Ownership Structure Influence On Initial Public Offering Pricing
This paper is concerning about the influence of ownership structure theory in China when explaining the IPO underprice problem.
China has a significant underprice problem, it has an average of 238% IPO underprice in the period 1991-2005, and which is the top around the world. This is due to its unique characteristic and ownership structure, as China is a planned economy and most of the shares are hold in hands of several large shareholders. This background is different from those developed countries.
Initially, there are other theories such as information asymmetry and signaling hypothesis in explaining the problem. However, due to the unique background of China, these theories do not fully explain the matter. Therefore, we try to use the ownership structure theory to explain the IPO underpricing in China.
This paper divides into two parts, the first part is talking about the theory of ownership and situation in China, the second part is the analysis of about firms that have initial public offering in 2010, we have about 200 samples in our analysis.
Initial Public Offering (IPO) always rises above the issued price on the first day of trading. It is priced at a discount to their original trading price. This has attracted lots of investors’ attention. There has been numerous papers and research explaining the reason for the underpricing of IPO. It is in fact a common issue over the world and is mainly caused by a significant low issue price of an IPO firm in the primary market in order to reduce risk. Loughran, Ritter, and Rydqvist (1994) have compared the degree of IPO underpricing in different countries around the world. Zhong-guo Zhou (2009) found that Chinese A share have severe initial under pricing IPO which constitute an average of 238% in the period 1991-2005, and which is the top around the world.
Information Asymmetry Theory
There are some theories explaining the IPO underpricing. The information asymmetry theory is talking about the information between the initial shareholders and the individual investors. The controlling shareholders know more information of the firm, while the individual investors cannot determine the good firms from the bad firms. The controlling shareholders in a good firm thus have to underprice the shares to ensure enough subscribe for IPO. They think that when the public know more about the quality of firm after IPO, as information has been revealed by the public, the good firm can gain back the costs of IPO underpricing.
In China, the situation is a bit different, the issuers of shares do not have the power to price share. CSRC took the responsibility to price the IPO. About 90% of investors are individual investors, who do not have access to sufficient information. To keep the uninformed individual investors in the market, the government has to set a lower price for IPOs and leave much money on the table for further development of IPOs market.
The asymmetric information theory is useful in explaining why IPO is generally underpriced, but it cannot fully explain the cause of underpricing in China and thus other theories are also needed. Our main objective is not to determine why the IPOs are underpriced, but is to investigate the level of ownership structure in influencing the IPO underpricing.
Besides information asymmetry, Signalling theory also try to explain the underprice problem. It suggests that the owners of good firms tend to hold larger amount of shares at the IPO and thus there should be a positive relationship between the amount of shares holding by the owner and the IPO price.
The signals that represent the information of firm quality are the underpricing of the IPOs, and the amount of shares hold by the initial shareholders. Leland and Pyle (1977) focus on the purpose of the initial owner why they still hold a certain amount of equity when they issue shares. They argue that the initial owners know more about the quality of the firm,and this information is not observable to the outside investor. However, the individual investors can estimate the quality of the firm by observing the share holding ratio by the controlling shareholder. A higher ratio may mean that it is a higher quality firm, as the owners are unwilling to share the potential future cash flows with the outside investors.
This model is based on the assumption that the initial owners only sell their shares to individual investors one time. This assumption certainly limits its explanatory power and is not fully applicable in reality. Besides, the model does not exclude the situation that a bad firm can also act as a good firm by holding a large amount of shares. Thus retained equity is an unreliable signal of the quality of the firm.
We would also argue that the largest shareholder tends to maximize the benefits by setting a higher offer price, and that the market will value the stocks of firms with several large shareholders lower, as there is a private gain for major shareholders. The major shareholders at the IPO stage can capture the benefit by setting a higher offer price or by the accrual of future benefits.
One of the potential future benefits is that larger shareholders can privatize the company more easily, the investors perceive this estimate the share have lower value. A second possible private benefit is that it can divide the number of shares to a large amount of shareholder’s hand which makes it more difficult to lose the control of the company.
