IPO Risk Management: Risks of an Initial Public Offering

Table of Contents

1.0 CHAPTER 1: INTRODUCTION
1.1 Introduction
1.2 Definition of IPO (Initial Public Offering)
1.3 Statement of the Problem: The Global IPO Slowdown in Saudi Arabia
1.4 Aims and Objectives of the Study
1.5 Background of the Study
1.6 The Research Question
1.7 Conclusion

2.0 CHAPTER 2: LITERATURE REVIEW
2.1 Introduction
2.2 Nature of the Saudi Arabian Stock Market Currently
2.3 Identification of the Characteristics of Potential Investors
2.4 Identification of the Specific Disclosures used by Companies to Attract Investors
2.5 Examination of the Attitudes and Perceptions of Investors towards IPO Risks
2.6 Identification of whether IPO Subscription is Influenced by Risks Associated with the Company

3.0 CHAPTER 3: RESEARCH METHODOLOGY
3.1 Introduction
3.2 Population Sampling and the Research Design
3.3 Data Collection
3.4 Designed Method of Data Analysis and Processing
3.5 Ethical Considerations
3.6 Limitations of the study
3.7 Methodology for Determining the Psychographic Characteristics of Potential Investors
3.8 Methodology for Determining the Specific Disclosures used by Companies to Attract Investors
3.9 Methodology for Determining the Attitudes and Perceptions of Investors towards IPO Risks and the Effect of Risks on the Subscription of an IPO

4.0 CHAPTER 4: RESULTS AND DATA ANALYSIS
4.1 Introduction
4.2 Empirical Results and Data Analysis on the Psychographic Characteristics of Potential Investors
4.3 Results and Data Analysis on Specific Disclosures Used by Companies to Attract Investors
4.4 Results and Data Analysis on the Attitudes and Perceptions of Investors towards IPO Risks and the Effect of Risks on the Subscription of an IPO

5.0 CHAPTER 5: DISCUSSION, RECOMMENDATIONS AND CONCLUSION
5.1 Introduction
5.2 Discussion; Relevance of the Results to the Saudi Arabia Stock Market
5.3 IPO’s Risk Management from a Global Perspective
5.4 Recommendations and Conclusion

6.0 REFERENCES

7.0 APPENDIX: THE QUESTIONNAIRE
7.1 A STUDY ON IPO RISKS IN SAUDI ARABIA

1.0 CHAPTER 1: INTRODUCTION

1.1 Introduction

Investing in the Saudi Arabia stock market must never be a ‘heart and gut’ affair founded on guesswork, hunches, speculations, rumours or hot tips. Going public is always a critical yet vital ‘u-turn’ for any company. Thus, a proper evaluation and consideration of the risks involved in using an initial public offering as a source of funding in Saudi Arabia is a very significant step in the determination of whether a company is on the right track. Although public ownership presents important advantages such as improved financial standing, enhanced access to capital and greater capacity to increase equity; it also has potential and at times unforeseeable risks such as reduced control, heightened scrutiny in the market and increased managerial demands all of which must be weighed before going public.

With all this said, this paper will delve into analyzing the risks and burdens associated with the use of an IPO as a source of funding in Saudi Arabia. To lay a general stage for the entire paper, this research will consist of five major chapters with chapter one covering the introduction, chapter two covering the literature review, chapter three covering the methodology, chapter four covering the results and analysis of data and chapter five covering the discussion, recommendations and the conclusion.

1.2 Definition of IPO (Initial Public Offering)

An Initial Public Offering or what is commonly referred to as an IPO, is defined by people in the corporate world as the initial sale of shares by a corporation to the overall public (Draho, 2006). A normal corporation is usually given a chance to come up with funds by way of debt or equity. The provision of equity to the general public initially with the purpose of obtaining funds is the most acceptable definition of an IPO. Corporations in Saudi Arabia are generally considered to be either public or private. For private companies in Saudi Arabia, they are limited on the business ventures they can engage in due to lack of huge capital resources that can be obtained from an IPO. Therefore, the desire to partake in ventures with vast capital sums is frequently the inspiring reason for private corporations to issue an initial public offering (Shin 2005).

