Submitted By

Deepesh Vaidya

15 July, 2012

Review of IPO Process in Nepal and Study of Prerequisites

for Introducing Free Pricing in IPOs in Nepal

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TABLE OF CONTENTS

LIST OF ABBREVIATIONS III

LIST OF TABLES AND FIGURES V

CHAPTER ONE: INTRODUCTION 1

RESEARCH TOPIC 1

BACKGROUND 1

PREFACE OF THE RESEARCH 2

OBJECTIVES OF THE RESEARCH 3

RESEARCH METHODOLOGY 4

LIMITATIONS 5

CHAPTER TWO: LITERATURE REVIEW 7

CHAPTER THREE: REVIEW OF RELATED REGULATIONS REGARDING ISSUE OF SECURITIES AND

PRICING MECHANISM IN NEPAL 11

REVIEW OF REGULATIONS GOVERNING PUBLIC ISSUE OF SECURITIES IN NEPAL 11

THE COMPANIES ACT 2063 (2006) 11

THE SECURITIES ACT 2063 AND SECURITIES ISSUE AND REGULATIONS ACT 2065 12

A PROCEDURE FOR AN IPO PROCESS IN NEPAL 14

CURRENT PRICING MECHANISM IN NEPAL 18

EMPIRICAL STUDY OF IPO PERFORMANCE UNDER PREVAILING PRICING MECHANISM 18

OVERVIEW OF SOME DIFFERENT PRICING MECHANISM USED IN NEPALESE CAPITAL MARKET 22

CHAPTER FOUR: REVIEW OF FREE PRICE DISCOVERY MECHANISM / BOOK BUILDING

MECHANISM IN NEIGHBORING COUNTRIES 26

BANGLADESH 26

CHINA 31

INDIA 33

MALAYSIA 40

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CHAPTER FIVE: STAKEHOLDER’S VIEW ON THE FREE PRICING MECHANISM IN IPO IN NEPAL 52

COMPANIES (ISSUERS) 53

INVESTORS 54

MARKET INTERMEDIARIES 59

REGULATORS 60

CHAPTER SIX: RECOMMENDATIONS AND APPROPRIATE MODEL FOR NEPAL 64

CHANGE IN REGULATION AND CAPACITY BUILDING OF STAKEHOLDERS 64

METHODS OF GOING PUBLIC 68

PAR VALUE METHOD 69

MARKET PRICING METHOD 69

PROCEDURE REQUIREMENTS 70

PAR VALUE METHOD 70

MARKET PRICING METHOD 70

CHAPTER SEVEN: CONCLUSION 75

BIBLIOGRAPHY 77

ANNEXURE I

ANNEX I: ILLUSTRATION OF PRICE DISCOVERY THROUGH BOOK BUILDING MECHANISM II

ANNEX II: ELIGIBILITY CRITERIA FOR INQUIRY OBJECTS IN CHINA III

ANNEX III: QUESTIONS ASKED TO CONCERNED STAKEHOLDERS REGARDING FREE PRICING SYSTEM IN IPO IN NEPAL IV

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List of Abbreviations

AGM Annual General Meeting

BFI’s Bank and Financial Institutions

BRLM Book Running Lead Manager

BSE Bangladesh Stock Exchange

CA Chartered Accountants

CCI Controller of Capital Issue

CHCL Chilime Hydropower Company Limited

CSRC China Securities Regulatory Commission

DIP Disclosure and Investor Protection

DSE Dhaka Stock Exchange

EII Eligible Institutional Investors

FII Foreign Institutional Investors

FPO Further Public Offerings

ICDR Issue Capital and Disclosure Requirement

IPO Initial Public Offering

NBER National Bureau of Economic Research

NBFIs Non-Banking Financial Institutions

NEPSE Nepal Stock Exchange

NTC Nepal Telecom

QIBs Qualified Institutional Buyers

SCBNL Standard Chartered Bank Nepal Limited

SEBI Securities Exchange Board of India

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SEBON Securities Board of Nepal

SEC Securities Exchange Commission of Bangladesh

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List of Tables and Figures

List of Tables

Table 1: Subscription and aftermarket pricing of some of the largest IPOs, 2063/64 – 2067/68 .............. 18

Table 2: Overview of SCBNL, NTC and CHCL issue under different pricing mechanism ............................. 22

Table 3: Allocation of shares under Book building in Bangladesh .............................................................. 29

Table 4: Restriction in IPOs in China ........................................................................................................... 32

List of Figures

Figure 1: Movement in Price of Ordinary shares after listing in NEPSE, 2063/64-67/68 ........................... 21

Figure 2: IPO value chain ............................................................................................................................. 51

file:///C:/Users/Admin/Documents/Deepesh%20Folder/2012/First%20Project/SEBON/first%20draft%20report%209-13-12%20(sent%20to%20SEBON)%20-%20for%20final.docx%23_Toc335555591

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Chapter One: Introduction

Research Topic

To review the current system of pricing of securities offered to public through Initial Public Offerings in

Nepal; to assess the need for free pricing mechanism in IPOs in Nepal; and to provide recommendation

on pre-requisites in terms of regulations/infrastructure necessary to implement system of free pricing of

securities in the Initial Public Offerings of securities in Nepal.

Background

Capital Markets of Nepal can be taken as ordinary shares dominated market, further skewed by the

ordinary shares of financial institutions and insurance companies. 80% of all listed securities in Nepal

Stock Exchange Ltd., the only stock exchange in Nepal, are ordinary shares. 78% of all listed ordinary

shares, in terms of listed value, are ordinary shares of financial institutions comprised of Commercial

Banks, Development Banks, Finance Companies, Insurance Companies (hereinafter referred to as BFIIs).

If government owned portion of Nepal Doorsanchar Company Ltd. (91.50%) is omitted, ordinary shares

of BFIIs comprises 89% of total listed ordinary shares. Due to overweight of the ordinary shares of BFIIs,

the stock market, which should have been an economic barometer of the country, is predominantly

influenced by the performance of financial sector rather than the performance of overall economy of

the country. The dominance of capital market by securities of BFIIs is largely explained by regulatory

requirements where companies established under Bank & Financial Institutions Act and Insurance Act

are mandatorily required to offer their shares to general public and list the shares in stock exchange.

Hence, such companies come to public by compulsion whereas companies from other sectors, besides

BFIIs, have no compulsion and generally have not shown eagerness to enter the capital markets in

Nepal.

In order to make the capital market deep and more diverse, it is necessary to bring companies from

various economic sectors of the country into capital markets by facilitating them to offer securities to

the public and by ensuring that such shares are continuously priced in the secondary market. Going

public is also beneficial for companies as they will have access to needed capital through broad base of

public fund, in addition to banks and private market. However, companies have simply shied away from

the market and have not shown interest to vie for the market. Ironically, except for few, most of the non

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financial sector companies listed in the Nepal Stock Exchange have not performed well, both in terms of

financial return and also in terms of regulatory compliances, vis-à-vis BFIIs. One of the main reasons

pointed out for such lax compliances by such non BFIIs was the absence of strong regulatory body to

oversee them that would require them to follow proper corporate governance as a public limited

company. At the same time investors are also fragmented and non-institutionalized to form a united

and strong force to demand compliances from such listed companies. Such experience has developed a

negative sentiment among the Nepalese capital markets investors toward securities of such non BFIIs

companies. The tasks would be hence not only to attract companies from the various sector of the

economy to capital market for access of funds but also to attract general investors’ to participate in

those offers knowingly and willingly.

Further, attracting companies from different sectors entails not only attracting existing and established

companies to issue their securities in the capital markets but also developing the market where fairly

new companies are able to issue their securities in the market. Existing companies will be interested to

come to the market only if there is an incentive for them to issue their shares to the public. One of such

incentives is being able to make existing shareholders’ investment liquid at market value. For fairly new

companies, the incentive would be an opportunity to collect much needed capital from the market at

right price. For both to happen, the market requires a mechanism under public offerings that allows

market to determine prices of securities. For market to determine prices in IPOs, the market needs to be

capable of doing so.

