Securities Exchange Board of India’s (SEBI), recently suggested that all IPOs be accompanied by mandatory hard underwriting. According to the regulator, there is a lack of quality control in terms of equity paper being issued via IPOs, pricing can tend to be aggressive and there needs to be more through vetting of the business and the risks involved. All this in SEBI’s opinion can be rectified by placing the onus and risk solely on the lead manager via hard underwriting. I would beg to differ. Not only does hard underwriting further complicate the already warped Indian investment banking, it offers no long term solution at all.
Investment banking landscape in India lacks depth. There are very few institutions capable of executing meaningful transactions and still fewer with adequate capitalization to hard underwrite issues. Thus with hard underwriting we risk placing a big chunk of Indian equity in a few hands. What happens in situations akin to the current volatile markets? There is a high probability that the underwritten stocks (if not already placed) would be sold at any level at which a bid was available. Result – a significant freefall of the Indian equity markets. Biggest losers – retail investors. In bull markets it is those investment banks with deep pockets that would undercut competition, resulting in IPOs being concentrated in a few hands. This would further curb any deepening of the Indian financial system. So from a macro view, hard underwriting will not serve the nation well.
The key phases involved in an IPO are due diligence, preparation of research and the finally pricing and allocation. Due diligence is a process whereby the lead manager (or the underwriter) assesses the suitability of the company to list on an exchange and verifies the facts presented. In order to ensure thorough vetting of the company and its risk factors, this process should be “independent”. Research subsequently constitutes of an “objective” presentation of the business and the valuation methodology. This is undertaken by sector experts to produce a comprehensive report. Valuation of the company should not be “influenced” by the views of the issuer or of the corporate financiers working on the mandate. Given the increased risk for a lead manager in a hard underwritten issue and the absence of Chinese walls in Indian banking system, this independence absolutely stands to be blurred and maybe significantly. Thus instead of advocating hard underwriting, SEBI should work towards strengthening Chinese walls in Indian investment banking to ensure systematic evaluation of businesses. At the same time efforts should be made to enforce arms length dealings between the issuer, investment banks and the individuals in these two fraternities.
The next key step is that of pricing and allocation. Majority of an IPO is subscribed to by institutional investors. These are sophisticated investors with global experience and access to information and tools which enable them to take well informed decisions. Not only do institutional investors meet the management to evaluate merit of the company but also conduct their own valuation exercise. The research provided by the lead manager is only a starting point. It is the institutional investors' own analysis that finally decides whether they will participate in the IPO and if yes at what terms. When hard underwriting a transaction, lead managers keep a buffer as protection against any price or demand mismatch. This leads to potentially underpriced issues, causing a loss for the issuer (notwithstanding the higher fee charged for hard underwritten deals). However, price discovery achieved via an offering to institutional investors (as a bookbuilding proposition) leads to optimal pricing and sizing as dictated by markets. (This is obviously assuming independence of investors from the issuer and the issue itself.) Bookbuilding thus offers a more relevant and sustainable solution to achieving reasonable pricing.
Last is the point of quality, which can be quite subjective. The quality of business is not just defined by its profitability but also by its management and shareholders. With most Indian firms being family owned, management is not where one can have immediate influence. However, SEBI can influence the shareholding pattern of Indian corporates. Given the thriving mutual fund industry in India, SEBI should consider curbing direct retail participation in IPOs (currently 30% - 35% of an IPO is reserved for the retail investor and a further 10% - 15% for HNIs). This will not only protect retail investors (mutual funds tend to be less volatile than equity markets) but also avoid participation from seemingly unrelated (to the issuer) but actually in-concert investors. In addition, the minimum dilution levels for promoters should be increased; thus increasing true free float and hopefully leading to improved corporate governance (with increased institutional participation).
Instead of looking at a quick fix, SEBI needs to consider the process as a whole and attack each problematic step in cohesion. There needs to be increased accountability and responsibility placed on each of the involved entities– the issuer, the investment banks, the investors and the regulator itself. Only then will we witness sustained discipline in primary Indian equity market.
Investment banking landscape in India lacks depth. There are very few institutions capable of executing meaningful transactions and still fewer with adequate capitalization to hard underwrite issues. Thus with hard underwriting we risk placing a big chunk of Indian equity in a few hands. What happens in situations akin to the current volatile markets? There is a high probability that the underwritten stocks (if not already placed) would be sold at any level at which a bid was available. Result – a significant freefall of the Indian equity markets. Biggest losers – retail investors. In bull markets it is those investment banks with deep pockets that would undercut competition, resulting in IPOs being concentrated in a few hands. This would further curb any deepening of the Indian financial system. So from a macro view, hard underwriting will not serve the nation well.
