Initial Public Offerings in the Cyprus Stock Exchange

Abstract

The academic literature is quite rich in exploring Initial Public Offerings (IPOs) in developed markets and to a lesser degree in emerging markets. However, seldom one can find research on IPOs in start-up stock exchanges. Such is the case of the Cyprus Stock Exchange which was inaugurated in March 1996 and this thesis looks at IPOs that took place over a period of six years (1997-2002). Therefore, the first motivation is to explore this setting for IPOs. Moreover, the Cyprus Stock Exchange is probably the least researched stock exchange in the European Union. Out of the 12 countries that joined the European Union between 2004 and today, only Polish, Bulgarian and Hungarian IPOs are researched. Due to the comparatively young age of the Cyprus Stock Exchange and the Capital Markets in Cyprus in general at the time of the sample, the various players (underwriters, auditors, regulators, investors) were relatively inexperienced vis-à-vis the IPO process and outcomes of their actions (or rather their lack of action) affected the development of the primary market. Therefore, the second motivation stems from the specific institutional and regulatory characteristics of the CSE at the time of the sample.

Cyprus, a start-up stock exchange with a relatively new but comparably densely populated market for listed companies (150 listed companies), poses an interesting research case. In particular, the institutional characteristics that existed in the Cypriot capital market over the period 1997 to 2002 (a novice stock exchange, inexperienced market participants, lack of investment options available and restrictions in capital flows, a weak legal and institutional framework) combined with a number of socioeconomic and political factors at the time make IPOs in the CSE an interesting subject for empirical research. This ‘cocktail’ of inexperience, inadequate regulation, and limited equity culture provided the platform for the formation of a large IPO ‘bubble’ which eventually imploded.

Therefore, the motivation for the study develops the following research questions:
1. What is the level of first-day returns for Cypriot IPOs and how does that compare with the available literature?
2. What are the explanations for the level of short-run underpricing recorded?
3. What is the long-run (12-, 24- and 36-months) aftermarket performance of these IPOs and how does that compare with the available literature?
4. What are the explanations for the documented long-run aftermarket performance?
5. Did CSE IPO firms employ income increasing accruals prior to the IPO?
6. What is the level of understanding of Cypriot Managers of the IPO process in relation to the extant literature?

This thesis consists of three inter-related empirical studies on companies that were listed on the Cyprus Stock Exchange during the period 1997 to 2002. In particular, this thesis investigates the short- and long-run IPO performance of these companies (chapter 1). The variables employed are grouped into four categories namely advisor/certifier-, market/institutional-, issuer-, and IPO-specific. It is observed that CSE IPOs over the sample period offered investors the highest returns in a European market and one of the highest in the world. Following the establishment of these ultra-high returns, and the independent variables that are related to this spectacular performance, the thesis investigates whether these CSE IPO companies engaged in income increasing accruals before their IPOs (chapter 2).

In Chapter 2, both univariate as well as multivariate tests are employed to test the hypothesis that these firms actually employed earnings management pre-IPO using income increasing accruals which reversed after the 1st year of listing. In order to establish also the relationship between the short- and long-run performance of IPO firms, the latter are regressed with the earnings management variable which takes the form of discretionary accruals, total accruals or the components of accruals which are creditors, debtors, inventory, depreciation and cash flow from operations. The results show that both the short- as well as the long-run performance are also affected by the earnings management variable together with the other variables that are found to affect IPO performance in chapter 1.

Having examined the two aspects of CSE IPOs, i.e., short, long performance and earnings management, the thesis presents also the results from a questionnaire survey which aims at revealing managers of CSE listed IPO companies level of understanding of the IPO process and IPO ‘anomalies’ (chapter 3) and comparing this with the extant academic literature and also with the responses of managers in the US. Great effort, both theoretical and empirical, has been made to understand managerial decision-making in the initial public offering (IPO) process. Most empirical IPO research relies on publicly available stock return data. However, there is a need to extend the literature by examining how well managers’ motivations for conducting IPOs and understanding of the IPO process correlate with existing academic theories. By surveying managers in an emerging market to obtain a real-world perspective on the IPO process, their beliefs and experiences can be compared to both academic theory and the findings from empirical research. Cypriot managers’ responses in an emerging/novice market such as the Cyprus Stock Exchange can also be compared with those of managers in a highly-developed market such as the US. The combination/integration of the above elements makes this study, the first of its kind for Initial Public Offerings in the Cyprus Stock Exchange.

The results from the first study indicate the following:
a. The existence of ultra-high first-day returns.
b. The existence of a hot issue period.
c. Long-run under-performance of IPOs over a three-year period.
d. Significant institutional deficiencies.