To heal the negative sentiments of public investors towards non BFIIs companies, the first responsibility

would be that of the Securities Board of Nepal (SEBON), the regulator of the capital market of Nepal,

followed by Company Registrar's Office (CRO), to ensure regulatory environment that regulates and

supervises such issuers; assures regulatory compliances by such issuers; and if needed takes necessary

actions against companies defaulting on compliances willfully. Further, concerned authority also need to

ensure proper capital markets ecosystem by encouraging emergence of various other market

intermediaries who brings long term capital, investment sophistication, professional advices/facilitation,

negotiating power with the issuers, and market intelligence to be a reference for the retail investors.

Preface of the Research

Capital markets channelizes funds from surplus group to deficit entity through direct undertaking of

agreed upon sharing of risk and return between two parties. The process of raising required capital from

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the capital markets can be done through private placement or offering securities to public at large

through public offerings. Initial Public Offerings is the first offerings of the company's securities to the

market to raise required capital by the company. Simultaneously, fund raising from the public can be

done through Further Public Offerings (FPO) or Right Offerings. One of the major issues in public

offerings is ensuring fair price of securities. Internationally, three difference approaches have been used

to price the securities: fixed pricing, book building and auction. Book building and auction comes under

free pricing method in IPO.

In the fixed pricing method, price is fixed by the issuer in consultation with the issue manager, whereas

in both the book building and the auction, price is set after obtaining feedback from the investors. In the

case of Nepal, fixed price is set by the regulatory regime whereby, BFIIs cannot offer shares at price

more than the par value and for other companies price cannot exceed more than the per share net

worth, after complying with prerequisites in the Company Act and Securities Regulations. Fixed pricing,

practiced internationally, bestows the responsibility of determining the price to the issuer and the issue

manager. The market price is determined in the aftermarket. However, in the context of Nepal, fixed

pricing has been set at not more than per share net worth value. Because of such provisions, it is very

likely that the securities are underpriced, which is commonly known as leaving money on the table. This

is a cost to the issuer and if such cost is high, the incentive for the issuer to take such cost without any

other offsetting benefit would be null. This has been one of the reasons pointed out why companies,

which are not mandatorily required to come to public, are not eager to come to public in Nepal.

Hence, to bring companies beside BFIs to the market willingly, the capital market needs to address the

issue of letting the companies issue their shares at fair price. But, for this to happen we need to assess

the current status of capital markets of Nepal and work towards creating an ecosystem where the

market is fully equipped to subscribes such issues where investors have the ability to make informed

investment decisions and also be assured that the market they are investing are well regulated with

proper supervision by the concerned authority.

Objectives of the Research

The objectives of this research are:

1. Review the prevailing IPOs mechanism in Nepal at fixed price (face value) or at premium (limited

to per share net worth value) and its limitation to attract companies from other sectors of the

economy to the market.

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2. Assess required changes in pricing mechanism in IPO to attract companies from the real sector

into the capital markets to raise capital.

3. Assess if investors are ready to invest in IPO under free pricing and highlight their concerns

4. Assess prerequisites required to allow/implement IPOs on free pricing in Nepal.

Research Methodology

Research Design The nature of the study is an exploratory study. An exploratory study is undertaken since not much is

known about the situation at hand and no information is available on how similar problems or research

issues have been solved in the past in the context. Since very few studies have been conducted and

knowledge is scant in the area of free pricing in Nepal, exploratory studies has been used to better

comprehend the nature of the problem.

Instruments Used Formal and informal communications (interviews and email correspondence) have been used for the

research. Some of the questions asked during the interviews and email correspondence are shown in

Annex III. The different questionnaire was prepared for different stakeholders such as potential

companies (10 questions), (representative) retail investors (10 questions), institutional

investors/potential to be institutional investors (13 questions), and Merchant Bankers (12 Questions).

Data Collection Procedure Because of the time and resource limitation only in-depth interview was used for data collection

procedure.

Sample and Sampling Being an exploratory research, non-probabilistic sampling has been used. The sampling method used for

the research is judgment sampling. This method is used since subjects are chosen to be part of the

sample with a specific purpose in mind. It is believed that subjects are better fit for the research

compared to other individuals. Some of the samples are listed in Annex IV.

Research Report Structure This research will cover five broad segments:

1. The first segment will review literatures to make a case for free pricing in IPOs.

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2. The second segment will highlight existing process of public issues of securities in Nepal. This

will start from reviewing the current regulatory provisions, securities pricing mechanism and

process followed to complete the IPO process. This segment will also analyze historical IPOs and

secondary market transaction to substantiate prevalence of under pricing of securities in IPOs in

Nepal. This segment will also highlight few non-traditional public issue processes tested in the

capital markets of Nepal.

3. The Third segment will highlight IPO processes in neighboring countries which include

Bangladesh, China, India and Malaysia. The segment will also look into regulatory environment

in the respective countries in brief.

4. The fourth segment reviews the ecosystem of capital markets in Nepal through interviews with

stakeholders of the capital market namely: Regulators; Market intermediaries; Individual

Investors; Institutional Investors; and companies' potential to go public. The basic mode of

collecting data would be through interviews or through review of published data. (Refer to

Annex III for the list of questions asked during the interview for different stakeholders).

5. The fifth segment will provide a suggestive free pricing model for Nepal. This segment will also

provide suggestions on the prerequisites needed to develop an ecosystem to promote free

pricing in IPOs in Nepal based on comments received from stakeholders and regulatory review

of such processes in neighboring countries.

Limitations

The comprehensiveness of this report may be limited by resources available to the researcher to

conduct in-depth research of each and every segment of the issue. An in-depth study in specific issues

may be required to complement the report. Some other factors that may have limited the research are:

The research is based on expert opinion of various stakeholders such as regulators, market

intermediaries, investors, and companies' potential to go public; hence, the report may suffer

from biasness of such experts.

Due to researcher's constraint, the research may also have not covered views of all the

stakeholders.

Stakeholders are highly dispersed and hence may not have been accommodated in the research

Data about the primary and secondary markets in Nepal are not easily available.

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Interviewee may not have been fully aware about the research topic hence their opinion may be

incomplete or wrong.

However, the report depicts views of selected representatives from each stakeholder group; refers

to the similar initiative in the neighboring countries; and the experience of the researcher in the

field. Hence, the report will serve as a basis to initiate discussions on free pricing system in IPOs in

Nepal and also serve as the framework for implementing free pricing system in IPOs in Nepal.

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Chapter Two: Literature Review

Why go public?

The term ‘going public’ refers to the process whereby a privately held company issues or makes a

provision to issue its shares to the general public. Initial public offerings (commonly known as IPOs) are

offering shares to the general public for the first time by going public companies or newly established

public companies. The decision to form a public company or the decision to convert a private company

to a public company marks a significant strategic decision as it not only increases its access to capital

market for required capital but also exposes the company to public scrutiny.

Going public entails both pros and cons to the issuing company. Public offerings invites large but

fragmented individual/institutional investors that buy the offered shares to share risk and reward based

on disclosed information and with a mandate to safeguard their interest through sending a

representative director/s from the public investors to the board of directors of the company. Hence, the

process of public offerings requires public companies, as compared to private companies, to be more

transparent and credible and have a process of meeting all the obligations towards all the stakeholders.

This requirement of corporate governance is the cost to the company, but the benefit of being a public

company also allows to access vast pool of public funds at comparatively low cost.

An article published in Chartered Accountants of Canada talks about the issues that need to be

considered before deciding to go public. The article highlights the need to analytically weigh both pros

and cons of going public. The benefits of going public are access to capital beyond which is privately

available, facilitation of mergers and acquisitions, access to secondary equity financing through FPOs,

increased publicity and improved financial status and most importantly, provision of an exit strategy for

original investors, including venture capitalists and angel investors, as well as owners (Deazeley, 2008).

On the flipside, the downside of going public include dilution of ownership, legal hassles, high auditing

and legal fees and increased scrutiny by regulators and public.

The decision of making public issues of securities depend upon different factors and situations and the

issues are timed accordingly (Ritter & Welch, 2002). Firstly, the life cycle theory explains that a company,

which becomes a potential target, will be better off if it is public as it will fetch higher value in the

market. Secondly, market timing theory explains that the decision to go public is affected by the market

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sentiments. Companies postpone equity issue if the market sentiment is against it and the issue is

delayed until the market is bullish. From the capital markets perspective, companies from various

industries going public bode well for the overall economy since it makes the capital market more

diversified and robust for investors to make informed investments.