1.3 Statement of the Problem: The Global IPO Slowdown in Saudi Arabia

Recently, late this year (2011), the value of IPO’s in Saudi Arabia sank by nearly by 66% as a result of poor investor appetite due to the global economic hit man that has slowed many stock markets on a global scale as reported by the largest bank (National Commercial Bank) in the Gulf kingdom. Saudi Arabia is the largest economy in the Arab world and it witnessed 2 IPO’s in the construction, building and cement sector in the year 2011. The total value of these IPO’s was $3.07 million representing a 66% decline compared with the same period in the year 2010 as reported by the National Commercial Bank. The bank continues to assert that this lack of investor appetite is attributable to the global deterioration and turmoil of investor sentiment.

Most importantly, the National Commercial Bank asserted that the risks involved in using IPO’s as a source of funding that are usually triggered by global uncertainties push majority of investors in Saudi Arabia to seek safer investments. This is a worrying trend and it is upon this backdrop that this paper seeks to analyze the risks involved in using IPO as a source of funding in Saudi Arabia in a bid to minimize them and thus enable companies in Saudi Arabia to build a good reputation and gain a competitive advantage among other Gulf countries. The figure 1 below shows the regional distribution of IPO’s among the Gulf States while figure 2 shows the sectoral distribution of the same.

1.3.1 Figure 1: Regional Distribution of IPO’s in the Year 2010

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1.3.2 Figure 2: Sectoral Distribution of IPO’s in the Year 2010

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1.4 Aims and Objectives of the Study

This study is aimed at comprehending the risks that are linked to the application of an initial public offering in Saudi Arabia as a basis of siphoning finances among corporations in Saudi Arabia. The main purpose of an IPO is to appeal to the ordinary citizens to invest their funds in the corporation via a prospectus. However, just like its risky investing in any business venture, investing in an IPO comes with its own risks. The study is also meant to give an overview on the hazards of an IPO for Investors who will be invigorated to be ardent in their examination of a corporation’s portfolio before making a decision to purchase shares in the corporation or invest in the corporation.

This research is also aimed at delivering vital facts on the risks of an IPO for Management officials in Saudi Arabia so as to ensure that they make the most of an IPO subscription, by guaranteeing that the corporation is untainted with bias or corruption and hence managed with transparency and all disclosures encompassed in the prospectus. The research is also intended to carrying out a proper investigation on the risks that are involved in an IPO, the predisposing factors for these risks and how to reduce the effect of these risks.

There are corporations already pursuing a profound IPO strategy in Saudi Arabia and hence for them, it is meant to make a vivid description and the thinking patterns of the potential investors and this could be a great contributor to the association in targeting the precise market perfectly. Furthermore, it is targeted at delivering profound opinion and advice to these corporations in Saudi Arabia with respect to the disclosures which usually have an effect on the probability of a potential investor taking a risk. Through analysis the discernments and insights of the potential investors towards IPO risk, the research is aimed at enabling these commercial associations to appreciate the morals and views that are a big part of the investors’ decision making process and which they can use to decide the method to apply when presenting to the investors and also invent new methods with suitable evidence appropriate to influence their attitudes towards the IPO in Saudi Arabia.

In the case of corporations not engaging in IPOs, the research results will give them an insight and overview of raising funds in the prevailing market climate. This will enable these corporations in Saudi Arabia to make a profound decision on whether the IPO way is worthy in terms of profitability. This research will also provide an overview of how to tackle the various IPO risks. In any IPO the magnitude of the risk involved is always directly related to the performance of the company. If a company is high performing the risk involved is minimal due to the fact that the high performing companies have a very stable sales and revenues. High performing companies have a very low risk of their revenue going down. Therefore these companies are most likely to experience a slight improvement or slight decline in their revenues.

1.5 Background of the Study

Saudi Arabia in the recent past has been seen to grow in terms of decreased inflation rate, the growth of the middle class within the region, the increase in the annual growth rate which over the years has been increasing in each preceding year and an increased in the performance of the Saudi Arabian market in terms of companies, turnovers and size of the market. But what has played the biggest role in the growth of the Saudi Arabian market has been the growth of investments within the country (Roberts, 2005).

There has been an influx in the number of multinational companies that have opened their branches in Saudi Arabia and even in some cases moved their headquarters there. This has been mostly due to the availability of cheap labour in Saudi Arabia which has been due to the huge population in the area this cheap lab or therefore means that companies have to spend less in the production process hence lesser cost of production means higher profits (Shin, 2007).