This finding contradicts to the signaling theory who maintained that a higher retained shareholding signalled higher quality of the firm, and should have greater IPO underpricing. In contrast, Our ownership theory assume that a higher retained shareholding signals the private benefits that may captured by majority shareholders, and should thus be associated with smaller IPO returns. We therefore expect the large shareholder factor have a negative impact on the IPO return.
The initial IPO underpricing theory is not sufficient to fully explain the phenomenon in China because of the following conditions:
As the theory is based on capital market in developed countries that the market is nearly saturated, the supply and demand of shares is sufficient to satisfy investor’s need. To avoid the failure of the underwriters, the issue price has to be reduced to attract investors. But for China, as a developing country, there is huge demand for the newly issued shares and the supply is insufficient, shares are a scarce resource for investors. Most of IPO did not face the risk of failure, thus the issuers have less motive to reduce the issue price because of this reason. The foreign IPO underpricing theory does not consider the problem of insufficient supply of shares.
Second, the existing theory of IPO underpricing are based on market economy
to analyze, it has not consider the situation of planned economy. In the planning economy, the government have influence on pricing the IPO, which makes the IPO underpricing is not a reflect of market value, but is the government’s decision.
Thus, these theories are only consistent in the developed countries, but do not match the status of China's stock market. They only have limited explanatory power when applied in explaining the situation in China.
As China has a unique characteristic with other countries, we need to develop a ownership structure theory that is specifically used to explain the underprice problem in china.
Situations in China
China is a socialist country and is a planned economy, majority of the company are partial privatization. The initial public offering process in China has to be proceed according to China’s socialist planning. First, the number of new shares to be issued is a part of the country’s financial plan each year. The new share issue quota is determined by the State Council Securities Committee (SCSC), the People’s Bank of China (PBOC), and the State Planning Commission (SPC). The quota is allocated to the provinces and municipalities. The allocation method used among provinces includes the assessment of different regional needs based on the production structure and industrial base to attain distribution objectives. Within each regional quota, the local government officials invite enterprises to list on the market and then make the selection based on the criteria that combines good performance as well as country’s development objectives. This process of selecting enterprises for listing in China differs from a mature market economy, where the decision to list an enterprise is usually determined by the stock exchange.
In the past, people mainly use the following two factors to explain the China IPO underpricing problem:
1. Government Regulation
The China Securities Regulatory Commission (CSRC) requires issuing firm price the IPO shares by use a fixed multiplier to multiply the net earnings per share, which is at a rate below the current market P/E ratios. Besides, the government also impose IPO quota, which restrict the number of IPO shares to a retail investors. The Chinese government control over the total amount of share issue each year and the issue price is set by the China Securities Regulatory Commission to ensure full subscription. This led to a high degree of under pricing in China.
2. Time Lag
Another factor is the time lag problem, the issuing firms must wait a long time after making public offerings, and this produces an average of 54 days and a median of 23 days listing time lag. This delay in time affects the investments of all IPO investors, including both outsiders and insiders. The information reflected by the issue price may be outdated.
There are substantial research that covered the above two concept. This explains the phenomenon happened in China. However, we will try to use another perspective to explain the phenomenon. China has unique characteristic in ownership structure. We believe that the ownership structure also have significant influence on the IPO price.
Ownership Structure Theory
First, Ownership theory assumes that controlling shareholders holding sufficient voting rights have less incentive to underprice the shares to prevent the exist of new blocks of shareholders that affect the control of the company. New issues include only a small proportion of outstanding shares. The reason for the owners of a firm to remain control in the company is that control can bring private benefits. The majority of shares are still owned by the original major shareholders. The theories of corporate control have a different view on the reason why IPOs are underpriced. It focus on the highly concentrated firm as it always provide major shareholders with control rights and diversify minority investor’s voting rights.