IPO Pricing Mechanism

The most important, and also one of the difficult aspects in going public, is the price discovery in IPOs.

Fair price discovery is important to both investors and issuers because underpriced securities translate

to cost to issuers whereas overpriced securities are cost to investors. If offering are under priced, the

issuer will not be able to realize the true value of the offering and thus, investors benefit at the cost of

the issuer. On the contrary, overpriced securities means that investors are paying more for the securities

than their actual worth and their value will decline in the secondary market.

Despite of the costs incurred because of mispricing, there is a general agreement that some money has

to be “left on the table” by intentionally offering securities at a discount to the fair value, so as to entice

investors in the issue at the beginning. A study by Chen, Hong and Wu attributes IPO positive initial

returns to two factors: deliberate under-pricing and market misevaluation based on the estimated fair

price. The study states because of noisy trading, the securities are traded at higher prices, which is the

primary reason, instead of deliberate under-pricing, for initial high returns (Chen, Hong, & Wu, 1999).

While deliberate under-pricing may serve the interest of the issuer, the unanticipated under-pricing is

not desirable. In both cases, fair price discovery is important either to determine the extent of

discounting (in case of deliberately under-pricing) or to issue securities at their market value.

Various mechanisms are widely used in IPO pricing. Broadly, the pricing mechanism can be categorized

into fixed pricing method, where issue is made at a fixed price without soliciting market demand; and

free pricing method, where pricing is done as per the market demand. Under fixed pricing mechanism,

pricing at premium based on net worth, pricing based on P/E ratio and pricing at face value are the

common methods employed, where the issue price does not necessarily reflect the market price. On the

other hand, in order to ensure fair price discovery, some issuers undertake costly methods to evaluate

the value of the firm, which include free pricing mechanisms like auction and book building method.

Book building involves the submitting of (legally) binding bids by relatively exclusive groups of

institutional investors. The book manager, in consultation with the issuing company, uses this crude

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approximation of the market demand curve to establish the price at which the share offering is sold and

exercises considerable discretion in the allocation of shares (Wilhelm, 2005). The author explains that

book building is a process of building a market, where no market exists.

Under book building, the underwriter arranges a road show and then collects indications of interest,

which are used to build the order book, based on which, the offering price is set (Jagannathan, Jirnyi, &

Sherman, 2010). SEBI, Disclosure and Investment Protection Guidelines, 2000 defines “book building” as

a process undertaken to elicit demand and to assess the price for determination of the quantum or

value of specified securities or Indian Depository Receipts, as the case may be, in accordance with these

regulations.

Another widely practiced method under free pricing mechanism is the auction method, which may take

various forms. Uniform price auctions, also called Dutch auction, are multi-unit sealed bid auctions in

which all winning bidders pay the same price, whereas, ‘dirty’ IPO auction is a uniform price auction

where they leave “something on the table” by pricing below market clearing price (Jagannathan, Jirnyi,

& Sherman, 2010). A discriminatory auction is another variation of auction method, where the issue

price is based on pay-what-you-bid.

The major difference between book building method and auction is that book building has discretionary

power in securities allocation. While some studies explain the discretionary power as a tool to reward

investors who help in price discovery process, others have claimed that it hinders the transparency of

pricing and allocation process under free pricing mechanism.

SSS Kumar (2010) makes a case of the significance of discretionary allocation in book building

mechanism. Under price discovery in book building mechanism, the article claims that investors need

some sort of compensation to disclose the fair price under free pricing (Kumar, 2010). Citing the work of

Benveniste and Wilhelm (1990), Kumar (2010) illustrates how book building can lead to efficient price

discovery, if investors are provided incentive to reveal information regarding the fair price. However, in

Indian context, the discretionary power of the book runner in allocation of shares to investors was

removed and it was mandated that the allocation must be made on the pro-rata basis to all categories

of investors.

The allocation discretionary power, made available to underwriter (or book runner as the case may be)

under book building mechanism, has also been a subject of criticism as the discretion has been abused

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(Jagannathan & Sherman, 2006). It states that book building mechanism has been criticized mostly

because underwriters exclude small investors from the bidding process, which allows them to use their

discretionary power to award their favorite clients (Sherman & Titman, 2002). The goal of discovering

fair price will not be achieved if access to participation is limited.

Book building, known as firm commitment in the US, has been extensively used in over forty countries.

The book building is preferred to other alternative options, auction and fixed price method, because it

helps to gather and report the optimal level of information required for fair price discovery of the

offering. In the context of India, relevant reference for Nepal, few empirical studies have been

conducted that depicts the efficiency of book building mechanism in India. In a study of 463 companies

from 54 industries, whose IPOs were issued during the ten years span of time and used either fixed price

offer or book building mechanism for the issue, it was found that book building mechanism is preferred

to the fixed price offer for price discovery (Bora, Adhikary, & Jha, 2012).

Complimentary to the benefit of price discovery, another advantage of book building mechanism is that

it gives the issuer an option to withdraw IPO when the demand is weak. Referring to the IPO mechanism

in the USA, Busaba (2006) sheds light on this feature of book building mechanism, which is generally

overlooked by the issuers to a large extent. The values of the option offsets, or even outweigh, the

possible costs of soliciting information from investors and costs of under pricing of securities which

might exist even if book building method is used.

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Chapter Three: Review of related regulations regarding Issue of

Securities and Pricing Mechanism in Nepal

Review of Regulations governing Public Issue of Securities in Nepal

The Company Act 2063 (2006)

A public company is a company other than a private company. There has to be a minimum of seven

promoters for the incorporation of a public company. A public company that is listed on the stock

exchange is called a “Listed company”. The number of shareholders in a public company has to be at

least seven in minimum and of any number in maximum. A public limited company should have a paid

up capital of at least Rs 10 million.

The Company Act, 2063 has the provision to convert private company to public company. Such provision

is essential and is a precursor even to talk about bringing real sector companies to the public market and

is pivotal to talk about free pricing of securities in IPOs.

Provisions for the conversion of private company into Public company

1. If a special resolution of a private company through its general meeting decides to convert a

private company into a public company

2. If twenty five percent or more stake of a private company has been taken by one or more public

companies then that private company has to convert into public company. Provided any bank or

finance companies holding shares as trustee does not count as taking stake in that private

company.

3. If a private company buys twenty five percent or more shares of a public company.

4. Upon the conversion of private company into public company, subsidiaries of the private

companies shall Ipso facto be converted into a public company

Procedure to be adopted for the conversion of a Private company into a Public company

Upon the passing of the mandate through special resolution for the conversion of private

company into public company, the company has to make an application with a copy of

resolution within thirty days to the Office of registrar. Company registrar shall give the

certificate for conversion of private company into public company within six days of application

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Upon the conversion of private company into public company through either of points 2 and 3

above, the company has to make an application to the office of registrar within seven days of

the occurrence of such a circumstance.

Pricing of securities as per the Company Act

Company Act, 2063 states the par value/ face value of shares of a private company shall be as specified

in its Article of Association whereas face value of shares of a public company should be at least Rs. 50 or

any amount above it divisible by ten as mentioned in the Memorandum of Association and Article of

Association but it does not restrict the public offering price. However, under the heading of ‘Shares and

Debentures’, Chapter 4 of Companies Act, 2063 it states that a company can issue shares at premium

upon fulfilling the following criteria.

o The company has been making profits and distributing dividends for three consecutive

years,

o The company’s net assets (net worth) exceeds its total liabilities

(Net worth in Company Act, 2063 means “the assets of a company remaining after

deducting all liabilities other than goodwill, if any, of the company along with

accumulated loss excluding the paid up capital, reserves, cumulative profit or free

reserve of whatever designation to which shareholders have right, from the total assets

of the company as of any date”)

o The company’s general meeting has decided to issue shares at a premium.

The existing regulation in the Company Act, 2063 allows company to issue shares at premium. But, the

act has not talked about the provision for existing shareholders of the private or public company to issue

shares to the public by divesting the shareholding of the existing shareholders. And also the Act has not

talked about if allowed, can such shares be issued in premium.

The clause 64 of Company Act, 2063 restricts company to go to public at discount.

The Securities Act, 2063 and Securities Issue and Regulations, 2065

Securities Act, 2063 defines incorporated public company as any company established with the provision

to issue its shares to general public. Clause 27 of the Act requires such company to register its shares

with Securities Board of Nepal before the issuance of the shares to the general public. Clause 29 of the

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same Act states that if the company wishes to sell its shares to more than 50 investors in a single

process, the company needs to do public offerings otherwise; the shares may be sold under private

placement.