1.6 The Research Question

As stated above, considering an initial public offering for any company is a monumental decision that forever changes a company’s model of doing business. Though going public enables a company to access more sources of funds and capital in comparison to a private company, the process of going public is often challenging with unique risks that any company should always be prepared to face. These risks can be classified into three major categories;

a) Regulatory Risks: These include the regulations and requirements laid down by the stock exchange market when preparing for an initial public offering.
b) Shareholder Related Risks: These include alleged omissions, misstatements and errors in the document containing the listing offer.
c) Contemporary Risks; These include potential risks of indemnification to the underwriters in the occurrence of an event that necessitates suing or being sued of an alleged error.

With all these risks prevalent in the market, companies intending to go public must stay informed on how to mitigate/minimize these risks. It is upon this backdrop that this paper seeks to analyse the risk involved in using an IPO as a source of funding in a bid to lay a strategy on how to minimize/mitigate these risks, in order to enabled companies to gain good reputations among investors and other stakeholders. This way, a company will have a competitive advantage in the market and will have the capacity to easily realize its goals. The major questions guiding the researcher in this study are;

1) What are the psychographic characteristics of potential investors?
2) Which specific disclosures are used by companies to attract investors?
3) What are the attitudes and perceptions of investors towards IPO risks?
4) What is the effect of risks on the subscription of an IPO?

1.7 Conclusion

In order to avoid risks that come with an IPO, organizations should formulate a proper IPO strategy. A proper IPO strategy ensures capitalizing on the organization strengths whereby the organizations strength is a wide market and hence a cost effective strategy enables us to full benefit from this strength as through production at lesser operation costs the organization is able to produce more for a wider market it least cost possible. Due to the wide market also the organization is able to easily open up branches and manufacturing plants a; over the world.

Proper IPO strategy will ensure reduction in the effects of the organisations weaknesses. The major weakness of the company is competition but through application of this strategy the company or organization is able to produce the same quality of products with its competitors or of set standards but at a lower price due to the decreased operation costs and hence reduced marginal cost of production. Organizational behaviour ensures full exploitation of the organization’s environment whereby through application of this strategy the organization has been able to exploit the cheap labour that is available in various parts of the world, acquire better contracts with suppliers and raw material providers and also production at the lowest possible cost

A good IPO strategy also goes a long way in Protecting the organization against threats whereby the organization will be protected against the threat of competition or loss of clients as it will be able to exploit the cheap labour that is available in various parts of the world, acquire better contracts with suppliers and raw material providers and hence the organization is able to maintain the high quality and standards of their products but sell them at a cheaper price than their competitors.

2.0 CHAPTER 2: LITERATURE REVIEW

2.1 Introduction

As a matter of fact, IPO’s are faced by many unique risks as stated in the introduction and it is alongside this vein that this section delves on reviewing previously written literature in regard to IPO risks.

Many scholars have delved into the IPO topic and covered topics such as IPO underpricing but literature on the risks associated with using an IPO as a source funding are not covered by many scholars. Thus, literature regarding IPO risks is scanty and tedious to find. Nevertheless, a few scholars have demonstrated an interest in the topic and this section brings out their views in regard to IPO Risks.

Of major focus in this research is identification of the characteristics of potential investors, identification of the specific disclosures used by companies to attract investors, examination of the attitudes and perceptions of investors towards IPO risks and identification of whether IPO subscription is influenced by risks associated with the company in a bid to minimize/mitigate the risks and cultivate some worthy investments in the Saudi Arabian dynamic market.

2.2 Nature of the Saudi Arabian Stock Market Currently

Stock markets in the GCC (Gulf Cooperative Council) were and still are heavily subdued against a scenery of political upheavals in the Arab states. This led to postponements and delays in IPO investments in the region. With all these setbacks, it wasn’t surprising that the year 2011 1st half in regard to IPO’s witnessed another hit below the belt in GCC performance, with the floats number trimming down by 50% to 4 in comparison to the 8 IPO’s in the year 2010 1st half (Mahlknecht and Hassan, 2005).

More so, deal values have also plunged down by 57% to $358 million in comparison to the $830 million that was made at the same time in the year 2010. This drop demonstrates the rising investor fears in regard to the current uncertainties in the global economy that has weighed down investor interests in IPO’s (International Monetary Fund, 1994).

Nevertheless, Drake; the head of PwC (an international IPO organization in the middle East) holds that even though Saudi Arabia has been out of the scene in regard to IPO’s in the 1st half of the year 2011, the 2nd half could witness various floatation’s in Tadawul. Nevertheless, Saudi Arabia’s Tadawul dominated GCC’s IPO activities the whole of last year (2010). The Saudi Arabian integrated Telecom Companies were the country’s IPO’s at Tadawul that raised $93 million in the month of May, 2011. Nevertheless, this was a huge drop from the $685 million that was raised by UAE’s 7 IPO’s in the 1st half of the year 2010 (O'kane, 2011).

