The underpricing of IPOs on the stock exchange of Mauritius

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1 The underprcng of IPOs on the stock exchange of Maurtus Artcle Accepted Verson Agathee, U. S., Sannassee, R. V. and Brooks, C. (2012) The underprcng of IPOs on the stock exchange of Maurtus. Research n Internatonal Busness and Fnance, 26. pp ISSN do: /j.rbaf Avalable at It s advsable to refer to the publsher s verson f you ntend to cte from the work. To lnk to ths artcle DOI: Publsher: Elsever All outputs n CentAUR are protected by Intellectual Property Rghts law, ncludng copyrght law. Copyrght and IPR s retaned by the creators or other copyrght holders. Terms and condtons for use of ths materal are defned n the End User Agreement. CentAUR Central Archve at the Unversty of Readng

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3 NOTICE: ths s the author s verson of a work that was accepted for publcaton n Research n Internatonal Busness and Fnance. Changes resultng from the publshng process, such as peer revew, edtng, correctons, structural formattng, and other qualty control mechansms may not be reflected n ths document. Changes may have been made to ths work snce t was submtted for publcaton. A defntve verson was subsequently publshed n Research n Internatonal Busness and Fnance, 26.2 (2012), DOI: /j.rbaf

4 The Underprcng of IPOs on the Stock Exchange of Maurtus Ushad Subadar Agathee Department of Fnance and Accountng, Faculty of Law and Management, Unversty of Maurtus. Emal: Raja Vnesh Sannassee Department of Fnance and Accountng, Faculty of Law and Management, Unversty of Maurtus. Emal: Chrs Brooks* ICMA Centre Unversty Of Readng Emal: ABSTRACT Ths paper nvestgates the underprcng of IPOs on the Stock Exchange of Maurtus (SEM). Takng nto account the whole populaton of frms whch went publc snce the ncepton of the SEM untl 2010, the results show an average degree of underprcng wthn the range 10 to 20%. Usng a regresson approach, we demonstrate that the aftermarket rsk level and audtor s reputaton both have a sgnfcant postve mpact on ntal returns. We propose the use of the Z-score as a composte measure of a frm s ex ante fnancal strength, and fnd that t has a sgnfcant negatve effect on the degree of short-run underprcng. Keywords: Intal Publc Offerngs, Underprcng; Ex ante Uncertanty hypothess; Underwrter Reputaton Hypothess; Stock Exchange of Maurtus * Correspondng author: Chrs Brooks, ICMA Centre, Unversty of Readng, Whteknghts, Readng RG6 6BA, UK. 2

5 1. Introducton Undoubtedly, ntal publc offerngs (IPOs) have generated an enormous amount of publc nterest and are one of the most researched areas n fnance. Common emprcsms have shown that IPOs are subject to three well documented anomales, namely, the shortrun underprcng of IPOs, the hot ssue market phenomenon and the long-run performance of IPOs. Wth regard to short-run underprcng, ssuers offer shares to nvestors at prces consderably below the subsequently revealed market value. The underprcng of IPOs s anomalous n the sense that t appears to contradct the effcent markets hypothess. In partcular, one would expect the underprcng of IPOs to dsappear over tme as the overwhelmng majorty of nvestors wll recognse the mpled proft opportuntes and make good use of them. However, the underprcng of IPOs seems to be persstent n most markets. Also, t would be dffcult to ratonally justfy the behavour of exstng owners to sell shares to outsders at dscounted prces. The fact that these anomales exst n numerous developed and developng markets makes them even more dffcult to explan. There are a number of theoretcal explanatons and models underpnnng ths IPO underprcng. The popular justfcatons for ths observed phenomenon rest upon the possble exstence of nformaton asymmetres, manly n the form of ex ante uncertantes about share prces. 1 Also, accordng to Welch (1989), Grnblatt and Hwang (1989), and other smlar studes, 2 there exsts a sgnallng mechansm where frms send sgnals to the market by underprcng ther IPOs. Moreover, there are other possble explanatons such as underwrter reputaton theores, nvestor sentment theores and prospect theores to explan the degree of underprcng n the IPO market. However, there are stll gaps n the lterature as most studes have focused on the developed and well known developng markets. Essentally, the newness of the Maurtan market, the relatve lack of nvestor sophstcaton and the dstnct nsttutonal features make the Stock Exchange of Maurtus (SEM) a unque envronment n whch to conduct 1 Rock (1986), Rtter (1984), Rtter (1991), Garfnkel (1993), Ljungqvst and Wlhelm (2003), and Adjas et al. (2011) amongst others. 2 For example, Leland and Pyle (1977), Espenlaub and Tonks (1998), Km et al. (2004), Habb and Ljungqvst (2001), Francs and Hasan (2001), and Loughran and Rtter (1995; 2002). 1

6 research. Addtonally, very lttle research has conducted wth regard to IPOs n Afrcan markets and the lterature s not abundant relatve to that on developed markets such as the US and the UK. Ths may be explaned by the fact that most stock exchanges 3 n Afrca are relatvely young and ndeed, most were set up n the early 1990 s. In partcular, there are only two prevous studes that have been undertaken on Maurtan IPOs by Gasbarro et al. (2003) and Bundoo (2007), focusng on the aftermarket performance and underprcng of IPOs. However, both studes are subject to some caveats. Frst, the sample perods of those studes are lmted. In fact, the frst study only contans frms whch are lsted from 1989 untl 1996, whle the second study takes nto account frms lsted untl Also, for both studes, some frms are not ncluded n the sample. Second, the studes do not consder the sgnfcance of the sgnallng and underwrter reputaton hypotheses n explanng the degree of underprcng. Thrd, the studes do not examne the ssung actvty of seasoned equty offerngs on the SEM. Fourth, the studes do not consder the motves for gong publc on the SEM. Gven these lmtatons, a reassessment of the market condtons of Maurtan IPOs seems warranted. Therefore, ths paper ams to fll the research gap by addressng all the lmtatons present n both studes. In effect, the focus of the research s to take nto account all frms lsted on the SEM from 1989 untl Moreover, the methodologcal contrbuton of ths research s to develop a good proxy for the ex ante uncertanty of the frm n explanng the underprcng of IPOs based on the Altman Z-score model. Indeed, pror studes have focused on varous proxes for ex ante uncertanty based on dfferent accountng ratos. However, most of these accountng ratos reflect a sngle aspect of the frm at one tme. For example, the fnancal leverage rato wll reflect the ex ante uncertanty of the frm by capturng only the gearng level of the company. On the other hand, the Z-score takes nto account several characterstcs of the frm smultaneously, namely lqudty, proftablty, productvty of assets, gearng and ncome generatng ablty. To the knowledge of the authors, applcaton of the Z- score as a proxy for ex ante uncertanty to explan the short-run underprcng of IPOs has not been consdered so far n the lterature. 3 Based on the UNDP 2003, Afrcan Stock Market Handbook. 2

