IPO Issue Management, Pricing and Role of External Auditor
Mahmood Osman Imam*
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 firm-specific information will be made available to the public.
Consistent with Securities and Exchange Commission (SEC) 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.
The main focal point of this paper is to discuss IPO pricing along with empirical findings of IPO
underpricing in Bangladesh by highlighting briefly IPO rationale, process, floatation methods and
issue management, and the extent of role of external auditor in certifying financial statement of
the issue that contains the parameters as the basis of determining the offer price of the issue. This
might indicate extended role & nature of due diligence of external 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. The extended role must also be viewed from the perspective of
professional’s code of ethics.
IPO Rationale
Firms undertake an IPO for two primary reasons (McConaughy, Dhatt, & Kim, 1995; see also
Sutton & Benedetto, 1988). One reason is as a mechanism for assisting the firms’ initial
shareholders in diversifying their holdings. A second rationale is to assist managers (often the
firms’ founder[s]) in procuring the necessary funding for undertaking new projects (e.g.,
Welbourne & Cyr, 1999). At the point at which firm management undertakes an IPO, managers
typically have a substantial portion of their personal wealth invested in the firm. The 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 (Rock, 1986). Both goals can be
simultaneously achieved. Managers 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, Arkebauer (1991) found that the need to
generate funds to pursue new projects dominated portfolio diversification. For many
entrepreneurial ventures, an IPO enables firm management to pursue growth opportunities that
would otherwise be impossible to fund. Entrepreneurs routinely leverage themselves to a point
where they are unable to further increase either their own or the firm’s debt load. Issuing firm
equity via an IPO can be beneficial in that it serves the dual purpose of providing needed funds
and reducing the firm’s debt to equity ratio. Even in those instances where additional commercial
credit is available to the entrepreneur, the covenants attached to the loan may be sufficiently
*
Mahmood Osman Imam, MBA, Ph.D is a Professor of Finance, and Ex-Chairman, Department of
Finance, University of Dhaka
†
There are limits on the amount of equity that IPO firm owners can sell at the time of IPO. These limits are
in the form of lock-up provisions that restrict owners from selling some portion of their equity for a
specified time post-IPO (see e.g., Lange, Bygrave, Nishimoto, Roedel, & Stock, 2001), as well as limits
as a function of the negative signal that the sale of large portions of their equity would send to potential
investors.
restrictive as to hinder his or her ability to pursue opportunities with high-growth prospects, but
also high risk (e.g., Pagano, Panetta, & Zingales, 1998; Rock, 1986).
IPO Process
The process of offering a firm’s stock to the general public for the first time is a complex and
lengthy one. It is not our intent to provide a comprehensive treatment of this process, as others
have provided excellent overviews (see, e.g., Ellis, Michaely, & O’Hara, 1999). Rather, our intent
is to provide some context for our analysis of the correlates of IPO underpricing. Upon deciding
to undertake an IPO, firm management must first secure the services of a issue-manager (& lead
underwriter as well) (also commonly referred to as the merchant banker). The issue-manager
assist firms’ managers in preparing the extensive paperwork involved in complying with SEC
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. The IPO marketing
process is punctuated by what is called a “road show.” Road shows involve the lead underwriters
and key firm managers marketing the firm to prospective investors (largely prominent
institutional investors) via presentations in major cities and one-on-one meetings with targeted
investors such as mutual/hedge fund managers (Ritter, 1998). These presentations focus on the
firm’s operations, products and services, and management. The 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 just 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. This 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 (Gordon & Jin, 1993). 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.
The changing regulations of IPO market along with a boom over the last one year have made
Bangladesh Stock market a very interesting destination for studying IPO pricing in the aftermarket. As such the plausible explanations for IPO underpricing in emerging stock markets like
Bangladesh is a major challenge for academicians .Underpricing is a cost to the issuer and has
drawn considerable attention in the academic literature over the last three decades. An initial
public offering or unseasoned new issue is a first time offering of shares by specific firms to the
public. The firms go public primarily to raise equity 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. But issuing new securities in the market involves some costs. One is direct cost
comprises of underwriting, legal, auditing fees. Another one is indirect cost i.e. underpricing. An
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 equilibrium. The direct and indirect costs have a
combined affect on the cost of equity capital.
The regulatory authority in Bangladesh Stock Market allows two basic and distinct issuing
techniques – fixed price, book building and direct listing for offloading of sponsor’s shares. From
the day of inception of stock exchange (1956) fixed price method was the only method that had
been used by the issuers in Bangladesh. The book building method–two-staged pricing method
introduced in 2010 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:
The Securities and Exchange Commission (Issue of Capital) Rules, 2001 requires that a
company intending to raise capital in Bangladesh shall first make an application to the
Securities and Exchange Commission for consent. The traditional procedure requires that
firms file registration statements that will include preliminary prospectus that specify
information about the firm, the securities being offered for sale, and the expected use of
proceeds. On receipt of the application, the Commission shall examine it, and if all the
requirements are fulfilled, it shall accord consent in writing to the issue of capital in
Bangladesh, as prayed for, within sixty days of receipt of the application. If the
Commission finds that the application does not fulfill all the requirements, it may, within
thirty days of receipt of application, direct the applicant to comply with the requirements
within such time as the Commission may determine, and on fulfillment of such
requirements the Commission 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 SEC requires firms to file pricing
supplements within two days of sale to notify market participants of the exact terms of
offerings.
