Raj Gandhi MMS Finance 18

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IPOs-A Balanced View

Introduction

Equity markets remained largely public for quite long. Public equity has a long history dating

back to about 200 years. The first publicly issued security can be tracked back to the 14th

Century in Venice.

In 1693, King William of England raised one million pounds from the public at a fixed

interest rate of 10 percent. A year later, the Bank of England was formed. The largest

company at that time to get listed was the South Seas Company, which was listed in 1711.

The company also set what is termed as the first stock market crash. It was about 60 years

ago the first steps in promoting private equity emerged which made rapid progress that

intensified in the 1990s.

In India one can probably say that the seeds of stock broking in India were probably sown by

the British East India Company way back in the 18th century. The term paper (promissory

notes, debt instruments) floated by the company to finance its activities is one of the first

recorded instances of group speculative activity of any kind in India. By January 1865,

Bombay had 31 banks, eight land reclamation companies, 16 cotton-pressing companies, 20

insurance companies, and 62 joint stock companies. But it took one man- as it often does- to

bring matters to a head. That was Premchand Roychand. He was the first big bull of

speculative trading in India and had a fan following and prestige in Bombay that was

unrivalled even by some of the biggest businessmen of the times.

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Public equity capital markets for long have played a stellar role in helping

the economic growth process by enabling and assisting corporates to raise

critical financial resources at fairly lower costs. Their contribution is

immense in providing risk capital crucial for the corporates and new

businesses. They also have undergone a massive transformation and

change in the form of adopting best practices, greater transparency and disclosure, wider and

frequent dissemination of information to investors, helping and assisting the regulators in

creating a conducive environment of healthy growth of securities markets. It is precisely due

to proactive initiatives of the public equity markets that enabled massive entry of retail

investors into securities markets in the last two decades and helped policy framework to

underline the importance of development of equity markets as an important aspect of the

financial policy both in mature and emerging economies.

A nations capital markets are the barometers of its economic climate. Any nation that is or

aspires to be economically strong must have efficient capital markets. They perform the

important task of transfer of funds from surplus units (savers) to deficient units (borrowers).

Capital Markets are bifurcated into

1. Primary markets and

2. Secondary markets.

Primary markets deals with funds, which gives rise to issues of new securities and lead to

asset creation and investment activity in a country. Secondary markets deal only with the

trading of securities already issued and does not lead to asset creation. The purpose of the

secondary market is to provide liquidity to the securities issued in the Primary market.

Primary and Secondary markets comprise of both the debt and equity markets. Public equity

markets are those where corporates raise resources through IPOs by getting listed in the stock

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exchanges. Public equity markets are subjected to a wide range of governance, disclosure,

transparency and compliance norms set by the securities exchanges commissions/

government agencies and also the self-regulatory functions set by the exchanges themselves.

Institutional and retail investors mostly use this channel.

Companies often find the need to raise new capital to support current operations, for

expansion, or for the development of new business opportunities. An initial public offering

(IPO) of stock is often chosen as the vehicle to raise a substantial amount of cash to

implement a company's growth plans. After an IPO, a company may still find the need to

raise additional cash and may choose to have a secondary (also known as follow-on) public

offering. A follow-on offering is simply a public offering of newly issued equity securities by

a publicly traded company. IPOs can also be for either debt or equity. Research shows that

the level of activity in the IPO market is directly related to the level of activity in the

secondary market.

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WHY DO COMPANIES GO PUBLIC?

The decision to take a company public in the form of an initial public offering (IPO) should

not be considered lightly. There are several advantages and disadvantages to being a public

company, which should thoroughly be considered. This section will discuss the advantages

and disadvantages of conducting an IPO. The reader should understand that the process is

very time consuming and complicated and companies should undertake this process only

after serious consideration of the advantages and disadvantages and discussions with

qualified advisors. There are a lot of parameters to look in to before a company goes public.

Although going public has many potential benefits, disadvantages also exist.

Some of the reasons why a company would go public are:-

New Capital: Almost all companies go public primarily because they need money. All other

reasons are of secondary importance. The typical IPO raises Rs.50-100

Crores, but offerings of Rs.500 Crores are not unusual either. This can vary

widely by industry. A public offering will allow a company to raise capital

to use for various corporate purposes such as working capital, acquisitions,

research and development, marketing, and expanding plant and equipment.

Future Capital: Once public, firms can easily go back to the public markets to raise more

cash. Typically, about a third of all IPO issuers return to the public market within 5 years to

issue a "seasoned equity offering". Those that do return raise about three times as much

capital in their seasoned equity offerings as they raised in their IPO.

Image: Public firms tend to have higher profiles than private firms. This is important in

industries where success requires customers and suppliers to make long-term commitments.

For example, software requires training and no manager wants to buy software from a firm

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that may not be around for future upgrades, improvements, bug fixes, etc. Indeed, the

suppliers' and customers' perception of company success is a self-fulfilling prophesy.

Mergers and Acquisition: Many private firms just do not appear on the "radar screen" of

potential acquirers. Being public makes it easier for other companies to notice and evaluate

the firm for potential synergies. If a sufficient volume of shares trade on a daily basis at a

positive, balanced multiple of the company's earnings, the company may be able to use its

own stock as currency to acquire other companies, thereby preserving cash for other

purposes. Such a company would also be more able to accomplish an acquisition that is not

taxable to the selling company or its shareholders, which could reduce the acquisition

purchase price.

Liquidity: Going public enhances the liquidity of a company's stock and it is one of the most

common techniques for achieving liquidity for early investors such as venture capitalists.

Once shares of a company are traded on a public exchange, those shares have a market value

and can be resold. Moreover, it also provides investors in the company the option to trade

their shares thus enhancing investor confidence.

Employee recruiting and Retention: A company may be able to attract and retain more

highly qualified personnel if it can offer stock options or other equity interests with a known

market value. Also addition to normal cash compensation, the company can offer an

ownership interest in the company that is readily tradable. Stock awards, stock options, and

stock appreciation plans are valuable tools in the quest to build a qualified and dynamic work

force.

Cashing Out: An entrepreneur or a venture capitalist who had invested in the company now

has the option to cash out by selling some of their stock in a public offering. The founders

can diversify their holdings and thereby reduce somewhat the element of risk from their

personal portfolios.

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Increased Net Worth And Credibility: The capital provided by an IPO will increase the

companys net worth, making the company more attractive to lenders, who might then loan

the company additional funds at more favorable rates, providing a means of entry into

different capital markets from which the company might obtain financing for future projects.

In addition, an IPO gives the small company a measure of national or regional exposure. The

mere undertaking of an IPO is a strong advertisement of a companys strength and financial

well being. A successful IPO only serves to enhance this reputation. One drawback should be

noted, however: as positive as a companys exposure may be as a result of a successful IPO,

it can be just as devastating to a companys reputation to be the victim of a failed IPO. So let

us also consider some of the disadvantages of an IPO.

Image and Prestige

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WHY DO SOME COMPANIES NOT GO PUBLIC?

While the picture might seem rosy, and the choice of whether to

undertake an IPO an easy one, the undertaking, like all business

ventures, is not without its disadvantages. A lot of consideration and

thought has to be given before coming out with a Public Issue. In

addition to the advantages, the disadvantages and risks if not considered and calculated can

result in some quite rude shocks.

