IPO initial return in Pakistan:
influence of country-level institutional quality
Waqas Mehmood, Rasidah Mohd-Rashid and Abd Halim Ahmad
School of Economics Finance and Banking, Universiti Utara Malaysia, Sintok, Malaysia, and
Ahmad Hakimi Tajuddin
School of Accounting and Finance, Taylor’s University, Subang Jaya, Malaysia
Abstract
Purpose–The present study investigated the influence of country-level institutional quality on IPO initial return using World Bank Governance indices.
Design/methodology/approach–This study analysed 84 IPOs listed on Pakistan Stock Exchange between 2000 and 2017 using cross-sectional data. The impact of country-level institutional quality on IPO initial returns was examined using ordinary least square, robust least square, stepwise least square and quantile regression.
Findings–Empirically, the values of political stability, government effectiveness and regulatory quality were positively significant, whereas rule of law and control of corruption were negatively significant in explaining the intensity of IPO initial return. The results also show the presence of significant risk in the market. Hence, investors were compensated with higher initial returns for weak country-level institutional quality. The results also reveal that improving country-level institutional quality would improve the financial market transparency, thereby reducing IPO initial returns.
Originality/value–No studies have been conducted regarding the influence of country-level institutional quality on IPO initial return in Pakistan. This study is a pioneering study that seeks to give insights into the link between these variables in the context of Pakistan.
KeywordsCountry-level institutional quality, Initial public offerings, Initial return, Uncertainty, Pakistan stock exchange
Paper typeResearch paper
1. Introduction
Firms often go public through the initial public offering (IPO) route, reporting high initial returns (underpricing) on the first day of trading. High IPO initial returns have been proven in all financial markets worldwide (Lowryet al., 2017;Mohd-Rashidet al., 2018). Persistent anomalies of high initial returns have also been reported in Pakistan’s financial market (Aslamand Ullah, 2017; Khalid and Farhat, 2018; Sohail et al., 2018b). Nevertheless, the intensity of IPO initial return and its determinants differ amongst countries due to reasons such as listing regulation, the involvement of underwriters, government intervention, economic condition and methodological issues (Khanet al., 2014). In the same vein, Pakistan differs from other countries in terms of equity market size, institutional structure, regulatory framework and market efficiency (Mehmoodet al., 2020a). Given the persistent anomalies surrounding IPO initial returns in Pakistan, there is a compelling reason to investigate this phenomenon within the Pakistani setting. In Pakistan, uncertainty and information asymmetry problems in the market play a role in firm valuations during IPO listing. As such, investors should welcome IPO listings, given that issuers tend to underprice their IPOs
IPO initial return in Pakistan
The authors are grateful to the anonymous referees of the journal for their extremely useful suggestions to improve the quality of the paper. The authors also would like to acknowledge their gratitude for funding from the Fundamental Research Grant Scheme (FRGS/1/2019/SS01/UUM/02/29) provided by the Ministry of Education (MOE), Malaysia.
The current issue and full text archive of this journal is available on Emerald Insight at:
https://www.emerald.com/insight/2398-628X.htm
Received 26 June 2020 Revised 20 November 2020 23 February 2021 Accepted 6 April 2021
South Asian Journal of Business Studies
© Emerald Publishing Limited 2398-628X DOI10.1108/SAJBS-06-2020-0209
to gain full subscription. The listing and pricing regulations in Pakistan must, therefore, consider eliminating the ambiguities concerning the bid price of IPOs. Accordingly, this study investigated country-level institutional quality that may affect IPO subscriptions through uncertainties.
After the liberalisation and deregulation of the Pakistani market, the rich history of IPOs in Pakistan began to evolve rapidly between 1992 and 1998. However, Pakistan’s financial market performance was adversely affected not only by the slowdown in the US but also due to the imposition of sanctions by the US following the country’s nuclear testing in 1998. In 1999, not even a single IPO was issued in Pakistan. This is followed by a period of low IPO activity, with only 84 IPOs performed between 2000 and 2017. This number is extremely low compared to the 272 IPOs listed during the 1992–1997 period. The discouraging IPO trend could be attributed to political instability, low industrial production, terrorist activity and social security issues, indicating a high degree of uncertainty in Pakistan’s stock market (Mehmood et al., 2020b). High uncertainty tends to increase equity market returns to compensate investors for the higher risk.
The costs of raising capital are exorbitant for firms experiencing high uncertainty in a weak legal protection environment (Love et al., 2002). The legal system and investor protection in Pakistan have failed due to the weak performance of the country’s macroeconomic environment and surrounding factors, which have increased uncertainty and caused high market volatility (Chang and Rajput, 2018). IPO initial returns are high in emerging markets because of high uncertainty and high information asymmetry (Autore et al., 2014;Engelen and Van Essen, 2010).Aslam and Ullah (2017)revealed that the high initial returns in Pakistan, as high as 46%, resulted from high information asymmetry and high uncertainty. To highlight the phenomenon of high initial returns, this study considered country-level institutional quality as a critical element that impacts individual investors and their market sentiment, since weak institutional quality is likely to cause high IPO initial returns due to high information asymmetry and high uncertainty.
Economic and financial developments are influenced by institutional factors and reforms to address uncertainties (Cherif and Gazdar, 2010). The capital market performance in emerging economies depends on political stability, legal regulation and implementation and the sound management of bureaucracies (Yartey, 2010).Papaioannou (2009)used the same institutional quality indicators to examine the impact of institutional factors on the mobilisation of international capital and found that well-functioning institutions are crucial for the dynamic flow of international banks. According to Shaghaghi et al. (2019), the government can facilitate capital market development by strengthening institutional quality, given the positive correlation between the stock market index and institutional quality.
Asongu (2012) found a significant positive correlation between institutional quality and equity market performance in the context of developing countries. This finding suggests that countries with an enhanced institutional quality framework have better market values, trading volumes and turnover ratios. A better governance index was found to positively and negatively impact firms that intended to obtain external funds through share offerings (Boulton et al., 2010). The authors also found more undervalued share prices and more dispersed ownership of firms listed in countries with proper investor protection regulations.