The key phases involved in an IPO are due diligence, preparation of research and the finally pricing and allocation. Due diligence is a process whereby the lead manager (or the underwriter) assesses the suitability of the company to list on an exchange and verifies the facts presented. In order to ensure thorough vetting of the company and its risk factors, this process should be “independent”. Research subsequently constitutes of an “objective” presentation of the business and the valuation methodology. This is undertaken by sector experts to produce a comprehensive report. Valuation of the company should not be “influenced” by the views of the issuer or of the corporate financiers working on the mandate. Given the increased risk for a lead manager in a hard underwritten issue and the absence of Chinese walls in Indian banking system, this independence absolutely stands to be blurred and maybe significantly. Thus instead of advocating hard underwriting, SEBI should work towards strengthening Chinese walls in Indian investment banking to ensure systematic evaluation of businesses. At the same time efforts should be made to enforce arms length dealings between the issuer, investment banks and the individuals in these two fraternities.
The next key step is that of pricing and allocation. Majority of an IPO is subscribed to by institutional investors. These are sophisticated investors with global experience and access to information and tools which enable them to take well informed decisions. Not only do institutional investors meet the management to evaluate merit of the company but also conduct their own valuation exercise. The research provided by the lead manager is only a starting point. It is the institutional investors' own analysis that finally decides whether they will participate in the IPO and if yes at what terms. When hard underwriting a transaction, lead managers keep a buffer as protection against any price or demand mismatch. This leads to potentially underpriced issues, causing a loss for the issuer (notwithstanding the higher fee charged for hard underwritten deals). However, price discovery achieved via an offering to institutional investors (as a bookbuilding proposition) leads to optimal pricing and sizing as dictated by markets. (This is obviously assuming independence of investors from the issuer and the issue itself.) Bookbuilding thus offers a more relevant and sustainable solution to achieving reasonable pricing.
Last is the point of quality, which can be quite subjective. The quality of business is not just defined by its profitability but also by its management and shareholders. With most Indian firms being family owned, management is not where one can have immediate influence. However, SEBI can influence the shareholding pattern of Indian corporates. Given the thriving mutual fund industry in India, SEBI should consider curbing direct retail participation in IPOs (currently 30% - 35% of an IPO is reserved for the retail investor and a further 10% - 15% for HNIs). This will not only protect retail investors (mutual funds tend to be less volatile than equity markets) but also avoid participation from seemingly unrelated (to the issuer) but actually in-concert investors. In addition, the minimum dilution levels for promoters should be increased; thus increasing true free float and hopefully leading to improved corporate governance (with increased institutional participation).
Instead of looking at a quick fix, SEBI needs to consider the process as a whole and attack each problematic step in cohesion. There needs to be increased accountability and responsibility placed on each of the involved entities– the issuer, the investment banks, the investors and the regulator itself. Only then will we witness sustained discipline in primary Indian equity market.
5 comments:
The quality of business is not just defined by its profitability but also by its management and shareholders.
More Cleavage
Good one...Why the 'reliance power' IPO failed to perform inspite of the most active participation from retail investors?
2.Doesnt the existing system of proportionate issue of IPOs work relegiosly?
Hi Tanushree
Let me start at the point that u raised about the fact that the merchant banker should be "independent" in the vetting and pricing process. Theoretically yes but practically no. The merchant banker derives his fees from the issuing company and hence there is a clear conflict of interest arising here. So it would be naive to assume that the investment banker has the investors best interest as the sole variable driving the process. We have experienced the same problem with rating agencies worldwide. Hard underwriting is putting your money where your mouth is.
Your point that the investment banker would exit the stock at any price would result in a loss not for the retail investor. More importantly it would also result in a loss for the investment banker. Considering that he would have a higher impact cost of exit bcos of higher volumes, it would induce to him to examine pricing of issues a lot better.
I would beg to differ on stating institutional investors as sophisticated investors. There have been numerous instances in the Indian context where institutional investors have flipped there investments in IPO's on listing. Clearly there were no long term investment objectives but pure short term trading profits in the peak of a bull run.
I think SEBI's move is in the right direction in terms building higher accountability by the investment bankers for the quality and pricing of offering.
Ninad
tend to agree with you - IPOs dont necessarily have to have a retail component (and there are many other good reasons to introduce institutional-only offerings).
But to me retail participation in direct equity seems to be a much wider and deeper question. Most of the IPO stocks in the last couple of years which have fallen out of favour, didnt suffer a freefall on listing or thereabouts, but could have been victims of general downtimes - how will the retail investors be protected even if they were not to buy before listing?
Indian retail investor is too deeply entrenched into the direct equity markets, unlike some of the more advanced capital markets. In that case, could setting up a separate market for institutions only trading help the cause?
I would beg to differ. Not only does hard underwriting further complicate the already warped Indian investment banking, it offers no long term solution at all. Trade With Trust
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