Anchoring IPOs to valuation certainty
By Rama Seth
Initial public offering (IPO) activity, allocation to investors and pricing have been the subject of much debate over the last two decades. A major difficulty in IPO research is the lack of direct evidence on IPO allocations made to institutional investors because book building details are not open to the public. We bridge this gap by using a legal experiment in India. On July 9, 2009, Sebi allowed a two-stage IPO process in which qualified institutional investors were allowed to act as anchor investors (or lead investors) in IPOs. Under the law, anchor investors are allotted shares on a discretionary basis and the price at which the allocation is made is disclosed by the lead investment bank one day before the opening of the offer to the public. If the price fixed for public issue through the book-building process is higher than the price at which the allocation is made to anchor investors, the additional amount is to be paid by anchor investors. However, if the price fixed for public issue is lower than the price at which the allocation is made to anchor investors, the difference is not payable to anchor investors. These investors face a short lock-up period of 30 days from the date of allotment. Thus, the Indian IPO process is a sequential hybrid mechanism in which anchor investors lead the price-setting process.
Here, we answer several important questions: How does the involvement of anchor investors affect underpricing? How do anchor investors decide in which issues to request allocations? Are anchor investors given disproportionate allocations in substantially underpriced IPOs? Do they have a destabilising impact on stock prices around the lock-up expiration date? Do anchor-backed IPOs have higher risk-adjusted returns in the long run?
Regulators have been concerned about the potential conflict of interest between investment banks and investors for many years. Investment banks have the discretion to allot shares in an IPO. Research on IPOs in the US has shown that investment banks allot shares in hot IPOs (i.e., highly underpriced IPOs) to institutional investors in return for assured investment in future IPOs. Our setting allows us to examine whether this is the case. By studying the Indian experiment, a larger issue we address is whether regulators should consider moving to a two-stage IPO mechanism and, if they do, how the process would affect issuers and investors.
If anchor investors have to truthfully reveal information about the intrinsic value of the IPO firm, then they must be offered more allocation or underpricing. We find that anchor backed IPOs are less underpriced. Underpricing falls by 6.4% when anchor investors are involved. This could be due to the certification effect anchor investors have on IPOs. It could also be that anchor investors solve valuation uncertainty for IPOs. IPOs backed by anchor have a narrower price band and these investors bid low, i.e., towards the lower end of the price band. Since later investors learn from valuations submitted by anchor investors, their bids tends to be in line with the latter’s bid. Consequently, these IPOs are less underpriced.
Who requests anchor investors to submit their bids? Naturally, smaller firms and smaller IPOs that suffer from asymmetric information (i.e., managers of the firm know more about the firm than outside investors) or firms facing difficulty in going public (measured by the time elapsed between the prospectus filing date and the offer date) would find an association with anchor investors beneficial. Indeed, this is what we find. Anchor investors are more likely to invest in these firms.
Research in the US shows that institutional investors are allotted disproportionately large number of shares in hot IPOs. In the Indian context, this is not an issue.
Anchor investors receive allocations in both under- and over- priced IPOs. In other words, the nature of book building in India prevents investment banks from expropriating wealth from retail investors.
As anchor investors invest in hard-to-place offerings, it must be that they are compensated for their efforts. The lock-up provision restricts them from selling shares on the listing day. Profits are determined by the allocation decision of underwriters and they may reward anchor investors by allocating shares in underpriced issues.
Because anchor investors face a 30-day lock-up, first-day returns (traditional definition of underpricing) are less relevant to them. We calculate the hypothetical returns to anchor investors if they were to sell upon lock-up expiration. Returns are calculated as the percentage difference between the price at which anchor investors are allotted shares and the price that prevails on the lock-up expiration day. IPOs backed by reputed anchor investors, on average, produce 137% returns up to the lock-up expiration date.
However, after adjusting for risk, IPOs backed by anchor investors do not earn abnormal returns in the long run. While all anchor-backed IPOs do not earn abnormal returns after adjusting for risk, it is likely that anchor-backed IPOs earn superior returns through monitoring when anchor investors invest along with certain types of investors. If monitoring causes superior performance, we expect the performance advantage to be the highest for firms backed by anchor investors, UTI, other mutual funds, and VCs and the lowest for firms with little or no investment from anchor investors, UTI, and VCs. Because of economies of scale in monitoring, institutional investors such as anchor investors may resort to active monitoring only when the level of institutional shareholding is above a threshold.
The results confirm our prediction that IPOs backed by anchor and other institutional investors perform better than IPOs with little institutional investor involvement. These firms generate a positive alpha of 1.25% per month (or 15% per annum).
Our article shows that the two-stage IPO process has several features that issuers, investors, and regulators consider desirable. Anchor investors help underwriters market hard-to-place offerings. The presence of reputed anchors can potentially reduce valuation uncertainty and underpricing.
(The author is Professor, Finance & Control IIM Kolkata)