In Public offerings, Company should mandatorily publish a Prospectus. The Act identifies that initial

offering of shares to general public is an act of issuing new shares to raise new capital. The Act does not

specifically states the provision of divestment by the existing shareholders of a company as initial public

offering. However, the Securities Registration and Issuance Regulations, 2008 (formed under the

Securities related act) talks about the different category of shares that could be sold to general public.

Some of the important criteria of the Regulations are:

Unless otherwise stated by any specific laws, any public limited company should have set aside

at least 30% of its issued capital to the general public. But, not less than 51% of the issued

capital should be held by the promoters of the company.

Promoter shareholders and any other shareholders of the company, beside the general public

shareholders, will not be allowed to sell their shares for the period of 3 years from the allotment

of shares to the general public, after the public issue.

Once the company has offered its shares to general public, promoter shareholders and other

shareholders beside general public, shall be able to sell their shares to general public by issuing

Offer Document instead of Prospectus.

Under the regulation 10.3.Kha. of the above referred Regulation, 2008, if promoters and other

shareholders, beside public shareholders, want to sell their shares to general public following

criteria need to be fulfilled

o Out of last five years, company should be operating in profit for three years and per

share net worth value should be more than per share paid up capital

o Conducted Annual General Meeting and has updated audited financials

o Required amendments in chartered documents of the company have been duly

approved by the Annual General Meeting

o If the issue price of the shares are more than the par value, then validation of the

process and assumptions used to fix the price

o In complete compliance with the governing Acts and Regulations and the directives

issued by regulators of the country

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Rule 11, of the above referred regulation, 2008 allows company that has issued shares to

general public and listed its shares in Stock Exchange, to issue further shares to general public, if

o Company has earn net profit in recent two years out of last five years and per share net

worth is more than the per share paid up capital

o Further public offering decisions have been made by the AGM

o If offered price is more than the par value of shares, need to provide basis of calculation

to validate the premium on shares to be issued

Rule 24 of above referred regulation, 2008 also allows company to issue its shares to general

public in the initial public offerings at premium, but

o The premium price that the company can charge has been pegged to net worth value

per share

o If securities are to be issued at premium, the methodology of fixation of price and basis

and justification of the premium must be mentioned.

The face value of securities has to be Rs 100 per unit for share, Rs 1000 per unit for debenture

and Rs 10 per unit for Collective investment scheme.

Provisions related to the issue of securities in Nepal

The Securities Registration and Issue Regulations, 2008 states that a public limited company has to

allocate at least thirty percent of the issued capital to public for public subscription. If a corporate body

is using natural resources/raw materials from the area for its business, it has to allocate 15 % of the

issued capital to general public and 10% of the issued capital to people residing in that area. Unless

otherwise stated, a public issue can be up to 49% of the issued capital, promoters must be holding must

be at least 51% of the issued capital.

A Procedure for an IPO Process in Nepal

1. Issuing company going public approaches merchant banks

Issuing company approaches the merchant banks, licensed to provide public issue services as per

Merchant Banker Regulations, 2008. Merchant banks submits written proposal accompanied by

tentative budget of the issue management process. After the terms and conditions are met, issuing

company appoints an issue manager and a formal agreement is signed.

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2. Registration of securities

A company incorporated as a public limited company to offer securities to public has to register its

securities to Securities Board of Nepal. For the purpose the company has to make an application to the

SEBON in a prescribed format given in Schedule 1 of Securities registration and Issue Regulation, 2008

along with the cash receipt voucher charged as securities registration fee. SEBON would issue a

securities registration certificate as part of approval of registration of securities

3. Preparation of prospectus

Upon signing of the agreement, issue manager acts on behalf of the issuing company and drafts a

prospectus in a format specified by the Securities Registration and Issue Regulations, 2008.

4. Agreement with the underwriters

Fifty percent of every issue has to be mandatorily underwritten by a qualified underwriter or group of

underwriters. After the approval of underwriters list, a separate MOU has to be made and signed by the

issue manager on behalf of issuing company with the individual underwriters, underwriting the

securities issued.

5. Obtain letter from Stock Exchange Ltd.

The issuing company via issue manager should submit one set of documents (prospectus and other

documents being registered in SEBON) to Stock Exchange Ltd. to obtain its letter stating that the

securities to be issued is qualified to be listed on Stock Exchange as per prevalent listing bylaws. The

stock exchange is required to submit its rebuttal against the proposed issue to the board within 7

working days from the submission of documents if any in reference to existing exchange by laws. If no

such response is received by the Board within the stipulated time, Board assumes the consent of Stock

Exchange to list the securities being offered to the public from the applied prospectus.

6. Registering Prospectus with SEBON

After preparing the prospectus, the prospectus with the required documents and fees need to be

registered in the SEBON for the consent and registration. The prospectus registered needs to be signed

by all the board of directors implying their responsibility as matters written in the prospectus to be true.

16

7. Finalizing the approval of issue

Issue managers should update any changes as directed by SEBON in the prospectus. Upon completion of

all the disclosure needed as per the Securities Registration and Issue Regulations, 2008, the SEBON

grants the registration of prospectus and approval to issue shares based on the information provided in

the prospectus. After receiving registration letter from the SEBON, issue manager should get the

prospectus registered with the company registrar’s office and if the company has a separate regulatory

authority, get the prospectus registered with the same as well. All registration has to be completed

before the orientations of the intermediaries and publicity being carried out.

8. Orientation of intermediaries

The issue manager/s in the mean time should appoint bankers to the issue and the collection centers.

Issue manager should make sure that intermediaries selected for the issue process know the job

assigned to them. For this, issue manager might require to prepare and give proper guidelines to them.

In short, issue manager should make sure that they work as directed by the issue manager.

9. Finalizing the date of issue opening

The issue manager should communicate the approval of prospectus to the issuing company and the

Issuing Company should decide on the date on which they wish to open the public offerings process and

inform the same to the issue manager.

According to Securities Issue Guidelines 2008, the issue has to be publicly sold within two months from

the date of receiving approval from SEBON.

10. Publishing announcement letter

After all the provisions have been made, issue manager willing to publish offer document or prospectus

has to publish announcement in the format prescribed by Securities Registration and Issue Regulations,

2008 Schedule-12 in at least one daily newspaper minimum one week prior to the opening of the issue

and the board has to be informed regarding it.

17

11. Opening of the Issue

The issue has to be opened for at least five working days from the date of opening. Issue can be opened

for only four days if the issuing company has at least a total of 10 collection centers in 5 development

regions

12. Share Allotment

Under former Securities Allotment Guidelines, 2051, more weight was given to small applicants.

However, the new directive (Share Allotment Directive, 2068) has made provisions to allot shares under

proportionate basis to ensure equal weight to all applicants irrespective of amount of application or

volume of oversubscription. The change in the allotment guideline is expected to encourage application

by institutional investors or high net worth individual for large number of shares in one name. Such

investors were largely discouraged under previous allotment model where applicants applying for large

number of shares were used to be allotted relatively less number of shares. After the change in the

allotment guidelines, Janata Bank made the first major IPO in the country.

Under the current allotment guideline, Investors applying for shares less than NRs. 50,000 are

categorized as retail investors, and 40% of the issued securities have to be mandatorily allocated for

them. Remaining 60% are to be allotted under pro rata basis of allotment. However, if total applications

by the retail investors represent more than 40% of total applications received all shares will be allotted

proportionately.

13. Refund of non allotted share application money

According to Securities Issue Guidelines 2065, Issue manager should start the process of distributing

allotment slips and refunding within five days of allocation of shares.

14. Distribution of Share Certificate

As per clause 33 of The Company Act, 2063 the share certificate has to be issued to the share holders

within 2 months from the date of allotment of shares

15. Listing of shares with Nepal Stock Exchange Ltd.

The issuing company should apply for the listing of the issued securities with the stock exchange through

an application within 30days from the date of allotment of shares. The shares can be traded only after

18

the application is approved by NEPSE, which might require further time. Securities could be traded in

the secondary market only after 7 days of the listing of securities on NEPSE.

