Underwriter allocation discretion, investor participation and IPO pricing: evidence from the Indian IPO market

In the US and other world markets, book building is a dominant mechanism for the issue of shares in initial public offerings (IPOs). A distinguishing feature of the book building mechanism is the discretionary power granted to underwriters to allocate shares to investors. We find that IPOs are generally underpriced in most countries. It is therefore of interest to financial economists and regulators to understand the role of underwriters as a financial intermediary in the allocation of IPO shares to IPO subscribers in this wealth transferring mechanism. Allocation discretion assists underwriters to develop and maintain information sharing relationships with institutional investors. This has a significant bearing on the richness of private information extracted from these investors that is used by the underwriters to price the IPO. This benefits the issuer through lower underpricing. However, granting allocation discretion to underwriters is also controversial as it can result in increased rent-seeking activity by underwriters, thereby leading to higher underpricing in the IPO.<br><br>On the other hand, imposing constraints on underwriters by regulating allocation discretion and enabling proportionate allocation of shares to institutional investors can have adverse implications for underwriters because of the difficulty in maintaining information sharing relationships with informed institutional investors. Such restrictions, therefore, affect the degree of information extracted from institutional investors, resulting in an IPO being less fairly priced. Also, the participation of regular institutional investors becomes more unpredictable, and this can negatively affect IPO performance. Thus, regulating allocation discretion has the potential to increase the overall risk for underwriters managing IPOs.<br><br>Against this background, in this doctoral thesis, I address the debate around regulating the discretionary allocation power of underwriters from the welfare perspective of market participants. Thereby, this thesis aims to contribute to an enhanced understanding of the IPO market mechanism. 2<br><br>In Study 1, I introduce an integrated conceptual framework of information sharing under two different allocation mechanisms to underwriters, namely with and without allocation discretion. Thus, I develop a theoretical understanding of information sharing and its effect on underwriters’ behaviour in the IPO market by linking information sharing theory with signaling and syndication theories.<br><br>In Study 2 and Study 3, of this thesis, I empirically investigate the significance of information sharing on underwriters’ incentives and its effect on IPO pricing in the Indian IPO market. The IPO market in India has two distinct characteristics. First, the Indian IPO market has both discretionary and proportionate allocation regimes, and second, there is an active grey market for IPOs. Together these characteristics provide a fascinating context to examine underwriters’ behaviour in the IPO process.<br><br>In Study 2, I apply the implications of signaling theory in the Indian IPO market setting to explain how underwriters can reduce the information asymmetry for uninformed retail investors. In addition, I investigate how allocation discretion affects underwriters’ intentions in the grey market and their choice in sharing information about IPO quality with market participants. This, in turn, can result in different outcomes for retail investor participation and IPO underpricing depending on the underwriters’ signaling behaviour in the grey market.<br><br>In deciding their participation, retail investors are positively influenced by the price signal in the grey market. Hence, the finding supports the conclusion that a grey market price signal can become a dominant influence in attracting retail investors to actively participate in an IPO, thus contributing to the IPO’s success. Moreover, allocation discretion motivates underwriters to manipulate the grey market for higher benefits for themselves, while regulating the allocation power of underwriters reduces their incentive to remain active in the grey market. Additionally, the finding suggests a positive relationship between retail investor participation and underpricing in IPOs. When allocation discretion is regulated, however, the relationship is insignificant. Finally, I find no relationship between the grey market price and IPO underpricing. 3<br><br>In Study 3, I advance a conceptual and empirical understanding of underwriting syndication in the Indian IPO market by examining the determinants of an IPO syndicate. In addition, I contemplate the usefulness of syndication as a substitution mechanism for higher information and risk sharing when allocation discretion is regulated. Finally, I explore whether reputation-based syndication is motivated by information sharing or price manipulation and investigate the effect of the regulatory intervention on this relationship.<br><br>The underwriting market in India is highly concentrated with continuing relationships among top underwriters to manage IPOs. I find that underwriters form a large syndicate when they do not have a reputation as a top performer, participation from investors is weak, and the issue size is large. Also, I do not find any evidence that the motivation for underwriters to form an IPO syndicate is due to market risk sharing or price manipulation. I do find that regulatory intervention results in reduced syndication amongst underwriters. In this regime, institutional investors share risk with reputed underwriters by acting as a mediating factor for them to syndicate. The evidence from the findings is that in the absence of allocation discretion, reputationbased syndication can act as an indirect medium of discretion for underwriters by way of higher risk and information sharing.<br><br>Overall, the evidence does not support the information sharing hypothesis that granting allocation discretion to underwriters results in improved price discovery. However, the results support the cronyism view that underwriters engage in rentseeking activity for higher incomes, which is made possible by the presence of a grey market for IPOs. The evidence does not support the risk sharing theory that proposes that underwriter syndication is aimed at sharing market risk. Rather, the results indicate that underwriters syndicate to share inventory risk for higher economic benefits, which in effect is indirect risk mitigation.<br><br>The combination of findings supports the regulatory intervention that limits the allocation power of underwriters. It is possible that regulatory intervention will be 4 more effective when the grey market is regulated, as the price signal in the grey market positively influences retail investors’ participation.