raj gandhi mms finance 18
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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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