Current Pricing Mechanism in Nepal

Par Value of NPR 100

– for companies registered under Bank & Financial Institution Act and Insurance Act

– for other companies who have not met condition to issue shares at Net worth

Net worth – for other public limited companies who comply with the terms and condition stated

in the clause 29 of the Companies Act, 2063 and Chapter 5 Clause 24 of Securities Registration

and Issue Regulation 2008.

As per clause 64 of Companies Act, 2063 shares are not allowed to be offered at discount (below

the par value). Securities Registration and Issue Regulation, 2008 does not cover the provision

related to issuing shares at discount.

Empirical study of IPO performance under prevailing pricing mechanism

Efficient price discovery mechanism is important to both issuers and investors because it ensures fair price

discovery. Underpriced and overpriced securities offering, in effect, are the cost to the issuers and the

investors respectively. IPO pricing mechanism in Nepal limits the role of market in determining the price.

Consequently, the issue price does not reflect the true price and the prices are corrected only in the

aftermarket. Table 1 depicts the aftermarket trading of some IPOs of selected companies, which verifies that

because of the restrictive pricing mechanism, the issue is mispriced to a large extent.

Table 1: Subscription and aftermarket pricing of some of the largest IPOs, 2063/64 – 2067/68

Name of the Issuer Listed

Amount

(Rs. In

millions)

Issued

Amount

(Rs. In

millions)

Issue

price

(Rs.)

Post IPO

Volume

weighted

price (Rs.)*

Post IPO

Percentage

gain

Subscription

(times)

FY 2067/68

Agricultural Development

Bank Ltd.

3,037.5 960 100 121.51 21.51% 2.97

Manakamana Dev. Bank Ltd. 1,000 300 100 120.71 20.71% 5.42

Jyoti Bikas Bank Ltd. 740 292 100 143.35 43.35% 6**

19

Surya Life Insurance Co. Ltd. 360 108 100 146.83 46.83% 4.22

FY 2066/67

Sunrise Bank Ltd. 1250 375 100 432.87 332.87% 26.75

Prime Com. Bank Ltd. 1000 300 100 641.46 541.46% 31.34

Vibor Bikas Bank Ltd. 680 265.20 100 384.46 284.46% 7.19

Prime Life Insurance 360 108 100 176.07 76.07% 10.17

FY 2065/66

Nepal Doorsanchar

Company Ltd.

15000 1500 600 1095.39 82.57% 0.35

Global Bank Ltd. 1000 300 100 596.78 496.78% 34.25

Citizens Bank International

Ltd.

1000 300 100 548.09 448.09% 20.54

Bank Of Asia Nepal Ltd. 1000 300 100 457.62 357.62% 18.90

FY 2064/65

Siddhartha Insurace Ltd. 100 25 100 302.06 202.06% 60.63

Infrastructure Development

Bank Ltd.

80 24 100 871.67 771.67% 93.55

ICFC Bittiya Santha Ltd. 75 22.40 100 846.55 746.55% 35.06

Annapurna Bikas Bank Ltd. 60 29.40 100 219.92 119.92% 21.94

FY 2063/64

Sanima Bikash Bittiya

Sanstha Ltd.

320 96 100 457.55 357.55% 40.31

Gurkha Dev. Bank Ltd. 320 96 100 420.04 320.04% 108.32

Sikhar Insurance Com. Ltd. 125 25 100 237.54 137.54% 43.75

Siddhartha Vikash Bank Ltd. 50 20 100 146.10 46.10% 2.22

* Post-IPO price refers to average of 14 trading days price after IPO weighted by number of shares traded in each day. **Source: http://businessjournalist.blogspot.com/2010/08/jyoti-bikas-bank-primary-issue.html

Source: SEBON Annual reports, NRB Previous daily prices and researchers own calculation

A study of four largest IPOs (all ordinary shares) over the last five fiscal years depicts that the

aftermarket price is much higher than the issue price. The selected 20 institutions include five

commercial banks, nine development banks, one finance company, three insurance companies, one

20

hotel and one Telecommunication Company. The secondary trading data (closing price) of the

companies for the first 14 days of trading were taken into account in order to find out the price move.

Nepal Stock Exchange determines the range for first day trading price at 1 to 3 time of net worth of

securities. Brokers are allowed to trade on their discretion within that range. The volume-based

weighted average price shows that the securities are traded in excess of 273% of the issue price in

average. It indicates that an IPO of Rs. 100 is traded at an average price of Rs. 373 in the secondary

market in the first two weeks, which reflects that the IPOs are highly underpriced during the public

issue. Thus, such jump of share price in first two weeks of trading in the secondary market signals a flaw

in the IPO pricing mechanism in Nepalese capital market and also explains the issue of IPOs being

oversubscribed in most cases, more notably in commercial banks, which are mispriced by a large extent.

This also explains the complain made by few private companies regarding the pricing of shares in the

IPOs as not issuer friendly, as the current system requires them to sell their shares at huge cost to the

issuer. In order to avoid such mispricing of securities, different efficient mechanisms for price discovery

of IPOs are introduced and practiced worldwide.

21

Figure 1: Movement in Price of Ordinary shares after listing on NEPSE, 2063/64-67/68

0 200 400 600 800 1000 1200

Agricultural Development Bank

Manakamana Dev. Bank Ltd.

Jyoti Bikas Bank Ltd.

Surya Life Insurance Co. Ltd.

Sunrise Bank Ltd.

Prime Com. Bank Ltd.

Vibor Bikas Bank Ltd.

Prime Life Insurance

Nepal Doorsanchar Company Ltd.

Global Bank Ltd.

Citizens Bank International Ltd.

Bank Of Asia Nepal Ltd.

Siddhartha Insurace Ltd.

Infrastructure Development Bank Ltd.

ICFC Bittiya Santha Ltd.

Annapurna Bikas Bank Ltd.

Sanima Bikash Bittiya Sanstha Ltd.

Gurkha Dev. Bank Ltd.

Sikhar Insurance Com. Ltd.

Siddhartha Vikash Bank Ltd.

Issue price Post-IPO gain

22

Overview of some different pricing mechanism used in Nepalese Capital

market

Except for IPO issue at fixed price at par, which has been the norm in Nepalese capital market, few

issues have been made under different method, both in the primary issue and secondary market. Closed

auction bidding method, with predetermined floor price, was used in case of IPO of Nepal Doorsanchar

Company Limited (referred to as NTC) and cross holding share transaction of Standard Chartered Bank

Nepal Limited (SCBNL) held by Nepal Bank Ltd. The IPO of NTC was done under privatization of public

entity by Government of Nepal whereas, shares of SCBNL held by Nepal Bank Ltd. were traded in the

market based on then prevailing market price. Chilime Hydropower Company Limited (CHCL) became

the second hydropower company to make IPO at a premium, based on its net worth. The first company

to do so was Arun Valley Hydropower Development Co. Ltd. Further, auction method is currently used

to sell unsubscribed ordinary shares issued by listed companies during the right offerings. Further public

offering (FPO) has also been tried by one company which sold its shares at market price to public. Table

2 gives a detail picture of these companies, where primary issues and secondary trading were priced

under different mechanisms.

Table 2: Overview of SCBNL, NTC and CHCL issue under different pricing mechanism

Company SCBNL NTC CHCL

Type of Issue Sell of Cross holding

share through offer

documents

IPO IPO

Date of Issue 2061/3/4 (June 18, 2004

– July 2, 2004)

2064/10/9 (January

23,2008 – February 26,

2008)

2068/2/17 (May 31,

2011 – June 3, 2011)

Modality of

Issue

Closed bid auction Closed bid auction Open invitation

Par Value of

offerings

NPR 31,248,800 NPR 1,500,000,000 NPR 134,400,000

Net worth per

share at the

time of

NPR 403.15** NPR 178.63* NPR 476.72 (based on

annual reports

2066/67)

23

offering

Trading price NPR 1600 (June 15, 2004) - NPR 900 (May 31,

2011)

Issue price NPR 1500 (floor price) NPR 600 (floor price) NPR 408.36

Basis of

premium

Secondary market price N/A Secondary market price

of promoters share

Number of

shares issued

312,488 15,000,000 1,344,000

Number of

shares

subscribed

551,221

(1.76 time subscribed or

76% oversubscribed)

5,299,690

(0.35 times subscribed or

65% undersubscribed)

1,344,000

(7 times subscribed or

591% oversubscribed)

Average bid

price

NPR 1548 NPR 612 -

Weighted

average bid

price

NPR 1621 NPR 678.84*** -

First day

closing price

(Next trading

day after

issue closure)

NPR 1720

(July 5, 2004)

NPR 900 NPR 845

(June 5, 2011)

* as of Ashad end 2064 ** as of Ashad end 2060 ***Calculated from Economic Survey 2008/09

Standard Chartered Bank Nepal Limited (SCBNL)

The ordinary shares of SCBNL under the ownership of Nepal Bank Limited (3,12, 488 ordinary

shares including 10% bonus shares) was offered to public, under closed bid auction, the floor

price being set at the prevailing market price of NPR 1500 per share.