Previous literature has established the influence of country-level institutional quality on capital market outcomes.La Portaet al.(1997,2002)contended that country-level institutional quality plays a significant role in the growth of the financial market, in addition to market sentiment, business entities and investors. The Worldwide Governance Indicators (WGIs) establishes country-level institutional quality using six indicators: voice and accountability, political stability, government effectiveness, regulatory quality, rule of law and control of corruption. According to the WGI database[1], developed countries perform exceptionally well in country-level institutional quality. The indicators are scored using percentile ranking
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from 0 (lowest) to 100 (highest). Based on this ranking, the US scored between 59.05 and 92.79 and Australia scored between 77.62 and 98.08 in all six dimensions of country-level institutional quality. On the other hand, Pakistan scored between 1.90 and 29.33 in all six dimensions, reflecting an extremely weak performance compared to the developed countries.
This is despite an overall improvement in the past 2 decades (Sherani, 2017).
Under a weak legal protection regime, operating firms are considered to have a high level of uncertainty, which could significantly impact investors’confidence. Consequently, issuers intending to go public might have to underprice their IPOs in order to attract investors’ interest. It has been observed that a higher uncertainty tends to occur when a country’s institutional quality is at its weakest, and in developing countries, information symmetry is higher due to market imperfection (Eldomiaty, 2008). Therefore, information asymmetry and uncertainty are the most likely causes for the high initial returns between insider investors and outsider investors.
Institutional quality information can have a significant impact on investors’sentiment in the IPO market. Effective governance signifies a country’s high performance in terms of policy regulation, enforcement of the rule of law and corruption control and may affect IPO investments. On the contrary, an inefficient government leads to information asymmetry and ultimately uncertainties. Investors are more attracted to highly effective and transparent markets with a low prevalence of information asymmetries. Poor information transparency leads to greaterex anteuncertainties, resulting in a higher prevalence of underpriced IPOs (Beatty and Ritter, 1986).
This study leverages the effects of country-level institutional quality on IPO initial return in two distinct ways. First, this study expands the existing literature that investigated the influence of governance mechanisms on financial markets’outcomes in developed countries [2]. Second, this study finds that the relationship between country-level institutional quality and IPO initial return is based on the high level of market uncertainty, which tends to influence the availability, value and control of private benefits. Additionally, this study’s results suggest that the composite interactions of country-level institutional quality among institutions affect the relative strength of overall investors and entrepreneurs in an environment of high information asymmetry and high uncertainty. Besides, corporate financial behaviour can influence institutional quality in various ways–such as when firms underutilise their leverage and the available mechanisms to outside investors–due to the potential association of country-level institutional quality.
This work is based on cross-sectional data of a developing country, namely Pakistan, unlike the previous studies that examined developed countries (Autoreet al., 2014;Engelen and Van Essen, 2010). This study examined 84 IPO firms listed on the Pakistan Stock Exchange between 2000 and 2017. This study also included the IPOs offered during the Badla financial crisis of 2005 as well as the pre-bookbuilding mechanism period and the post-bookbuilding mechanism period in the Pakistani market. Ordinary least square (hierarchical), robust least square with opening price measurement, stepwise least square and quantile regression approaches were used to explain the phenomenon of IPO initial returns. This study’s outcome is expected to shed new light on whether the influence and intensity of country-level institutional quality on Pakistani IPOs are similar to developed markets’experiences.
The remainder of this paper is organised into several sections.Section 2presents the literature review. This is followed by the outline of the research methodology inSection 3and the results and discussion inSection 4. Lastly,Section 5presents the overall conclusion of this study.
2. Literature review
Researchers have examined various models in an attempt to justify the phenomenon of IPO underpricing[3].Rock (1986)introduced the winner’s curse model, which suggests the need
IPO initial
return in
Pakistan
for underpricing due to information asymmetry among investors. As it is, some investors have better access to information about the value of a company as compared to others. Poorly informed investors prefer to purchase new shares of each IPO, whereas more informed investors will only purchase shares of highly attractive IPOs (Kumaret al., 2016). Since firms typically issue only a limited number of shares, highly attractive IPOs are likely to be oversubscribed. Hence, unattractive IPOs will make their way to less-informed investors, with only a small portion of the attractive ones made available to them [4]. As such, uninformed investors usually obtain returns below the average underpricing or even negative returns (Ritter and Welch, 2002). This scenario will eventually discourage uninformed investors from participating in IPO bids. According toRock (1986), uninformed investors are equally important to the IPO market because informed investors’demands alone are inadequate for the market’s survival. Uninformed investors will only consider IPO investments if they anticipate positive returns (or breaking even at a minimum), leading to the need for underpricing (Ljungqvist, 2007)[5].Beatty and Ritter (1986)extended this model by demonstrating that the increase in the underpricing level is commensurate with the level ofex anteuncertainties regarding firm value. Empirical evidence has been provided to confirm the aforementioned correlation (seeBeatty and Welch, 1996;Beatty and Zajac, 1994;Welbourne and Cyr, 1999). Companies with higher uncertainties regarding their growth prospects typically have greater underpricing than their counterparts (Ritter, 1984). The literature in the field generally acknowledges the significance ofex anteuncertainty for the IPO process and the fact that greater uncertainties lead to higher underpricing levels (Ljungqvist, 2007).
Therefore, IPO-related uncertainties will be revealed automatically at various levels.
