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India Knowledge@Wharton | Public benefits of public offerings

India Knowledge@Wharton | Public benefits of public offerings
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First Published: Mon, Mar 31 2008. 12 17 AM IST
Updated: Mon, Mar 31 2008. 12 17 AM IST
Last year, a record number of firms went public in India and many realized spectacular returns on the opening day. The euphoria was dampened earlier this year, however, when realty firm Emaar MGF Land Ltd withdrew its public offering, and Reliance Power saw its initial public offering (IPO) shunned by the equity market, dropping 17% on the first day.
All of this news has kept the media busy. But, according to Vinay B. Nair, a senior fellow at the Wharton Financial Institutions Center and a visiting professor at the Indian School of Business, the vast amount of attention given to IPOs should not be focused on their returns, but rather on their broader economic benefits.
“IPOs provide more transparency into the functioning of the economy,” Nair writes in a recent India Knowledge@Wharton op-ed piece. “In the past, with so many notoriously opaque private firms, how the corporate sector was performing was as much guesswork as reality. This new spurt of IPOs will, in the future, provide up-to-date and valuable information to policymakers and to investors interested in India.”
IPOs also “spur innovation”, he adds, by taking some of the guesswork out of valuing young start-ups and providing “an attractive exit opportunity” for “venture capitalists and other financiers of innovation”. Additionally, the “transition from a private to a public economy will spur an active market in mergers and acquisitions”, ultimately leading to “an active market for corporate control, and better allocation of resources in the long run”, he writes.
These advantages “are often lost amid the din of returns,” Nair notes. “But, over time, they are more important than the fast profits—and sometimes equally fast losses—that IPO news tends to focus on.”
Can overconfidence make executives cross the line?
No one makes it to the top ranks of corporate management without a healthy amount of self-assurance. Confidence underlies decisive, strong leadership, but does overconfidence lead managers to cross the line and commit fraud?
Wharton accounting professor Catherine M. Schrand and doctoral student Sarah L.C. Zechman are developing a paper, Executive Overconfidence and the Slippery Slope to Fraud, that examines patterns in frauds to determine if some frauds evolve, not out of pure self-interest, but because executives are overly optimistic that they can turn their firms around before fraudulent behaviour catches up with them.
According to the researchers, “earnings management”—or stretching the rules to cover up poor corporate performance in a single period—is likely to go undetected if performance does improve. If not, managers continue to engage in earnings management in increasing amounts.
“Eventually, the manager’s only option is to ‘cook the books’ by falsifying documents and making the kinds of accounting misstatements that are prosecuted by the SEC (the US Securities and Exchange Commission),” the authors write. An overconfident manager with unrealistic beliefs about future performance is more likely to engage in fraud “because he is less likely to correctly anticipate the need for more egregious earnings management in subsequent periods.”
The researchers reviewed SEC accounting and enforcement releases from the 1990s and 2000s to examine patterns in companies that engaged in fraud. They explored the relationship between executive confidence and fraud across industry, firm and individual variables. They found fraud is more likely in industries that are complex and undergoing rapid growth, such as high-tech. Schrand notes that the most meaningful variable in linking fraud to specific industries is high stock-return volatility.
“The sample demonstrates industry clustering in risky, dynamic, high growth industries that face significant idiosyncratic risk,” the researchers note. “The management literature has shown that such industries are attractive to overconfident executives.” But, Schrand acknowledges that such industries also may exhibit more fraud because the incentives to commit fraud are greater or because it is easier to commit it.
Schrand adds that overconfident leaders also have assets that any firm needs to succeed. “Given that the firm has to hire the whole person, you might actually want somebody who exhibits this bias. But, you should recognize that the overconfidence, which has its positive aspects, can also have a downside.”
Interested in more articles like these? If so, sign up for India Knowledge@Wharton (http://www.ikw.in), the Indian edition of Knowledge@Wharton, the online research and business journal of the Wharton School of the University of Pennsylvania. To receive India Knowledge@Wharton alerts on your mobile phone, SMS START IKW to 98453 98453
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First Published: Mon, Mar 31 2008. 12 17 AM IST