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Of Primary Concerns

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September was not good for 66-year-old Joe Saldana (name changed). His investments via initial public offerings (IPOs) fell 16 per cent. Three of them — Orient Green Power, Ramkay Infra and Electrosteel Casting — are down 3-21 per cent from issue price. For the year, Saldana's IPO portfolio of six stocks is trading 10.5 per cent lower, though SKS Microfinance and Bajaj Corp helped recover some losses.

A retired government employee, Saldana first ventured into stocks in 2005, in the follow-on public offering (FPO) of Syndicate Bank. He applied for 500 shares and was allotted 125. His subsequent investments in Yes Bank, IDFC, Indian Bank and Power Grid have paid off hugely. But now, he wants to avoid the IPO market. "Initially, the reason to invest was simple: guaranteed returns and the confidence that the capital would be safe," says Saldana. "The IPO market was an opportunity to invest in new and emerging sectors. But today, I can still get my stock at a discount in the secondary market after listing."

C.J. George, managing director at Geojit BNP Paribas Securities, adds: "More retail investors are staying on the sidelines as they are not sure of making money through IPOs." Ironically, the Securities and Exchange Board of India (Sebi), at its 25 October board meeting doubled the retail bucket size from Rs 1 lakh to Rs 2 lakh per application.

IPO markets boom in a bull market. Usually, there will be stocks that are overpriced. There are also companies that may not stand up to serious scrutiny, but ride the IPO euphoria.

Over the years, the IPO market has also changed structurally — from being a market that brings in new investors, new companies and entrepreneurs, it has become a sophisticated betting game of probabilities (how many times will it be subscribed) through estimating demand (how much application money will generate the maximum allotment) to what the return could be (what price will it list at).

The market is no longer geared towards exciting retail interest — other than as a marketing ploy — but towards bringing in large institutions and high networth individuals (HNIs) as investors. That has changed the players, the behaviour of market intermediaries, investment bankers' pricing strategies, and even impacted the rules. Now the game is about the best chips your money can buy at the casino tables and less about the best company to invest in; less about corporate performance, and more about market performance.

The New Order
Following the global crisis, when equity markets opened up after May 2009, many companies raised capital mainly through qualified institutional placements (QIPs). Companies paid the debt they had taken on for ambitious expansions and acquisitions in 2007.

The resurgence in equity capital markets continued in 2010, which led to an active primary market. "We saw IPOs from companies in the broader consumption segment, infrastructure and financial services receiving an outstanding response from investors," says S. Ramesh, chief operating officer at Kotak Mahindra Investment Banking.

If demand is robust, then why has it not been rewarding for investors? The difference has been pricing. "Unlike in 2007, when any deal could get done, in 2010, for a deal to be successful, it has to be priced right," says P.V. Krishna, executive director of global capital markets at Morgan Stanley. That seems to be borne out in actual experience too.

Ten of 15 companies that tapped the primary market in September this year are trading lower than their offer prices, even as the BSE Sensex crossed 20000. The biggest fall is in Tirupati Inks, which is trading 54 per cent lower than its offer price of Rs 43 per share.

Going back further, a quick glance through the 37 public issues that came to market this financial year (till 15 October 2010) shows that 17 gobbled investors' capital; six gave just single-digit returns and below the ‘risk-free' rate of return of 7.8 per cent (the coupon rate of 10-year government bonds) (see ‘Report Card: How IPOs Have Fared'). Only 14 made investors happy: Career Point Infosystems doubled investor wealth on the day of listing, and now everyone is waiting for the opening of Coal India on 4 November.

 Last year was similar. Of 44 companies to hit the primary market, 20 gave reasonable gains, while investors made losses in 17, and seven delivered single-digit returns. Issues that have made money, have received good response from institutions, HNIs and retail investors.

 "Investors are exercising caution and are seeking more details about the company before committing to investing in an IPO," says Rahul Chawla, head of global markets solutions group at Credit Suisse India. "Why some aren't doing as well is not because of the quality of paper, but because of less attractive pricing," he adds. Are investment bankers getting it wrong?

Mary, Mary, Quite Contrary…

"There isn't anything called fair pricing or price discovery," says a senior banker on condition of anonymity. "Everything is pre-sold between the filing of the document and before the issue hits the market. So institutions that invest in a company's IPO are guaranteed positive returns (bankers try and ensure a pop-up on listing of about 10-15 per cent on most if not all IPOs)."