The most common focus in the recent IPO literature is on high initial returns (Engelen and Van Essen, 2010;Lowryet al., 2017;Mohd-Rashidet al., 2014). Some studies found that the intensity and determinants of initial returns vary from country to country (Burroweset al., 2004;Khanet al., 2014). High initial returns can be described as the direct transfer of wealth to outside shareholders (or new investors) from the perspective of the existing shareholders or original owners (Bedardet al., 2008). Notably, high IPO initial returns are the most recurring phenomenon found in every financial market, including in the US (Lowryet al., 2010), France and Germany (Goergenet al., 2009), the United Kingdom (UK) (Reberand Fong, 2006), New Zealand (NZ) (Chiet al., 2010), Poland (Sieradzki, 2013), Brazil (Nogueira Freitaset al., 2008), Sri Lanka (Samarakoon, 2010), Thailand (Vithessonthi, 2014), Malaysia (Che-Yahya et al., 2018) and Pakistan (Aslam and Ullah, 2017;Javid and Malik, 2016;Sohailet al., 2018b). In the context of Pakistan,Aslam and Ullah (2017)reported an average initial return of 46.00%. The anomaly of IPO initial returns in the Pakistani market is, therefore, noticeable and cannot be ignored since it could fail the efficient market hypothesis (EMHs), as the inefficiency of this market has already been documented in previous studies (Haider and Nishat, 2009;Khan and Khan, 2016;Rehman and Qamar, 2014).Table 1summarises several studies that investigated
Author Sample period Sample size Initial return
Khalid and Nasr (2007) 2000–2005 50 35.66%
Sohailet al.(2010) 2000–2009 73 42.10%
Kayani and Amjad (2011) 2000–2010 59 39.87%
Afzaet al.(2013) 2000–2011 55 28.03%
Yar and Javid (2014) 2000–2012 59 51.57%
Aslam and Ullah (2017) 2001–2010 59 46.00%
Sohailet al. (2018b) 2000–2012 83 39.64%
Mehmoodet al.(2020d) 2000–2017 90 33.23%
Source(s):Compiled by authors Table 1.
Previous studies on Pakistan’s initial return
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IPOs in the context of Pakistan, indicating that the tendency towards high initial returns increased following the implementation of the book-building mechanism.
Previous studies that explored IPO initial return in Pakistan have highlighted a number of factors that significantly influence initial return, such as ex ante uncertainty, market capitalisation, information asymmetry, corporate governance, market sentiment, ownership structure, issue size, aftermarket IPO risk, issue timing, market volatility, underwriter, premium and pricing mechanism (Afzaet al., 2013;Aslam and Ullah, 2017;Javid and Malik, 2016;Kayani and Amjad, 2011;Khalid and Raheman, 2009;Mumtazet al., 2016;Sohailet al., 2018a; Mehmood et al., 2020d). The existing literature of IPO initial returns, therefore, recognises issue-specific and firm-specific factors but neglects country-specific characteristics that may impact theex anteuncertainty concerning the value of the firm (Mike, 2009;North, 1991). Hence, this study’s focus is on investigating country-level institutional quality that could influenceex anteuncertainty, thereby leading to high IPO initial returns.
According toNorth (1991), institutions are described as“the rule of the game in a society or, more formally, the humanly devised constraints that shape human interaction”.Van Essen et al. (2013)highlighted the fact that institutions have a significant impact on the overall structural formation, compliance and law enforcement of the economy in order to promote efficient and sustainable business practices. Mike (2009) predicted that the significant behaviour of formal and informal institutions enhances the process of economic specialisation that improves wealth creation. Likewise,North (1994)asserted that institutions are the only factor that mitigates uncertainty, offering a stabilising foundation for the economy.
The importance of corporate finance institutions has already been demonstrated in the law and finance literature (La Portaet al., 1997). In a related discussion, a country’s legal framework affects theex anteuncertainties, and hence, the values of firms. When the IPO legal framework increases, theex anteuncertainty also decreases in the same way the firm- specific factor does. For example, high technology involvement is a firm-specific factor that could reduce the risk factor. Besides,Claessens and Laeven (2003)argued that when firms have lower protection of intellectual property rights while investing in intangible assets under a weak legal environment, they tend to generate a lower firm value and growth.
Subsequently, investors face a higher uncertainty regarding managerial decisions and post- IPO strategies, leading to an adverse influence on the firm’s value. In effect, the appropriate valuation of the firm depends on the higherex anteuncertainty that results in a higher initial IPO return. Thus, investors are more uncertain about their investment return in countries with weak legal protection (La Portaet al., 1997), which increases theex anteuncertainty of their investment value.
To encourage investor participation in IPO subscriptions and not to be expropriated, ex- post, issuers and underwriters must underprice their IPOs. When an IPO is associated with a high expropriation risk, a higher initial return is needed to compensate investors againstex anteuncertainty. In assuring the investors, a high IPO initial return is considered as a paid premium against the existing adverse outcome of expropriation. Therefore, operating firms are expected to provide a higher initial return in a country with lower legal protection.
Empirical and theoretical evidence supports the relationship between country-level institutional quality and IPO initial return due to higherex anteuncertainty.Giannetti and Simonov (2006) observed that investors were reluctant to invest due to weak investor protection and thus could not enjoy the benefits of higher ex ante uncertainty. Besides market-related factors, this study anticipates the potential influence of information asymmetry concerning theex anteuncertainty of IPOs and initial returns by presenting a comprehensive discussion on six country-level institutional quality indicators, namely voice and accountability, political stability, government effectiveness, regulatory quality, rule of law and control of corruption (Autoreet al., 2014;Engelen and Van Essen, 2010). These indicators are defined as follows:
IPO initial
return in
Pakistan
(1) Voice and accountability: Citizens’participation in selecting their government is a central aspect. It explores the role of freedom of expression, association and independent media.
(2) Political stability: Captures perceptions of the likelihood of destabilising or overthrowing the government.
(3) Government effectiveness:Perceptions of the quality of public services provides by civil service, and the degree of civil service’s independence from political pressures, the formulation and implementation of policies and the credibility of the government.
(4) Regulatory quality: The government’s willingness to enforce sound policies and regulations that permit and encourage private sector growth.