7 The remander of the paper s organsed as follows. Secton 2 revews the key contrbutons n the lterature on the underprcng of ntal publc offerngs. Secton 3 brefly descrbes the Stock Exchange of Maurtus and the nsttutonal framework. Secton 4 outlnes the methodology employed, whle the results are presented and analysed n Secton 5, wth Secton 6 offerng concludng remarks. 2. Pror Research Though many studes have been conducted n dfferent markets, the IPO market n the Unted States remans the most extensvely examned. Overall, wth a few exceptons, most studes clam an average ntal return n the 10-20% range n the US IPO markets. 4 Wth regards to the European markets, the studes show that the average level of underprcng can be below 10% n some European countres and above 20% n other markets. 5 However, compared to the European, the US markets and Latn Amercan markets 6, the average underprcng n most Asan stock markets 7 s consderably hgher. Yet one has to be cautous n any comparsons made across markets as consderaton has to be gven to the dfferences n sample sze, tme-frame and methodologes n calculatng the average ntal returns across the studes. Consderng the Afrcan markets, the emprcal evdence s lmted relatve to research work n other developed and emergng markets. In partcular, the stock markets are relatvely young. Wth the possble excepton of South Afrca, academc research on IPO ssues n general s ether lmted or nonexstent. 8 Overall, the degree of underprcng vares from country to country. Indeed, the characterstcs pertanng to each market are dstnct. Some markets are known to be 4 See, for example, Rtter (1991), Ibbotson et al. (1994), Rtter and Welch (2002), Bommel, Dahya, and Sh (2005), Lowry et al. (2010), and Chahne and Saade (2011). 5 E.g., Jelc and Brston (2003), Kazantzs and Levs (1995), Levs (1993), Ljungqvst (1997), Lyn and Zychowcz (2002), Günther and Rummer (2006), Gounopoulos, Nouns, and Stylandes (2007), Boulton et al. (2007), and Banerjee et al. (2011). 6 Aggarwal et al. (1993), Brau et al. (2009) 7 E.g., Km et al. (1993), Hameed and Lm (1998), Isa and Yong (2003), Hbara and Mathew (2004), Chen, Cho, & Jang (2007), Chorruk and Worthngton (2010), Samarakoon (2010), and Moshran, Ng and Wu (2010). 8 A few noteworthy publshed studes on Afrcan markets are Reyneke and Page (1997), Omran (2005), Gasbarro, Bundoo and Zumwalt (2003),All, Subrahmanyam and Gleason (2008) and Adjas et al. (2011). 3

8 hghly sophstcated and well developed; others are termed emergng markets whle a few markets wll be regarded as small and underdeveloped. Pror studes n emergng markets are sgnfcant to ths research gven that the Maurtan market can be categorsed as a relatvely young and emergng market. As such, the lterature n the context of emergng markets show that IPOs from the Chnese, Bangladesh and Indan markets 9 seems to enjoy the hghest average ntal returns (more than 90%). In partcular, Jenknson and Ljunqvst (2001) clam that these levels are hgher relatve to other emergng markets. However, the exstng evdence of underprcng n other Asan emergng markets shows ntal returns of 21.43%, 61.81% and 70.30% n Hong Kong, Malaysan and Korean markets respectvely. 10 In partcular, t seems that the emergng Asan markets are experencng a much larger degree of underprcng than markets n any other regon. 2.1 Theores and Models of Underprcng A smple theoretcal framework ntegratng all factors affectng underprcng does not yet exst. Therefore, a number of competng theoretcal models have been developed to explan the ntal underprcng of stocks. The man theores found n the IPO lterature are the Wnner s Curse hypothess, Bookbuldng theores, the Prncpal-Agent hypothess, Sgnallng theores, the Law-sut avodance hypothess, the Ownershp and Control hypothess and the Investor Sentment theory. One of the most mportant models of underprcng s the one developed by Rock (1986) based on the wnner s curse hypothess. Rock dstngushes between nformed and unnformed nvestors. If the ssues are underprced, IPOs wll be oversubscrbed by nformed nvestors, resultng n a lmted number of shares beng avalable to unnformed nvestors. If the ssues are overprced, IPOs wll be sold exclusvely to unnformed nvestors who wll earn negatve ntal returns. Thus, unnformed nvestors wll be wnnng the entre ssue but at an unfavourable prce, creatng a stuaton termed the wnner s curse. In order to keep unnformed nvestors n the IPO market, securtes are offered at a dscount from ther expected after market prces. Thus, accordng to the 9 See Chen, Cho, & Jang (2007) for the Chnese market, Islam et al. (2010) for the Bangladesh market and Ghosh S. (2002) for the Indan market. 10 Moshran, Ng and Wu (2010). 4

