IPO Issue Management, Pricing and Role of External Auditor

Mahmood Osman Imam

1
Prelude
Undertaking an IPO moves the firm from the private to the public domain. Few organizational
transitions will receive the concentrated attention that an IPO generates, as this generally
represents the first time that firmspecific information will be made available to the public.
!onsistent with "ecurities and #$change !ommission %"#!& guidelines, any firm undertaking an
IPO must provide a series of documents that contain detail on the firm, the intended uses of the
capital generated from the IPO, and the firm's managers.
(he main focal point of this paper is to discuss IPO pricing along with empirical findings of IPO
underpricing in )angladesh by highlighting briefly IPO rationale, process, floatation methods and
issue management, and the e$tent of role of e$ternal auditor in certifying financial statement of
the issue that contains the parameters as the basis of determining the offer price of the issue. (his
might indicate e$tended role * nature of due diligence of e$ternal auditor in case of firms going
public %IPO& for not only certifying the financial statement but also furnishing sufficient
disclosures that turned out to be relevant for determining the offer price. In doing so, the paper
resorted to the findings of author's own and other's research works with regard to IPO and
discussed few cases as a sample where due diligence by the auditing firm has not been properly
and sufficiently discharged. (he e$tended role must also be viewed from the perspective of
professional's code of ethics.
IPO Rationale
Firms undertake an IPO for two primary reasons %+c!onaughy, ,hatt, * -im, .//01 see also
"utton * )enedetto, ./22&. One reason is as a mechanism for assisting the firms' initial
shareholders in diversifying their holdings. 3 second rationale is to assist managers %often the
firms' founder4s5& in procuring the necessary funding for undertaking new pro6ects %e.g.,
7elbourne * !yr, .///&. 3t the point at which firm management undertakes an IPO, managers
typically have a substantial portion of their personal wealth invested in the firm. (he IPO enables
these individuals to sell a portion of their holdings in the firm and utilize the funds generated
from the sale of stock to diversify their investment risk %8ock, ./29&. )oth goals can be
simultaneously achieved. +anagers can divest some of their ownership interests in the firm and
utilize the capital generated to diversify their personal portfolio and pursue new ventures at the
firm level.
:
Of these two reasons for undertaking an IPO, 3rkebauer %.//.& found that the need to
generate funds to pursue new pro6ects dominated portfolio diversification. For many
entrepreneurial ventures, an IPO enables firm management to pursue growth opportunities that
would otherwise be impossible to fund. #ntrepreneurs routinely leverage themselves to a point
where they are unable to further increase either their own or the firm's debt load. Issuing firm
e;uity via an IPO can be beneficial in that it serves the dual purpose of providing needed funds
and reducing the firm's debt to e;uity ratio. #ven in those instances where additional commercial
credit is available to the entrepreneur, the covenants attached to the loan may be sufficiently
.
+ahmood Osman Imam, +)3, Ph., is a Professor of Finance, and #$!hairman, ,epartment of
Finance, University of ,haka
:
(here are limits on the amount of e;uity that IPO firm owners can sell at the time of IPO. (hese limits
are in the form of lockup provisions that restrict owners from selling some portion of their e;uity for a
specified time postIPO %see e.g., <ange, )ygrave, =ishimoto, 8oedel, * "tock, :>>.&, as well as limits
as a function of the negative signal that the sale of large portions of their e;uity would send to potential
investors.
restrictive as to hinder his or her ability to pursue opportunities with highgrowth prospects, but
also high risk %e.g., Pagano, Panetta, * ?ingales, .//21 8ock, ./29&.
IPO Process
(he process of offering a firm's stock to the general public for the first time is a comple$ and
lengthy one. It is not our intent to provide a comprehensive treatment of this process, as others
have provided e$cellent overviews %see, e.g., #llis, +ichaely, * O'@ara, .///&. 8ather, our intent
is to provide some conte$t for our analysis of the correlates of IPO underpricing. Upon deciding
to undertake an IPO, firm management must first secure the services of a issuemanager %* lead
underwriter as well& %also commonly referred to as the merchant banker&. (he issuemanager
assist firms' managers in preparing the e$tensive paperwork involved in complying with "#!
guidelines, including the registration statement, of which the prospectus is a part. It is these
materials that serve as the primary marketing tool for the firm's securities. (he IPO marketing
process is punctuated by what is called a Aroad show.B 8oad shows involve the lead underwriters
and key firm managers marketing the firm to prospective investors %largely prominent
institutional investors& via presentations in ma6or cities and oneonone meetings with targeted
investors such as mutualChedge fund managers %8itter, .//2&. (hese presentations focus on the
firm's operations, products and services, and management. (he road show is designed to gauge
the anticipated demand for the firm's stock and serves as a key input in the merchant banker's
final determination of the price at which the firm's stock will initially trade.