(5) Rule of law:Captures agents’perception or confidence regarding compliance with the rules of society, the quality of the enforcing contracts, property rights, the police and the judiciary as well as the possibility of violence and crime.
(6) Control of corruption:Explores views regarding the degree to which public authority is exerted for private advantage. It investigates all types of corruption, petty or grand and captures elite and private interests by the state.
3. Research methodology
This study’s model was constructed from data of 84 newly listed firms on Pakistan Stock Exchange between 2000 and 2017 in order to explore the anomaly in IPO initial returns in Pakistan. A total of 90 IPOs were made between 2000 and 2017. This study examined 95% of all IPOs performed during the period, and important financial and specific variable details were extracted from published flotation, IPO prospectuses and Worldwide Governance Indicators’database. The current work was done to determine the factors limiting Pakistan’s IPO market. For instance, Pakistan’s nuclear testing had led to a sanction on the country by the US in 1998, which dampened the IPO market and resulted in zero IPO performed in 1999.
However, IPO activities were subsequently decreased as a consequence of the poor performance attributed to macroeconomic factors, such as terrorism, social and political issues.Figure 1shows the total number of IPOs offered in Pakistan between January 2000 and December 2017. As can be seen in the figure, the highest numbers of IPOs were observed in 2005 (12 IPOs), 2007 (11 IPOs) and 2008 (8 IPOs), whereas the lowest numbers of IPOs were reported in 2013 (1 IPO) and 2017 (3 IPOs). The trend demonstrates the rich IPO history in Pakistan, but since 2000, the country’s IPO market has shrivelled due to high market uncertainty.Figure 2depicts the total numbers of IPOs offered in various sectors in Pakistan,
3 4 4 4
9 12
3 11
8
4 5
4 3
1
5 4
3 3
0 2 4 6 8 10 12 14
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Figure 1.
Number of IPOs from 2000 to 2017
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where investment banking and technical communication were the most prominent sectors in the country at the time.
Table 2provides a summary of the description and measurement of all the variables analysed. To evaluate the initial performance of IPOs, the percentage change between the
0 2 4 68 10 12 14 16
2
6 7
5 8
2 2 2 3 2 1
15
1
4 6
1 4
1 14
6 1
Symbol Calculation Data sources
Dependent variable First listing day initial return
IRCLOSING Closing price on the first trading day on the secondary market minus offer price, divided by offer price
PSX
First listing day initial return
IROPENING Opening price on the first trading day on the secondary market minus offer price, divided by offer price
PSX
Independent variables Voice and
accountability
VA Percentile rank among all countries (ranges from 0 (lowest) to 100 (highest) rank)
WGI Political stability PS Percentile rank among all countries (ranges from
0 (lowest) to 100 (highest) rank)
WGI Government
effectiveness
GE Percentile rank among all countries (ranges from 0 (lowest) to 100 (highest) rank)
WGI Regulatory quality RQ Percentile rank among all countries (ranges from
0 (lowest) to 100 (highest) rank)
WGI Rule of law RL Percentile rank among all countries (ranges from
0 (lowest) to 100 (highest) rank)
WGI Control of corruption CC Percentile rank among all countries (ranges from
0 (lowest) to 100 (highest) rank)
WGI Control variables
Risk of IPO RISK Risk is reciprocal of offer price that is calculated as 1 divided by offer price
Self- computation Oversubscription OS Total number of IPOs subscribed divided by total
number of offered unit
Flotation Offer price OP Offer price is measured as individual price in
Pakistani rupees of each IPO at the time of offerings Firm prospectus Premium DPA Dummy of premium offered (without premium 0,
otherwise with premium 1)
Firm prospectus DF-crisis DFC Dummy of financial crisis period (IPO offered during
crisis period 0, otherwise without crisis period 1)
Self- computation Pricing mechanism DPM Dummy of pricing mechanism (Bookbuilding 1,
otherwise with fixed price 0)
Prospectus
Figure 2.
Industry–wise IPO offered from January 2000 to December 2017
Table 2.
Operationalization of the variables
IPO initial
return in
Pakistan
closing price on the first day of listing and the offer price was used (Che-Yahyaet al., 2018;
Mohd-Rashid et al., 2014; Barth et al., 2017). Further, for robustness purpose, the percentage change between the opening price on the first day of listing and the offer price was also used because the initial return based on the closing price on the first day of listing included market noises (Abdul-Rahim and Yong, 2010;Acedo-Ramırez and Ruiz-Cabestre, 2018). IPO initial returns, based on closing and opening prices, were calculated using Equations (1)and(2).
IRc¼
pclosing Poffer 1
3100 (1)
IR+¼
Popening Poffer 1
3100 (2)
Country-level institutional quality is the only independent variable in this study. Data on country-level institutional quality between January 2000 and December 2017 were derived from the WGI database, which presents an overall view of the quality of governance based on a survey conducted on a large number of enterprises. Moreover, country-level institutional quality is a perception-based measurement developed byKaufmannet al.(1999)that they recently updated, which is assessed based on the six dimensions of WGI, namely voice and accountability, political stability, government effectiveness, regulatory quality, rule of law and control of corruption.
Six control variables, which were found to have a significant relationship with IPO initial return in previous studies, were included in the regression analysis. The control variables are IPO risk, over-subscription, offer price, premium, financial crisis period and pricing mechanism. IPO risk was proxied by the reciprocal of the offer price; this definition was also used in previous studies (seeAbdul-Rahim and Yong, 2010;Bradley and Jordan, 2002). The associated risks of IPOs are reflected in offer prices as high-risk firms set a lower offer price to attract investors, leading to higher subscription rates and consequently, higher IPO initial returns (Mehmoodet al., 2020c). Oversubscription and IPO supply have contradictory effects on an IPO’s initial return. In this study, oversubscription is defined as the number of times an IPO was oversubscribed (Tajuddinet al., 2018). IPO demand is linked to IPO initial return, and it is a critical element in an IPO’s success (Tajuddinet al., 2015,2018).