9 Wnner s Curse theory, IPO underprcng should decrease f the nformaton asymmetry between nformed and unnformed nvestors s reduced. One of the most common actons to reduce underprcng s to seek assstance from a prestgous underwrter or audtor to certfy the qualty of the ssue. 11 Ths may decrease the number of nformed nvestors n the market and as such, reduce the wnner s curse problem. However, more recently, Hoberg (2007) and Lu and Rtter (2011) clam that prestgous underwrters wll underprce more as they beneft from underprcng. In partcular, Hoberg (2007) predcts that hgh underprcng underwrters have access to superor nformaton, and they use ther advantage to wn mandates wth more valuable ssuers. The emprcal evdence as to whether more prestgous underwrters are assocated wth lower underprcng s mxed. On one hand, Carter and Manaster (1990) and Meggnson and Wess (1991), usng data on the US market from the 1970s and 1980s, fnd a negatve relatonshp between ntal returns and underwrter reputaton, whlst on the other, Beatty and Welch (1996), usng data from the 1990s, clam a postve relatonshp. Accordng to Loughran and Rtter (2004), the shft n ths relatonshp may be due to a strategc decson by prestgous banks ether to favour ther nvestment clents or to weaken ther crtera for selectng IPOs. Furthermore, Beatty and Rtter (1986) extended Rock s model of underprcng to predct a postve relatonshp between underprcng and ex ante uncertanty. Accordng to Beatty and Rtter (1986), the greater the ex ante uncertanty about the value of a new ssue, the greater wll be the assocated nformaton asymmetry, leadng to hgher underprcng. In lne wth ths dea, emprcal studes have employed varous proxes for ex ante uncertanty. Accordng to Ljungqvst (2006), the proxes can be loosely categorzed nto four groups: company characterstcs, offerng characterstcs, prospectus dsclosure, and aftermarket varables. Consderng company characterstcs, some studes have used age, 12 frm sze, 13 or ndustry. 14 For nstance, Beatty and Rtter (1986) predct a negatve 11 Booth and Smth (1986), Ttman and Trueman (1986), Carter and Manaster (1990), Mchaely and Shaw (1994) and Carter et al. (1998). 12 Rtter (1984), Rtter (1991), Garfnkel (1993) and Ljungqvst and Wlhelm (2003), and Adjas et al. (2011). 13 Rtter (1984), Beatty and Rtter (1986), Levs (1990), and Adjas et al. (2011). 14 Benvenste, Ljungqvst, Wlhelm, and Yu (2003), and Al-Hassan et al. (2010). 5

10 relatonshp between a frm s sze and underprcng gven that small frms prces are assumed to be more volatle and uncertan. Accordng to Beatty and Rtter (1986), the sze of IPOs can be used as a proxy for ex ante uncertanty about ther ex post value. The exstng evdence on IPO performance suggests that a smaller ssue s more lkely to have greater ntal underprcng followed by a worse aftermarket performance. Also, rsk factors 15 and uses of gross proceeds 16 dsclosed n the prospectus, can serve as proxes for ex ante uncertanty. Smlarly, some studes 17 have focused on aftermarket varables such as volatlty or tradng volume. For nstance, Reber and Fong (2006), usng a sample of 100 Sngaporean ntal publc offerngs (IPOs) durng the perod , fnd a postve and sgnfcant relatonshp between underprcng and after-market tradng volume on the frst day of tradng. On the other hand, bookbuldng theores 18 consder underprcng as a mechansm used by underwrters to extract prvate nformaton from nvestors. The theory predcts hgher levels of underprcng to be assocated wth hgher levels of nformaton asymmetry between underwrters and nvestors. In effect, based on the Benvenste and Spndt (1989) framework, the nvestment bank can provde some ncentves to reveal truthful nformaton manly n terms of awardng the ssue to nvestors that bd n the most aggressve way aganst those that bd conservatvely. However, for nvestors to be aggressve and wantng to reveal ther nformaton, underwrters wll have to leave money on the table,.e. the ssues wll have to be underprced. Moreover, the prncpal-agent model documents the nformaton asymmetry between ssuers and underwrters, wth the latter havng an expertse n marketng shares. As such, the underwrter has an ncentve to underprce the shares ether to reduce marketng 15 Beatty and Welch (1996), and Jog and Wang (2002). 16 Beatty and Rtter (1986), Islam et al. (2010), and Samarakoon (2010). 17 Mller and Relly (1987), Rtter (1984, 1987), Wasserfallen and Wttleder (1994), and Reber and Fong (2006). 18 Benvenste and Spndt (1989), Hanley (1993), Cornell and Goldrech (2003) and Jenknson and Jones (2004). 6

11 efforts or to favour some establshed clents. Accordng to Loughran and Rtter (2004), there s a prncpal-agent problem between the ssuer (prncpal) and the underwrter (agent) n that the agent wll not always act n the best nterests of the prncpal. To ths effect, Baron (1982) argues that nvestment banks (underwrters) have an ncentve to underprce as a way of favourng ther establshed clents. There are mechansms such as underwrtng fees beng dependent on IPO proceeds that can control the agency problem faced by ssuers. However, underwrters may, at tmes, be rewarded more by the commssons receved from underprcng the ssues than by the ncrease n underwrtng fees. Other theoretcal models post the dea of underprcng as a sgnallng mechansm used by frms. Based on the sgnallng models developed by Welch (1989) amongst others, 19 hgh qualty frms underprced ther IPOs n order to sgnal ther hgh valuatons to the market. In fact, underprcng n such cases wll ntally brng reduced ssue proceeds to the frm but wll leave a good taste n nvestors mouths. 20 However, gven the ntal good sgnal sent to the market, the frm wll be able to make a subsequent seasoned offerng at a hgher prce. Thus, the ntal reducton n ssue proceeds s assumed to be recovered n subsequent offerngs. Therefore, underprcng s vewed as a sgnal of frm qualty n the market. However, accordng to Allen and Faulharber (1989), underprcng s just one among several varables whch can be used to sgnal a gven frm s qualty. For nstance, the choce of underwrters, 21 choce of audtors, 22 board of drectors, operatng results, etc. can be used to covey nformaton about a frm s qualty Furthermore, the lawsut avodance hypothess clams that companes underprce ther shares to reduce the probablty of lawsuts from nvestors due to any omssons or errors n the prospectus. 23 Rtter (1998) argues that ths hypothess s consstent wth the provson of the Securtes Act 1933 n the US, where omssons of sgnfcant materals can set off lawsuts. Consstent wth the predctons of the lawsut avodance hypothess, 19 Grnblatt and Hwang (1989), Allen and Faulhaber (1989) and Ravd and Spegel (1997). 20 Ibbotson (1975). 21 Booth and Smth (1986), and Corwn and Schultz (2005). 22 Ttman and Trueman (1986), Beatty (1989), and Adjas et al. (2011). 23 Based on the basc dea of Logue (1973) and Ibbotson (1975). 7