Time and Expense: Conducting an IPO is time consuming and expensive. A successful IPO

can take up to a year or more to complete and a company can expect to spend several

hundreds of thousands of dollars on attorneys, accountants, and printers. In addition, the

underwriters fees can range from 3% to 10% of the value of the offering. Due to the time

and expense of preparation of the IPO, many companies simply cannot afford the time or

spare the expense of preparing the IPO. Attorneys, accountants, financial printers, and

financial analysts will also command significant cash outlays months before an IPO even hits

the market. The national stock exchanges and automated quotation systems on which the

companys stock may be listed also have fees. Altogether, these expenses can easily surpass

Rs.50 Crores, depending, again, upon the size and nature of the IPO. Even in an IPO raising a

modest amount of proceeds, such as Rs.5 Crores for a relatively small company, fees and

expenses, not including the underwriting discount can exceed Rs.1,25,00,000.

Profit-sharing: If the firm is sitting on a gold-mine, future gold has to be shared with

outsiders. But if the price is right, this is worth it. After the typical IPO, about 40% of the

company remains with insiders, but this can vary from 1% to 88%, with 20% to 60% being

comfortably normal. Also if the company expects to experience rapid increases in

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profitability after the IPO, the profits must be shared with outsiders. Thus, a company may

want to delay an IPO

Control Issues: If a large portion of the company's shares are sold to the public, the company

may become a target for a takeover, causing insiders to lose control. Founders may lose some

flexibility in managing their company's affairs, particularly when shareholders must approve

their actions. Most stock exchanges require at least two independent directors on the

company's board of directors. Consequently, the company may have a new and independent

board of directors, allowing outsiders to take control of the company and even fire the

entrepreneur.

Public Disclosure: Perhaps the most difficult matter for private companies to come to grips

with is that they must, by law, disclose the intimate details of their business operations,

including financial information. The SEC disclosure rules are very extensive. Once a

company is a reporting company it must provide information regarding compensation of

senior management, transactions with parties related to the company, conflicts of interest,

competitive positions, how the company intends to develop future products, material

contracts, and lawsuits.

Pressure to Perform: There can be increased pressure by the investors on the company to

perform well and to maintain its position in the market. The price of a company's stock is

largely dependent on how the company performs against the expectations of financial

analysts, not necessarily against its own past performance. Substantial time and effort, and

thus money, must be expended in dealing with the investing community in order to ensure

that investors and analysts remain satisfied with the companys performance over the short

term, while at all times keeping in mind, and working towards, managements long term

goals for the company.

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Loss of flexibility: Once a company is publicly owned, management inevitably will consider

the impact on the market price of its stock when making various decisions. For example, a

decision whether to undertake a research and development program, which can adversely

affect income in the short run, or a decision whether to risk a strike in a labor negotiation,

might then be considered in light of its impact on the stock. Even though management's

preoccupation with day-to-day stock market price fluctuations is unwholesome and should be

avoided.

Immediate Cash-out usually not permitted: Typically, IPO entrepreneurs face various

restrictions that do not permit them to cash out for many months after the IPO.

Legal Liability: All IPO participants in the coalition are jointly and

severally liable for each others' actions. In practice, this means that they

can be routinely sued for various omissions in the IPO prospectus. In a

litigious environment, a public company and its officers and directors are

vulnerable to lawsuits alleging violations of securities laws. Even for

claims without merit, defending against these actions can be time-consuming and expensive.

Once a company has weighed the advantages and disadvantages of being a public company,

if it decides that it would like to conduct an IPO it will have to retain a lead underwriter to

sell the securities, an attorney to assist in the preparation of a registration statement, and

auditors to prepare financial statements. There are certain matters that have to be looked into

before a company comes out with an IPO. There are certain Guidelines laid down by SEBI

which have to be adhered to, secondly a company must also fulfill some other essential

requirements and do some advance preparations for an IPO.

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ADVANCE PREPARATIONS & OTHER CONSIDERATIONS

Undertaking an IPO is a business decision that must be based on consideration of a number of

factors that indicate whether an IPO is an effective use of the companys, and its

managements, time and resources. Balancing key characteristics of a company, such as size,

stability, product lines, markets, and management, determines whether an IPO is advisable

and, ultimately, whether it will be successful. Once the decision to consider an IPO at some

time in the near future is reached, preparations can begin to better position a company for the

long and complicated IPO process. A company should have experienced, securities counsel

review its organizational documents to determine whether any additional provisions are

desirable in light of the potential for public ownership.

SEBI Guidelines/Norms: In order to make an IPO in India, an unlisted company must

satisfy the following: -

1. It must have a pre-issue net-worth of not less than Rs. 1 crore in 3 out of the 5

immediately preceding years with a minimum net worth to be met during the

immediately preceding 2 years.

2. It must have a track record of distributable profits in terms of Section 205 of the

Companies Act, 1956 for at least 3 out of the immediately preceding 5 years.

3. In addition to this, the issue size should not exceed five times its pre-issue net worth

as per the latest audited accounts.

An unlisted company can make a public issue of equity shares only through the book-

building process if: -

1. The 2 conditions mentioned above are not satisfied, or,

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2. The proposed issue size exceeds five times its pre-issue net worth

3. In addition to this, 60% of the issue size would have to be allotted to Qualified

Institutional Buyers (QIBs).

Record Keeping: Companies need to require audited financial statements for the last three

years before they can go public. As has been mentioned previously, an unlisted company

going in for a public issue of shares is required to have a track record of distributable profits

in terms of Section 205 of the Companies Act, 1956 for at least 3 out of the immediately

preceding 5 years. The track record would be considered only if the financial statements have

adequate disclosures as required by Schedule VI of the Companies Act, 1956. Also, the

financial statements are required to be duly certified by a chartered accountant. Also the firm

is legally liable for the information it provides. Any existing, operating company planning to

go public in a few years should begin to produce financial statements in accordance with

GAAP.

Solid Management Team: A solid management team composed of active and involved

professionals can go a long way towards ensuring that an IPO is successful. A company must

be able to depend upon its financial systems and the managers that control these systems for

sound advice on the financial positioning of the company. An independent member of the

Board of Directors, a so-called "outside director," can be helpful in injecting an objective

voice into decisions regarding company policy and direction. Above all, the top positions in

the company must be staffed with people in whom the investment community can have

confidence that the ultimate goals of the company will be met with speed and integrity. These

top people will form a crucial marketing tool, "selling" the company through contacts with

the media and other similarly situated business men and women.

Business Plan: A good business plan is a selling tool to both advisors (ranging from VCs to

investment bankers to other clients) and outside investors. Most of the information in the

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business plan is of immediate relevance to the IPO prospectus. Having a good business plan

significantly shortens the time required to produce an IPO prospectus.

Earnings Management: Earnings should show a systematic up-trend. Earnings can be

legally managed--Accounting Principles Board Opinion 20 allows IPOs to restate their

financials to look good for an IPO. It makes no sense to accelerate earnings recognitions two

years before an offering and "pay for" it in lower earnings in the recently reported earnings

read by investors just before the offering. GAAP permits firms to take reasonable accruals, to

recognize earnings either before or after the physical cash has come in. A firm that does not

manage its earnings appropriately is throwing the entrepreneur's money away!

Public Relations: IPO firms have two sets of customers: those buying products and those

buying shares. Sometimes the two are the same. For example, in preparation of its upcoming

IPO, Maruti Udyog heavily advertised on TV to both its customers and potential share

buyers. It is important for entrepreneurs to talk not only to their customers, but also to the

investment community.

Market Conditions: Finally, the companys position in its relevant market is also very

important to the success or failure of an IPO. A company in a trendy industry that is likely to

fade with the fickle consumers loss of interest will have greater difficulty completing an

IPO. Generally, a company must have a solid position in an industry with a proven track

record. It is possible, however, for a company that offers a unique product in an entirely new

market or, in the case of an internet play, a company that is first to market in its given space,

to pull off a successful IPO. Stability and a proven market, however, are much more likely to

produce success.