Offer price refers to the final product price ascribed to an IPO. In this study, offer price was measured as the individual price in Pakistani rupee for each IPO at the time of the offer. A higher offer price reflects a lower uncertainty of future performance (Dailyet al., 2003). The study introduced premium as a dummy variable, where an IPO offered without a premium was represented by 0 and 1 otherwise. It is contended that a premium included in the offer price signals growth opportunities because investors are willing to pay a high premium. In addition, higher premiums indicate high-quality IPOs, thereby generating greater demands and higher initial returns on the first day of trading. Financial crisis refers to the recession period, during which the economy faced uncertainties, high deficits and the lowest GDP recorded. This period is referred to as the“badla”financial crisis. In this study, it was considered as a dummy variable, represented by 1 if an IPO was offered during the financial crisis and 0 otherwise. During a financial crisis period, investors are discouraged from participating in the stock market due to the bearish condition. Ordinary least square or OLS (hierarchical), robust least square, stepwise least square and quantile regression analysis were used to investigate the relationships between each independent variable and IPO initial return. The regression model are presented inEquations (3)and (4), respectively.
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3.1 Regression equations
IRclosing¼αþβ1Voice and accountabilityiþβ2Political stabilityi
þβ3Government effectivenessiþβ4Regulatory qualityiþβ5Rule of lawi
þβ6Control of Corruptioniþβ7Riskiþβ8Oversubscriptioniþβ9Offer pricei þβ10Premiumiþβ11Financal crisisiþβ12Pricing mechanismiþε
(3)
IRopening¼αþβ1Voice and accountabilityiþβ2Political stabilityi
þβ3Government effectivenessiþβ4Regulatory qualityiþβ5Rule of lawi
þβ6Control of Corruptioniþβ7Riskiþβ8Oversubscriptioniþβ9Offer pricei þβ10Premiumiþβ11Financal crisisiþβ12Pricing mechanismiþε
(4)
4. Empirical results and discussion 4.1 Preliminary results
Panel A ofTable 3presents the descriptive statistics of the 84 IPOs listed on Pakistan Stock Exchange between January 2000 and December 2017. In this study, the descriptive statistics method was employed to explain the relationships among the variables in terms of mean, median, minimum, maximum, SD and variance inflation factor. For IPO initial return (underpricing) on the first day of trading, the results reported a mean value of 34%, a median value of 15% and minimum and maximum values of42.31 and 228%, respectively. The IPO initial returns reported in this study are extremely high compared to those of many other Asian and developing countries (see Khalid and Nasr, 2007; Zubair and Ahmed, 2014).
Additionally, this study statistically measured country-level institutional quality and the percentile rankings (from 0 for the weakest governance to 100 for the strongest governance) based on the following indicators: voice and accountability, political stability, government effectiveness regulatory quality, rule of law and control of corruption. For voice and accountability, this study obtained a mean of 22.13, a median of 24.17 and minimum and maximum values of 12.94 and 28.08, respectively. Political stability reported a mean of 3.76, a median of 2.40 and minimum and maximum values of 0.47 and 15.87, respectively.
Government effectiveness recorded a mean of 32.46, a median of 31.25 and minimum and maximum values of 22.27 and 41.33, respectively. For regulatory quality, the study obtained a mean of 26.48, a median of 27.88 and minimum and maximum values of 17.73 and 34.31, respectively. Rule of law reported a mean of 22.16, a median of 21.91 and minimum and maximum values of 17.79 and 27.49, respectively. Lastly, control of corruption had a mean of 28.70, a median of 31.15 and minimum and maximum values of 20.85 and 39.39, respectively.
Overall, Pakistan’s governance performance was found to be weak compared to other developed nations, such as Canada, France, Germany and the UK. As such, local and international investors face higher uncertainty due to the weak country-level institutional quality in Pakistan.
The results for the control variables, namely IPO risk, oversubscription, offer price, premium, financial crisis and pricing mechanism, are shown inTable 3(Panel A). The six control variables were examined and used to investigate the hypotheses to explain IPO initial return, as done in previous studies. First, the risk of IPOs was measured using the reciprocal of the offer price. The newly listed stocks had various levels of risk associated with new offerings, with an average of 7% and minimum and maximum values of 4.13 and 10%, respectively. Notably, the associated risk was lower when the offer price was lower, and a higher offer price represented a higher risk. According toBradley and Jordan (2002), the offer price typically precedes the IPO process, implying that the market has a minimal
IPO initial
return in
Pakistan
influence over the offer price, yet the offer price serves as a good indicator of high or low risk.