12 Banerjee et al. (2011) clam a postve relatonshp between the accessblty of legal recourse and IPO underprcng usng a sample of 8,776 IPOs from 36 countres. However, accordng to Ljungqvst (2006), the securtes laws are specfc n that some countres do have strct lablty laws. Yet, underprcng s observed worldwde. As such, the lawsut hypothess may be regarded as a second drver of underprcng. Indeed, many researchers 24 have concluded that the probablty of lawsuts s nsgnfcant n markets such as Australa, Japan, Germany, the UK, Fnland, etc. In addton, Brennan and Franks (1997) consder montorng costs as an ncentve to underprce. They develop the reduced montorng hypothess to clam that frms have an ncentve to underprce the IPO of ther frm s stock to ensure ts wde dstrbuton, thus reducng the lkelhood of beng montored or removed by new shareholders, and n partcular, by large nsttutonal shareholders. Managers or drectors have some prvate benefts, whch may not be consstent wth the benefts of shareholders or non-drectors. As such, there s a conflct of nterest or an agency problem between managng and nonmanagng shareholders. Wthn ths agency-cost framework, Brennan and Franks (1997) argue that managers have an ncentve for more dffused ownershp through the underprcng of shares to avod beng montored by a large outsde shareholder. In effect, managers use underprcng as a means of control. Based on the nformaton cascades theory, Welch (1992) argues that ssung companes underprce to attract the frst few potental nvestors to buy, and thereby nduce a cascade n whch all subsequent nvestors want to buy rrespectve of ther prvate nformaton. In such a stuaton, nvestors look nto whether the ssues are strongly demanded or not before decdng to subscrbe. Essentally, subsequent nvestors, gnorng ther own prvate nformaton, would examne the reactons of earler nvestors. Hence, t can be argued that companes underprce to set up a cascade effect to attract those subsequent nvestors. Fnally, nvestor sentment theores argue that optmsm from nvestors wll lead to the underwrter settng a hgher offer prce beyond the fundamental prce as t s expected 24 Ljungqvst (1997) and Keloharju (1993). 8

13 that these nvestors wll buy shares n the aftermarket. However, as the prce reverts to ts fundamental value n the long run, underperformance s observed. To ths effect, Aggarwal and Rvol (1991) document fads or overvaluatons n the IPO market usng a sample of 1598 offerngs for the perod Essentally, they fnd that prces fall n the year followng ther offerngs. Also, Rtter and Welch (2002) report over-enthusasm among retal nvestors whch may account for the ntal tradng prce rse as well as for low aftermarket returns on the frst few years. Addtonally, Derren (2005) documents a postve lnk between nvestor sentment, proxed by large ndvdual nvestors demands, and hgh ntal returns. 3. An Overvew of the Stock Exchange of Maurtus (SEM) The Stock Exchange Act was enacted n 1988 to provde for the settng up of a Stock Exchange Commsson (SEC), a regulatory body, as well as the Stock Exchange of Maurtus Ltd (SEM), a prvate company, establshed to operate and mantan the stock exchange. On 5 July 1989, the frst tradng sesson took place wth fve companes lsted on the offcal market. Also, the SEMDEX, 25 a market-weghted ndex, was created to reflect the collectve prce movements of all companes lsted on the offcal market. In 1990, the over the counter (OTC) market, now known as the Development and Enterprse market (DEM), and the debt market, were launched. Furthermore, the offcal market of the Stock Exchange has categorsed the companes lsted nto 7 sectors namely, Banks and Insurance, Industry, Investments, Sugar, Commerce, Lesure & Hotels, and Transport. Other major developments n the Maurtan equty market nclude the settng up of a centralsed clearng and settlement system n 1997, the settng up of a new regulatory body known as the Fnancal Servces Commsson n 2001, and the mplementaton of the Stock Exchange of Maurtus Automated Tradng System (SEMATS), replacng the open-outcry sngle aucton method and the replacement of the old Stock Exchange Act 1988 by the Securtes Act 2005, amongst others. 25 The SEMDEX s an all shares ndex. It reflects captalsaton based on each lsted stock whch s weghted accordng to ts shares n the overall market. The current value of the SEMDEX s expressed n relaton to a base perod, 5 July 1989, wth a value of

14 4. Research Methodology 4.1 Sample and Data Collecton Methods The sample used n ths study conssts of all Maurtan frms whch went publc on the offcal market of the Stock Exchange of Maurtus for the perod 1989 untl Gven the lmted number of frms, we have ncluded those whch delsted durng the sample perod. 26 However, Gasbarro et al. (2003) argue that the sample sze s also relatvely small n other emergng market IPO studes. For nstance, Hameed and Lm (1998) and Omran (2005) both use a sample sze of 53 frms to assess IPO anomales on the Sngaporean and Egyptan markets respectvely. There are also other studes such as Lyn and Zychowcz (2002), and Dawson (1987), who consder 33 and 21 new ssues on the Hungaran and Malaysan markets respectvely. Four types of data are requred for the purpose of the study: prospectus data, annual reports, publcatons by the stock exchange and share prce data. The prospectus s used to collect data pror to lstng. These nclude the offer prce, ssue detals, dates and amounts, the sponsorng stockbroker, the audtor, and fnancal nformaton from balance sheets and ncome statements. However, for some frms there s no prospectus and n such cases the annual reports before the year of lstng are used to collect ex ante nformaton. Also, nformaton on the ssue detals of such frms s manually collected from the Regstrar of Companes, whch keeps fles for all prvate and publc companes n Maurtus. Furthermore, the SEM Handbook, whch provdes a fve year summary of ncome statements and balance sheets for all lsted companes, s also consulted. Moreover, the SEM Factbook, an annual publcaton ssued by the SEM to dssemnate nformaton to nvestors, s used to collect nformaton on the man market ndcators as well as nformaton pertanng to rghts ssues and bonus ssues by lsted companes. In addton, daly prce hstores were collected for each sample frm through the perod 1989 to In partcular, daly share prce data for all sample frms from the lstng date up to three years subsequent to lstng are obtaned from the SEM s own quotes as well as from dfferent stock brokng companes. Fnally, the SEMDEX values for the perod 1989 to 2010 are collected to proxy the market returns. 26 There are seven frms whch have delsted durng the perod The SEM codes for these frms are CIT, COURTS, DELPHIS, GBH, LIT, MDA(O) and MOUNT. 10