Second, a higher ownership concentration is often associated with inferior governance characteristics. Near half of our sample have controlled over 51% of the company, 84 companies that only counted the top 3 shareholders, they have the decision making power and control right that can affect the firm’s decision. Financial reports may be less credible and informative when an inferior governance structure is in place (Fan and Wong, (2002)). Therefore, both underwriters and individual investors lower the IPO share price expectation for firms in which the controlling shareholder has the dominant voting rights. The hypothesis predicts a negative relationship between the IPO’s market price valuation and a concentrated ownership structure.
Third, there is conflict of interest between different interest group, especially between the controlling shareholders and minority shareholders. It creates an agency conflict that is as large shareholders enjoy the control power and monitoring of managers, they may become selfish and pursue for their own interests by extract from the minority shareholders. The controlling shareholder may be strongly motivated to extract benefit from minority shareholders through transactions in which profits are transferred to other companies that are controlled by the controlling shareholder. A high concentrated ownership also means that an owner will be less subject to board governance and market discipline. Private control benefits are captured by the large shareholders that are not shared with the minority shareholders, and that the market recognizes the potential loss of benefit and thus reduces the returns of the IPOs.
There is an agency problem of concentrated ownership that caused from the conflicts between the majority shareholder and minority shareholders. Grossman and Hart (1988) and Harris and Raviv (1988) say that separating ownership and control lowers the value for single shareholders, and may not be socially optimal. Shleifer and Vishny (1997) illustrate that when ownership exceeds a certain proportion and large shareholders gain almost full control, private control benefits are captured by the large shareholder that are not shared by the minority shareholders. Claessens et al. (2002) say that the difference between the voting rights and cash flow rights of the largest shareholders is associated with a drop in value, and that this drop in value is larger when the difference between voting and cash flow rights is larger.
In China, the control of listed company is almost entirely held in the hands of major shareholders, and they will naturally become the Board of Directors to achieve the purpose of holding the decision making power. This ownership structure is similar to a high degree of equity concentration, and the board’s decision is based on pursuit of maximizing their own benefits. The major shareholders have the largest influence to the company.
Corporate law in China requires that important decisions should be made with the agreement of no less than two thirds of the shareholders, but a high concentration of share ownership may sometimes enable one or several large shareholder to accept or reject important projects. There is sufficient evidence that the attendants at Annual General Meetings are usually the representatives of the largest shareholders, and usually the decisions are made by the representative that representing only less than ten shareholders even when the total number of shareholders in the listed companies exceeds 10,000. Another example of the private benefits of control rights is provided by the case of Hengtong Co. Ltd. Hengtong Co. Ltd. was the largest shareholder in Lengguang Communications plc, listed on the Shanghai Stock Exchange, and used its control power to require Lengguang to guarantee a bank loan to the total asset value of Lengguang. It is also very common for controlling State companies, as the largest shareholder, to borrow capital from listed companies at very low cost.
In China’s share issue market, which is characterized by information asymmetry and uncertainty in the market, ownership structure can be seen as a piece of evidence in valuing shares. Such information not only outlines a firm’s governance structure, which indicates its resource allocation, but also reveals the purpose of the controlling shareholder, who may have an choice to either run the firm properly or to exploit minority shareholders. Although the company in China does not have the right to determine the price independently, the investors can also estimate the value of share by considering this factor and affecting the IPO underprice.
The main argument in this paper is that there is a negative relationship between the majority shareholder and the IPO premium because the market knows the value of control rights and its influence, and this information will affect the share price, causing a smaller IPO premium. The underpricing will becomes smaller if the control of the company is not expected to change and there is poor internal governance.
2. Objectives of the study
The objective of this paper is (1) to examine the relationship of ownership and the IPO price in China stock market, to determine whether they are positive or negative relationship. (2) To measure how much is the influence to the IPO price, we will use analysis and discussion to estimate. (3) Decide the factors that may affect this phenomenon e.g. firm size, monitoring system. The result is useful for those potential investors who want to invest in IPO.
