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IPO financing makes primary market riskier for small investors

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Chastened by aggressive IPO pricing, small investors perhaps would do well to bide their time and invest in the secondary market after the IPO dust has settled.

IPO financing makes primary market riskier for small investors
IPO financing targeting high net worth individuals is not a recent phenomenon in India but it has hogged headlines in recent times with the Reserve Bank of India (RBI) cracking its whip last week—come April 1, 2022, no non-banking financial company (NBFC) can finance a borrower more than Rs 1 crore for IPO financing.
As it is, High Networth Individuals (HNI) push the envelope by leveraging their resources to heighten their investments in IPOs. Suppose an HNI has at his disposal Rs 30 lakh and an NBFC is ready to finance him provided he puts up 30 percent as margin money. Now, by placing Rs 30 lakh with the NBFC, he can secure a loan of Rs 1 crore from it and thus heighten the chances of allotment.
Every IPO has risk factors. For an HNI resorting to leveraging, there is an additional risk factor—interest payable at the rate of 12 percent to 14 percent on the short duration loan usually for a week or 10 days. This interest has to be spread on the shares allotted to him. Lesser the shares allotted vis-à-vis the application, the greater the burden on each share.
The active NBFCs doing this business are the ones floated by broking houses. Some of them don’t consider loan applications for anything less than Rs 10 crore.
RBI must have been constrained to act presumably at the behest of the market regulator Securities and Exchange Board of India (SEBI). Already IPO prices in India are on the higher side on the back of aggressive pricing by merchant bankers.
Time was when IPO was supposed to be the safest starting point for the small investors. That was when the bean counter, if one may call the office of the erstwhile Controller of Capital Issues (CCI), was extremely niggardly in allowing premium on shares even to most profitable companies. This endeared the primary market to the small investors.
With the abolition of CCI and the SEBI stepping into the breach, the equation has been reversed—losing companies too can charge a premium, often unconscionable, so long as they embrace the 100 percent book building route.
In book building, the lynchpins are the Qualified Institutional buyers. They bid aggressively. Now they bid even more aggressively with HNIs snapping at their heels more furiously, thanks to the leveraged financing or IPO financing.
SEBI has adopted the Dutch model under which the price discovered is the bid amount for the last share on offer. To wit, suppose 10 crore shares are on offer. QIB 1 bids for two crore shares at Rs 200 each, QIB 2 bids for four crore shares at Rs 150 each and QIB 3 bids for fiv crore shares at Rs 140 each. Now the price discovered is Rs 140 per share across the board including to the small investor to whom the company might condescend to give a small discount. French model brings greater seriousness into bidding.
In the example on hand, QIB 1 will have to pay Rs 400 crore for two crore shares, QIB 2 Rs 600 crore for four crore shares and QIB 3 Rs 560 crore for four crore shares (though it had bid for 5 crore shares, it can be allotted only four crore with QIB 1 and 2 cornering between them the remaining six crore shares).
The French model makes the bidder stew in his own juices. The winner’s curse is more pronounced in the French model. In India, there is a 35 percent reservation for the mutual fund and retail investor category. So, it is strictly not 100 percent book building but let that not detain us. Dutch or French, small investors are at the mercy of the QIBs who play the pied piper. With IPO pricing getting more and more aggressive, equity cult enthusiasts are having to rethink their entrenched positions. Small investors may have to stay out of IPOs lest they are singed in the crossfire.
HNIs resorting to margin financing from NBFCs look for listing gains to pay back the loan and make a tidy profit in a short time which is a gamble. Small investors too have the same objective. In fact, equity cult enthusiasts held out listing gains as the spur for encouraging small investors so they are hooked to equity in the long run.
Now, chastened by aggressive IPO pricing, small investors perhaps would do well to bide their time and invest in the secondary market after the IPO dust has settled. After all true price discovery takes place in the secondary market over a long enough period of time. Sanity reigns the secondary market in the long run.
— S. Murlidharan is a CA by qualification and writes on economic issues, fiscal and commercial laws. The views expressed in the article are his own.
Read his other columns here
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