Among the four major GCC stock markets, the Saudi Arabian stock market is the only one where trading takes place across the counter unlike the ‘exchange based trade’ that takes place in the other three GCC markets. Shares are traded in by commercial banks using an electronic monetary system that was established by SAMA (Saudi Arabia Monetary Authority) which also closely monitors stock market activities (O'kane, 2010).

The stock market in Saudi Arabia is the largest compared to the rest and more so, it is also the largest market in regard to other Arab stock markets. The Saudi Arabian stock market witnessed over $59 billion in the 2nd half of the year 1997, and dropped to about $50 billion in the year 1998. Though the Kuwait market has always been ranked the most active, the Saudi Arabian market managed to surpass it in the last few years. Table 1 below represents indicators of the four GCC markets as per the month of March, 1998 and table 2 represent the background information regarding the GCC stock markets in the years 2003, 2004, and 2005 (Westenberg, 2011).

2.2.1 Table1: GCC Capital Markets Indicators for the Month of March 1998

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2.2.2 Table 2: Background Information on the GCC Capital Markets

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2.3 Identification of the Characteristics of Potential Investors

There is a rising interest in analyzing and carefully understanding the significance of potential investor characteristics in IPO share allocation decisions. Much of the previously done research focuses on share allocations to retail investors versus institutional investors. These previously done research generally arrive at the conclusion that ‘strong hands’ or rather institutional investors receive a higher percentage of IPO share allocations than the retail investors do (Wilhelm and Hanley, 1995).

In assessing the characteristics of a potential investor, Jones and Jenkinson (2004) use a proprietary grading of the investors in a bid to assess whether an investor is a long term investor or a mere ‘flipper.’

1) Long Term Investment in the Stock Market

In IPO’s, the underwriters have the discretion over shares allocation to an organisations investors. It is upon this backdrop that this section delves into analyzing the importance of the characteristics of investors in the determination of IPO allocations and most importantly, which investors are preferred by underwriters when making share allocations in IPO. However, literature in regard to this topic proves that institutional investors are usually favoured by underwriters but little is known relating to the characteristics of potential investors (Kleeburg, 2005).

Jones and Jenkinson (2004) hold that long term investors are usually favoured by underwriters and majority of investment banks claim that the quality of an investor greatly influences their decision in IPO investment. Jones and Jenkinson (2004) continue to define a quality investor as an investor who is a long term holder in the stock market. Thus, it is of crucial importance to not that long-term investment is an important characteristic of a potential investor.

Aggarwal (2000) is of the view that underwriters have a preference for long term investors since the major objective in share allocations is the minimization of the support price and the after-market stabilization. Share flippers (investors who flip off their shares immediately in the aftermarket) usually slow down the trading share prices and consequently, the support price costs and the aftermarket stabilization. This is the reason why underwriters discourage share flipping through future IPO exclusions or penalties.

Matos, Massa and Gasper (2005) and Li, Harford and Chen (2007) propound that long investors have a high probability of effectively monitoring organisations when contrasted to short term investors. These scholars hold that short term investor organizations yield poor returns as compared to long term investor organizations.

2) Regular/Frequent Investment in the Stock Market

Goldreich and Cornelli (2001) present proof that frequent investors (investors who previously participated in initial public offerings offered by the same underwriters) are also accorded favourable IPO allocations. Fishe and Boehmer (2004) emphasize the significance of relationship-founded IPO participation.

They prove that underwriters favour frequent institutional investors in offerings that are more profitable. Pirinsky, Binay and Gatchev (2007) also assert that relationship-founded IPO participation enhances underpricing.

3) Generation of Large Commission Revenues on Investment

Majority of researchers have paid much of their attention on the ‘quid pro quo’ perspective of IPO allocations, where underwriters allocate the shares underpriced on the basis of future and past commissions or other sorts of trade (Ritter and Loughran, 2002-2004).

Investors who have generated large commissions on revenue in the past or investors with the potential of generating large commissions on revenue in the future are usually favoured in IPO allocation of heavily underpriced shares. Reuter (2006) puts this ‘quid pro quo’ perspective to the test and proves that there is a strong correlation between the brokerage commissions usually paid to the underwriter and their holding on the stock of a previous conducted IPO allocation by the same underwriter.

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