Empirical Results
Following is a discussion of the empirical results.

IPO of Tata Consultancy Services Ltd

(with variables used in regression model)

Tata Consultancy Ltd issued shares through the IPO on 29th July 2004 with face value of Re 1 per share.
Price band (in Rs) : Rs 775Rs 900 Rs 850 Rs 987.95 (first day closing price) Rs 5428.90 crores

Final offer price per share (in Rs) : List price (in Rs) Offer size (OS) Percentage of post issue promoter holding (PIPH) Initial rate of return (underprice) : : : :

82.69 % 16.01%, which is far less than the average underprice of 46.63% reported for whole sample.

Market adjusted abnormal rate of return : 15.97% 36 years 3 JM Morgan Stanley Pvt Ltd, DSP Merril Lynch Ltd, JP Morgan India Pvt Ltd. Source: Public issue offer document; http://www.nseindia.com

Age of the firm at the date of issue : Syndicate size (SS) Book running lead managers : :

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Investment Bank Prestige and IPO Underpricing: An Empirical Study

Hypothesis 1
Investment Bank Prestige and Underprice: We find that the initial return is inversely related with underwriter prestige. As the rank value points of investment banks go up the initial return declines. In other words, high prestige value leads to lower deviation from the fair value, resulting in marginalised risk of under valuation. The OLS model in Eq (1) results in: UP = 71.78 1.49 (IBP) Model summary: R = .245 R2 = 0.60, F value = 2.61 and Significant at 0.01 level. The significant negative regression coefficient signals inverse linear relationship between UP and IBP. High ranking investment banks are associated with IPOs exhibiting less underpricing.

underprice is given in column four and calculated as per Miller and Reillys model52. Column five indicates the number of IPOs (out of 43 issues analysed) managed by different investment bank groups. Exhibit 8 indicates that underprice percentage varies from 35.28 to 62.56 for the three groups. Our finding is consistent with the findings of Neuberger and Hammond, Logue, Black and Stanley, and Neuberger and LaChapelle53. Further, this analysis has been extended by taking into consideration the rank value of the top two investment banks (from the syndicate) instead of taking the cumulative rank value of all of the syndicate members, and then comparing the mean rate of underpricing among the three prestige groups. Among these three groups, the difference in mean initial return remains unchanged like the previous analysis with the rank value points of all syndicate members. However within a group, there is no difference in mean initial return when only the top two investment banks are considered. Hence it can be concluded that the top two lead underwriters shadow the involvement of other group members. In other words, the market gives more importance to the prestige of leading investment banks in the syndicate than the whole group of investment banks.

Hypothesis 2
Prestige Group and Underprice: The observed relationship between initial return and the investment bank prestige further motivates us to analyse the inter group (among Tier 1, Tier 2 and Tier 3) comparison of underpricing. For the purpose of finding out the inter group comparison, single factor ANOVA test was undertaken for the entire sample of 43 companies at 95% level of significance. The results indicate that the null hypothesis is rejected at 95% level, signifying that there is a difference in the mean rate of return (underprice) among three groups of investment banks. The high rank group exhibits lower initial return than the low prestige group. Exhibit 8 reports the relationship between investment bank groups and the relative underprice percentage. Columns one and two show the classification of investment banks as Super group, Major group and Least group. The percentage of

Findings for the Proxies for Investment Bank Prestige

Our finding suggests that investors are willing to pay more for the IPOs managed by prestigious investment banks. In other words, IPOs managed by prestigious underwriters exhibit less underpricing. The same logic is also applicable to the investment banks. High profile banks want to manage issues coming from fundamentally good companies, with commendable business stories and which command growth prospects. Multiple regression method [as given in Eq (2)] is undertaken to find out the effect of offer size (OS), age of the firm (Ag), post issue promoter holding (PIPH), issue price (IP) and syndicate size (SS) on the prestige of the investment bank. Exhibit 9 summarises the multiple regression model for investment bank prestige. The investment bank prestige (IBPP) is taken as predicting variable, while size of the syndicate (SS), age of the IPO firm (Ag), and post issue promoter holding are considered as independent variables. The variables offer size (OS), and issue price (IP) proved insignificant and hence were
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Exhibit 8 Investment Bank Prestige Group and IPO Underprice