3. Literature review
Xiu Shi yu say that the empirical results reveal the degree of IPO underpricing measured by first-day return is more than 100% in China. Mok and Hui (1998) say there is an underpricing of 289% for a sample of 87 Shanghai IPOs listed from 1990 and 1993. Jenkinson and Ljungqvist reported that the underpricing level in Chinese market is much higher than the average of 60% in the emerging markets.
Lihui Tian say that the Chinese stock and initial public offering market is distorted by government regulation. He used a sample of 1397 IPOs listed on the Shanghai and Shenzhen Stock Exchanges between 1991 and 2004 to make this conclusion. His empirical result showed that the average underpricing of Chinese IPOs is 247 percent, the highest in any world market.
Jing Chi (2002) use the cross sectional analysis to explain the extraordinarily severe underpricing of Chinese IPOs, and find that IPO underpricing is caused by the high demand because of the quota system, and the hign proportion of uninformed individual investors. The asymmetry hypothesis explain the underpricing in Chinese IPO market while Signaling hypothesis does not.
Xi li (2005) say that prior debt and equity investments are the significant factor to cause IPO underpricing. Mr Alexander Ljungqvist say that theories of underpricing can be grouped under four board headings, control, behavioral, institutional and asymmetric information, the key parties to an IPO transaction are the issuing firm, the bank underwriting and marketing the deal, and the new investors.
The signaling model is proposed by Leland and Pyle (1977), they describe the issuer’s function in the IPO process. The basic idea is that high quality firm sends signals to the investors so as to differentiate themselves from inferior issuers. This idea is because of the prediction that company retains a large amount of shares after IPO means that the shares are of higher quality. The signaling model is a famous technique to explain the principle-agency problem. Allen and Faulhaber (1989) gave an extension of Leland and Pyle’s (1977) signaling model. Some IPO issuer under price his IPO on purposely to convey the massage of high quality to investors. However, this model is lack of the empirical support.
Ting Yu(2003) have a different prediction with us. He says that the main reason for the high IPO underpricing in China is due to winner’s curse hypothesis. And the signaling model and manager’s strategic underpricing model do not stand.
Dr. Sunder Venkatesh say there is a weak and negative relationship between underpricing and the ownership concentration. He uses a rank correlation method to identify the relation. This certain extent validates the wide spread idea in emerging markets that high concentration can lead to the pursuit of private benefits.
4. Procedures and methodology
In this paper, we use the IPO in china share market to test our hypothesis. All the data including the stock prices and stock price indexes collected from the Shenzhen Stock Exchange in 2010, 200 new shares from different industry are selected randomly for explanation. We have collected the name of firm, its industry classification, offer date, first trading date, offer price, first day closing price, successful lottery rate, market capital, P/E ratio, and the sum of largest three shareholders.
Stock Price Indexes
Shenzhen Exchange have two major stock price index. One is the composition index including all the stocks traded and it is weighted by the proportion of a firm’s market value. The other one is a component index including the share price of thirty large firms. The IPO share price from the first day to a month is excluded in the calculation of index to avoid influencing from the fluctuation of IPO.
We will use the Shenzhen Composite daily opening and closing index to obtain comparable returns for different individual stocks. For example, if the offer day and the first trading day of a stock is on 1 April 2010 and 15 April 1010 respectively. We will use the 1 April 2010 and 15 April 2010 daily opening composite share price indexes and daily closing composite share price indexes respectively to obtain the comparable return of the share. We will discuss the detail formula in the next section.
The Measurement of IPO Returns
It is essential to consider the measurement IPO returns. Returns can be expressed in terms of simple returns or market-adjusted returns, and both can also be expressed as natural logarithms.
The formula of simple return :
Where = the simple IPO return of the company
= the initial offer price of the company
= the closing price of the ith company on the first trading day
The simple return is a measurement of the stock’s performance during the IPO, and may fluctuate with the general market. We need to calculate the market adjusted return to exclude the factors affecting the stock market. We can simply subtract the simple return by the return on the whole stock market to get a adjusted return. Below is the formula.