Second, oversubscription refers to the excess demand for an IPO that affects its aftermarket price and appears to offset the initial return. In this study, oversubscription reported an average frequency of 2.56 times, a minimum of 0.01 times and a maximum of 17.46 times, demonstrating a wide difference between the minimum and maximum frequency. The average oversubscription is lower than reported for other countries, such as
Mean Median Max Min Std. Dev VIF
Panel A: Descriptive statistics from January 2000 to December 2017
IR (percentage) 0.34 0.15 2.28 0.42 0.48 –
VA (percentile) 22.13 24.17 28.08 12.94 4.68 9.376
PS (percentile) 3.76 2.40 15.87 0.47 3.57 8.295
GE (percentile) 32.46 31.25 41.33 22.27 6.92 4.143
RQ (percentile) 26.48 27.88 34.31 17.73 4.60 7.851
RL (percentile) 22.16 21.91 27.49 17.79 2.59 1.491
CC (percentile) 18.11 18.93 25.76 13.17 4.03 5.561
RISK (ratio) 7.06 6.01 10.03 4.13 0.03 3.886
OS (times) 2.65 1.19 17.46 0.01 3.28 1.180
OP (PKR) 24.36 13.50 235.00 10.00 30.69 2.102
DPA (PKR) 0.55 1.00 1.00 0.00 0.50 1.770
DFC (times) 0.13 0.00 1.00 0.00 0.34 3.572
DPM (method) 0.29 0.00 1.00 0.00 0.45 3.413
Panel B: Country-level institutional quality percentile rank from January 2000 to December 2017
Year VA PS GE RQ RL CC
2000 12.94 15.87 30.26 20.00 24.37 21.78
2001 14.43 11.11 35.54 20.97 22.79 24.01
2002 15.92 6.35 40.82 21.94 21.21 26.24
2003 14.93 7.54 41.33 22.96 25.76 25.74
2004 16.83 5.83 38.92 17.73 13.17 19.62
2005 20.67 5.34 39.71 26.47 14.15 22.01
2006 24.52 2.90 40.98 34.31 21.95 22.97
2007 21.15 0.97 37.38 31.07 20.87 21.05
2008 25.48 0.96 26.70 30.58 18.93 17.79
2009 24.17 1.42 23.44 30.62 14.83 21.80
2010 27.49 0.47 25.36 29.67 13.81 27.49
2011 25.82 0.47 22.27 28.91 14.69 19.72
2012 24.88 0.95 25.59 25.59 14.22 21.13
2013 25.35 0.95 24.17 26.07 17.54 22.07
2014 27.09 3.33 23.08 28.37 22.12 25.00
2015 27.09 1.43 27.88 28.85 21.63 24.52
2016 27.59 1.43 28.37 27.40 17.31 20.19
2017 28.08 1.90 31.25 29.33 22.60 24.04
Note(s):Initial return is the dependent variable, which is measured by the percentage change in offer price and closing price on the first day listed.Kaufmannet al.(2009)asserted the measure of country-level institutional quality through voice and accountability (VA), political stability (PS), government effectiveness (GEs), regulatory quality (RQ), rule of law (RL), control of corruption (CC) computed by percentile rank which is ranked as 0 (lowest) to 100 (highest). Risk refers to the reciprocal of offer price that is computed by 1 divided by offer price. OS is the oversubscription which is computed by the total IPO subscribed divided by total number of offered unit. OP refers to the offer price which is the final offer price of listed IPO. DPA is dummy of premium offered which is display as without premium 0 and with premium 1, DFC is dummy of crisis period which shows listed IPO during crisis period 0, other than crisis period 1. DPM is a dummy of pricing mechanism IPO offered with fixed price 1, otherwise with book building 0
Table 3.
Descriptive statistics
SAJBS
Bangladesh with an average of 20.20 times and Malaysia with an average of 30.45 times (Rahmanet al., 2017;Tajuddinet al., 2015). Nevertheless, Pakistan’s low oversubscription between 2000 and 2017 prescribes that IPOs with the lowest demand tends to attract more investors since these IPOs were traded below the offer price before the aftermarket.
Subsequently, higher prices are likely to be possible in the aftermarket, as confirmed by the high initial returns made by investors and issuers.Abdul-Rahim and Yong (2010)concluded that oversubscription is positively significant in explaining IPO initial returns on the first day of listing.
This study found an average offer price of PKR24.36 and minimum and maximum offer prices of PKR10 and PKR235. The results suggest that the highly varied offer prices tend to attract investors differently.Kutsunaet al.(2008)argued that lower offer prices for new offerings are associated with higher initial returns on the first trading day. The study’s results also show that 55% of the IPOs were offered at premium prices on average. IPOs with a high premium are regarded as of high quality and low risk. Investors expect to receive a high initial return to compensate for the high premium paid.Titman and Trueman (1986)found that in offering large IPOs at a premium to investors, underwriters used the quality tactic, which increased both the demand and initial returns (Mohd-Rashid et al., 2019).
As mentioned earlier, financial crisis was introduced as a dummy variable in this study.
The results show that the Pakistani IPO market outperformed during the financial crisis due to higher uncertainty. Besides financial crisis, pricing mechanism was also used as a dummy variable. Pakistan has two methods of establishing the IPO offer price: fixed price and book- building mechanisms. Book-building was introduced in 2009 and has since become a popular method for new equity offerings in Pakistan. This study found that 29% of the IPOs were offered using the book-building mechanism.
This study also checked for multicollinearity using variance inflation factors (VIFs).
Kleinbaumet al.(2013)posited that a VIF value that is below 10 indicates that there is no multicollinearity problem. This study reported the VIF values of between 1 and 10; hence, multicollinearity was not an issue in this study.
Panel B of Table 3 shows the overall trend of country-level institutional quality performance in Pakistan. The results show that voice and accountability scored 12.94 percentile in 2000 and 28.08 in 2017. Political stability scored 15.87 percentile in 2000 and 1.90 percentile in 2017, the lowest performance during the study period. Government effectiveness ranged between 30.26 and 31.25 percentile from 2000 to 2017. Meanwhile, regulatory quality scored 20.00 percentile in 2000 and 29.33 in 2017. Rule of law reported a declining trend from 24.37 in 2000 to 22.60 in 2017. Finally, control of corruption scored 21.78 percentile in 2017, displaying a continuously increasing trend from 2000. Thus, Pakistan performed much lower than many other developing countries in all six dimensions of country-level institutional quality performance.
Table 4 shows the results of correlation analysis between the variables. Generally, political stability, government effectiveness, regulatory quality, rule of law, IPO risk, oversubscription, offer price, premium, financial crisis and pricing mechanism had a linear relationship with IPO initial return. However, voice and accountability had no link with IPO initial return. The results show a positive association between political stability, government effectiveness, regulatory quality, over-subscription, pricing mechanisms and initial return.
However, rule of law, control of corruption, IPO risk, offer price, premium, financial crisis were negatively correlated with initial return. The correlation analysis did not indicate problems with multicollinearity. A correlation that is greater than 0.9 indicates a strong relationship between two variables. The Variance Inflation Factor (VIF) is normally used to test multicollinearity problems.Asteriou and Hall (2007)explained that the cut-off point for multicollinearity is 10.