Prestige Group Tier 1 Tier 2 Tier 3 Prestige Definition Super group Major group Least group Prestige Points >15 6.515 < 6.5 Underprice Percentage 35.28 54.25 62.56 Number of IPOs 18 14 11

F value: 8.87, Significant at 95% level. IIMB Management Review, September 2009

Exhibit 9 Summary of the Model for Explaining Investment Bank Prestige

Models with predictors constant SS SS, Ag SS, Ag, PIPH R R2 Adjusted R2 Standard error of estimate 5.0122 4.8197 4.6192

Exhibit 10 Regression Results for Investment Bank Prestige as Predictor Variable

Unstandardised Standardised t value Significance Coefficients Coefficients Beta Standard Error Constant SS Ag PIPH -.205 6.320 .116 .115 3.028 .580 .045 .054 .844 .206 -.157 -.068 16.904 2.642 -2.133 .946 .000 .012 .039

.887 .898 .909

.786 .807 .827

.781 .797 .814

Definition of variables: SS: syndicate size; Ag: age of firm; PIPH: post issue promoter holding.

excluded from the model. The empirical result as shown in Exhibit 9 reports that investment bank prestige is adequately influenced by the magnitude of the syndicate (SS), age of the issuing firm (Ag) and the post issue promoter holding (PIPH). Collectively SS, Ag and PIPH explain 82.7% of the variation in the prestige. Among all the three variables, the syndicate size defines a maximum of 78.6% followed by age or maturity of the firm and post issue promoter holding. The OLS model in Eq (2) results in: (IBP)i = -0.205 + 0.118(Ag) + 0.115(PIPH) + 6.320(SS) The model results are given in Exhibit 10. The result documents that investment bank prestige is significantly influenced by syndicate size (SS), post issue promoter holding (PIPH), and age of the IPO firm (Ag). The F value for the model found 62.22. Greater value for syndicate size indicates that prestigious investment banks tend to manage the issue with a bigger syndicate size. The t value for all of the variables was found significant at 95% level of confidence. To understand the relevance of these three important variables, individually these three have been analysed in relation to investment bank prestige. Investment bank prestige and age of the IPO firm: We find a direct positive relationship between age of the firm and investment bank prestige. Tier 1 or the Super group of investment banks is associated with more mature firms. The IPOs from younger firms are managed by the least prestigious investment banks. Detailed distribution of the prestige group and maturity of the firms is given in Exhibit 11. Column one highlights the classification of the investment banks. Mean age of the IPO firms is
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Definition of variables: SS: syndicate size; Ag: age of firm; PIPH: post issue promoter holding.

calculated as the simple arithmetic mean of the age of the firms being managed by that category. In the Super group category, the average age of companies is 27.11 years. Average age of the IPO firms for the Least group (Tier 3) stands at 12.10 years. Further, a large number of firms (44.18%) in the sample are managed by more prestigious investment banks. The reason can be attributed to the fact that a significant number of public sector firms with large offer size have floated IPOs during the period 20012005. Investment bank prestige and syndicate size: Exhibit 12 shows the statistical distribution between investment bank prestige and magnitude of the syndicate. Values for the mean syndicate size documented at column four are calculated as the average (simple arithmetic mean) of investment banks participating in the syndicate. Column five shows the number of IPOs managed by specific groups of investment banks. Reputed banks are found to be associated with large syndicate structure. The result shows that the Super group underwriter (Tier 1) prefers to be associated with an average syndicate size

Exhibit 11 Investment Bank Prestige Group and Mean Age of the Firm
Investment Prestige Bank Prestige Definition Group Tier 1 Tier 2 Tier 3 Super group Major group Least group Prestige Mean Age of Number of Points the firm Companies >15 6.515 < 6.5 27.11 22.86 12.10 19 14 10

Investment Bank Prestige and IPO Underpricing: An Empirical Study

Exhibit 12 Investment Bank Prestige Group and Syndicate Size

Investment Prestige Bank Prestige Definition Group Tier 1 Tier 2 Tier 3 Super group Major group Least group Prestige Mean Syndi- Number of Points cate Size Companies >15 6.515 < 6.5 4.05 2.29 1.30 18 14 11