Where = the market-adjusted return for the ith company
= the opening stock market index of the ith company on the date that the offer price is set
= the closing stock market index of the ith company on the first day that listed in the market
Although the simple return () and the market-adjusted return () are useful statistical measures for expressive purposes, it is problematic in regression analysis. . The use of Ordinary Least Squares (OLS) assumes that the variables are normally distributed. However, both the () and () we used are not normally distributed, therefore we need to use two additional measures of return in our regression model to generate a more accurate calculation. They are the natural logarithm of the market adjusted return and the simple return.
The natural logarithm of the simple return is:
Where = natural logarithm of the company’s simple return and and are defined as the above formula
The natural logarithm of the market-adjusted return is:
where = natural logarithm of the ith company’s market-adjusted return
and , , and are defined as above
The various measurement of stock return is summarized. For description of IPO under pricing, and are used respectively to express the simple return and market-adjusted return. For using regression of IPO under pricing, and are used respectively to express the simple return and market-adjusted return.
Descriptive Statistic on IPO Under pricing
Table 1 shows the IPO return for 200 firms, including the simple return and market adjusted return. The mean of simple return is 47.16% and the median simple return 34.201%. The adjusted market return are more or less the same, with a mean return of 47.16 and a median return of 35.4%. The mean and median of the simple returns and the market adjusted returns shown in the descriptive statistic are similar and which underlies that market movements is not useful in explaining the huge returns of IPOs. There is other factors constitute the under pricing of the IPOs which we will explain below.
Hypothesis of relationship between ownership concentration and IPO underprice
We will use 10% significance level, same as 90% confidence level, as testing. This hypothesis suggests that we should accept if the static is significant so that there is significant relationship between ownership concentration and IPO under price.
We use regression model to find out whether the relationship between ownership structure and IPO under pricing is significant or not. Regression model emphasis on the relationship between a number of dependent variable and a independent variable. There are other factors including, oversubscription rate, time gap, earning per share, and proportion of large shareholder and company size. The model to be estimated was:
Where is random term with zero mean and variance
Determinant of IPO underprice
UP is the dependent variable measured by the logarithm of the simple return , as in Asquith, Jones, Kieschnick (1999); and by the logarithm of the market-adjusted return ) as in Dewenter and Malatesta (1997), representing the degree of under price premium in the first day. It is determined by the five independent variables , , , and in the formula above.
The first variable is the number of days between the offer day and first trading day. (Koh and Walter, 1989) use the period between the closing application day and the first trading day while (Booth and Chua, 1996) use the period of the first application day and the first trading day. We follow Booth and Chua (1996) 's method. Baron (1982) and Rock (1986) have proved that a long the time gap between application day and first trading day will definitely greater the risk involve in the investment due to with information asymmetry. Investors will then ask for more under pricing to compensate for their risk. Therefore, the relationship between and IPO return is positive.
The second variable is the earning per share before IPO issue which is a proxy of market value, proposed by Kim and Ritter (1999). A positive relationship is expected between EPS and the IPO return.
The third variable is the market capitalizationrepresenting the firm size. Common findings showed that the return on share is negatively related to the size of the issuing firm. Since the transparency of large size firm is higher, investor can acquire internal information easily from large company than small ones, Megginson and Weiss (1991) also have similar point of view. Therefore, we suggest there is a negative relationship between IPO return and (MKTCAP) under the information asymmetry theory.
The forth variable is, which is the percentage of unsuccessful subscription as a proxy of oversubscription to the IPO offer. Beatty and Ritter (1986) reported that IPO which is oversubscribed to a greater degree are linked with higher under pricing. Chemmanur (1993) confirms their empirical findings with an IPO under pricing model. A greater unsuccessful rate implies that investors get less lottery in value, so that the external shares will be more dispersed. Therefore, we expect a positive relationship between oversubscription and IPO return.