Lock In: In case of IPO by unlisted company, the promoters have to necessarily offer at least

20% of the post issue capital. In case of public issues by listed companies, the promoters shall

participate either to the extent of 20% of the proposed issue or ensure post-issue share

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holding to the extent of 20% of the post-issue capital. In case of any issue of capital to the

public the minimum contribution of promoters shall be locked in for a period of 3 years, both

for an IPO and Public Issue by listed companies. In case of an IPO, if the promoters

contribution in the proposed issue exceeds the required minimum contribution, such excess

contribution shall also be locked in for a period of one year. In case of a public issue by a

listed company, participation by promoters in the proposed public issue in excess of the

required minimum percentage shall also be locked-in for a period of one year as per the lock-

in provisions as specified in Guidelines on Preferential issue.

Adequate time: The Process of issuing a public offer can be quite tedious and demanding. It

can take almost upto to a year to plan and come out with an IPO. And the company must be

equally vigilant Post Issue. The table given shows how long does the procedure of coming

out with an IPO could actually take.

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COSTS OF GOING PUBLIC

One of the most important points to be considered while going public is the

cost of coming out with a public issue. Cost can vary considerably

depending upon an individual company's history, size and complexity. In

order to go public a company has to first register and file the required documents in the

required formats by various authorities. And in order to make the process smooth and error

free a company has to appoint various types of professionals IPO consultants, accountants,

attorneys, underwriters and PR specialists. The following figures are considered minimums

and many larger offerings will have costs that greatly exceed these numbers.

Underwriters Compensation: The most important role is that of an underwriter. The

underwriter is the principal player in the IPO, providing the firm with various services like

finding investors, after market support, pre-offering sales, future services, etc. The services of

good underwriters do not come cheap, however. Most IPO's pay a flat 7% of the offering size

to the underwriter, plus they grant an over allotment ("green shoe") option, and on occasion

pay significant legal expenses on top. (The entrepreneur should make sure to negotiate a cap.)

Underwriters may request the right of first refusal to do future public offerings, but it is

advisable for issuers either not to agree or to limit this right to 2-3 years. Also, underwriters

prefer lower prices: lower prices make selling shares a lot easier, and allow the underwriter to

reward his/her best customers by giving them share allotments. In a sense, pricing that is too

low is an expense that an entrepreneur should factor into the costs of underwriting.

Auditors: Auditors are highly concentrated. The top 4 auditors (Ernst and Young, Deloitte

and Touch, KPMG, Price Waterhouse Coopers) control about 90% of the IPO market (by

dollar volume and roughly in the quoted order). So, the choice is easy: choose one of the Big-

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4. It helps getting the appropriate credibility with investors. The cost of auditors' services in

the typical IPO ranges from Rs.50lacs to Rs10Crs, with most firms paying between Rs.50lacs

and Rs1.5Crs. Clearly, auditor cost varies mostly by firm size and age: more complex and

older operations require more auditing. Offerings below Rs.50Crs typically pay Rs.25 lacs-

Rs.50lacs, offerings above Rs.500Crs typically pay Rs.1.5-2Crs.

Lawyers: Lawyers are basically advisors. They typically are not liable.

Their role is to make sure that documents conform to legal standards, and

that participants are properly indemnified. Although there are a few law

firms that are expert for IPO's (and in a particular field), there are many

more reasonable choices for legal services than for auditing services. The

cost of legal services in the typical IPO ranges from Rs2.5lacs to Rs2.5Crs, with most firms

paying between Rs75lacs and Rs.2Crs. Offerings below Rs.50Crs in size typically pay

Rs.50lacs-Rs.1Cr, offerings above Rs.500Crs typically payRs.2.5Crs- Rs.3.5Crs.

Printing Costs: These costs cover printing of the registration

statement, the prospectus, and the underwriting documents. The

registration statement and prospectus account for the largest portion of

the printing expenses. These are governed by the length of the

prospectus, the number of prospectuses printed, and the number of proof corrections.

Other Fees: Although these costs are much smaller in comparison to other costs, yet they

cannot be ruled out. Registration fees to register with various authorities, Cost of listing on

the stock exchanges, additional professionals and staff might have to been employed on

contract or regular basis. Also stamp duties, postal/ courier fees, costs of the road shows etc.

should also be taken into consideration.

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ALTERNATIVES TO AN IPO

The preparation that is necessary before undertaking an IPO can be quite daunting, especially

to a small, new company that may be on the fringes of the acceptable size and other

characteristics necessary for its IPO to be a success. As a result, there are a number of

alternatives that should be explored. A company short on capital might explore the possibility

of bank or other financial institution financing, a possible joint venture with another company

or a sale of some of the assets of the company as other methods of finding ready capital.

Venture Capital: Many IPO issuers are financed by Venture Capitalists (VCs) before they

go public. In general, VCs prefer high-risk, high-return investments. VCs generally take an

active interest in the firm's management. On the plus side, this provides the company with

additional management expertise, industry expertise, and financing expertise. On the

downside, VCs are expensive. They take a large share of the company's stock, and often

acquire "control," which permits them to fire management or sell the company altogether.

Private Placements and Limited Offerings: If a company has access to interested high net

worth individuals and the publicity of an IPO is not important, private placements and limited

offerings are an excellent alternative. Unlike VCs, private investors typically play a smaller

role in the management of the company. The biggest advantage of the private placement over

the IPO is cost the cost of completing the IPO and the cost associated with periodic

disclosure and reporting obligations following the IPO. At just a fraction of the cost of an

IPO, but typically at much lower multiples, a private placement may be possible.

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Bank and Finance Companies: Banks and finance companies are another source of capital

that tend to work better than IPOs for stable, profitable, non-growth

companies that can provide collateral.

Leases: Some companies enter into leases which avoid initial outlays (a

sale-leaseback can often be used when the property is already owned.

Government Loans (Small Business Loans): Government loans are a great source of capital;

however a company should be prepared to deal with government red tape.

Funds from Suppliers/Customers: The company's suppliers and customers know the

company's potential better than unaffiliated investors, and may be amenable to becoming

investors and providing the company funds on better terms than outside investors. They also

have something to lose: the company's business so they may be willing to invest in the

company to help their own business.

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DETAILS OF BOOK BUILDING

There are 2 methods of pricing an IPO issue:

o Fixed Price Offering

o Book Building

o Fixed Price Offering

IPOs are traditionally priced using the fixed price method. In this method the issuer and

the merchant banker agree upon a certain price which then becomes the issue price. The

subscriber has to apply for shares at this price.

Extensive research has shown that this method is a poor way of pricing IPOs. It often results

in transfer of wealth from the issuers to the investors. This is because firms tend to underprice

their shares to attract subscription. In India, on an average, the fixed price is around 50%

below the price at first listing; i.e. the issuer obtains 50% lower issue proceeds as compared

to what might have been the case. (In the UK, it has been found that fixed price offers result

in a 23% value loss).

o Book Building

Book building is a mechanism through which an offer price for public issues is determined.

Book Building is a process used for marketing a public offer of equity shares of a company

and is a common practice in most developed countries. Book Building is so-called because

the collection of bids from investors is entered in a "book". These bids are based on an

indicative price range. The issue price is fixed after the bid closing date. The process aims at

tapping both wholesale as well as retail investors.

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How is the book built ?

