(This is a piece I had written for Moneylife in 2008- Before it became readable- the rough draft)

IPO’s and the merchant bankers- Takeaway for investors

Quotes from a newspaper:

“regulator’s inspection showed that the details of the promoters as mentioned in the IPO document were different from the one filed with the Reserve Bank of India.

, the merchant banker had not even verified the plant and machinery of the companies, the issues of which they had managed

one IPO, the regulator found out that the post-issue capital of the company was higher than its authorised capital —“

Above are some “omissions & commissions” by merchant bankers whilst managing IPO’s, according to a press report. The report also says that the regulator is likely to impose penalties on the merchant bankers concerned.

IPO business is funny business. Every issuer wants to sell shares at the highest possible price. Obviously, once an issuer short lists a few merchant bankers, then the actual choice would be made on who would offer the highest price. In any IPO, the fee is large. It could be a lowly 1% to as high as 5%. For an issuer, the total expenses can be in the range of 7 to 11% of the issue. Naturally, a 10% higher pricing means that the issue expenses are covered.

IPO’s, under the book building route can only proliferate in a bull market. In general, most IPO’s tend to be overpriced. All IPO pricing is based on some rosy picture of the future, so it is but natural that at least half of them will fail to live up to promises.

Once an IPO goes under water, the IPO investor feels cheated. Once many go, the noise levels increase. Investor forums start shouting and ask for action against lead managers etc.,

Firstly, no investor is forced by anyone to invest. He makes a conscious choice. He is being misled by the noise surrounding an IPO. He has no access to the prospectus or has no expertise to understand the same. So, he goes by his broker/friend/media views and plonks his money. Most investors I know want to keep flipping each IPO on allotment and move on to the next. One group just keeps piling up the IPO allotments. Over time, they sell where they see gains and hold on to the ones under water. In many cases, the reasons for holding on are psychological. Further, in each issue, the amounts involved are small (though it all adds up to a tidy sum) so there is a tendency to hang on. Over time, some of them become worthless and move on to the “vanishing companies” list.

What about the lead manager? To my mind, the lead manager/s should be punished only if there are compliance issues. If there are mis-statements, suppression of facts (which any due diligence should have thrown up) or any other act/omission which could have materially altered the story, then they should be punished. Here, the punishment should be severe and not nominal. I would say that suspending all the business of the entity for six months to a year plus a financial penalty which is at least four to five times the total fees involved in the issue should be levied. The penalty should hurt. A few lakhs does not make a difference to most merchant banks. Suspension of activities (all business done by the entity/group) in capital markets is a must. Only then would it hurt.

There would be instances where the lead manager is taken for a ride by the company. Such cases would be complex in nature. For instance, one of the cases cited above relates to the company filing some return with the RBI. It is very unlikely that the merchant banker would be able to verify this and to my knowledge, would not fall in the check list for due diligence. However, non-existence of plant and machinery is something that is amazing. So is the case of the authorised capital not being adequate. These are elementary errors and the punishment should be very severe. In fact, taking away the capital markets business licence would be a fit action in these cases. When a merchant banker takes on an IPO mandate, his responsibilities are huge. He may not have all the expertise himself, so he has to hire the right people to help him in this. On pricing, it is what the traffic can bear, so no issues with them. I would not blame a merchant banker on this. If he does this frequently, the market place would judge him over time.

Pricing is something we all like to hold the merchant banker responsible for. If an issue lists at a huge premium, then the issuer has lost. Similarly, if the issue lists at a discount, the investors get hurt. There is no answer to this. The merchant banker gets paid by the issuer. Naturally, his first loyalty lies there. As far as the investor is concerned, he has to take his call. There is no point in saying that if institutional investors put in money, they would have done their homework. World-over, there is an unholy nexus between institutional investors and merchant bankers (who also are brokers). The institutional investor can move more quickly, he has access to much more information than the retail investor would have.

The retail investor is all alone in this. The IPO grading system has been discussed in our magazine. Whilst it is a useful tool, it gives no help on pricing. This brings home the lesson that equity investments are fraught with risk. IPO investing is perhaps more risky than a secondary market investment. In the secondary market, you would have access to more information, research and price history. Further, in most IPO’s one has no idea about the management quality and capabilities. You may end up with a multi-bagger or end up with tissue paper. It is best to be cautious. In IPO’s, the advantage is typically with the issuer. He comes in at a time and price convenient to him. It need not coincide with what is good for an investor.

One issue relates to pricing disclosure. Whilst giving the mandate to a merchant banker, all issuers insist on a “price range” at which the merchant banker can place the shares. Without this, no issuer will give a mandate. However, the public get to know of a price only when the issue is about to open. All offer documents have a blank in the price disclosure. I understand that pricing can change, in tune with market conditions. However, why not give the indicative price band whilst filing the red herring or the draft prospectus with SEBI? This would give time to analysts to give their views on the issue. Today, most analysts do not get time to do this efficiently, because the price band fixation and the issue opening happens with a gap of a few days. This is something for the regulator to consider. Let the issuer be free to fix a totally different price when actually opening the issue. By giving the indicative price range up front, it would help the investor to take a better view and lead to more analysis and information to the potential investor.

The funny thing is that we all get introspective and rational when the markets are down. When a bull market resumes, all of us forget our lessons and plunge headlong in to putting our money back in to the markets, hoping to make a quick killing. By and large, IPO’s do give an opportunity to make money, depending on whose greed is greater at a point in time. In a bull market, the issuer takes advantage of the investor greed. In a bear market, unless the issuer is desperate, he waits it out.

 

 

August 23, 2008.

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