After that the issuer should publish an abstract format of the prospectus in four national
dailies. The rules also specify the minimum and maximum fees for listing with the Stock
Exchange. The most significant provision of the rule is that it reinstates the compulsory
dual listing in the market. It is expected that due to reduction of IPO flotation cost
reputed entrepreneurs would prefer capital market as a source of financing over bank
borrowing.
In Bangladesh there are mainly two IPO floatation methods. One is fixed price method
another is book building method.
Fixed price Method: In a fixed price method shares are offered for sale at predetermined price set by the underwriter on behalf of the issuer. For obtaining the consent
of the regulatory authority the issuer apply to the SEC 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 justification 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 tax for immediately preceding five years or projected
earnings per share for the next three accounting year as per the issuers own assessment duly
certified by the auditor of the issuer; 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.
Book 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, etc; In Information Memorandum (IM), the issue
manager provides an indicative offer price being justified for premium. Secondly Issuer in
association with issue manager and eligible institutional investors shall quote a final indicative
price (arithmetic mean of indication of interests for offer price) in the prospectus and submit the
same to the Commission. Rationale for the indicative price must be included in the prospectus i.e.
the issuer is required to disclose in detail about the qualitative and quantitative factors justifying
the indicative price. The indicative price shall be the basis for formal price building with an
upward and downward band of 20% (twenty percent) of indicative price within which eligible
institutional investors shall bid for the allocated amount of security; No institutional investor shall
be allowed to quote for more than 10% (ten percent) of the total security offered for sale, subject
to maximum of 5 (five) bids. The institutional bidders will be allotted security on pro-rata basis at
the weighted average price of the bids that would clear the total number of securities being issued
to them. General investors, which include mutual funds and NRBs, shall buy at the cut-off price.
Findings of Underpricing and Asymmetric Information associated with IPO
Market capitalization of DSE increased 21% from Tk. 776.4 billion in June 2008 to Tk. 938.0
billion in July 2009. New issues (a total of 16) accounted for only Tk. 4.1 billion of this increase.
It can be safely assumed that margin lending played a role in this significant advance; excess
liquidity drove up the share prices in a market that experienced security supply consequently. In a
rising market, margin lending encourages speculative trading and creates significant risk for
investors, for banks and for the market. A portfolio created out of borrowed funds magnifies the
risk of losses. A 10% market correction causes as much as 25% loss to an investor who is
leveraged 150%. A 40% correction in the market could wipe off the entire equity of the investors
and expose the margin lender to losses. This risk is reflected in the new banking supervision
rules; under Basel II framework, investment in equity should be risk weighted at 100%. Margin
lending , on the other, exacerbates market volatility.
An 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 40 countries and their results indicate that underpricing is a
worldwide phenomenon; from US to South Korea, Norway to New Zealand, 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. This view was supported
by most empirical findings that price adjusts 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 non-financial firms that go
public during the period of 1991 to 2007 have been underpriced on an average of 92.54% (first
day initial return) and 84.29% on equilibrium day (Event Day15). The following graph shows the
price performance of non-financial IPOs that came into public during 1991 to 2007. The first day
excess initial return over return on equilibrium day is the outcome of overshooting behavior that
does exist in our market.
Abnormal Holding period Return (Non-Financial)
94.00
92.54
Abnormal returns
92.00
90.00
88.00
86.00
84.46
84.29
84.00
82.83
82.00
83.03
81.90
80.00
78.00
76.00
1
15 (EQ Day)
16
17
Event Trading day
18
19
It is found that controlling for industry effects, the well known proxies for uncertainty-size and aftermarket standard deviation, oversubscription and free float were found to be
the significant factors in explaining underpricing.
In this context oh high degree of underpricing in Bangladesh, it is perceived that due fair price for
the issue at a arm’s length was not obtainable under fixed price Method and hence it was resorted
to Book Building Method whereby price discovery process would be employed to get fair price
for the issue. An 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 justification in sub-clause-16 of Public Issue Rule 2006 –
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 quoting 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. However, 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. Here lies the role of external auditor in discharging due diligence
with regard to earnings quality, 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 quality themselves while others are. It is
now the duty of CA professionals to address this issue intuitionally.
As we all knew that Mark Bd. came as an IPO under FP method prior to 1996 share market scam,
and in its prospectus, it carried out some revaluation of its assets but there was a over-valuation of
its fixed assets that are more than their purchase price and depreciation of these were kept in
historical level despite upward-revaluation of its assets. The then valuer and auditing firm of
Mark bd. were implicated due to non-compliances of due-diligence and violation of rules/norms.