The shares were bid in the range of NPR 1500 – NPR 1900, the weighted average bid price being

NPR 1621. Despite of its relatively high offer price, the issue was 1.76 times subscribed, which is

an oversubscription of 76%.

24

Nepal Telecom (NTC)

In April, 2004, Nepal Telecommunications Corporation was converted into a public limited

company, and its name was changed to Nepal Doorsanchar Company Limited (commonly known

as Nepal Telecom). However, the government continued to retain its full ownership. On January

23, 2008, NTC launched an IPO of 15 million shares, under auction method, worth about 10%

stake of the company at a premium price of NPR 600 per share as floor price.

The minimum number of shares to bid was set at 100 shares, worth Rs. 60,000. The restriction is

assumed to have discouraged retail investors from participating in the bid. No individuals or

institutions were allowed to buy more than 5000 shares.

The IPO auction of NTC faced several controversies like the basis for determining the premium

was not justified and use of auction system has unnecessarily drove the price higher, thereby

marginalizing the retail investors.

The IPO issue, although being the largest issue in Nepalese capital market history, received a

subdued response from the investors. Only about 35% (slightly more than 5 million) of the issue

was subscribed.

Formerly, the company has sold 7.5 million shares or 5% stake of the company to the

employees.

Chilime Hydropower Company Limited (CHCL)

CHCL issued its shares to public at premium. CHCL first issued its shares to the employees of

Nepal Electricity Authority and the employees of the company itself and then to local resident of

area affected by the project and finally to the general public. Shares sold to employee were sold

at par. shares sold to locals of affected area were sold at two different prices: i) NPR 100 for

locals of three VDCs and ii) NPR 324 per share, with the premium of NPR 224 per share to locals

of 15 other VDCs'. However, the price of the IPO of CHCL shares to general public was set at

NPR 408.36, involving a premium of NPR 308.36. The price is determined adhering to the

companies Act, 2063 and Securities Act which allows company to issue shares at premium to the

extent of net worth per share (Securities Board of Nepal (SEBON)). The minimum quantity to

apply is 20 shares, instead of 50 shares. Another hydropower company Arun Valley Hydropower

Company had also issued its shares to public at NPR 184 per share.

25

The IPO of CHCL was approved by SEBON on May 18, 2009 and the company announced to

release 2,304,000 shares worth Rs. 230.4 million on June 15, 2009. The IPO, however, was

withheld as per the notice by Supreme Court as a case was filed against the company by the

people from the affected areas as they were allocated just 5% of the total issue instead of 8% as

agreed upon earlier. The company launched its IPO later on May 31, 2011.

Out of the total issue, only 1,344,000 shares were offered to the public after allocating 960,000

shares to the local resident. The issue, despite being made at premium, was hugely

oversubscribed (by 591%).

Above-mentioned cases illustrate that different forms of pricing mechanism have been tried in the

Nepalese market and the market response to such issues have been fairly positive, as depicted by their

enthusiastic participation both in the auction method and IPO issue under fixed price at premium. Both

SCBNL and CHCL issue were highly oversubscribed, whereas, NTC shares received a lukewarm response

as the issue was undersubscribed. To make a note here, in all three cases, the prices were fixed by the

issuer. But, the offering of SCBNL shares by Nepal Bank Ltd. was a secondary offering and market price

had been determined. Though, CHCL offering was primary to the public, it had already listed its shares

sold to its employee in the Stock Exchange and hence secondary market price had been determined.

But, in the case of NTC, the price had not been determined by the market and was fixed by the issuer

and there were no reference point to the investors to compare or rely on.

The references of these issues reflect that market demand has been considered, albeit only partially, in

the auction process. The auction price used is comparable to the discriminatory auction, where the

bidders have to pay the price that they have bid. However, no attempt has been made in understanding

the market and determining the issue price completely on the basis of the market demand.

26

Chapter Four: Review of Free price discovery mechanism / Book

Building Mechanism in neighboring countries

Bangladesh

Securities and Exchange Commission (Public Issue) Rules, 2006 and Securities and Exchange Ordinance

1969, governs the process of public offering in Bangladesh. The regulation has gone through numerous

amendments especially on the book building method of public offering. According to the regulation,

company going public has to adopt either of the two pricing methods, Fixed Pricing or Book Building.

Review on Fixed Pricing Method

If a company is planning to float ordinary shares to public through fixed price method , various

factors affecting the pricing decision has to be clearly stated in the prospectus

This generally means that if company issues shares through fixed price model in premium , it

has to be justified in reference to following criteria:

o Net Asset value per share at historical or current cost

o Earning value per share (as per weighted average net profit after tax) for five preceding

years or such shorter period during the commercial operation of the company.

o Projected EPS for the next three years as per rational assumption of the issuer which has

to be certified by the auditor.

o Average market price per share (MPS) of similar stocks for the past one year, if it’s a FPO

then MPS of common stock of the issuer in the aforesaid period. All of the factors that

have been considered in fixing the premium price of the shares.

(Note: the amount of premium charged on the public offering under this method should not exceed

the amount of premium charged on share issued within the immediately one preceding year

(Premiums on bonus shares are excluded))

Review on Book Building Method

In regard to Securities and Exchange Commission (Public Issue) Rules, 2006 (Amended) following are

the criteria for issuer to be eligible to go into book building process in Bangladesh

Must have at least Tk. 30 crore net worth

27

Must offer at least 10% share of paid up capital (including intended offer) or 30 crore face value

offering whichever is higher.

Must be in commercial operation for at least past 3 years

Should be in profit for immediate past two years and should not have any accumulated losses at

the time of application

Should have regularly held AGM and should have audited its latest financial statement from a

registered CA.

Price discovery for determining indicative price

According to Securities and Exchange Commission (Public Issue) Rules, 2006 “indicative price” means

the price which the issuer indicates in the draft prospectus taking input from the eligible institutional

investors on which the bidders bid for final determination of price.

Eligible Institutional Investors

Merchant bankers except the issue manager concerned to the proposed issue;

Foreign institutional investors registered with or approved by the Commission;

Recognized pension funds and provident funds;

Bank and non-bank financial institutions under regulatory control of Bangladesh Bank;

Insurance companies regulated under Insurance Act, 1938 (Act No. IV of 1938);

Institutional venture capital and institutional investors registered with or approved by the

Commission;

Stock Dealer registered with the Commission; and

Any other artificial juridical person permitted by the Commission for this purpose.

Asset Management Companies

“Any Eligible institutional investors where Directors/Promoters/Sponsors of Issuer Company

have interest under related party definition of International Accounting Standard (IAS), shall not

be eligible to participate in the bidding process.”

“Issue manager in which sponsors/directors of Issuer Company have ownership interest cannot

be eligible to act as issue manager because of conflict of interest.”

28

Procedure followed while determining price under book building process

The issuer/ issue manager shall be responsible to issue an invitation to Eligible Institutional

Investors both in writing and in at least five widely circulated national dailies, at least ten days

before the road show/ presentation/ seminar clearly indicating time and venue of such event.

The invitational letters to EII’s should also have an Information memorandum containing all the

financial statement of the past five years or such shorter period during which the issuer was in

operation. CEO and Financial Analyst should jointly sign and submit indicative price to issuer/

issue manager by stating out all the rationale behind the price within the three working days of

said road shows or presentation.

Representatives from stock exchanges shall participate in road shows as observers.