15 4.2 Underprcng Measurement There are a number of methods avalable to compute a measure for underprcng. For comparatve purposes, the basc methodology followed n ths study s smlar to those used n earler studes. 27 A smple, raw measure of underprcng or frst day ntal return (R 1 ) for each frm s calculated from the date of ssue as follows: R 1 ( P 1 / P 0) 1 where P 0 s the offer prce of the frm, P 1 s the frst day closng prces of the shares n frm, and R 1 s the total frst day return on the stock. (1) If markets are hghly volatle such that there s a major change n the prce of most stocks durng the IPO perod, then ntal returns should be market adjusted. To compute the frst day market adjusted return, the return of the market ndex s ntally calculated as R P / P ) 1 (2) m1 ( m1 m0 where R m1 s the one-day return for the market ndex (SEMDEX) correspondng to the offerng by frm, P m1 s the closng value of the market ndex on the ssue date correspondng to the offerng by frm and P m0 s the value of the market ndex correspondng to the offerng prce of the frm. The market adjusted return abnormal return for each IPO on the frst tradng day s therefore computed as: MAAR {[(1 R 1) /(1 Rm 1)] 1} where MAAR 1 s the one day excess return correspondng to the ssue by frm, R 1 s the one day return for frm, and R m1 s the one day return for the market ndex correspondng to the offerng by the frm. (3) 27 See the studes from McDonald and Fsher (1972), Aggarwal, Leal and Hernadez (1993), Affleck- Graves, Hegde and Mller (1996), Dongwe and Flesher (1999), Mok and Hu (1998), and Paudyal, Saadoun and Brston (1998). 11

16 However, the measure n equaton (3) rests upon the assumpton that the systematc rsk of the IPOs under consderaton s the same as that of the ndex. Indeed, t s hghly unlkely that the betas of the IPOs average to unty, as a number of studes (e.g., Ibbotson (1975), and Affleck et al. (1996)) have shown that the average betas of the newly lsted frms are systematcally hgher than one. As such, the MAAR 1 may be upwardly based n the sense that a hgher ntal performance of the IPO relatve to the market could be observed. 28 The average frst day ntal return ( R 1 ) and the average frst day market adjusted return ( MAAR ) are calculated as R 1 1 N N 1 R 1 (4) MAAR 1 N N 1 MAAR 1 (5) Accordng to Kool and Suret (2002), frst day returns are generally approprate where there s no tme gap between the applcaton closng date and the frst day of tradng. As such, some studes 29 have used frst week or frst month returns to assess the degree of underprcng. The tme gap for the Maurtan market s relatvely long compared to developed markets and so t may be useful to consder frst week or frst month returns, although they are rarely used as measures of underprcng n the lterature. To calculate the underprcng level based on frst week or frst month returns, the same methodologes as defned above are used. 28 To cater for ths anomaly, t would be most approprate to construct a portfolo havng the same rsk as the IPO. As such, some studes (e.g., Rtter, 1991; Loughran and Rtter, 1995) consder ntal returns whch are adjusted by takng nto account the returns of matchng frms. However, matchng adjustment methods are rarely used, probably because t s tme consumng and dffcult to fnd matchng frms unless there s a very large sample avalable to the researcher. Indeed, the sample sze s sgnfcantly lmted for the Maurtan market. Therefore, the MAAR 1 wll be used as an adjustment to the raw underprcng measure. Ths s also consstent wth the exstng lterature whereby most studes prefer to use the market adjusted returns. 29 Relly and Hatfeld (1969), McDonald & Fsher (1972), and Beatty and Rtter (1986). 12

17 4.3 Explanng the Short-run Underprcng of IPOs: The Regresson Model To explan the factors accountng for the short run underprcng of IPOs, two measures are used as the dependent varable: the smple raw ntal returns and the market-adjusted ntal returns of IPOs that went publc from 1989 untl The explanatory varables, based on the lterature dscussed above, nclude proxes for the ex ante uncertanty of the frm, sgnallng mechansms and underwrter reputaton. The multple regressons employed are Rt 1ROA 2SIZE 3AGE 4FINLEV 5RISK 6ZSCORE EPS SEO BROKREP AUDITREP u (6) MAAR t ROA SIZE AGE FINLEV RISK ZSCORE EPS SEO BROKREP AUDITREP u (7) where R and MAAR 1 1 are the frst day raw and excess return (as defned above) correspondng to the ssue by frm respectvely. A descrpton of the ndependent varables used as well as the expected relatonshps s summarzed n Table 1. [INSERT TABLE 1 AROUND HERE] 4.4 The Fnancal Strength of IPOs and the Altman Z-score Model Accordng to Gasbarro et al. (2003), the fnancal strength of IPOs can be proxed usng Altman s (1968) Z-score model, whch was ntally used to predct the survval rates of publc companes. To the authors knowledge, there has not been any comprehensve applcaton of the Z-score model to estmate the ex ante fnancal strength of IPOs. Altman (2000) argues that, the most frequent nqury that I have receved from those nterested n usng the Z-Score model s, What should we do to apply the model to frms n the prvate sector?. To ths effect, Altman (2000) undertakes a re-estmaton of the orgnal Z-score model. 30 In ths model, the book value of equty s replaced by the market value of equty. As such, based on Altman s bankruptcy model, the fnancal strength of IPOs s measured as Z 0.717X X X X X5 (8) 30 Altman (2000) suggests a complete re-estmaton of the model.rather than smply nsertng a proxy varable nto an exstng model to calculate Z-scores. 13