IPO initial
return in
Pakistan
IRVAPSGERQRLCCRISKOSOPDPADFC VA0.1501 PS0.19**0.83 GE0.05**0.700.46 RQ0.19**0.770.710.41 RL0.13**0.03**0.130.03**0.05** CC0.13**0.08***0.250.02**0.180.38 RISK0.06**0.310.180.170.160.060.16 OS0.62**0.08***0.00**0.1580.00**0.170.09***0.03** OP0.08**0.09***0.130.01**0.140.09**0.140.640.02** DPA0.20**0.130.06***0.100.120.06***0.03**0.590.02**0.37 DFC0.15**0.120.170.400.00**0.02**0.380.02**0.07**0.04**0.00** DPM0.08**0.620.370.570.240.230.140.320.190.02**0.04**0.246 Note(s):**indicatessignificantat5%and***indicatessignificantat1%.Initialreturnisthedependentvariable,whichismeasuredbythepercentagechangeinoffer priceandclosingpriceonfirstdaylisted.Kaufmannetal.(2009)assertedthemeasureofcountry-levelinstitutionalqualitythroughvoiceandaccountability(VA),political stability(PS),governmenteffectiveness(GEs),regulatoryquality(RQ),ruleoflaw(RL),controlofcorruption(CC)computedbypercentilerankwhichshows0(lowest)to 100(highest).Riskreferstothereciprocalofofferpricewhichiscomputedby1dividedbyofferprice.OSistheoversubscriptionwhichiscomputedbythetotalIPO subscribeddividedbytotalnumberofofferedunit.OPreferstotheofferpricewhichisthefinalofferpriceoflistedIPO.DPAisdummyofpremiumofferedwhichis displayaswithoutpremium0andwithpremium1,DFCisdummyofcrisisperiodwhichshowslistedIPOduringcrisisperiod0,otherthancrisisperiod1.DPMisa dummyofpricingmechanismIPOofferedwithfixedprice1,otherwisewithbookbuilding0
Table 4.
Correlation matrix
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4.2 Regression results
In quantifying the role of country-level institutional quality in explaining IPO initial return, all samples were considered in order to plot the results of ordinary least square or OLS (hierarchical multiple regression analysis), as shown inTable 5. The autocorrelation problem is the most common in secondary cross-section data, given the observations used in the dataset were for a specific time series (Gujarati, 2003). Therefore, the Durbin Watson (DW) test was used to detect the autocorrelation problem, and the Newey–West test was incorporated to generate coefficients to correct the autocorrelation problem (Savinand White, 1977). Based on the results in Panel A ofTable 5, the Durbin Watson value was 2.15 and the adjustedR-square was 11.04%, which explained the total variance of the phenomenon of IPO
Panel A independent
variable
Panel B control variables
Panel C all variables
Panel D after book-building
Panel E before book-building
VA 0.04 – 0.00 0.00 0.25*
1.63 0.05 0.15 3.26
PS 0.02 – 0.04** 1.01** 0.27*
1.21 2.11 1.99 3.10
GE 0.02* – 0.03* 0.01* 0.05
2.93 3.82 2.97 1.10
RQ 0.01 – 0.06* 0.04** 0.08**
0.90 2.80 2.10 2.24
RL 0.04** – 0.02** 0.01 0.00
1.89 1.88 1.23 0.083
CC 0.04* – 0.03** 0.43*** 0.35***
2.96 1.88 1.71 1.93
RISK – 4.83 5.90** 1.16 25.03*
1.62 2.10 0.73 3.49
OS – 0.09* 0.08* 0.09* 0.05
6.61 5.01 6.46 0.82
OP – 0.00 0.00** 0.00 0.02*
1.34 2.11 0.98 4.01
DPA – 0.35* 0.38* 0.00 0.00
2.43 2.99 1.01 1.68
DFC – 0.10 0.54* – –
1.22 3.59
DPM – 0.10 0.29** – –
0.97 2.07
R-squared 0.17 0.52 0.62 0.71 0.64
Adj.R- squared
0.11 0.48 0.56 0.6521 0.36
Durbin– Watson stat
2.15 1.98 2.30 2.6029 2.33
Note(s):*, ** indicates significant level at 1% 5% and *** indicates significant level at 10%. Initial return is the dependent variable, which is measured by the percentage change in offer price and closing price on first day listed.Kaufmannet al.(2009)asserted the measure of country-level institutional quality through voice and accountability (VA), political stability (PS), government effectiveness (GEs), regulatory quality (RQ), rule of law (RL), control of corruption (CC) computed by percentile rank which shows 0 (lowest) to 100 (highest). Risk refers to the reciprocal of offer price which is computed by 1 divided by offer price. OS is the oversubscription that is computed by the total IPO subscribed divided by total number of offered unit. OP refers to the offer price that is the final offer price of listed IPO. DPA is dummy of premium offered which is displayed as without premium 0 and with premium 1, DFC is dummy of crisis period which shows listed IPO during crisis period 0, other than crisis period 1. DPM is a dummy of pricing mechanism IPO offered with fixed price 1, otherwise with book building 0.
Table 5.
Ordinary least square
IPO initial
return in
Pakistan
initial returns in Pakistan with the presence of only the independent variables in the model.
Panel A also provides the results of all country-level institutional quality variables used in this study. It was found that voice and accountability, political stability and regulatory quality were not significant in explaining IPO initial returns. However, government efficiency and control of corruption were significant in influencing IPO initial returns and rule of law was negatively significant in explaining IPO initial returns. Additionally, Panel B ofTable 5 shows the results of all the control variables included in this study. As presented in the panel, oversubscription was positively significant, but premium was negatively significant in explaining IPO initial returns. On the other hand, IPO risk, offer price, financial crisis and pricing mechanism did not significantly influence IPO initial returns. The R-square was 52.30% and the adjustedR-square was 48.49%, indicating the total variance of IPO initial returns with the presence of the control variables in the model.