Issuer in consultation with issue manager should quote its own indicative price in its draft

prospectus based on quotation received from EII’s. The Information memorandum send to EII’s

should be without the indicative price. The indicative price should be disclosed to the EII’s after

the quotations have been received. This indicative price has to be supported by at least 20 EII’s

including at least three quotations from each of the following categories :

o Merchant Bankers, Commercial Banks, Asset Management Companies, Non-Banking

Financial Institutions (NBFIs), Insurance Companies and Stock Dealers. EII’s who have

supported the indicative price should participate in the electronic bidding system at

least with their intended quantity and indicative price. The intended quantity by the

EII’s who support the indicative price should be at least 10% of total issue size for that

indicative price to be discovered.

The draft prospectus shall be simultaneously submitted to stock exchange and commission

along with the due diligence report by all concerned. The rationale behind the indicative price

has to be clearly stated in the draft prospectus.

Formal price shall be within the band of 20 per cent (both upward and downward) of the

indicative price within which EII’s have to bid.

EII’s bidding shall commence after getting a go from the commission

The hard copy of Information memorandum without the indicative price shall physically be sent

to the following institutions/associations at least 5 (five) working days prior to the Road Show:

Stock Exchanges, Bangladesh Merchant Bankers’ Association (BMBA), Bangladesh Association of

Banks (BAB), Bangladesh Leasing & Finance Companies Association (BLFCA, Bangladesh

Insurance Association (BIA), Association of Asset Management Companies.

29

Associations shall ensure dissemination of hard copy of draft prospectus among their respective

members.

Institutional investors are not permitted to apply for more than 5% of total security offered for

sale to institutional investors; they are subject to maximum of five bids.

Bidding Period for institutional investors will be (forty eight) hours which may be changed with

commission’s approval.

The Company and The Issue Manger shall submit the status of bidding and the cut off price

along with the final draft prospectus, simultaneously to the Commission and the stock

exchanges within 5 working days from the closing day of the bidding.

There should be 15 days gap between the closure of subscription for the institutional investors

and opening of bidding for general investors.

Table 3: Allocation of shares under Book building in Bangladesh

In face value Institutional

investor

Mutual

Fund

Non Residential

Bangladeshi

Public Portion

Tk. 30 to Tk. 50

crore

40% 15% 10% 35% or balance

amount

Over Tk. 50

Crore to Tk.100

crore

50% 15% 10% 25% or balance

amount

Over Tk. 100

crore

60% 15% 10% 15% or balance

amount

The lock-in period of securities held by institutional investors should be 4 (four) months from

the first trading day.

Amendments of various clauses under Book building Process in Bangladesh

In January of 2011, Book Building system in Bangladesh was suspended amid share market debacle that

caused equity market in Bangladesh to plummet. The wrong doings of foul players in the system was

attributed to market crash. The current regulations in book building were also blamed for breeding

ground for collusion in pricing of offering. So SEC made amendments to the book building process in

30

Bangladesh in October 2011. A review above showcases all the new amendments made to the book

building process in Bangladesh. The reasons for the new amendments are discussed below:

In order to ascertain more transparency and disclosure, representatives of Dhaka Stock

Exchange (DSE) and Bangladesh Stock Exchange (BSE) should participate in road shows/

presentation. These are the stock exchanges where security will eventually be listed.

Parties have been blamed in fixation of prices of securities, in order to combat it; SEC has

included a clause to not allow issuer’s subsidiaries or any EII’s with interest of promoters/

directors /sponsors of the issuer to participate in the bidding process.

In order to expedite the process of IPO , SEC has reduced the institutional bidding time to 48

hours.

Asset Management Companies were not previously included in the EII’s category , new clause

includes these institutions ; inclusion of AMC is said to assist in the discovery of indicative price

as these institutions will have very good research team.

In order to ascertain the commitment of EII’s to quote indicative price, SEC has made a new

clause that while submitting price they also have to submit the intended quantity of security

that they are willing to purchase. For an indicative price to be said discovered, the quantity

demanded by EII’s who support the indicative price should be at least 10% of total issue size.

EII’s need to deposit 20% of the bid amount at the time of bid submission to the designated

bank account and the rest amount has to be settled within five working days prior to the

opening of the issue to the retail investors ; if EII’s fail to do so 50% of the advance money would

be confiscated.

Quotas for institutional investors have been increased by SEC so as to support better price

discovery through proper valuation. If more institutional investors are allowed to participate

there will be better chance of price discovery.

Lock in period for EII’s has also been increased from 15 days to 4 months.

In the newer version of the regulation issuer / issue manager and EII’s are not collectively

allowed o fix the indicative price. The detailed of the clauses have previously been explained,

this will check on the degree of collusion in price setting by different parties (Institutional

investors) involved.

31

China

Evolution and Development of pricing mechanism

The establishment of China Securities Regulatory Commission (CSRC) in 1992 is a key milestone in capital

market development of China. In October 1992, State Council Securities Commission (SCSC) was

established to oversee the securities market and was responsible to draft relevant laws, rules and

regulations for securities market, develop long-term strategies, deliver guidance and coordinate among

central and local governments, conduct supervision and inspection of market activities (China Securites

Regulatory Commission (CSRC), 2008). SCSC merged with CSRC in April, 1998 and it has been operating

with the core objective of facilitating listing and trading of securities in public, developing market rules

and regulations, supervising the securities firm and ensuring development of capital market as a whole.

Regarding the pricing of IPOs, different methods have been tried and tested in the capital market. Prior

to the establishment of stock exchanges, shares were issued at par and there were no mechanism as

such to determine the issue price. Afterwards, the IPO issue pricing was determined on the basis of a

fixed price-earnings ratio, taking into account the profit after tax. Fixed pricing method was used

because of immaturity of both issuers and underwriters and lack of institutional investors. However,

with the increasing capacity of institutional investors and maturity of the market, market driven pricing

gradually replaced government driven pricing. At the end of 2004, CSRC enacted the Circular on Several

Issues concerning the Book-building Procedures for IPOs, which marked the introduction of free pricing

mechanism in Chinese securities market. Further, the Administrative Measures for Securities Issuance

and Underwriting, issued in September, 2006 explained the pricing and share allotment under book-

building.

Prevailing Pricing Mechanism in China

The prevailing IPO pricing mechanism is a market-oriented one, which has been preceded by fixed

pricing and controlled P/E ratio-based pricing. Inquiry pricing system was introduced on a trial basis

from 1 January, which, in essence, is a book-building pricing system involving two stages. Initial price

band is discovered by soliciting price offers from institutional investors in the first phase while final price

of the offering is determined on the basis of second-round feedback from the institutional investors.

Previously used IPO Pricing methods: Fixed price method, price based on P/E ratio, criticized for

lack of flexibility and depriving underwriters from pricing freedom

32

IPO pricing of securities is governed by Chapter II of Administration Measures on Securities Issuance and

Underwriting, CSRC Decree No. 37 (effective from September 19, 2006), under the heading ‘Inquiry and

Pricing’. The key highlights of the chapter are as follows:

Specified institutional investors, referred to as inquiry objects, are solely responsible for

determining the issuance price of an IPO stock. Inquiry objects refer to the securities investment

fund management companies, securities companies, trust and investment companies, financial

companies, insurance institutional companies, and qualified foreign institutional investors that

meet the conditions prescribed in the Measures, and other institutional investors approved by

the CSRC.

The basis for making inquiry is a research report on investment value provided by lead

underwriter to the inquiry objects. The issuer, underwriter and the inquiry objects should not

publicly disclose the information contained in the report in any form.

A research report, based on certain analyses, should help predict the reasonable investment

value of an issuer’s stock by using valuation methods generally recognized in the industry.

Inquiry process is divided into initial inquiry and accumulative tenders and bid inquiries. Through

initial inquiry, an issuer and its lead underwriter determine the issuance price range and

subsequently the issue price is determined through the accumulative tenders and inquiries.

Any institutional investor, who does not participate in the initial pricing inquiry, or who

participates but does not make valid quotation, are not eligible to participate in the

accumulative tenders and inquiries.

After the initial inquiry, if less than 400 million shares are publicly offered and less than 20

inquiry objects provide valid quotations, or if more than 400 million shares are publicly offered

and less than 50 inquiry objects provide valid quotations, the issuer and its lead underwriter

shall not determine the issuance price and shall suspend the issuance.