18 where Z proxes the fnancal strength of frm and X 1, X 2, X 3, X 4 and X 5 measure the lqudty, proftablty, productvty of assets, leverage and ncome generatng ablty of the frm respectvely. In partcular, frms wll be parttoned nto two categores, hgh and low fnancal health groups, based on the Z-scores. Followng Altman (2000), those frms havng of a score less than 1.23 wll be consdered to be n the low fnancal health group. 5. Analyss and Fndngs 5.1 Aggregate Underprcng The secton examnes whether an nvestor who bought all IPOs from when the SEM was set up untl 2005 at the offer prce and sold them on the frst day, frst week or frst month of ther lstng, earned a sgnfcant abnormal return. In partcular, a fxed amount of money s assumed to be nvested n every IPO. As such, the null hypothess entals that the average raw or abnormal returns are not sgnfcantly dfferent from zero. Table 2 reports the average frst day, frst week and frst months returns for the 44 IPOs durng the perod 1989 to It s observed that the average raw (unadjusted) ntal return s 14.29%, whle the average market ndex-adjusted ntal return s 13.14%. In addton, an nvestor can earn at least an addtonal average return of 3% f the IPOs are held ether untl ther frst week or frst month of lstng. The average returns are the hghest f the nvestor buys and holds every IPO untl the end of ther frst month. However, one must also note that rsks are the hghest for frst month returns relatve to the frst day or frst week returns. [INSERT TABLE 2 AROUND HERE] As the dstrbuton of the frst day, frst week and frst month returns are not symmetrc, 31 a bootstrapped skewness-adjusted t-statstc 32 s used to test the null hypothess of no sgnfcant average return. The results show that n all cases, the returns are statstcally sgnfcant at the 1% level, ndcatng that Maurtan IPOs are on average underprced. Ths evdence s consstent wth that for almost all IPO markets n dfferent countres. In partcular, t s found that the level of underprcng on the SEM s consstent wth fndngs 31 The mean beng greater than the medan n all cases, mplyng that the returns are postvely skewed. 32 The bootstrapped skewness-adjusted t-statstc s developed by Lyon, Barber, and Tsa (1999). Rajesh Tharyan and Scott Merryman from Centre for Fnance and Investment, Unversty of Exeter, UK provded the programme code n Stata to compute the skewness adjusted t-statstc. 14

19 for countres such as the U.S, U.K, Australa, and Germany, where the degree of underprcng s found to be n the range 10-20%. 33 However, the extent of average underprcng s much smaller when compared to some major South-East Asan markets such as Malaysa, Korea, Thaland, Sngapore or Japan, 34 where an average underprcng level of least 30% s reported. Compared to the Afrcan markets, Maurtan IPOs generally experence a hgher degree of average underprcng, as All et al. (2010) and Omran (2002) report an average frst day return of 7.08% and 8.4% on the South-Afrcan and Egyptan markets respectvely. From Table 2, one can note that the average frst day return s around 14%. Also, most of the prce reactons are lkely to occur durng the frst days of tradng gven that the ntal frst day market adjusted return s approxmately 13%, whle the frst week and frst month underprcngs do not exceed 17%. Ths s n lne wth Aggarwal et al. (1993), where an underprcng level of 78.5% s observed for the Brazlan market on the frst day of tradng whle monthly underprcng (ncludng the frst day) s 90.2%. Although there may be postve average ntal returns on the Maurtan IPO market, there s a wde varaton across the ndvdual ssues. None of these IPOs suffer from negatve ntal returns and one n four IPOs closes on the frst day at the offer prce. The probablty of an IPO closng at the offer prce s relatvely hgher n the Maurtan market consderng that Rtter (1998) reports that one n sx IPOs termnates at the offer prce on the US market. In addton, a lmted number of companes (only eght out of 44) on the Maurtan market have exceeded a return of 20% on ther frst day. In fact, there are only two IPOs whch have managed to earn a return of greater than 50%. Overall, eght out of ten IPOs on the Maurtan market have a return between 0 and 20% on ther frst day. 33 Rtter and Welch (2002) for the US markets, Levs (1993) for the UK market, and Ljungqvst (1993) for the German Market. 34 Isa & Yong (2003) for the Malaysan market, Km, Krnsky and Lee (1995) for the Korean Market, Dawson (1987) for the Sngaporean market, and Hbara and Mathew (2004) for the Japanese market. 15

20 5.2 The Sze Effect and Average Underprcng To analyze the effect of the frm s sze on the ntal returns of the companes on the SEM, the sample s dvded accordng to the medan market captalsaton of the frm. In lne wth the ex ante uncertanty hypothess where small frms are subject to more ex ante uncertanty, Table 3 shows that average unadjusted and market adjusted ntal returns are hgher for smaller companes and lower for larger companes. However, the Wlcoxon test shows that the dfference n the underprcng between large and small frms s statstcally nsgnfcant. In effect, when the sample s segregated nto quartles, there are no dscernble patterns between the market captalzaton and the level of underprcng. Hence, on the bass of those results, the sze of the company gong publc on the SEM s not related to the return obtaned by the nvestor on the IPO. Ths result s nconsstent wth the fndngs of Rtter (1991), Barry et al. (1991) and Clarkson and Merkley (1994) amongst others. However, ths result may be supported by the fact that the large frms n ths sample are not really large by nternatonal standards. [INSERT TABLE 3 AROUND HERE] 5.3 Motves for Gong Publc and Average Underprcng To reflect the ssuers motves for gong publc, the sample s dvded nto two categores by offer type. In the Maurtan context, as per the lstng rules of the SEM, t s only when frms go publc through an offer for subscrpton that new shares are ssued and sold to the publc, whereas other methods of lstng such as ntroducton, offer for sale or placngs do not nvolve any ssue of new securtes. As such, n Table 4, the NEW category ncludes 14 frms ssung new shares only whle 30 frms n the OLD category offer old shares. In partcular, frms normally ssue new shares as a means to fund captal projects. However, snce the ncepton of the SEM, a relatvely low proporton of frms have gone publc wth the prmary motve of rasng captal. In the Maurtan context, ths can be explaned by the fact that frms were manly attracted to the tax reductons from 35% to 25% whch were provded to lsted companes by the government n the early 1990s as an ncentve to boost the local stock exchange. Also, frms were keen to lst as the stock exchange provded opportuntes for exstng shareholders to ncrease the marketablty of ther shares. 16