Upon completion of the road shows, and 6ust prior to the actual first day of trading %typically the
day prior to opening day&, firm managers and the underwriters shepherding the process will set
the initial offering price. (his is a critical decision point for firm management because once the
price has been set, shares cannot be offered to the initial investors at a higher price the first day of
trading regardless of the level of demand %Dordon * Ein, .//F&. It is this initial stock price that
forms the basis for underpricing given that underpricing represents the difference between the
initial stock price set by IPO firm managers and the underwriters and the price of the stock at the
close of the first day of trading.
(he changing regulations of IPO market along with a boom over the last one year have made
)angladesh "tock market a very interesting destination for studying IPO pricing in the after
market. 3s such the plausible e$planations for IPO underpricing in emerging stock markets like
)angladesh is a ma6or challenge for academicians .Underpricing is a cost to the issuer and has
drawn considerable attention in the academic literature over the last three decades. 3n initial
public offering or unseasoned new issue is a first time offering of shares by specific firms to the
public. (he firms go public primarily to raise e;uity capital for the firm and to create a public
market in which the founder and other shareholders can convert some of their wealth into cash at
a future date. )ut issuing new securities in the market involves some costs. One is direct cost
comprises of underwriting, legal, auditing fees. 3nother one is indirect cost i.e. underpricing. 3n
issue is said to be underpriced if the price rises in the after market above the offer price and the
rise up prices have been maintained into e;uilibrium. (he direct and indirect costs have a
combined affect on the cost of e;uity capital.
(he regulatory authority in )angladesh "tock +arket allows two basic and distinct issuing
techni;ues G fi$ed price, book building and direct listing for offloading of sponsor's shares. From
the day of inception of stock e$change %./09& fi$ed price method was the only method that had
been used by the issuers in )angladesh. (he book building methodGtwostaged pricing method
introduced in :>.> is comparatively new method for the issuers and of late a few number of
companies have chosen to issue their shares by this method.
IPO Mechanism in Bangladesh:
(he "ecurities and #$change !ommission %Issue of !apital& 8ules, :>>. re;uires that a
company intending to raise capital in )angladesh shall first make an application to the
"ecurities and #$change !ommission for consent. (he traditional procedure re;uires that
firms file registration statements that will include preliminary prospectus that specify
information about the firm, the securities being offered for sale, and the e$pected use of
proceeds. On receipt of the application, the !ommission shall e$amine it, and if all the
re;uirements are fulfilled, it shall accord consent in writing to the issue of capital in
)angladesh, as prayed for, within si$ty days of receipt of the application. If the
!ommission finds that the application does not fulfill all the re;uirements, it may, within
thirty days of receipt of application, direct the applicant to comply with the re;uirements
within such time as the !ommission may determine, and on fulfillment of such
re;uirements the !ommission shall accord the consent as prayed for within thirty days of
such fulfillment. Once the staff declares registration statements effective, firms are free to
price and sell securities, and they typically access the market as soon as possible
thereafter. Following the sale of securities, the "#! re;uires firms to file pricing
supplements within two days of sale to notify market participants of the e$act terms of
offerings.
3fter that the issuer should publish an abstract format of the prospectus in four national
dailies. (he rules also specify the minimum and ma$imum fees for listing with the "tock
#$change. (he most significant provision of the rule is that it reinstates the compulsory
dual listing in the market. It is e$pected that due to reduction of IPO flotation cost
reputed entrepreneurs would prefer capital market as a source of financing over bank
borrowing.
In )angladesh there are mainly two IPO floatation methods. One is fi$ed price method
another is book building method.
Fixed price Method: In a fi$ed price method shares are offered for sale at pre
determined price set by the underwriter on behalf of the issuer. For obtaining the consent
of the regulatory authority the issuer apply to the "#! along with some necessary
documents namely ten copies of prospectus, audited financial statement of issuer etc. It
the offer price is higher than the par value 6ustification of the premium should be
mentioned in the prospectus with reference to the fundamentals such as net asset value
per share at historical or current cost or earning based value per share calculated on the
basis of weighted average of net profit after ta$ for immediately preceding five years or pro6ected
earnings per share for the ne$t three accounting year as per the issuers own assessment duly
certified by the auditor of the issuer1 average market price per share of similar stock for the last
one year immediately prior to the offer for common stocks. If the issue is oversubscribed then
rationing occurs.