Exhibit 13 Investment Bank Prestige Group and Post Issue Promoters Holding
Investment Bank Prestige Group Tier 1 Tier 2 Tier 3 Prestige Definition Super group Major group Least group Mean PIPH Percentages 62.58 56.99 55.61 Number of Companies 19 14 10

of 4.05, while for the Prestige group of Tier 2 and Tier 3 the size of the syndicate is 2.29 and 1.30 respectively. Positive regression coefficient of 6.320 further indicates positive relationship between syndicate size and investment bank prestige. A plausible reason for this can be that large syndicates are capable of spreading the risk among the syndicate members. Low profile investment banks are unable to spread out the risk by expanding the syndicate size, which may be due to the following: (i) small issues cannot afford large syndicates, because every additional member in the syndicate adds costs to the company, (ii) low prestige effectnobody likes to join hands with low profile banks. Prestige group and post issue promoter holding: We find a positive relationship between investment banker prestige and post issue promoters holding (positive regression coefficient of 0.115). A promoters group having more stakes in the IPO prefers to select more prestigious investment banks to manage the issue. Exhibit 13 highlights investment bank prestige group and the average post issue promoters group holding. Post issue promoters group holdings are reflected in column three, which is calculated as the difference between pre IPO holding and the magnitude of stakes being diluted through IPO by the promoters group. Exhibit 13 documents an average post issue promoters group holding of 62.58% for all the IPOs managed by the Super group of investment banks (Tier 1), while for Tier 2 and Tier 3 group, the average holding stands at 56.99% and 55.61% respectively.

Undervaluation persists in the Indian IPO market during the period 200102 to 200405. The average undervaluation of 46.63% implies that the issuer leaves too much on the table in order to attract higher subscription for the issue. To gain a good response from the market, issuers deliberately underprice IPOs. This can be seen in the light of the dotcom bubble burst that occurred just preceding the period of our study. Percentage underpricing also has inverse relationship with the investment bank prestige, represented by the collective sum of prestige points of all syndicate members. Prestigious banks (Super group) have more influence on minimising underpricing than those in the low prestige group (Least group) of investment banks. The lower the prestige rank, the more is the magnitude of underpricing. The findings are inconsistent with Loughran and Ritter, and Beatty and Welch54. Hence the role of the investment banks in the valuation of IPOs cannot be undermined. However within a group, there is no difference in mean initial return when only the top two investment banks are considered compared to all members in the syndicate. Hence it can be concluded that the top two investment banks overshadow the involvement of other syndicate members. Super group of investment banks manages issues with high offer size. Offer size exhibits positive correlation with investment bank prestige. The literature documents that size reflects risk content more explicitly. Ritter, and Loughran and Ritter55 have empirically documented that underpricing is more pronounced for small firms, than the bigger and more mature firms. The findings of this study are consistent with their models. The empirical result documents the size of the syndicate as the leading factor in estimating the prestige value for the investment banks. Prestigious investment banks are managing issues in association with large syndicate
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Interpretation of Findings
This study explores the relationship between investment bank prestige and underprice of new issues for the sample of 43 companies for the period 200102 to 200405. The study documents the following on the basis of empirical findings:
IIMB Management Review, September 2009

members. With a large syndicate to support an IPO issue, investment banks as well as the issuer company are insuring the risk associated with the issue. Age of the issuing firm has a direct positive correlation with investment bank prestige. The findings of this study indicate that the higher the maturity of the firm, the more likely it is to be managed by prestigious underwriters. Offer size has been bigger for aged firms. Further, aged firms have a long operational and financial history which supports higher fund requirements. Confirming our previous findings (Super group of investment banks manage issues having high offer size), prestigious investment banks are associated with more mature firms. Investment bank prestige is positively correlated with the post issue promoter holding. Prestigious banks have managed issues having higher post issue promoter holding. Higher post issue promoters holdings convey the intrinsic worth of the firm more credibly to prospective investors thereby reducing the information asymmetry and underpricing.

the type of investment banks associated with a specific issue. This kind of study has specific relevance in the Indian context, as many investors (mostly retail investors) subscribe to IPOs to gain profit on listing day and not to hold the security for long-term benefit. Investors can also take the post-issue promoter groups holding as the signalling variable to reach a conclusion about degree of underpricing i e listing day profit. This paper also tries to extend the academic pursuit in Indian IPO aspects, which is at best at a nascent stage compared to research undertaken in other advanced capital markets.