Panel C presents the results of all the independent and control variables. Voice and accountability had no significant influence on IPO initial returns in Pakistan. However, political stability, government effectiveness and regulatory quality were positively significant. On the other hand, rule of law and control of corruption were negatively significant in explaining IPO initial returns. The results suggest that political stability would influence the financial success of a firm, which is consistent with the findings of prior studies (seeBusse and Hefeker, 2007;Holmeset al., 2013). The result for political stability is also similar to that of Autoreet al. (2014), which reported a significant positive relationship between political stability and IPO initial return. Interestingly,Kesten and Mungan (2015) found that high IPO initial returns were reported during a period of high political uncertainty.
The results of this study indicate that Pakistan’s growth depends on the government’s effectiveness. This argument is supported byAlamet al.(2017)andAutoreet al.(2014), which reported a positive link between government effectiveness and economic growth.
Additionally, this study found that regulatory quality improvement resulted in market transparency, thereby reducing uncertainties. This study’s result is similar to the work of Autoreet al.(2014), which reported a positive association between regulatory quality and IPO initial return.
This study found that a weak rule of law led to higher IPO initial returns, while minor or marginal improvement in the rule of law reduced IPO initial returns. This finding is in line withHearn (2014), which found a negative association between rule of law and IPO initial return.Engelen and Van Essen (2010)also found that in countries with a better legal system, the rule of law was linked with a lower IPO initial return, which is in line with the findings of Hopp and Dreher (2013).
This study also found that countries with poor control of corruption had higher IPO initial returns, whereas an increase in corruption control resulted in lower initial returns. This result is similar to that ofHearn (2014), which reported a significant negative relationship between control of corruption and IPO initial return. The results in Panel C ofTable 5also show an adjusted R-square of 56.40, which shows the total variance of IPO initial returns by incorporating all the independent and control variables in the model.
Among the control variables, IPO risk, offer price, premium and financial crisis were negatively significant in explaining IPO initial returns. IPO risk was proxied by the reciprocal of the offer price (Abdul-Rahim and Yong, 2010;Bradley and Jordan, 2002). The associated risks of IPOs are reflected in the offer price since high-risk firms provide a lower offer price to attract investors, leading to higher subscriptions and consequently, high IPO initial returns.
Further, lower uncertainty is indicated by a higher offer price that signifies a better prospect of firm performance.Dimovskiet al.(2011)found that a higher level of IPO initial return was recorded when the offer price was set lower. This study also found that premium had a negative influence on IPO initial return. This finding suggests that larger firms offer a higher premium than do smaller firms, and this higher premium indicates a lower level of
SAJBS
uncertainty and lower volatility in asset value. In line with this, a firm with a higher premium report a lower underpricing due to a lower level of information asymmetry. This finding is consistent withChhabraet al.(2017). For financial crisis, the result shows that the Pakistani IPO market outperformed during the financial crisis due to higher uncertainty.Taufil-Mohd (2007) demonstrated that during a financial crisis period, issuers tend to increase underpricing in order to attract investors. Thus, the financial crisis period influenced IPO initial return.
Further, this study found that oversubscription and pricing mechanism had a significant positive influence on IPO initial return. The results indicate that the demand for an IPO increases due to the pre-offering characteristics mentioned in the prospectus that subsequently increases the IPO’s initial return due to the quality signals. Lastly, the pricing mechanism is a distinctive feature of the Pakistani IPO market. Before 2009, the fixed price mechanism alone was used in IPO exercises. The pricing mechanism liberalisation, which saw the introduction of the book-building mechanism, was an initiative to increase the transparency and efficiency of the Pakistani IPO market. However,Khalid and Farhat (2018) found that after the introduction of the book-building pricing mechanism, the intensity of high initial returns had reduced in India and Sri Lanka but Pakistan had reported higher IPO initial returns than previously.
Panel D of Table 5 presents the results after the book-building implementation in Pakistan. Political stability, government effectiveness, regulatory quality and IPO oversubscription were positively significant in explaining IPO initial return. However, control of corruption was negatively significant in explaining IPO initial return. These results are consistent with Panel C results. The book-building pricing mechanism allows investors to make and opinion to invest in IPO before the IPO pricing (Rocholl, 2009). This mechanism is considered as a demand generation tool by involving investors through their bids. Similarly, in Pakistan, price is determined based on the bidding made by institutional and high net- worth investors. During the book-building process, quality information is revealed, and the offer price is adjusted accordingly based on market feedback either upwards or downwards in the prospectus (Benveniste and Spindt , 1989). If the offer price of an IPO is adjusted upwards, the initial return will be higher compared to a downward adjustment. The results in Panel D ofTable 5show the adjustedR-square of 65.21, which indicates the total variance of IPO initial returns with the incorporation of all the independent and control variables in the model.
Besides the book-building pricing mechanism, the fixed price mechanism is also used in IPO pricing in Pakistan. This method is commonly used in other Asian countries such as Hong Kong, Malaysia and Thailand. Thus, it is essential to examine the determinants of IPO initial return before and after the introduction of the book-building pricing mechanism.
Panel E ofTable 5shows that voice and accountability, control of corruption, IPO risk and offer price were negatively significant in explaining IPO initial return. On the contrary, political stability and regulatory quality were positively significant in explaining IPO initial return. Besides, this study reported an adjustedR-square of 36.79, showing the total variance of IPO initial returns with the incorporation of all the independent and control variables in the model.
InTable 6, Panels F, G and H present the results of robust regression, stepwise regression and quantile regression in order to achieve the objectives of this study. Robust regression has fewer restrictive assumptions than least square regression and is consequently considered an alternative method for identifying the relationship between dependent and independent variables. Also, robust least square provides regression results through coefficient estimates after omitting data outliers. Outliers violate the assumption of normally distributed residuals in the least square’s regression, as they tend to distort the least square coefficients. Due to this distortion, it is difficult to recognise smaller residuals when there are only one or two