Boo Building Method: In a book building method, Issuer shall invite for interest for
indicative price offer from the eligible institutional investors through proper disclosure,
presentation, document, seminar, road show, etc1 In Information +emorandum %I+&, the issue
manager provides an indicative offer price being 6ustified for premium. "econdly Issuer in
association with issue manager and eligible institutional investors shall ;uote a final indicative
price %arithmetic mean of indication of interests for offer price& in the prospectus and submit the
same to the !ommission. 8ationale for the indicative price must be included in the prospectus i.e.
the issuer is re;uired to disclose in detail about the ;ualitative and ;uantitative factors 6ustifying
the indicative price. (he indicative price shall be the basis for formal price building with an
upward and downward band of :>H %twenty percent& of indicative price within which eligible
institutional investors shall bid for the allocated amount of security1 =o institutional investor shall
be allowed to ;uote for more than .>H %ten percent& of the total security offered for sale, sub6ect
to ma$imum of 0 %five& bids. (he institutional bidders will be allotted security on prorata basis at
the weighted average price of the bids that would clear the total number of securities being issued
to them. Deneral investors, which include mutual funds and =8)s, shall buy at the cutoff price.
Findings of !nderpricing and As"mmetric Information associated #ith IPO
+arket capitalization of ,"# increased :.H from (k. II9.J billion in Eune :>>2 to (k. /F2.>
billion in Euly :>>/. =ew issues %a total of .9& accounted for only (k. J.. billion of this increase.
It can be safely assumed that margin lending played a role in this significant advance1 e$cess
li;uidity drove up the share prices in a market that e$perienced security supply conse;uently. In a
rising market, margin lending encourages speculative trading and creates significant risk for
investors, for banks and for the market. 3 portfolio created out of borrowed funds magnifies the
risk of losses. 3 .>H market correction causes as much as :0H loss to an investor who is
leveraged .0>H. 3 J>H correction in the market could wipe off the entire e;uity of the investors
and e$pose the margin lender to losses. (his risk is reflected in the new banking supervision
rules1 under )asel II framework, investment in e;uity should be risk weighted at .>>H. +argin
lending , on the other, e$acerbates market volatility.
3n issue is said to be underpriced when a share is offered to the public at lower than that it could
fetch in after market. Underpricing is generally estimated as the percentage difference between
the price at which the shares were sold to investors during the IPO and the price at which the
share are traded afterwards in the secondary market. Underpricing phenomenon has been
empirically researched in more than J> countries and their results indicate that underpricing is a
worldwide phenomenon1 from U" to "outh -orea, =orway to =ew ?ealand, almost all studies
documented underpricing but their magnitude differed from country to country. It was generally
accepted that high initial returns resulted from deliberate underpricing. (his view was supported
by most empirical findings that price ad6usts rapidly to the high initial return on the first trading
day and there after no systematic abnormal returns are realized anymore in the aftermarket
specially in the developed market.
In a research study using event study methodology, we found that nonfinancial firms that go
public during the period of .//. to :>>I have been underpriced on an average of /:.0JH %first
day initial return& and 2J.:/H on e;uilibrium day %#vent ,ay.0&. (he following graph shows the
price performance of nonfinancial IPOs that came into public during .//. to :>>I. (he first day
e$cess initial return over return on e;uilibrium day is the outcome of overshooting behavior that
does e$ist in our market.
It is found that controlling for industry effects, the well known pro$ies for uncertainty
size and aftermarket standard deviation, oversubscription and free float were found to be
the significant factors in e$plaining underpricing.
In this conte$t oh high degree of underpricing in )angladesh, it is perceived that due fair price for
the issue at a arm's length was not obtainable under fi$ed price +ethod and hence it was resorted
to )ook )uilding +ethod whereby price discovery process would be employed to get fair price
for the issue. 3n issue manager was used to be employed to manage issue including the
determination of indicative price for and was found to come up with an indicative price for the
issue %employing methods of premium 6ustification in subclause.9 of Public Issue 8ule :>>9 G
using relative valuation methods& that might turn out to be overpriced in most of the cases. On the
other potential institutional investors were engaged in ;uoting indication of interests for
indicative price in line with the issue manager %either in connivance or not fully understood& and
secondarily in the bidding, as there prevailed high demand for stocks in the bullish market. For
determining issue price, the issue manager must be accountable because of its reputation stake. It
has to determine fair price not only for the issuer but also for the general investor. @owever, one
of the basic premise of the determining issue manager's indicative price with premium %even in
premium under FP method& and institutional indications of interest is %should be& based on
audited financial statement. @ere lies the role of e$ternal auditor in discharging due diligence
with regard to earnings ;uality, revaluation of assets and proper * sufficient disclosures of IPO
issues in particular. Perhaps this is more related with their professional code of ethics that they
must stick to. Otherwise these auditing firms will have to take some blame on their shoulders. It
is notable that top auditing firm are not compromising ;uality themselves while others are. It is
now the duty of !3 professionals to address this issue intuitionally.