References and Notes

1 Issuing firm includes the company along with other insiders i e venture capitalist, promoter, manager etc who hold the shares prior to the issue. 2 Beatty, R, and J Ritter, 1986, Investment Banking Reputation, and the Underpricing of Initial Public Offerings, Journal of Financial Economics, Vol 15, No 1/2, pp 213232; Carter, R, and S Manaster, 1990, Initial Public Offerings and Underwriter Reputation, Journal of Finance, Vol 45, No 4, pp 10451067; Chemmanur, T, and P Fulghieri, 1994, Investment Bank Reputation, Information Production, and Financial Intermediation, Journal of Finance, Vol 49, No 1, pp 5779. 3 Ibbotson, R, 1975, Price Performance of Common Stock New Issues, Journal of Financial Economics, Vol 2, No 3, pp 235 272; Ibbotson, R, J Sindelar, and J Ritter, 1988, Initial Public Offerings, Journal of Applied Corporate Finance, Vol 1, No 4, pp 3745; Ritter, J R, 1998, Initial Public Offerings, http://bear.cba.ufl.edu/ritter/rittipo1.pdf. Last accessed on Aug 19, 2007. 4 Rock, K, 1986, Why New Issues are Underpriced, Journal of Financial Economics, Vol 15, No 1/2, pp 187212. 5 Benveniste, L M, and P A Spindt, 1989, How Investment Bankers Determine the Offer Price and Allocation of New Issues, Journal of Financial Economics, Vol 24, No 2, pp 343361. 6 Ruud, J R, 1993, Underwriter Price Support and the IPO Underpricing Puzzle, Journal of Financial Economics, Vol 34, No 2, pp 13551. 7 Ibbotson, et al, Initial Public Offerings. 8 Brennan, M, and J Franks, 1995, Underpricing, Ownership and Control of Initial Public Offerings of Equity Securities in UK, Journal of Financial Economics, Vol 45, No 3, pp 391413. 9 Loughran, T, and J Ritter, 2004, Why Has IPO Underpricing Changed Over Time?, Financial Management, Vol 33, No 3, pp 537. 10 Baron, D P, 1982, A Model of the Demand for Investment Banking Advising and Distribution Services for New Issues, Journal of Finance, Vol 37, No 4, pp 955976; Rock, K, Why New Issues are Underpriced; Beatty and Ritter, Investment Banking, Reputation, and the Underpricing of Initial Public Offerings; Levis, M, 1993, The Long Run Performance of Initial Public Offerings: The UK Experience 19801988, Financial
Investment Bank Prestige and IPO Underpricing: An Empirical Study

Conclusion and Scope of Study

This paper documents the inverse or opposite relation between investment bank prestige and underprice. The study finds that Indian IPOs were significantly underpriced (46.63%) during the period 200102 to 200405 for the sample of 43 new issues analysed. The magnitude of underpricing is less for issues managed by prestigious investment banks compared to less prestigious ones. In other words, issue price reflects more rationality in valuation when IPOs are managed by high rank banks compared to low rank banks. This study also finds large syndicate size to be the most suitable proxy for the prestige ranks of investment banks. Prestigious banks are managing IPOs with the help of a larger number of syndicate members than their non prestigious counterparts. This paper also posits that prestigious investment banks tend to manage issues having a high magnitude of offer size. The age or the maturity of the firm has a positive correlation with the prestige of the investment bank. Prestigious investment banks are also managing issues with higher post issue promoter holding. The findings of this study can be used by companies in deciding on investment banks. Prospective investors can form a view about the listing day price by keeping in mind
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Seshadev Sahoo is a Research Scholar at the Vinod Gupta School of Management (VGSOM), Indian Institute of Technology, Kharagpur, and Associate Professor, Institute of Management and Information Science (IMIS), Bhubaneswar, (Orissa). seshadev@vgsom.iitkgp.ernet.in Prabina Rajib is Associate Professor (Finance), Vinod Gupta School of Management, Indian Institute of Technology, Kharagpur. prabina@vgsom.iitkgp.ernet.in

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