CROWDED: IPOs such as those from Reliance Power, DLF and BSNL are cashing in big (AP)

The american architect, designer and inventor Buckminster Fuller once said “Every time I draw a circle, I step out of it.” Paraphrase that to the Indian market for initial public offerings (IPOs) and you will have to think in terms of concentric circles. Ever since the Reserve Bank of India (RBI) drew a circle around banks by banning them from financing IPO investment in the wake of a scam three years ago, financial services companies have been finding innovative ways to get out of circles. Let’s use the Reliance Power IPO as an example, given its prominence and the market hype. 

First circle. A stockbroking firm goes to a credit rating agency and seeks a rating for money it wants to raise from the market, ostensibly to finance its trading operations. Usually, these borrowings are short-term to enable the firm to be able to fund its stock-in-trade, purchases made on behalf of its clients. It borrows at say 16 per cent. 

Second Circle. Buyers of these firms’ paper — usually commercial paper — are mutual funds, for whom the rating is enough a guarantee that the paper the funds are investing in will give them the kind of returns investors in the mutual fund’s schemes are looking for. The main investors in such schemes are usually corporations sitting on cash. The fund pays the corporation 13 per cent, say, keeping a spread of 3 per cent. 

Third Circle. Usually these funds would have ended up in the inter-corporate debt market, but exposure and disclosure limits prevent these cash-rich companies from lending to other companies. But an investment in a mutual fund for a short period — usually less than 25 days — is permissible, and carries a lower risk; compared to returns of say 8 per cent on government bonds:the company gets a relatively risk-free return of 5 per cent.  

Fourth Circle. With the money so raised, stockbroking firms then approach high net worth individuals (HNIs) with a proposition for investing in IPOs. The proposition goes thus: based on the grey market — the equivalent of what is called a when issued market — the possible levels of oversubscription are worked out, of which there can be many: 100 times, 125 times, 150 times, etc.  

Based on the assumption that an investor gets 10 shares for every 1,000 applied for, the HNI puts up Rs 4,500 (Reliance Power is around 450 a share). The balance (Rs 4,45,500) is funded by the stockbroking firm. Coincidentally, note that the amount funded equals the expected refund amount, which implies that the lender is covered fully on principal.
The interest rate could be 18 per cent or higher.  

The allotment is complete, the refund goes to the lender, and the shares to the HNI. At 18 per cent on Rs 4,45,500 (the loan amount for a 1,000 share application minus the investor’s contribution) the interest works out to about Rs 461 per share. Total cost of one share to the investor: Rs 911. If the share is listed at Rs 1,211 — which is what this elaborate scheme is all about, taking advantage of as high a listing price as possible — the investor makes a per share return of Rs 300 in 21 days (the allotment process time) or Rs 3,000 for an initial outlay of Rs 4,500 — about 67 per cent in absolute terms. 

The firms, in their emails to HNI investors, have suggested that their segment — 2,28,00,000 shares, or 10 per cent of the issue — would be oversubscribed 150 times. The Reliance Power IPO has generated thousands of crores in investor interest. Apply the math to the size of the HNI segment, and the returns look phenomenal. Welcome to the world of ‘structured’ finance. Meanwhile, regulators also circle around — watching helplessly.

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(Businessworld Issue 22 January - 28 January 2008)