Specifically, it is observed that IPOs in the CSE offered investors initial (first day) returns that are among the higher in the world even after adjusting for the hot issue period of 1999. IPOs ‘younger’ in age, offered higher short-run returns than ‘older’ ones. Furthermore, smaller IPOs as measured by the size of gross proceeds perform better in the short-run than larger IPOs. Moreover, IPOs in certain industrial sectors offered investors the highest initial returns. It is observed that gross proceeds, the time from application to listing, the capital structure of the IPO firm (leverage), the standard deviation of market returns 21 days after the listing, and return on shareholders’ equity provide a highly explanatory model of raw initial returns.

It is also found that Cypriot IPOs underperform in the long-run as the majority of IPOs in academic studies do. Cumulative Abnormal Returns (CARs) are negative for all years in the sample period during the 24-, and 36-month periods. In contrast, the 12-month period average CARs over the sample period are all positive. Moreover, IPOs in the ‘hot’ issue period have worse performance than the rest of the pack which confirms that findings of many researchers that IPOs in ‘hot’ periods have a worse performance than the rest in the long-run.

The standard deviation of returns 21 days after the listing of the IPO, the capital structure of the IPO firm (leverage), the return on equity of the IPO firm prior to listing and its sales growth prior to listing offer a satisfactory explanatory model of 36-month cumulative average returns.

Cypriot firms exploited a ‘window of opportunity’ that was opened in the market for listing. However, the high inefficiencies that existed and continuous changes that took place in the regulatory and institutional framework of the market as reflected predominantly by the large time span between application and listing (probably the longest in the World), had as a result huge delays in listing. Consequently, IPOs were caught up by the declining returns in the secondary market and the majority of them after the third quarter of the year 2000 opened below their offer price.

In summary, the findings suggest that the institutional and market aspects of the Cypriot capital markets affected the CSE IPO returns in a manner that produced astonishingly high returns. This thesis contributes to the existing literature by demonstrating that start-up stock exchanges with institutional and regulatory deficiencies offer a platform for highly abnormal IPO returns, which fade away though, in the long-run.

The results of the second study point out to the fact that earnings management cannot be ruled out for CSE IPO firms over the sample period. Specifically, using both univariate and multivariate tests it is observed that both discretionary accruals and total accruals rise within the prospectus time frame (pre-IPO) and reverse post-IPO. Moreover, change in profitability measures, namely return on sales, return on assets and return on assets net of cash, demonstrate significant statistical difference when compared pre-IPO and post-IPO.

Finally, when the IPOs price performance (short and long) is regressed against a set of independent variables and among them, a variable for earnings management which takes the form of discretionary accruals, or total accruals, or the components of accruals over the same period it is observed that discretionary accruals have a positive relationship with short-run returns, meaning that as accruals rise, underpricing increases. This can be attributed to the faster adjustment by underwriters of valuations to take into account income increasing accruals, and at the same time the inability of investors to revise with the same degree and speed their valuations due to the high levels of exuberance that existed in the market as these were manifested by the high level of secondary as well as primary returns as well as possibly their lack of sophistication to do so. Moreover, it is argued that the components of accruals explain well the long-run stock price performance.

The third chapter of this thesis presents the findings from a questionnaire survey of managers of listed companies in the Cyprus Stock Exchange. It is suggested that in some areas, there is harmony between managers’ beliefs and academic theory. Nevertheless, in other key areas, managers’ perceptions diverge from traditional academic theory. It is also evident that Cypriot managers’ overall views coincide at large with views of US managers, a country with arguably the most advanced capital market in the world.

Several general implications can be drawn out of this thesis for academics, regulators and policy makers, investors, professionals such as security analysts and certifying agents and companies aiming at listing their shares. Specifically:
 The academic community, which could utilise the findings from the study to understand better the role of institutional setting on IPO ‘anomalies’ as well as the ‘maturity’ of stock exchanges on IPO price performance behaviour.
 Policy makers and regulators alike to assist them in drafting improved laws for the future as well as avoiding mistakes of the past. Specifically, the laws must aim at protecting the minority shareholders and making more accountable certifying agents and managers of IPO firms.
 Investors and portfolio managers who will be more educated and informed on making better decisions in the future regarding IPOs especially in newly formed equity capital markets. In particular, stock exchanges that lack strong institutional framework could offer excellent opportunities for ultra-high short-run returns.
 Professionals (such as corporate financiers, accountants and lawyers), especially those dealing with IPOs who will be able to draw on the findings of the study to improve the knowledge and professional practices when dealing with issuers. Principally, certifying agents to become more wary of firms that employ accruals aggressively to enhance valuation parameters and achieve higher gross proceeds.
 Prospective issuers to become more educated on matters involving avoiding the boosting accruals and consequently IPO valuations as this is a short-lived trick of becoming unpopular with market participants.