A company that is planning an initial public offer (IPO) appoints a category-I Merchant

Banker as a book runner. Initially, the company issues a draft prospectus which does not

mention the price, but gives other details about the company with regards to issue size, past

history and future plans among other mandatory disclosures. After the draft prospectus is

filed with the SEBI, a particular period is fixed as the bid period and the details of the issue

are advertised. The book runner builds an order book, that is, collates the bids from various

investors, which shows the demand for the shares of the company at various prices. For

instance, a bidder may quote that he wants 50,000 shares at Rs.500 while another may bid for

25,000 shares at Rs.600. Prospective investors can revise their bids at anytime during the bid

period that is, the quantity of shares or the bid price or any of the bid options. The book

runner appoints a syndicate member, a registered intermediary who garners subscription and

underwrites the issue.

On what basis is the final price decided ?

On closure of the book, the quantum of shares ordered and the respective prices offered are

known. The price discovery is a function of demand at various prices, and involves

negotiations between those involved in the issue. The book runner and the company conclude

the pricing and decide the allocation to each syndicate member.

When is the payment for the shares made ?

The bidder has to pay the maximum bid price at the time of bidding based on the highest

bidding option of the bidder. The bidder has the option to make different bids like quoting a

lower price for higher number of shares or a higher price for lower number of shares. The

syndicate member may waive the payment of bid price at the time of bidding. In such cases,

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the issue price may be paid later to the syndicate member within four days of confirmation of

allocation. Where a bidder has been allocated lesser number of shares than he or she had bid

for, the excess amount paid on bidding, if any will be refunded to such bidder.

Determination of issue price :

The issuer in consultation with the book runner determines the issue price on the basis of

demand. This is explained with the help of this example:

Company ABC wants to issue 100 shares through book building. The applications received

are as follows:

No. of Price per

Shares Share (Rs.)

25 100

30 90

40 80

50 70

The level at which all the shares get subscribed shall be the issue price. In the above example,

all the shares are subscribed at a price between Rs. 70 and Rs. 80. Assuming a price of Rs. 75

where are the shares are placed, then this Rs. 75 is the issue price. Applicants with bids lower

than the issue price are refunded within a specified period of time. Successful bidders are

allotted their shares and those who have bid above the issue price get a refund of the surplus

application money.

When the issuer chooses to issue securities through the book building route then as per SEBI

guidelines, an issuer company can issue securities in the following manner:

1. 100% of the net offer to the public through the book building route

2. 75% of the net offer to the public through the book building process and 25% at the

price determined through book building.

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3. 90% of the net offer to the public through the book building process and 10% at the

price determined through book building.

Initially, when book building was introduced in the Indian market, it was the 75-25 and 90-10

route. This was done since it was thought that the retail investor should have a chance of

participating in the issue. It was mainly done to avoid a situation in which there was

absolutely no retail participation since the retail investor would not understand the book

building process and was likely to stay out of the process. However, a few years down the

line there have been quite a few issues that have been done through the book building route

and the market has experience about what book building is all about. So 100% book building

has been introduced.

The book building process involves the following steps :

Step 1: The issuer who is planning an IPO appoints a category I merchant banker as a book

runner. The issuer also appoints syndicate members with whom orders can be placed by the

investors.

Step 2: Initially, the company issues a draft prospectus, which does not mention the issue

price but mentions other details about the company such as issue size, its history and future

plans among other mandatory disclosures.

Step 3: After filing a draft prospectus with the SEBI, a particular period is fixed as the bid

period (minimum of 5 days) and the details of the issue are advertised. Circulate all

documents like RHP, Final Prospectus etc along with bid cum application form.

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Step 4: The Issuer also appoints syndicate members with whom orders can be placed by the

investors. Investors place their order with a syndicate member who inputs the orders into the

'electronic book'. This process is called 'bidding' and is similar to open auction.

Step 5: The book runner builds an order book. He makes note of the bids from various

investors, which shows demand for the shares of the company at various prices. Prospective

bidders can revise their bids at any time during the bid period.

Step 6: A Book should remain open for a minimum of 5 days. The issuer declares a floor/

minimum/ reserve price. Bids cannot be entered less than the floor price. Bids can be revised

by the bidder before the issue closes. If no offers are received above the floor price then the

auction is closed.

Step 7: Submission of bid cum application forms to BRLM or syndicate members. In one

form the investor can make a maximum of three different bids for three different prices.

Money paid along with application should be paid by cheque/ draft.

Step 8: Details of all bids to be transmitted to the computer system of BSE/ NSE every hour.

Step 9: Money received from investors to be deposited in a Escrow account and would

remain deposited till the designated dated.

Step 10: There can be any number of revisions or withdrawals but it should be with the same

BRLM or syndicate member.

Step 11: On the close of the book-building period, the book runner evaluates the bids on the

basis of various factors such as price aggression, investor quality, earliness of bids, etc. The

price discovery is mainly a function of demand at various prices and involves negotiations

between those involved in the issue.

Step 12: The book runner and the company conclude the final price at which it is willing to

issue the stock and allocation of securities. Generally, the number of shares are fixed, the

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issue size gets frozen based on the price per share discovered through the book building

process

Step 13: Issue of Confirmation of Allotment Number (CAN) and dispatch of CAN letter to

investors takes place.

Step 14: Determination of Designated Date, between issue of CAN and actual allotment. On

the Designated Date, the money will flow from the Escrow a/c to the companys a/c.

Step 15: Issue of final allotment letter within 15 days of issue closure. Within 2 days from

the date of allotment, the company must credit the shares in the dematerialisation a/c of

investors.

Advantages of book building

1. The process ensures that the price is as close to the market price as possible. Thereby

it reduces the need to offer a discount to the price at which shares are being offered.

Thus it makes the offer less dilative to existing shareholders.

2. There is less chance that the underwriter will be left with a large number of securities

for which he needs to procure subscribers as the book build should match supply and

demand for the securities.

3. The issuer has control over the shareholder base. This is possible since at the end of

the book build it can choose investors to whom shares are being issued. The issuer

company, in consultation with the lead manager has the discretion to allocate shares to

any of the investors who have bid at or above the issue price. First, weight-age would

be given on the rates quoted by institutions. Next, the early bids, that is those who

have applied for the shares before the issue became very popular, would get

preference. The earliness criterion is meant to reward those who, by moving in

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ahead of others, created the right atmosphere for the issue. Importance can be given to

those institutions that are regarded as long-term investors. Those who may be

perceived as being keen on making quick profits would be at a disadvantage in the

allocation.

4. Also, the time taken for the completion of the entire process is much less than that in

the normal public issue. This is because in the case of book building, the issuer and

the lead manager have to deal mainly with institutional buyers who are

knowledgeable and few in numbers. It also reduces the back-office work in terms of

processing of applications and cheques. This happens because institutional investors

subscribe for a substantial portion of the shares. Since they are few in number, it

reduces the number of applications and cheques received.

There are a few newspaper articles that suggest that the Indian market is not yet mature

enough for book building. The authors of the articles are of the opinion that the Indian market

lacks depth and that the investors are not educated enough as far as the book building process

is concerned. They are also of the opinion that in India, many institutional intermediaries

involved in the book-building process act in concert with the lead managers to manipulate the

process. Before the issue, hype is created about the company fundamentals to justify the price

arrived through book building and the retail investors are lured. The investors end up paying

more for the overvalued stock on the listing day.

However merchant bankers think otherwise. They share the feeling that the Indian market is

very much prepared for book building and that book building is here to stay. They feel that

the very fact that more and more issues are being approached via the book building route is

proof enough that book building is working fine in India. The book-building experience over

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the past three years suggests that it has served the interests of investors quite well. If small

investors still stay away from the IPOs, it is because of their bad experience in the mid-1990s

- a process that actually continued till 1998, albeit on a smaller scale. In the IPOs through the

book-building route, it would be hard to find dubious issues of the kind that put off investors.