In simple terms, the IPO market has become an ‘operator's market', a term reserved for the kind of activity that prevailed in the 1980s, when the market was less developed. In all fairness, not all companies that hit the primary market have a promoter-operators nexus. But in today's IPO market, smaller issues (Rs 200-300 crore) are unlikely to succeed without such a nexus, feel analysts. So size matters.

The shift in size has been fundamental, with average issue size going up five-fold. Average issue size increased to Rs 852 crore in 2010 so far, (this could go up), and to Rs 1,067 crore in 2009, compared to Rs 421 crore in 2007 and Rs 268 crore in 2006. Between April and 21 October 2010, 38 public issues raised Rs 32,375 crore, compared to Rs 46,957 crore raised through 44 issues in FY2010 (see ‘Catching On').

Click here to view enlarged graphBut there is a caveat: once the government's disinvestment plan (Coal India, SJVN and Engineers India) is accounted for, and a couple of large IPOs (Standard Chartered Bank's IDR and Jaypee Infratech), the average IPO size drops to Rs 280 crore. It is always easier to ‘manage' stock prices of smaller issues.

But while Rs 1,000 crore-plus issues are not unusual, even greenfield projects have been financed through large IPOs. Cases in point: Reliance Power, Indiabulls Power and JSW Energy. These companies have raised money only on the promoters' reputation, and much like the Internet boom in the US in 2000, financial parameters have no bearing.

…How Does Your Garden Grow?
If the IPO market is a members-only casino table for a few ‘operators', how does it work?  Boiled down to basics, it is about managing demand. Say, a company raises Rs 100 crore in an IPO. According to the listing agreement, it has to compulsorily dilute 25 per cent (for market cap of Rs 4,000 crore and above, it can be 10 per cent, with 15 per cent to be diluted in the next three years). The other 75 per cent is locked in for at least one year; no selling by promoters.

Trading history numbers suggest that on the day the stock is listed, about 60 per cent investors come to sell. In the first two days, there is huge selling and thereafter the stock stabilises. Once the operators corner shares worth about Rs 30 crore, and if there is demand for the stock during the IPO, it is easy for the operator to jack up the stock price further. Even with other anchor investors in place, operators can play the stock for at least a month.

Here's an example: the Rs 115-crore Career Point Infosystems IPO. Such was the frenzy for the stock that it was oversubscribed over 41 times. Anchor investors also bought the stock at the higher end of the price band of Rs 310 per share. On the first day of listing (6 October 2010), the price doubled to close at Rs 632.35 per share. The next day, it hit its all-time high of Rs 711 per share. Since then, it has drifted down, and is currently trading at Rs 482-levels. Since listing, the stock has closed lower almost every day from the previous day's closing price.

Some investment bankers say promoters are not averse to playing this game either. Everyone wants to make sure they take their piece of the profit. "Today a fund manager asks for 5 per cent in gains on the very first day, besides wanting an exit," says a senior banker on condition of anonymity. "Despite the bull run, the primary market continues to remain a buyer's market and investors still have a reasonable say in pricing," says Sanjay Sharma, head of equity capital markets at Deutsche Equities.

Hay And Sunshine
The operators usually charge 15 per cent of the total issue size and for any company the cost incurred to raise money through IPO ranges from 6-10 per cent depending on the issue size: smaller the issue, greater the cost and vice versa. The total cost incurred by a company for a Rs 100-crore issue is about Rs 22 crore.

If a company requires Rs 100 crore to fund its project, the first step is to raise the valuation cost and increase the issue size to Rs 120-125 crore. The operator plays a dual role in garnering interest in the stock —  through grey market activity and market-making after listing. If the market is ready to pay Rs 80, it will generate interest and demand in the grey market will start from Rs 90 to Rs 110-120 a share before the stock even lists.

Click here to view 'Report Card: How IPOs Have Fared'

Then why have most small- and mid-size issues bombed? Because investors are staying away. Like for Bollywood movies, if the audience does not turn up in theatres on the first day, the movie flops. Similarly, on listing, if the mood in the market is bad, the stock will only drift down and lose interest among investors.

Operators take the risk if the issue fails. But out of 10 issues, they make a killing in at least 3-4 stocks. Which worries a lot of people. "The worry is that the operator is also getting fatter and his ability to take risks is increasing," says Vineet Suchanti, managing director of investment banking firm Keynote Corporate Services. "The concern is their influence may spread from small issues to the larger ones."

Brokers and intermediaries with large retail distribution networks aren't pushing IPOs the way they used to either: it's too costly. Gone are the days when application forms were included in your daily newspaper docket; the long lines outside banks and collection centres have disappeared with the arrival of demat. So distributors get no revenue for pushing an issue.