Table 4: Restriction in IPOs in China

Date Reasons

February 2005 - May, 2006 ‘to halt a four-year market slump and to allow more than USD 200 billion

of mostly state-owned equity to be converted into tradable shares’

September 2008 – 19

June, 2009

To reduce pressure on the liquidity by a large number of IPOs

China halted IPOs on September 2008 after the Shanghai index tumbled 60

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per cent from its high the previous year. At that point, 37 companies had

received regulatory approval for IPOs.

India

Evolution and Development

Before the decade of 1990, the primary issue market of India was governed by the Controller of Capital

Issue (CCI), which determined the issue price of IPO. In 1992, the Indian capital market moved to a freer

capital market with the SEBI taking over as the new market regulator. Subsequently, the control over

price and premium was removed and companies were able to raise funds by filing an offer letter with

SEBI, thereby ensuring a more liberal capital market. The Disclosure and Investor Protection (DIP)

Guidelines, 2000, Chapter III, states that an unlisted company eligible and desirous of making public

issue can price freely its equity shares or any securities convertible at a later date into equity shares.

Therefore, the prevalent pricing mechanisms in India are based on fixed price method, book building or

the combination of both.

The book building mechanism in India was introduced by SEBI on the basis of recommendations of an

expert Committee under the Chairmanship of YH Malegam in October, 1995. The purpose of the

committee was to “to review the (then) existing disclosure requirements in offer documents” and two of

the terms of references were “the basis of pricing the issue” and “whether substantial reduction was

possible in the time taken for processing applications by SEBI”. The proposed recommendations were

accepted by SEBI in November, 1995 (Gangadhar & Reddy, 2005).

The book building method in India has evolved to be quite different from other countries like the US, the

most notable distinctions being in the retail participation and discretionary power of lead managers. In

Indian market, retail investors are also allowed to participate in the book building process, unlike in the

US and they have the option to place either market bids or limit bids. Likewise, the Book Runner Lead

Manager (BRLM) do not have the allocation discretionary power to allocate securities, which is regarded

to be the basis for discovering the efficient price of offerings.

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Amendments

The book building mechanism has constantly evolved in India since its inception in the mid 90s. Initially,

the book building mechanism was available only to the issues exceeding IPO of 100 crore. Because of

the stringent restrictions, book building did not have a good start and no companies adopted book

building mechanism in issuing IPOs. The restriction was later changed and the issue requirement was

reduced to 25 crore in 1998-99 (http://www.citeman.com/6075-book-building-guidelines.html). In July,

2001, the restriction of minimum public issue size of 25 crore was removed from the guidelines.

Various changes were brought by SEBI on March 29, 2005. Allocation of securities to Retail investors

under book built issue was increased to at least 35% from 25% earlier. Likewise, allocation to non

institutional investors was decreased to 15% from 25% earlier. As per the DIP Guidelines, 2000, the

category of ‘retail individual investors’ was redefined to ‘an investor who bids for securities of or for a

value not more than Rs. 1,00,000’, which is an increase from Rs. 50,000 on March 29, 2005.

Likewise, formerly, both the allocations (to institutional investors) as well as determination of the issue

price were under the discretion of the BRLM and issuer respectively (Allocation was made on a

proportionate basis to retail and non-institutional investors, whereas discretion could be used by BRLM

in case of allocating securities to institutional investors). However, from November, 2005, SEBI

mandated that the allocation should be made on pro-rata basis to all investor categories. The regulatory

change has been under scrutiny as some of the studies suggest that the discretionary power in the

allocation of securities under book building method helps in efficient price discovery of the offering,

which is the inherent objective of the mechanism.

SEBI also introduced the concept of Anchor Investor in public issues through book building route in July

9, 2009. Anchor investors are from the investor category of Qualified Institutional Buyers (QIBs), for

whom the minimum application size will be Rs. 10 crore and subscribe to the maximum of 30 percent of

the proportion allocated to QIBs. SEBI required issuers to have at least two anchor investors for issue

size upto 250 crores and five for issue size exceeding 250 crore. The intention of introducing the concept

was to boost investor confidence as availability of buyers with prior commitments will enhance the

issuer’s ability to sell.

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Book building mechanism in brief

The Book building process is described in ICDR (Issue of Capital and Disclosure Requirement) under

Schedule XI. The process is explained as under:

The issuer company appoints a lead merchant banker as Book Runner Lead Manager (BRLM).

BRLM is given a definite period of time to conduct awareness programs like campaigns and road

shows.

The BRLM appoints syndicate member, which is a SEBI registered company, to underwrite the

issue to the extent of ‘net offer to the public’. The syndicate member creates demand in the

market by asking for the bid price and quantity of the issue to be offered.

The BRLM builds up an order book, based on the feedback from the syndicate members about

the price and quantity of the bids received, which depicts the demand for shares at various

price.

Based on the order book, the issuer company in consultation with the BRLM, determines the

issue price, which is also known as market clearing price. (See Appendix)

After determining the final price, allocation is made based on several factors like earliness of

bids, investor’s quality etc. The allocation is entirely under the discretion of the issuer company

and the BRLM.

Allocation on fixed price method commences only after the placement portion is closed (one

day after the closing).1

Types of Book Building process

As per Securities Exchange Board of India (Disclosure and Investor Protection) Regulations, 2000, an

issuer company proposing to issue capital through book building can do so in the following methods:

75% Book Building Process

Offer to Public Through Book Building Process

o 100% of the net offer to the public through the book building process, or

o 75% of the net offer to the public through book building process and 25% at the price

determined through book building

1 The issue of securities through book-building process shall be separately identified/ indicated as ‘placement portion category’.

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The 75% book building process allows bids to be submitted only by institutional investors and

underwriters, excluding retail investors. The mechanism is adopted as an alternative to firm allotment,

which provides for allotment to institutional investors and permanent/regular employees of the issuing

company. Remaining 25% of the total public issue is reserved to be offered exclusively to individual

investors who have not participated in the bidding process at fixed price (the price determined by the

book building method).

In contrast, the 100% book building process allows all investor category (retail investors, institutional

investors and QIBs) to participate in the bidding process and allocation is made accordingly (discussed in

the later section). Both retail and institutional investors are allowed to bid in the issue. Retail investors

have option of market bids or limit bids whereas institutional investors are required to place limit bids

only.

A modification of the 100% book building process is the 75% of the offering to be made through book

building process and 25% at the price determined through book building. Under this system, both

institutional as well as individual investors are allowed to participate in the bidding process, from which

the issue price is determined. The remaining 25% of the issue is made on fixed price basis (at the price

determined by the book building method) and shall be available to those who have either not

participated in the bidding process or have not received any allocation in the book built portion.

The 2nd method of book building allows reservation to be made so that book building shall be for the

portion other than the promoters’ contribution and the allocation made to permanent employees of the

issuer company, shareholders of the promoting companies and persons who have business association

with the issuer company.

Pricing process under Book Building

The pricing process under book building mechanism starts once the book running lead manager

prepares a Red Herring Prospectus which contains an indicative price range. As required by Issue of

Capital and Disclosure Requirement Guidelines, if the floor price or price band is not mentioned in the

red herring prospectus, the issuer is required to announce the floor price or price band at least two

working days before the opening of bid (in case of IPO) and at least one working day in case of FPO, in all

the newspapers in which the pre issue advertisement was released. The indicative price range (or price

band) is determined jointly by the issuing company and the book running lead manager, on the basis of

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the valuation effort of the BRLM and the minimum acceptable (floor price) stipulated by the issuer. The

cap on the price band shall not exceed to 120% of the floor price as per the guidelines. As per DIP

guidelines, 2000, Chapter XI, 11.3.1 viii (b), the price band can be revised up to the extent of 20% up or

down of the floor price disclosed in the red herring prospectus and the upper limit will be adjusted

accordingly.

The issue price is determined by the issuer company and the BRLM based on the bids received through

the ‘syndicate members’ (See Appendix I). The bids above the cut-off price are valid and subject to

allocation as per the guidelines.

As per the circular published on September 3, 2009, 75% book building route has been omitted.

However, it is still mentioned in the DIP Regulations, 2000. Likewise, the requirement to disclose price or

price band in the draft prospectus was omitted. Total issue period could not exceed 10 days, including

any revision in the price band as per the new guidelines.

Application

As per the DIP guidelines, the broker/syndicate member shall submit at least ten percent of the

application money as margin money in respect of bids placed by qualified institut