Indian retail investors are skipping the price-discovery process in the

book-built public offers.

Latest data shows that 97% of all retail applications made during 04 were at cut-off prices.

This means that these investors are letting institutional and high net-worth investors

determine the issue price and are accepting allotments at these given prices without

exercising their right to influence the issue price.

Consider this example to see how: Say the price band for a 100% book-built issue is

announced as Rs 10-Rs 12, and all the retail bids that form 25% of the issue are received at

Rs 10. Also, all the HNI bids (25% of the issue) and the institutional bids (50%) come in at

Rs 12. Merchant bankers say that in this case, allotments to the retail segment will have to be

made at Rs 10, even though 75% of the total applications have been submitted at Rs 12. This

is because 25% of the allotments have to be mandatorily allocated to retail applicants.

Regulations require that 25% allotments in such issues be reserved for retail investors, with

the balance 75% going to HNI (25%) and Qualified Institutional Buyers (QIBs).

Another point to be noted is that the demand of securities by institutional investors is based

on the knowledge of the issuer that they have gathered on the basis of the research reports

prepared by analysts working with them. On the other hand, retail investors tend to base their

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demand more on market sentiment or on the basis of what their brokers advise them. This is

also another factor that works in favour of institutional investors having a substantial

participation.

Suggestions for the book building system

Increasing number of bidding centers: The book building system involves a bidding

process. As per the SEBI guidelines, bidding is permitted only if electronically linked

transparent facilities are used. The bidding centres also require the necessary connectivity to

NSE/BSE. When book building started in India, at the time of the first issue through this

process, there was connectivity only in 14 cities. Hence there is a need to increase the number

of connected cities. We seem to be making progress in this direction. In the case of the

Maruti Udyog IPO, 65 cities had the required connectivity.

Reducing period between IPO and listing: Currently, as per SEBI requirements, allotment

of shares has to be made within 15 days from the closure of the issue. In addition to this, it

takes another week to get the shares listed. However in the U.S, trading in shares starts on

the very next day after allotment. Thus there is a need to reduce the time gap.

Introducing closed book-building process: In India, the demand and bid prices are required

to be displayed online. However, abroad, the books are kept closed. For true price discovery

to take place, it is desirable that the books be kept closed. When the books are kept open, one

institutional investor is likely to get influenced by the bid made by the others. As a result it

hampers the process of true price discovery. As the Indian market gets mature, it should

adopt the closed book-building process.

Enhancing NRI participation: NRI face several logistical issues, making it cumbersome

and occasionally impossible for them to participate in primary issues from outside India.

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Existing guidelines require 10 prospectus copies and 1000 forms to be sent to the India

International Centre in Delhi, and it is unclear how such a limited distribution, and that too

through a government agency distanced from the capital market, can satisfy the demands of

NRIs. In practice, NRIs need to obtain application forms from syndicate members or brokers

to the issue in India, and are required to pay for their subscriptions through their NRE or

NRO accounts in India. While this may continue, it is strongly desirable to introduce

alternative channels for subscribing to primary issues for NRIs.

Electronic Credits of Refunds: The suggestions made above should also apply to all

domestic investor refunds. ECS is not widely used at present for refunds. In contrast, the

experience of UTI-1 and UTI-2 in the payment by ECS of redemption proceeds and

dividends suggests that ECS can be comprehensively used in cities and towns where it has

been authorized, and provides added security. It is therefore desirable to forthwith make it

mandatory for refunds in primary issues to be also sent by ECS. The ECS facility is at present

available at 45 cities, and RBI is currently proposing an increase in the number of locations.

Preventing the Bunching of Applications: The adequacy of the primary market

infrastructure is invariably tested on the last day of an issue on account of the bunching of

applications. While efforts are clearly required to strengthen the processes and systems

involved in an issuance, policy intervention is also simultaneously required to directly

address the issue of bunching itself. This is important because bunching arises out of the

efforts by investors to gain an informational advantage by delaying their bids till they have

ascertained issue trends. Applicants on the last day therefore have a clear advantage in a

strictly pro rata system of allotments. There are several policy interventions which can

moderate the bunching of applications and reduce the extent of "gaming" that investors adopt

in timing their applications. The possibility of giving `early bird` price incentives is one, but

is not favoured on the grounds that multiple price allotments would be messy and differential

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pricing could create a new set of problems. A second alternative of allowing, at the issuers

discretion, an early closure of the issue would inject the right note of uncertainty to induce

investors not to automatically wait for the last day, but too early a closure may deprive

investors of the opportunity to participate. A third option is to have a closed book, where the

extent of bidding participation is not revealed to investors at the end of each day. However, it

must be recognized that many intermediaries (BRLMs and syndicate members) would be

aware of the extent of applications and bids received, and keeping this information secret is

therefore impossible; this option would thus continue to have the existing deficiencies. A

fourth alternative is the possibility of improving the basis of allotment in cases of early

applications (a gradually falling weight being given to allotments for later applications). This

could be a sensible way to approach the problem once it is recognised that investors bidding

on the first day are on an unequal footing vis--vis those bidding on subsequent days, as later

bidders have access to information on the aggregate bidding patterns, not available to the

early bidders. The fact that the principle of pro rata allotments would not be strictly followed

need not therefore cause concern. Allotment weights would then compensate for this

informational asymmetry and thereby become an instrumentality for redressing the bunching

problem. It appears desirable to accept such a principle, and SEBI may like, in the first

instance, to consider dividing the period for which the issue remains open into two sub-

periods with differential weights. Any such weighting system should be clearly laid out by

the issuer in the prospectus.

Margin requirement on applications from QIB: At present QIBs are not required to bring

in any funds to back their applications and do so only upon confirmed allotments. This is

radically different from the retail investor who brings 100% of the application funds along

with the application. This places the two sets of investors on an unequal footing. While this

fact does not in itself offer sufficient grounds for a policy intervention, at times QIB

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applications for large amounts have later been revised significantly downwards and

sometimes cancelled altogether. Persistent rumours that such applications are meant to show

an inflated book in the early stages of the issue, thereby luring unsuspecting retail investors

who are impressed by the size of the "multiple" which is often taken as a proxy for a "good"

issue, thereby gain credence. This merits an intervention. The possibility of not permitting

QIBs to revise their bids would overcome the problem, but would be unfair as a revision of

bids is fundamental to the process of bidding and price discovery. Nevertheless, such a

gaming process is harmful to the issue and unfair to retail investors, and should be

discouraged. A straightforward way of doing so is to insist on margin requirements. The level

of margining should not discourage the applicants who bid in accordance with their

requirements but should dampen attempts by others to inflate their bids. It is suggested that a

10% margin requirement be imposed on every QIB bid, to be remitted into the issuers

escrow account.

IPO rating and assessment system: A new development that could bring transparency and

efficiency to the capital market is an IPO rating and assessment system, which is expected to

reduce risk by helping investors take more informed decisions. The model, proposed to be

named the CRISIL Public Issue Report, has been developed by CRIS INFAC, a 100 per cent

subsidiary of Crisil. It will assess a company on a five-point scalemanagement quality,

business prospects, financial position, corporate governance and project-related factors.

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Differences in the book building process in India and in the U.S.

1. In India, there is a requirement for an online real-time graphical display of demand

and bid prices at the bidding terminals. However, in the U.S, there is no such

requirement. Out there, the lead manager is allowed to maintain the confidentiality of

the bids received by him.

