Last Sunday I was playing golf with a couple of senior military officers and post golfing we happened to share a beer and a bite. The conversation veered towards stocks, IPOs and whether they are really worth investing. It gave me some food for thought. Are investors in the share market aware of the dynamics of an IPO?
One often hears the term IPOs while watching the financial media channels on TV or reading in print. What is an IPO? An IPO is an initial public offering (IPO) of shares of a business. When a company wants to raise capital from the public, it approaches them through an IPO. The approach can be through an offer for sale i.e the promoters want to sell their existing shares to the public or through an increase in share capital.
Why do companies approach the public for raising finances? Because in layman terms, you do not have to repay this money and it is cheaper than debt, though in financial terms it is costlier. Why is it costlier? Because if I have a profitable business, why should I make the public, a partner in my profits? I would be better off taking a loan from a bank or friend, pay interest on it and return the loan after a certain period of time without diluting my ownership of the business (that is a different subject), the best example of this is Times of India Group (Benett & Coleman), they do not want the public to be a shareholder in their business. It is a very profitable company, but privately held.
But a lot of businesses need to approach the public for their money because of mainly two reasons — Start up firms usually do not get big loans easily. A bank needs a viable business to lend money to. As a result, they have to rely on friends, family and Private Equity(PE) or Venture Capitalist (VC) funds. They take up a portion of your equity but the caveat is PE funds always want an exit route, usually at a profit in any new venture, and the exit route is through an IPO. Or I may be an established business which may find interest rates to be too high, I may therefore, want to take the equity route since paying interest on the debt and repayment of principal would reduce my profits. And lastly due to government regulations or diktat as happened in India in 1973 courtesy the Foreign Exchange Regulations Act (FERA). The growth in the Indian Capital Market was kicked off for the first time by the heavy handed policy laid down under FERA. It forced multinationals to reduce their share holdings to 40%. Multinationals unloaded en-masse and that too very cheaply. The shares of MNCs like Hindustan Lever were sold during that period at Rs.16/- to the public.
Do IPOs imply the public becomes the controller and decision maker of the business? No, it is not that simple. The public gets to own the shares , they may or may not be able to control the company. If I keep 74% shares as a promoter and give 26% shares to the public, I still retain the decision making. Some companies have as little as 26% shares with promoters, yet they control the company because they have the largest block of shares in their control alongwith Institutional investors and Corporate Bodies.
In the past a lot of stock investors made money through the IPO route. They would apply for shares, get allotment and sell the share on listing. Ask your parents who invested through this route and benefited a lot. At that time there was a body called Capital Controller of Issues(CCI). The CCI ensured that the price of IPOs was at the par value or a little above the par value. As a result, a good business if held for a considerable period of time would give humongous returns. A case in point are Colgate, Hindustan Unilever and Reliance.
Until the Second World War, raising of capital in India from the Securities Markets was free from all controls. After the Second World War, the Defence of India Rule was introduced which imposed restrictions for the first time on the issue of capital. It continued even after Independence and was incorporated in the Capital Issues (Control) Act, 1947. The office of the Controller of Capital Issues (CCI) administered the Act. After independence in the year 1947, the Indian Government followed the policy of giving predominance to public sector enterprises in the economy. As part of this policy, various industries were nationalised and certain sectors of economy were reserved for the public sector. Private Sector Corporations were restricted and access to equity was only through the CCI. New companies were allowed to issue shares only at par value. And generally, only existing companies with substantial reserves could issue shares at a premium which had to be calculated in accordance with CCI norms, and was based on an estimate of “fair value” and not on the “prevailing market price”. There were tight controls on the issue of rights and bonus shares. Thus, shareholders had a lot to gain, whereas the promoter could not. With the repeal of the Capital Issues (Control) Act, 1947 on 30th May 1992, post the Harshad Mehta scam, the Securities and Exchange Board of India (SEBI), the regulatory authority for Indian securities market, was established in 1992 to protect investors and improve the microstructure of capital markets. In the same year, Controller of Capital Issues (CCI) was abolished, removing its administrative controls over the pricing of new equity issues. Companies today are able to raise capital without requiring any consent from any authority either for making the issue or for pricing it. Restrictions on rights and bonus issues have also been removed and are left to the shareholders to decide. New as well as established companies are now able to price issues according to their estimate of market conditions. That is the reason in a bull market( when markets are rising), there is a sudden plethora of IPOs as the public does not look at quality. A case in point is IPO of Reliance Power in 2008, which started the bearish phase of 2008 to 2012. It was an overpriced IPO which was meant to benefit Mr Anil Ambani and not the share holder. And a lot of investors thought that they would double their money on listing within 3 months. Doubling your money in 3 months happens in Ponzi schemes and Las Vegas casinos only, not in real life. So, people took short term loans to put that money in the IPO and burnt their fingers very badly. Some of them will never come back to equity markets.
The dynamics of an IPO do not favour the public but the promoter. The promoter hires a merchant banker and pays his fees. The merchant bankers advise the promoters as to what price the issue should be floated to the public. For the merchant bankers, it is the case of the famous german quote, “Whose Bread I Eat, His Song I Sing”. They have an incentive bias and could not care less whether you make a profit or not. The public does not even remember the merchant banker to the issue.
The base rates of IPOs suck. Therefore, never apply for an IPO. At the most there may be a speculative gain of 10 to 15% in some good PSU/govt owned company. But the odds are not in your favour in this gamble. As far as private companies going public are concerned, the jury is already out.