3s we all knew that +ark )d. came as an IPO under FP method prior to .//9 share market scam,
and in its prospectus, it carried out some revaluation of its assets but there was a overvaluation of
its fi$ed assets that are more than their purchase price and depreciation of these were kept in
historical level despite upwardrevaluation of its assets. (he then valuer and auditing firm of
+ark bd. were implicated due to noncompliances of duediligence and violation of rulesCnorms.
In recent times, in the Information +emorandum %I+& of D+D 3irlines, some of the issues
concerning financials in the =otes of 3udited Financial "tatements can be raised to be
;uestionable. One of this is the recent hike of net profit after ta$ in nine months of :>.> and :>>/
after making small net profit after ta$ in :>>2, :>>I * :>>9 and then making losses for last 2
years continuously since its operation in .//2. (here is inconsistency raising concerns that in /
months of :>.>, D+D 3irlines has made increased operating revenue by F0H from the last year
through selling tickets %Footnote.2& while travel agency commission and K3( has been reduced
by around 9>H %Footnote./.F&. +oreover, there is recognition of deferred e$penses for G
revenue, !!heck, lease rent and preliminary e$penses as intangible assets %Footnote .>&. 3s we
know, preliminary e$penses and revenue e$penses need be e$pensed %instead of deferred& in the
year in which it was incurred, while there wasn't any proper disclosure of the nature of deferred
e$penses for !!heck to be amortized. (he figure of these deferred e$penses under intangible
assets increased by (k. .00.29 crores in / months of :>.> from the (k. F..I crores to (k. .2I.09
crores even after yearly charging these e$penses in the year prior to IPO. In addition, these
intangible assets are not deducted from the total assets for the calculation of =3K per share
%furnished in )alance "heet&. 3l these raises doubts in managing earnings that affects earnings
;uality of the IPO, which have impounding effect on the determination of indicative price.
)esides, the disclosure of e$isting shareholding structure spelt out in I+ %)e$imco * its
3ssociates G J9..2H, foreign investor 9.9H, local Institutions G .>.F/H * general public
:I.I.H& is ;uite different from that in footnote F of detail position in shareholdings of share
capital %)e$imco.F.FFH, general public * institutions I9.J9H& and the bungling in share
premium account of :J> crores %footnote J& can not be digested.
In I+ of -P!<, there is a pro6ection of financial statements and earnings for the year :>.>:>.J
as per issuer own assessment and accordingly pro6ected earnings based value has been estimated.
"ubclause .9 of public issue rule :>>9 re;uires that this pro6ection as per issuer own assessment
is duly certified by the auditor. @owever, it was not certified by the auditor. (o the best of my
knowledge that this rule can only prevail in )angladesh, nowhere in the world and the author
argues that an auditor can only certify the past statement, not the future.
(his paper draws the attention of the author's own research findings of detection of earnings
management and testing value relevance hypothesis of IPOs in )angladesh, which came into
public between the period of Eanuary .//. and ,ecember :>>>. Imam et al %:>.>& finds
evidence, using +odified Eones' +odel of discretionary accrual testing methodology, that
entrepreneurs of IPOs coming to the market during .//.:>>>, behaved myopically in boosting
earnings in the year prior to going public. +ean managed accruals of sample IPO firms accounted
for 9.>H of the total assets %it was around :.2H of total assets in developed country's conte$t&
under the +odified Eones' +odel. It is also documented in that study that earnings management
had a positive impact on initial firm's value.
$oncluding Remars
(he paper addresses the IPO process, floatation method and issues for determining IPO Offer
price with premium under Fi$ed Price method and indicative price under book building method
and in that conte$t, the issue manager and issuer are held accountable primarily for pricing the
issue and secondarily the regulator as it approves the vetting of the prospectus. (he paper
provides the short run price performance of IPOs that came into public during .//. to :>>I and
argues that overshooting behavior does e$ist in the stock market in )angladesh. (his paper also
argues that issuers has the incentive and motivation to engage in myopic behavior attempting to
influence investors' belief and hence to achieve a high stock price at the floatation by pumping up
preIPO earnings through the accounting choices. @ence this paper argues for e$erted role of
auditor in discharging due diligence in ensuring earnings ;uality, revaluation of assets, while
certifying financial statements and furnishing full, proper and sufficient disclosures for IPO firms
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