2. The underwriting that is carried out in India is not underwriting in the true sense. It is

more in the form of a standby agreement. In the event that the syndicate members are

unable to fulfill the underwriting liability that has devolved on them, the lead

manager/book runner is required to meet the liability. However, in the U.S the

procedure is different. Underwriting is carried out there in the true sense. The

underwriters actually take the shares on their own books. Thereafter, it is the

responsibility of the underwriter to attract investors to the issue.

3. In India, it takes about a week after allotment for trading in the shares to start. In the

U.S, trading starts the very next day after allotment of shares.

4. Abroad, there exists what is called a Greenshoe Option. This is a provision in the

underwriting agreement that if there is an exceptional public demand, the issuer will

authorize additional shares for distribution by the underwriter. The greenshoe option

allows prices to stabilize post-listing. Usually, there is a lot of volatility in the prices

of book-built issues immediately after listing, which is attributed to the demand for

the stock exceeding supply. In the event of a right to retain oversubscription, the

additional liquidity in the stock acts as a balancing factor. In India few companies like

ICICI Bank have included such clause in their IPOs; Green shoe Options seems to be

gaining ground in India.

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PROCEDURE TO ARRIVE AT A VALUATION FOR THE SECURITY

BEING ISSUED

The following are the broad steps that one follows while valuing an IPO for a company:

Sector outlook:

Carrying out valuation for an IPO is a long-drawn process. First and foremost, it is a must to

carry out a sector analysis in order to determine the performance of the sector as a whole and

also how it is expected to perform in the future. This would give us an idea about the future

prospects of the company under consideration, which would be required in order to arrive at a

fair issue price.

SWOT analysis:

Thereafter, one needs to carry out a detailed Strength-Weaknesses-Opportunities-Threat

(SWOT) analysis of the company under consideration. This would help us understand what

strengths the company possesses vis--vis other companies in the sector. Besides, it would

give an idea about the business mix of the company. The strengths would not only include the

financial strengths of the company but also qualitative aspects such as rapid adoption of

technology, low employee turnover, unique market positioning, etc. The SWOT analysis

would help in making adjustments to the fair value arrived at for the company on the basis of

company-specific information.

Establish a peer group:

It is necessary to determine the peer group for the company that wants to go in for an IPO.

This is because we need a basis against which the performance of the unlisted company can

be evaluated vis--vis listed companies. The SWOT process carried out above would help us

establish the size of the company, the risks it faces, its turnover, its areas of operations and

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various other aspects. All these would, in turn, help us establish an appropriate peer group for

the company on the basis of these various aspects. Normally, the peer group would consist of

about 4 to 5 companies. However, if the sector itself is a relatively new one, (for e.g.

Biotechnology, airlines) then the number of listed companies would be few. Hence the

number of companies in the peer group would also be less.

Sometimes it may so happen that there is no comparable company available within the

country. In such a case, one has to look at comparable companies in other countries. As far as

India is concerned, companies in countries such as Malaysia, Latin America and South Africa

would have to be looked at.

Valuation technique:

Thereafter, we have to select a valuation technique suitable for the sector to which the

company under consideration belongs. Relative valuation or comparable multiples is the most

widely used approach for valuation. Within relative valuation itself, we have a wide range of

multiples that can be used. However, by focusing on EBITDA, it is possible to avoid the

problem of valuing these companies. Secondly, differences in depreciation methods across

different companies would distort the calculation of net income. Besides, capital-intensive

industries would be leveraged. Different companies would have different leverage ratios. By

considering pre-debt earnings, it becomes far easier to compare the companies. Certain

multiples like the P/E ratio are used commonly across all sectors as support for the prices

arrived at by using other multiples.

Determine multiples for the companies in the peer group:

Once the multiple to be used has been decided upon, the relevant multiples for the various

companies in the peer group are arrived at. These multiples are determined on the basis of the

audited results of those companies. Though the multiple may be available from the audited

results, it is not taken as it is. This is because different companies would have used different

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methods for arriving at the multiple. For example, in case of the P/E ratio, the earnings

considered may be either before or after extraordinary items. Also, the earnings may be based

on earnings of the current financial year or on the basis of expected earnings in the next year.

Hence, the merchant banker has to independently determine these multiples for each

company in the peer group based on his judgment of what method would be more

appropriate.

Industry Composite:

Once the required multiple has been calculated for each of the companies in the peer group,

the industry composite is arrived at by taking the average of the multiples of all the

companies in the peer group.

Determine multiple for the company under consideration:

The industry composite calculated above forms the basis of arriving at the issue price.

However, it would be necessary to make certain adjustments to this composite on the basis of

the SWOT carried out for the company. Based on the results of the SWOT, we would give

either a premium or a discount to the industry composite arrived at above. Thus, if the

company has much strength which give it a clear edge over the others in the peer group, then

the multiple can be adjusted upwards. Similarly, if there are some weaknesses that the

company is facing, then it would be prudent to adjust the multiple downwards. The amount

discount or the premium to be given to the industry composite is subjective. It depends upon

the valuer and his judgment about how much discount or premium should be given. In most

cases, the discount/premium would be decided by the lead manager after consultation with

the issuer.

Arrive at a fair value for the company:

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Once necessary adjustments have been made to the industry composite, we simply plug in the

required figures of EPS, growth rate (depending on the multiple being used) and arrive at the

issue price for the company under consideration.

Discount to the fair value:

Normally, in the case of IPOs we discount the issue price for the following reasons:

o Firstly, issuing shares at a discount would help the investors to have some capital

appreciation.

o Secondly, since the share capital of the company would increase after the IPO, it is

important to discount the issue price to the extent of dilution of earnings due to

increased share capital. Normally, the discount is within the range of 20-25%.

However, if the promoters share is expected to considerably reduce after the IPO, say

by 40% or so, then the discount to the issue price would accordingly be higher.

o Lastly, the investors should have some incentive for purchasing the shares of the

unlisted company. If these shares are available at more or less the same price at which

shares of similar companies are trading, then the investors would have no incentive to

purchase these shares. They would rather go in for shares of a company that is already

listed and can be readily purchased from the secondary market.

Different factors have to be looked into while valuing companies belonging to

different sectors. However there are some factors that remain common across all

sectors and have to be looked into irrespective of which sector the company belongs

to. They are as under:

Financial results:

o Accounting polices and their effect on reporting

o Assets

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o Cost of capital

o General and administrative expenses as a percent of sales

o Historical and projected growth rate of sales and earnings

o Long term debt

o Profit margins

o Receivables

o Stockholders equity

The company itself

o Cost of production

o Experience and quality of management

o Growth opportunity in geographic or technological terms

o Industry outlook

o Whether it is a regional or national company

o Market share

o New product development from conception to production as opposed to the rest of the

industry

o Percentage of sales the largest customers account for out of total sales

o Raw material suppliers

o The scope of the product line as compared to the industry leaders

o Years the company has been in operation

Legal Considerations

o Environmental considerations

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o Liabilities and lawsuits

o Patents, trademarks, or proprietary knowledge

DUE DILIGENCE

While the investment bankers are valuing the company, they also perform a due diligence

examination, an exhaustive process of insuring the accuracy and completeness of all

information about the company.

The due diligence examination involves sessions in which key

management personnel are questioned about company activities that may

or may not be disclosed in the prospectus. Attorneys and the underwriters'

counsel will review all significant corporate documents (articles of

incorporation, by-laws, minutes of board meetings, major contracts, employment agreements,

stock option plans, etc.) to verify that the prospectus disclosures are accurate. Accountants

and attorneys will also probe extensively into the affairs of the company.