21 As documented by Km et al. (1993), f frms need funds for projects, there wll be more pressure on the IPO proceeds, leadng to a lesser degree of underprcng. As expected, the ntal performance of the NEW group, 15.05%, s hgher than the OLD category, 12.24%. However, a test for the dfference of performance between the two groups s statstcally nsgnfcant. As such, the results confrm that, on the SEM, the degree of underprcng does not depend on the motves of the frm gong publc. [INSERT TABLE 4 AROUND HERE] 5.4 Stock Broker Reputaton, Audtor Reputaton and Average Underprcng Accordng to Carter and Manaster (1990), hgh qualty underwrters are, on average, assocated wth IPOs whch have a lower degree of underprcng. In order to test ths hypothess, two proxes are used, namely the stockbroker s reputaton and the audtor s reputaton. In the fnance lterature, pror studes 35 have tradtonally focused on frm sze as a proxy for measurng qualty. 36 DeAngelo (1981) argues that the ratonale for ths standard s that larger audt frms supply hgher qualty snce they stand to lose more than smaller frms n terms of reputaton. In ths respect, stockbroker reputaton s measured takng nto account the number of IPOs whch have been sponsored by respectve stockbrokers whle the measure of audtor reputaton takes nto account the proporton of the total number of IPOs whch have been audted by that frm. The sample s ntally parttoned nto two groups on the bass of stockbroker and audtor qualty (HIGH and LOW). In partcular, frms are grouped n the hgh category f they are sponsored by ether MCB or CIM Stockbroker Ltd snce these two stockbrokng companes capture more than 55% of the IPO market. Smlarly, frms whch are audted by DCDM are grouped n the hgh category as DCDM audts more than 55% of lsted frms on the offcal market of the SEM. From Table 5, 29 and 25 out of 44 offerngs are brought to the market by hgh qualty stockbrokers and audtors respectvely. [INSERT TABLE 5 AROUND HERE] Wth regards to stockbroker reputaton, Table 5 shows that the average values for the ntal unadjusted prce run-up are hgher, as expected, f ssues are sponsored by low 35 Becker et al. (1998), DeAngelo (1981), Francs and Wlson (1988) and Krshnan and Schauer (2000). 36 However, Beatty (1989) argues that the classfcaton of a frm s sze may be nsuffcent for capturng varatons n audt qualty. 17

22 qualty stockbrokng companes. However, when returns are market-adjusted, ths result s nsgnfcant. Moreover, a test for the dfference of performance between the HIGH and LOW stockbroker groups s statstcally nsgnfcant. Based on these results, the degree of underprcng s not related to the reputaton of stockbrokers on the SEM. As far as the audtor s reputaton s concerned, Table 5 ndcates that the average ntal prce run-ups are postvely related to the qualty of the audtor. The mean of the ntal market adjusted returns s 15.09% for HIGH qualty audtors and 10.57% for LOW qualty audtors. Also, the average unadjusted and adjusted ntal returns of IPOs n the HIGH audt category are hgher than the underprcng level of IPOs n the LOW audt category. The Wlcoxon test shows that the dfference n the underprcng s statstcally sgnfcant at the 5% level. In effect, one would expect that a hgher audtor s reputaton wll be assocated wth lower ex ante uncertanty so that such frms should exhbt a lower degree of underprcng. Ths result s confrms the sgnfcance of the sgnallng effect of audtor s qualty n the Maurtan market. In partcular, the value of the IPO seems to be an ncreasng functon of the audtor s qualty such that the appontment of hgher qualty audtors contrbutes to hgher underprcng. Measurng stockbroker and audtor reputaton s somewhat trcky n Maurtus snce the market s completely domnated by two frms that capture over half of the market share. Those bg frms are manly the local poneerng fnancal servces provders and have buld a sold reputaton over the years such that there are less uncertanty surroundng ther future. In ths respect, the context of Maurtan market qute unque gven the smallness of the market and the monopolstc nature of ts fnancal servces ndustry. In effect, to test the valdty of the reputaton measure, the audtng and stock brokng frms were also ranked n terms of ther turnover and age. The results are consstent wth our earler predctons n that those frms wth the hghest turnover and age also fall wthn the hghest reputaton category. As such, we consder the number of IPOs sponsored or audted as a reasonable proxy for the stock brokerng or audtng frms reputaton. Ths measure has also been adopted by a number of exstng studes 37 n the lterature. 37 Francs and Wlson (1988), Becker et al. (1998), Jelc et al. (2001), Krshnan and Schauer (2000) and Bulut et al. (2009) 18

23 5.5 Fnancal Strength and Average Underprcng Table 6 presents nformaton on the relatonshp between the fnancal strength and the level of underprcng. In partcular, fnancal strength s proxed by the Altman (2000) Z- score. The sample s parttoned nto HIGH and LOW fnancal strength groups. Frms havng a score less than 1.23 are placed n the LOW fnancal health group. From Table 6, the results show that there are slghtly more frms n the HIGH fnancal group. Also, the average underprcng s hgher for frms n the HIGH strength group than frms wth lower fnancal strength. In addton, the Wlcoxon test shows that the dfference n underprcng s statstcally sgnfcant at the 5% level. The results are consstent wth the ex ante uncertanty hypothess 38 but nconsstent wth the predctons of sgnallng theores as supported by Allen and Faulhaber (1989), Welch (1989) and Grnblatt and Hwang (1989). [INSERT TABLE 6 AROUND HERE] Whle the Z-score s probably the most relable and well respected composte measure of fnancal strength, n order to nvestgate ts robustness, we also employ another proxy based on aftermarket nformaton. In partcular, based on the a number of prevous studes, 39 the return to rsk rato s used and s calculated as the average monthly return durng the frst three years of lstng dvded by the standard devaton of post IPO returns. The results show that hgher fnancal strength s assocated wth lower average underprcng, consstent wth when the Altman Z-scores are used as proxes for fnancal strength. In addton, through further analyss, companes wth lower Z-scores seem on average to have lower return to rsk ratos and vce-versa. To ths effect, the Z-score model based on fnancal statement nformaton seems to be consstent wth the rskreturn partton whch s based on market returns. 5.6 Short-Run Aftermarket Performance and Average Underprcng Table 7 presents the ntal and short-term returns for the sample of IPOs lsted on the SEM. On average, the nvestor earns a return of 13.14% f the stock s bought at the offer 38 Rtter (1984), Beatty and Rtter (1986), Rtter (1991), Garfnkel (1993), Ljungqvst and Wlhelm (2003), and Ljungqvst (2006), amongst others. 39 Rtter (1991), Carter and Manaster (1990). 19