Last, but most importantly, the explanatory variable is representing the effect of ownership structure in IPO underpricing. It is measured by the portion of shares held by the largest three shareholders. As discussed before, the largest shareholders have intention to maximize their proceeds by setting a higher offer price, and the market will automatically adjust the stock price of companies having large shareholders to a lower price. Since there is high private advantage of corporate control and low IPO return, therefore we expect the variable have a negative relationship with initial IPO under price.
We will first consider the result of regression on 200 IPOs. Refer to Table 3, the result shows a significant negative relationship between the IPO market return and (SHAREBYTOP), which means that the higher the proportion of shares held by large shareholder, the lower the IPO return holding all other factors. The regression result is consistent with our theory. When there are more dominant shareholders in a company, controlling shareholders will protect their interest in IPO. They are more likely to set a higher offer price to maximize their proceeds and other future benefits.
This result may be related to the business law in China, which stated that major decisions should be made with no less than two third shareholders consent. However, if a single shareholder holds large percentage of voting right, he can influence the important decision independently. Many past researchers have investigated this issue and they have proved that the decision markers in the Annual General Meetings are usually several major shareholders other than the numerous small minority shareholders.
The coefficients of the other control variables (EPS, MKTCAP, OVERDEMANDED) were all significant except (DAY). Nethertheless, The model at different levels is consistent with our predictions.
Although the coefficient of (DAY) is insignificant, the model shows a positive relationship with IPO under pricing which is consistent with our past findings. Longer time gap between the application date and first trading day will increase the risk of investor because of asymmetric information and under pricing is a compensation for their risk.
The regression results also show that there is significant positive linkage between the (MKTCAP) and IPO underpricing. This is not consistent with the findings of the IPO studies by Booth and Chua (1996) and by Brennan and Franks (1997) as they expect that the investors can obtain information for large firm easier than small firms and reduce information asymmetry. The inconsistent finding may be caused by the inaccuracy in using the market capitalization as a proxy representing the firm size.
The result shows that (EPS) has a negative sign inconsistent with our prediction although it is statistically significant. We have no evidence to prove that better firms are priced higher.
(OVERDEMANDED) is the variable with highest significant value in the model which is positively related to the IPO under pricing and it matches with our prediction. A greater unsuccessful rate implies that investors get smaller value of lottery. In order to encourage a more disperse ownership and remain control after issuing IPO, owners will use IPO under pricing to attract oversubscription.
We have tried to separate the data to different industry categories to evaluate the level of IPO returns on different industries. We have followed one of the stock analysis website to classified the data into eight industries, including Infrastructure, utilities and construction, Consumer goods industry, Basic industry and chemicals, Medical industry, Property, real estate and building construction, Agriculture, Banking and Finance, Trading and service and Miscellaneous industry . The model was projected by robust regression and OLS model using dummy variables to capture the industry effects, but we found that none of them are significant which means that there is no direct relationship between different industry and the IPO underpricing. Thus the regression results that incorporating the dummy variables are not reported here.
This study has investigated how the ownership concentration affect the degree of under pricing by using 200 IPO shares listed in Shenzhen Stock Exchange from April 2010 – December 2010. Most past researches have illustrated the relationship between ownership structure and IPO returns by signaling theory which explains that IPO under pricing signal the quality of the firm, and a high proportion of ownership should be related to high IPO return. However, after a comprehensive analysis on the characteristic of China’s stock market, we found that the signaling model may not able to explain the phenomenon of high IPO under pricing in China. We suggest that major shareholders have high intention to set a higher price to enjoy private benefit of corporate control and low IPO return and therefore propose a negative relationship between ownership concentration and IPO return. The regression result supports our argument and shows that there is a significant negative relationship between the ownership structure and IPO under pricing. Although the asymmetric information theory provides a good explanation of IPO under pricing, it is insufficient to explain the degree of IPO among different company in different countries. The ownership concentration can supplement the insufficiency.
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