Whither The Retail Investor?
Making money for the ‘small' investor — the definition of that has changed too — has become difficult. "Valuations are seemingly higher. Bankers are to be blamed as they are offering the highest premiums to get the mandate," says George of Geojit BNP Paribas Securities. "Earlier, manipulation was visible where pricing was not realistic. Today, even good companies' valuations are not realistic." He blames the large bankers for spoiling the market, and for creating hype about a company. Promoters, too, get greedy and want an over-valued price.

Institutions, too, are cornering a large chunk of the offer, even in small and mid-sized IPOs. With greater liquidity being available, and FIIs bringing in large amounts, aggressive pricing has become the norm. Institutions, and HNIs,  put in large amounts and if the stock gets a lukewarm response on listing, they flip.

The just-concluded Coal India IPO, India's largest so far (Rs 15,500 crore), attracted a number of large US-based long-only and pension funds. "We have seen a change in the type of investors participating in IPOs," says S. Subramanian, managing director of investment banking at Enam Securities. "We see large US-based funds directly investing in Indian IPOs. In the domestic market, too, we have seen the emergence of new provident funds tapping the IPO market." Prior to July, most FII investors in the IPO market were from the Far East.

Add to this the growing number of investment banking firms that are competing for a share of the IPO market, and the ever-growing number of FIIs. Growing demand, greater  competition for the business pie, and so many companies looking to raise capital, all add to aggressive pricing and selling.

 "There could also be an investor category that churns the money multiple times in various equity offerings," says Sharma of Deutsche Equities. "But the buoyant primary market has created a balance in the market by absorbing a reasonable portion of the large inflows from FIIs so far. In absence of this, the secondary market could have zoomed up to dizzy heights." That is an unintended consequence, though.

The frenzy in the IPO market has not translated into interest in other instruments like foreign currency convertible bonds (FCCBs) though, because investors want to stay liquid, says George. "Besides, FCCBs are unsecured, and if there is a default, they are secondary to domestic creditors," says Suchanti of Keynote. "Large companies such as Bharti Airtel, which have assets overseas, do better with FCCBs."

Click here to view enlarged graphInstitutions also have to bear foreign exchange risk from the time they apply in an IPO till the date of refund. If they do not receive the said allocation, they can lose up to 10 per cent due to currency fluctuation alone. In the Coal India IPO, investors are said to have lost close to 6-7 per cent before the opening of the issue.

An Eye on the Horizon
Despite all this, investment bankers remain gung-ho. The Coal India IPO created a platform for future IPOs. Bankers say the impact is similar to that of the ONGC FPO in 2004, which revived the overall primary market and brought retail investors into the fray. Coal India attracted 1.7 million retail investors.

"We see the start of a new investment cycle and expect Indian entrepreneurs to undertake expansion and diversification plans," says Ramesh of Kotak. He sees significant issuances in 2011. "Companies with negative cash flow (predominantly in infrastructure and asset-heavy industries like real estate) will continue to need to tap the IPO market," adds Enam Securities' Subramanian.

So will the IPO party go on? Well, 62 companies are waiting to raise around Rs 1 lakh crore from the primary market; half of this is expected to come from the gargantuan follow-on offerings of Indian Oil (Rs 20,000 crore), SAIL (Rs 18,000 crore) and ONGC (Rs 15,000 crore) (see ‘Raring To Go', page 33). But "with barely two months left in the current calendar year, I don't expect large offerings," says Sharma.
"The momentum in the primary market will continue, but not all companies — state-run or private — will be offering attractive returns for investors," says Chawla of Credit Suisse.

In such a scenario how should retail investors tread the IPO market waters? With caution. nPromoters: Check past records, performance and criminal proceedings against them. nIPO: Is the promoter cashing out, or is the business in growth stage? nSector: The industry should be growing at a decent clip or should have the potential to grow.

  • Company: Compare with industry peers. Look carefully at financials, balance sheets, profit and loss statements, industry growth, products, etc. It should be able to grow in size.

  • Valuation: Should be fair. Profit visibility should be near-term. It should not account for profits that are two-to-three years down the line. Ideally, it should be valued lower than  similar-sized companies.

Raising money in India's booming economy cannot be a one-time affair; if a company does not maintain a good relationship with its investors and rewards them well, it may not be able to go back to them when it wants to raise money later. Retired folk like Joe Saldana have long memories. Unlike a casino, they do not take their money to the market and leave a portion of it behind thinking they had a good time. They want it back, with interest.

Click here to view 'IPO Elements'