In recent times, in the Information Memorandum (IM) of GMG Airlines, some of the issues
concerning financials in the Notes of Audited Financial Statements can be raised to be
questionable. One of this is the recent hike of net profit after tax in nine months of 2010 and 2009
after making small net profit after tax in 2008, 2007 & 2006 and then making losses for last 8
years continuously since its operation in 1998. There is inconsistency raising concerns that in 9
months of 2010, GMG Airlines has made increased operating revenue by 35% from the last year
through selling tickets (Footnote-18) while travel agency commission and VAT has been reduced
by around 60% (Footnote-19.3). Moreover, there is recognition of deferred expenses for –
revenue, C-Check, lease rent and preliminary expenses as intangible assets (Footnote 10). As we
know, preliminary expenses and revenue expenses need be expensed (instead of deferred) in the
year in which it was incurred, while there wasn’t any proper disclosure of the nature of deferred
expenses for C-Check to be amortized. The figure of these deferred expenses under intangible
assets increased by Tk. 155.86 crores in 9 months of 2010 from the Tk. 31.7 crores to Tk. 187.56
crores even after yearly charging these expenses in the year prior to IPO. In addition, these
intangible assets are not deducted from the total assets for the calculation of NAV per share
(furnished in Balance Sheet). Al these raises doubts in managing earnings that affects earnings
quality of the IPO, which have impounding effect on the determination of indicative price.
Besides, the disclosure of existing shareholding structure spelt out in IM (Beximco & its
Associates – 46.18%, foreign investor 6.6%, local Institutions – 10.39% & general public 27.71%) is quite different from that in footnote 3 of detail position in shareholdings of share
capital (Beximco-13.33%, general public & institutions- 76.46%) and the bungling in share
premium account of 240 crores (footnote 4) can not be digested.
In IM of KPCL, there is a projection of financial statements and earnings for the year 2010-2014
as per issuer own assessment and accordingly projected earnings based value has been estimated.
Sub-clause 16 of public issue rule 2006 requires that this projection as per issuer own assessment
is duly certified by the auditor. However, it was not certified by the auditor. To the best of my
knowledge that this rule can only prevail in Bangladesh, nowhere in the world and the author
argues that an auditor can only certify the past statement, not the future.
This paper draws the attention of the author’s own research findings of detection of earnings
management and testing value relevance hypothesis of IPOs in Bangladesh, which came into
public between the period of January 1991 and December 2000. Imam et al (2010) finds
evidence, using Modified Jones’ Model of discretionary accrual testing methodology, that
entrepreneurs of IPOs coming to the market during 1991-2000, behaved myopically in boosting
earnings in the year prior to going public. Mean managed accruals of sample IPO firms accounted
for 6.0% of the total assets (it was around 2.8% of total assets in developed country’s context)
under the Modified Jones’ Model. It is also documented in that study that earnings management
had a positive impact on initial firm’s value.
Concluding Remarks
The paper addresses the IPO process, floatation method and issues for determining IPO Offer
price with premium under Fixed Price method and indicative price under book building method
and in that context, 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. The paper
provides the short run price performance of IPOs that came into public during 1991 to 2007 and
argues that overshooting behavior does exist in the stock market in Bangladesh. This 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
pre-IPO earnings through the accounting choices. Hence this paper argues for exerted role of
auditor in discharging due diligence in ensuring earnings quality, revaluation of assets, while
certifying financial statements and furnishing full, proper and sufficient disclosures for IPO firms
References:
Aharony, J., C. Lin, and M. Loeb. 1993. Initial public offerings, accounting choices, and earnings
management. Contemporary Accounting Research 10: 61-82.
Arkebauer, J.B. (1991). Cashing out. New York: Harper Business.
Dechow, P.M., R.G. Sloan, and A.P. Sweeney. 1995. Detecting earnings management.
The Accounting Review 70: 193-225.
Ellis, K., Michaely, R.M., & O’Hara, M. (1999). A guide to the initial public offering process.
Corporate Finance Review, 3, 14–18.
Gordon, M.J. & Jin, J. (1993). Risk, asymmetric payoffs, and the underpricing of initial public
offerings. Research in Finance, 11, 133–165.
Imam, M. O and Md. Ilias Jaber., (2009). Earning Management of IPOs in Bangladesh-Test of
value Relevance Hypotheses: Evidence from Dhaka Stock Exchange, working paper,
presented in the International Conference organized by AIS, University of Dhaka
Jones, J. 1991. Earnings management during import relief investigations, Journal of
Accounting Research 29: 193-228.
McConaughy, D.L., Dhatt, M.S., & Kim, Y.H. (1995). Agency costs, market discipline and
market timing: Evidence from post-IPO operating performance. Entrepreneurship Theory
and Practice, 20(2), 563–647.
Pagano, M., Panetta, F., & Zingales, L. (1998). Why do companies go public? An empirical
analysis. The Journal of Finance, 53, 27–64.
Ritter, J.R. (1998). Initial public offerings. Contemporary Finance Digest, 2, 5–30.
Rock, K. (1986). Why new issues are underpriced. Journal of Financial Economics, 15, 187–212.
Sutton, D. & Benedetto, W. (1988). Initial public offerings: A strategic planner for raising equity
capital. Chicago: Probus Publishing.
Welbourne, T.M. & Cyr, L.A. (1999). The human resource executive effect in initial public
offering firms. Academy of Management Journal, 42, 616–629