Although the due diligence examination will be most intensive during the first several weeks,

due diligence procedures will continue throughout the registration statement process. For

example, the companys attorneys and the underwriters' attorneys may later distribute

questionnaires to the company's directors and officers requesting them to review, verify, and

comment on the information contained in the draft registration statement. The attorneys may

also interview directors and officers.

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As part of their due diligence procedures, the underwriters will request "comfort letters" from

independent accountants with respect to information that appears in the registration

statement, outside the financial statements, and on events subsequent to the accountants'

report date. It is common for underwriters to request comfort on as much information as

possible.

Generally, more information the underwriters seek, the more expensive the process. So it is

important that accountants and underwriters agree in the early stages of the registration

process about the information on which the accountants will give comfort.

Ordinarily, comfort letters are issued to the underwriters on the effective date of the

registration statement, followed by an updated letter at the closing date. In some instances,

they may also be issued at the registration statement filing date.

After the registration statement is filed, but before it becomes effective, the principal

underwriter usually conducts a due diligence meeting of the principal members of the

underwriting group, independent accountants, attorneys, counsel for the underwriter, the

company's senior officers, and the director.

At this meeting, the members of the underwriting group are afforded the opportunity to

exercise additional due diligence by asking further questions concerning the company and its

business, products, competitive position, recent developments in finance, marketing,

operations and other areas, and future prospects.

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INVESTORS PARAMETERS

The primary market is once again witnessing a boom.

A sustained demand in these Initial Public Offers is

because of the significant premiums that these stocks

have been able to command on listing. Seeing past

performance of some IPOs the investor is tempted to

subscribe to new listing. But keep some factors in

mind before going in for an IPO. Financing by banks and NBFCs has been the other major

driver of the IPO market. This financing facility has enabled an investor to leverage his

capital and apply for a much larger number of shares which in turn increases the probability

of an allotment.

The selection of an IPO is not very easy. Retail investors often tend to get lost in the booming

stock market euphoria. There is a very high probability that a retail investor will apply in an

IPO more on the basis of the hype created for a stock rather than on the company's

fundamentals. The following are some of the parameters that an investor should look into

before investing in a new issue.

Some points to remember:

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Track record of promoters: The background and experience of promoters in the business of

the company coming up with an IPO needs to be studied in detail. Historically, it has been

observed that in times of capital market booms, several fly-by-night promoters take this

opportunity to swim with the tide. As these kinds of IPOs carry an element of risk with it,

these issues could best be avoided.

Financials: Most of the companies try to fudge their statement of accounts by window-

dressing and disclosing inflated numbers for the financial year immediately prior to the issue.

Consistency in growth of a company historically over atleast a 3 year period prior to the IPO

adds a lot of weight in the credibility of the financials of a company and should be one of the

parameters to be evaluated for selecting an IPO.

Issue price: Price-Earnings Multiple (P/E multiple) at the issue price should be compared

with the industry average and the best and the worst in the sector. The P/E multiple indicates

the price to earnings per share. Based on the growth projected in the prospectus, the P/E

should also be discounted for the next 2 years to arrive at Growth Adjusted P/E. Wide

deviations from the industry multiples should be well taken care of in your analysis.

Face value of shares: An investor is very likely to get confused by the different face values

that the companies are having in the market. For example, HCL Technologies had announced

it price band of Rs 500-580 which was for a face value of Rs 5/- per share. At the same time

Geometric was a Rs 10/- face value share priced at Rs 300. Hence, one should not look at the

issue price in absolute terms but should try and compare the prices on a common scale. This

common scale could be derived at by converting into a common face value. He should also

compare the P/E multiple.

Lead managers to the Issue: Quality of an issue could also be gauged from the lead

managers / investment bankers managing the issue. The lead managers usually would have

done a due diligence of the company before pitching for the mandate. Moreover, the bigger

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investment bankers also have a superior capability in share placement and market

development.

Demat facility by the company: The Company should have entered into an agreement with

one of the depositories to provide a facility for its shareholders to apply for shares in the

electronic form. This is a very critical aspect in evaluating a company, as selling of securities

on listing becomes much easier if the shares are in the demat form. This also eliminates the

risk of delay in receiving the shares due to external factors like loss, theft or pilferage of

physical shares.

Exchanges on which the shares are proposed to be listed : The shares should atleast be

proposed to be listed on the exchange where the applicant resides or the National Stock

Exchange. This is necessary to facilitate the selling of shares on allotment. If the shares are

not listing on an accessible stock exchange, the applicant might lose on an opportunity in case

of an allotment, due a time lag in selling.

Amount to be paid on application: Besides over subscription, the amount to be paid on

application is an equally critical parameter for evaluating an IPO. Part payment on

application enables an investor to leverage his capital and gives him an opportunity to apply

for a much larger number of shares. This is also a form of an IPO financing.

Prospectus: Read the prospectus for the company carefully. The prospectus called as red-

herring prospectus is a document that every company that goes for a public offering has to

file with the SEBI. The prospectus has all the details about the company, the risk factors and

the company's financials.

A proper and detailed evaluation of the above parameters will definitely reduce the chance of

an investor getting caught on the wrong foot. However, prevailing market condition is the key

in determining a premium on listing.

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MUTUAL FUND IPOs INVESTORS BEWARE

Over 4 lakh investors are in many ways a betrayed lot today after investing their savings into

brand new mutual fund equity schemes. Fund houses, which raised rs.3,685 crore (rs.36.85

billion) in the last three months (December 04-February 05), have invested only rs.293 crore

(rs.2.93 billion) into shares, as per latest statistics from market regulator SEBI. Even as

several new fund houses, including Principal Mutual, Tata Mutual, Cholamandalam Mutual

and UTI Mutual, are lining up equity IPOs, those who raised money from investors include

Franklin Flexi (Rs 1950 crore), Tata Infrastructure (Rs 700 crore), Kotak Mid-cap (Rs 570

crore), Sundaram SMILE (Rs 360 crore) and Chola Multi-cap (Rs 103 crore). Internal and

external switches from existing mutual fund schemes are evident from the hectic trading

activity by mutual funds during the past three months. While funds purchased Rs 12,406

crore worth shares during this period, they also sold Rs 12,113 crore in the open market.

Funds are taking full advantage of the common perception that IPOs are cheap and

innovative.

But is that true? Is it really a good option for the investor? To probe deeper into that questions

clarity on few Myths regarding Mutual Funds IPO is given below:

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A case of diminishing returns

Unlike in the case of an equity share, the units of a mutual fund are never issued at a

discount. They are marked to market. So it is very hard to make money on a MF IPO. Also if

one compares the returns on listing that the last 10 mutual fund IPO offer with the last 10

companies, the picture is shocking.

Even if one were to look only at returns of mutual funds, funds like the Tata Infrastructure

Fund and the Franklin Flexi Cap Fund were listed at less than the face value. That's often due

to huge expenses, or could be because of idle cash.

There is nothing like a zero entry load

This is another marketing gimmick. Investors buying into units of an existing scheme have to

bear an entry load of between 2-2.5%. But no such load is levied on an IPO issue. That does

not mean IPO issues are free from such charges. Although they are not called entry loads, the

initial issue expenses incurred by the fund house (costs of advertisement and distribution

during the IPO) are passed on to the investor later. According to SEBI regulations, initial

issue expenses are capped at 6% of funds raised at the time of IPO, and can be deferred over

five years. So while this 6% may not hit a buyer at one go, it will have an impact on the

NAV. That's likely to wipe out benefits, net-net.

Lock in and lose out

Mutual fund IPOs have a lock-in period, sometimes as long as 30-45 days. This means an

investor cannot withdraw funds if the markets are falling during that period.