24 prce and sold thereafter on the secondary market on the frst lstng date of the IPO. However, for those buyng IPOs n the aftermarket, the opportunty to earn a smlar average return s not avalable as the hghest average abnormal returns after the frst day of tradng do not exceed 3.67%. In fact, after the fourth day of tradng, the average ntal abnormal return turns negatve. As such, for the overall sample, the observed ntal abnormal day-to-day returns are postve but dsspate beyond the frst four days of tradng. Ths fndng s consstent wth results for the South Afrcan market where All et al. (2010) clam that the opportunty for an abnormal return s only avalable to those nvestors able to buy the offerng at the offer prce and not to those buyng these stocks n the aftermarket. [INSERT TABLE 7 AROUND HERE] Consderng the ntal returns by ndustry segment, IPOs n the Commerce sector seem to beneft from postve average abnormal returns durng sx out of seven days after the lstng event. However, the ntal average market adjusted return s postve and hghest on the lstng date, but fall after the frst few days of tradng. Ths fndng also seems consstent when controllng for market sze, offer sze, offer type, stockbroker reputaton, audtor reputaton and fnancal strength. 5.7 Underprcng Regresson Analyss and Emprcal Results In ths secton, several cross-sectonal regressons are estmated usng ordnary least squares (OLS) to assess the factors affectng short-run underprcng. In partcular, the dependent varable s level of underprcng based on two proxes, namely the ntal raw returns and the market-adjusted ntal returns. 40 The explanatory varables are proxes based on the ex ante uncertanty hypothess, the sgnallng hypothess and the underwrter reputaton hypothess. The regresson results to explan the short-run ntal raw returns are presented n Table 8. There s no serous multcollnearty among any of the explanatory varables and heteroscedastcty n the resduals s accounted for by adjustng the standard errors usng the procedure of Whte (1980). 40 However, only the results from the regressons usng the market-adjusted returns are presented to avod repetton. The fndngs are qualtatvely dentcal. 20

25 Despte that we nclude all IPOs on the Maurtan market snce ts ncepton, the sample sze s necessarly small. Therefore, n order to ensure that our nferences are as robust as possble and to account for the mpact that non-normalty of the resduals may have at such sample szes, we mplement a bootstrap procedure to construct p-values for each parameter n a fashon that does not requre the normalty assumpton. Specfcally, the bootstrap approach that we adopt s conducted as follows. For all models estmated, we collect the resduals and produce 10,000 bootstrapped samples each of the same sze as the orgnal sample (44 observatons). For each of these replcatons, we reconstruct the dependent varable by addng the resampled resduals to the orgnal regresson ftted values to obtan a set of bootstrapped observatons on the dependent varable. We then rerun the regresson for each of these 10,000 replcatons and collect the t-ratos for each parameter estmated. We can then compare the actual t-ratos wth these smulated dstrbutons to obtan a bootstrapped p-value for each parameter that can be examned alongsde the conventonally calculated p-values. Ths approach s adopted for all of the regressons that we conduct n ths study. The frst regresson model n Table 8 tests for the relevance of the ex ante hypothess to explan the short-run underprcng of IPOs. Model 1 shows that, among several proxes for the ex ante uncertanty of IPOs, the aftermarket rsk level and the ex ante fnancal strength are the only varables whch are statstcally sgnfcant at the 5% and 10% levels respectvely. In effect, the results confrm a postve and margnally sgnfcant relatonshp between underprcng and the aftermarket rsk level. In addton, the results show that frms wll on average underprce less f they are fnancally stronger. Nether s sgnfcant accordng to the bootstrapped p-values for the large models ncludng all ten explanatory varances, although they are sgnfcant n model 5. These results are consstent wth the predctons of prevous studes, 41 and confrm that the greater s the ex ante uncertanty of the ssue, the greater s the expected underprcng. However, other varables such as the return on assets, age, sze of the offerng and fnancal leverage, actng as proxes for the ex ante uncertanty of the ssue, are statstcally nsgnfcant n the Maurtan market. In ths respect, t must be hghlghted that none of the accountng 41 Beatty and Rtter (1986), Aussenegg (2003), and Lowry et al. (2010), amongst others. 21

26 varables tested can be consdered good proxes for ex ante uncertanty. However, the Altman Z-score, takng nto account several aspects of the fnancal statements, seems to reflect nvestors perceptons regardng the ex ante uncertanty of the frm. [INSERT TABLE 8 AROUND HERE] On the other hand, model 2 shows lmted support for sgnallng theores on the SEM as frms havng hgher proftablty ratos and exercsng seasoned offerngs do not on average experence hgher underprcng. 42 In addton, there s a sgnfcant (at the 10% level accordng to the standard and bootstrapped p-values) and negatve relatonshp between the ex ante fnancal strength and the level of underprcng suggestng that the ex ante uncertanty effect of ths varable domnates the sgnallng effect. In partcular, the hgh Z-score s vewed by the market as a proxy surroundng the uncertanty of the ssue rather than as a proxy for the qualty of the ssue such that the negatve relatonshp s consstent wth the ex ante hypothess. Wth regard to model 3, two proxes stockbroker reputaton and audtors reputaton are used to test the underwrter reputaton hypothess. The results suggest that there s no sgnfcant relaton between stockbroker reputaton and the level of underprcng. However, there s a postve and sgnfcant relatonshp between the audtor s reputaton and the ntal raw returns for both the conventonal and bootstrapped p-values. In partcular, IPOs whch are audted by a well known and prestgous audtng company wll on average exhbt a hgher level of underprcng. Ths result, though sgnfcant, s nconsstent wth the expected predctons of the underwrter reputaton hypothess as one expects a negatve rather than a postve relatonshp to preval. 43 Hence the sgnallng role of audt qualty seems to domnate the Maurtan market. In effect, one may clam that the better the audtng frm, the better the perceved qualty of the company such that there s a hgher aftermarket demand for the IPO, leadng to a hgher aftermarket prce. Ths seems consstent wth the sgnallng theores of Allen and Faulhaber (1989), Grnblatt and Hwang (1989) and Welch (1989), where frms whch are more lkely to be underprced. 42 The results are consstent wth the fndngs of James (1992), and Mchaely and Shaw (1994), who fnd no support for the sgnallng hypothess. 43 Balvers et. al. (1988), Carter and Manaster (1990), and Km et al. (1993). 22