Idle cash may be lazy cash

A fund manager may often hold on to some cash hoping for a correction. This strategy may

not pay off if he sits on too much idle cash for too long a period, and the markets dont

correct e.g. as per the data from SEBI, out of nearly rs. 5200 crore, only rs.300 crore were

invested into equity markets.

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Old wine in new bottle

Managers often claim they bring out product innovations, for instance, a mid-cap fund. But

closer analysis will prove that MF IPOs, especially for diversified equity schemes, is just a

new name, in most cases, there is no difference between an IPO and an existing fund.

An issue open at par is eyewash

Does this make them really cheap? The answer is no. Remember - an MF IPO is not a

company IPO. That's because in the case of the latter, the issue price depends on investors'

perception of its value. And the share gets listed at market value. But the same does not apply

to mutual fund IPOs. But in the case of MF IPOs, the value of units are always marked to

market, whether it is an IPO or an existing scheme. So all the money, whether collected at the

time of IPO or otherwise, is invested in equity shares at market price then. So, if one invests

Rs 10 in a unit of an IPO, and the value of the investments has grown at 20% between the

closing and listing of the issue, then the scheme will list at Rs 12. Had the same money been

invested in a good scheme with a similar asset allocation, the NAV again would have grown

by 20%.

Thus even any mutual fund is not as simple as it seems. Investor should go through the

following checklist before investing in Mutual Fund IPO:

A mutual fund initial public offering (IPO) is little different from a stock IPO. Both versions

of IPOs require a certain level of research and analysis. However, as opposed to a stock,

investing in a mutual fund can be slightly complex as it consists of a group of stocks that

move in different directions on a daily basis. Unlike in the secondary market, investing in the

primary market involves 'a fear of the unknown', and this holds true even for mutual fund

IPOs. In addition to verifying the credentials of the sponsors and the track record of the asset

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management company (AMC) in fund management, an investor needs to evaluate the mutual

fund IPO based on some critical criteria

Risk: Does the risk level of the mutual fund suit your own? The answer to this question lies

in the prospective portfolio allocation outlined in the letter of offer of the IPO and the history

of the fund manager. Many investors learn the hard way later, the wide chasm between their

perceived risk level and the actual risk level. A careful risk evaluation at the time of the IPO

can save a lot of a grief and embarrassment later and therefore this is perhaps the most

important criterion, which determines the investor's investment decision.

Return: The answer to this question is closely linked to the risk level. Then, as is the case

with all investments, a higher level of risk fetches relatively higher returns. In other words, a

high risk-low return investment must be avoided at all costs. Conversely, a low risk-high

return investment must be embraced. However, investors would be hard pressed to find such

investments

Load: IPOs generally have a load, mostly at entry. For instance, an entry load, of say 2%,

implies that only Rs 98 out of every Rs 100 invested by you is put to work by the fund, with

the load - Rs 2, is employed by the fund to meet its expenses. This implies that your

investment is already down by Rs 2 from Day 1, even before the fund begins investment

Portfolio allocation: Evaluation of this criterion is relatively easy and can be gauged from

the letter of offer. The portfolio allocation needs to be evaluated based on the asset allocation

and sectoral allocation

Asset allocation: The letter of offer outlines the proposed asset allocation and the fund

cannot deviate from it. However, the allocation is very broad and can only be taken as

indicative. Its only after the fund IPO opens for repurchase and when the investor sees the

factsheet, will he learn the actual asset allocation in terms of equity, fixed income and cash

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Sectoral allocation: Again the letter of offer gives a very broad picture of the proposed

investments in terms of sectors. The investor cannot draw any conclusions from it. However,

at times reliable news reports mention the fund manager's inclination for a particular sector or

group of sectors, in which case the investor will have a fairly good idea about where the fund

is headed sectorally. Here again, the investor will learn the precise sectoral allocation only

after the first factsheet is released by the fund house

Fund management pedigree: A mutual fund is as good as its fund manager. To that extent,

the fortunes of an IPO can be evaluated based on the performance of the existing funds

managed by the same fund manager. The first two criteria in this checklist - risk and return,

are governed by the investment style of the fund manager. Therefore, it is important for

investors to understand his investment style, which is best reflected in his existing funds

Economic scenario: The economic scenario is perhaps the most important test for the fund

manager, largely because it is beyond his control. Although gauging the economic scenario is

a complex exercise and one most investors should best leave alone, it is imperative to

understand the market scenario and the interest rate scenario in order to evaluate the fortunes

of the IPO

Markets: As it is oft-quoted, 'a good fund manager is one who can steer the fund off

disasters even in a falling market, for any fund manager can clock robust growth in a

booming market.' The fund at the IPO stage may make investments in stocks at higher prices,

only to see the markets fall subsequently, bringing down the (net asset value) NAV below par

(normally Rs 10) at the time of its initial declaration

Interest rates: A lower interest rate regime has a positive impact on the stock market as well

as bond yields. Conversely higher interest rates affect corporate profitability and push bond

yields higher

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Investment horizon: What is your investment horizon? This is a question the investor needs

to ask himself before he enters a mutual fund IPO. Once he determines his investment time-

frame, the investor must stick to the fund through its ups and downs, unless of course the

fund manager is headed on a suicidal course, in which case the investor must redeem at the

earliest

LEVEREGED INVESTING: THE PITFALLS

In today's times, where practically every second bank is providing loans to invest into IPO it

makes much sense to look at the possible pitfalls of investing through borrowed funds, also

known as leveraged investing. IPOMF basically facilitates an investor to invest beyond

his/her capacity (leveraged investing). An investor prefers to apply for more shares during

bullish times not only to increase his chances of getting some allotment but also on the belief

that he will be able to make handsome return on his investments. However, it is not as simple

as it seems.

Firstly it must be understood that leveraged investing is a high-risk proposition, especially if

one fails to consider the risk-return profile. This form of investing undoubtedly increases

your profits but at the same time, it significantly enlarges the quantum of losses that the

investor might have to bear, just in case the markets decide to go into reverse gear. Here, if

the investor has failed to assess his 'bearable' risk, then it could lead to some serious

consequences.

This is because, though the banks/institutions would have readily sanctioned the loan, in a

falling market they would be forced to call for additional margins (in case of margin trading)

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or further collaterals, in order to make good their losses in the market value of the portfolio of

the investor. If the investor fails to provide either of the above two, the probability of him

losing his pledged collaterals as security is very high; this would permanently terminate all

his possibilities of recouping his losses, even if the markets bounce back.

If investments in IPO are made from either personal funds (assuming that the investor is not

going overboard by stretching his personal financial situation) or by liquidating current

holdings, the investor has the option to hold on to his investments despite sharp movements

in stocks (especially on the downside). It must be noted that volatility has been the order of

the day for sometime in the case of Indian stock markets, where 150-200 points intra-day

index movements has the potential of unnerving even the most savvy of investors. However,

if investments are made through borrowed funds, and the markets correct, even if

temporarily, the investor might have to let go off his holdings (probably at a loss).

Below given illustration shows in a little more detailed manner, how IPOMF will affect

investors returns:

Company XYZ

Offer price (Rs/share) 100

You want to apply (nos. of shares) 1,000

Investment required (Rs) 100,000

You have (Rs) 25,000

IPO Margin Finance (Rs) 75,000

Interest & other charges on margin finance 2%Interest & other charges (Rs) 1,500

The table above indicates the details of an investor wanting to apply in the IPO of a company

XYZ whose offer price is Rs 100 per share. The investor intends to apply for 1,000 shares for

which the investment required is Rs 100,000. Since he does not have the capacity to invest

the full amount, he op

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Raj Gandhi MMS Finance 18