GREATER GAINS FOR THE INVESTOR! OR IS IT?

An Initial Public Offering; IPO is the process where a previously unlisted company sells new or existing securities and offers them to the public for the first time.

What is an IPO?

IPO is a route of resource mobilization that provides a greater access of capital and flexibility in financing to the company. The IPO holds importance for investors as well, as high returns in the issue make it an attractive investment opportunity for investors. Generally new and smaller companies issue IPOs; to expand their capital, but sometime it can also be done by larger companies. There is another term Follow on Public Offer; FPO it is when an already listed company makes either a fresh issue of securities to the public or an offer for sale to the public. There are further classifications of issues in India, they are: rights, bonus and private placement. Rights issue; when an issue of securities is made by an issuer to its shareholders existing as on a particular date fixed by the issue. Bonus issue; when an issuer makes an issue of securities to its existing shareholders as on a record date, without any consideration for them. And, private placement; is a sale of securities to a relatively small number of select investors as a way of raising capital. Investors involved in private placements are large banks, mutual funds, insurance companies and pension funds.  

Reasons for IPO issues

The primary impetus for an IPO is generally either to raise capital or to offer an exit strategy. In fact the firm is most incipient stage of development generally relies entirely on personal loans, savings, family and friends for their initial financing. But generally there are two reasons why an IPO is issued in the first place. They are: for funding needs and for non-funding needs. First, for funding needs, funding capital requirements are needed for organic growth, expansion through projects, diversifications, funding global requirements, funding joint ventures and collaborators, financing working capital requirements, investing in business through other companies, repaying debt to strengthen the balance sheet and meeting issue expenses etc are among the needs that are met in for funding needs. Second, for non-funding needs, enhancing corporate stature, retention and incentive for employees through stock options and provide liquidity to the shareholders is met through in for non-funding needs.

History

The IPOs came into India in the 1980s when a large number of companies and organizations came out with public issues, which triggered a growth in the primary market. As a consequence of these developments an entire industry of Merchants Bankers, Brokers, Agents and Retail investors grew in the primary market. One of the biggest IPOs brought out by Dhirubhai Ambani of Reliance Petrochemicals Pvt. Ltd was issued during this period. The downside of this was that during the 1980s and 1990s many of the companies disappeared after the listing was done, as a result most investors lost their money, some all their savings. Liberalization, Privatization and Globalization changed the whole facet of Indian capital market. Earlier there was the iron set rules of Controller of Capital Issue; CCI that ruled the primary market, according to which, issues needed to be priced strictly as determined by CCI. All this transformed when Indian Securities market was initialed in 1992 with the establishment of the Securities and Exchange Board of India; SEBI, a statutory autonomous regulator. SEBI’s main aim is to protect the interests of investors, to regulate the securities market and to facilitate the smooth functioning of the entire capital market. The Primary issues market resurrected itself after 2003 largely as a result of divestment program of public sector companies. Case in point: Maruti Udyog Limited, the government sold part of its stake in the company for Rs.1000 crores. Thereon Indian IPO market went from strength to strength, and in 2007 it was named as the seventh biggest IPO market of the world.  In 2010, India saw a string of IPOs and follow on offering from many previously state owned enterprises in the materials sector such as steel, oil and gas which helped the India Government raise funds to build roads, ports and power plants. Between 2007 and 2013, Indian corporation made 8,022 debt offering and 291 equity offerings to raise capital, and they were worth Rs. 2,053,846 crores. And in 2018 IPOs have raised above Rs. 28,000 crores.   

Company launch an IPO

Going public is a monumental decision for any company. Typically, the company selects an underwriters or group of underwriters to make offers and sales of the stock to the public. This discount is called the underwriting discount; it is generally 7% for many IPOs. The company files a registration statement with SEC and the registration statement is required by the SEC staff. This registration statement include a prospectus, which is the document delivered or made available to investors in the IPO. The prospectus describes the company, the securities being offered, the terms of the offering and other information that is important for investors to know when deciding to buy stock in the IPO. While the registration statement is being revived by the SEC staff, the company and the underwriters may offer the shares to potential buyers to obtain indication of interest. If any offers are made in writing, the company and the underwriters may generally only do so by means of a preliminary prospectus. During the review the SEC staff may provide comments to the company and require the company to make changes or additions to the prospectus in order to comply with disclosure requirements. And once the SEC staff’s comments have been addressed, the SEC will declare the registration statement effective. At that time the company will determine the IPO price after consultations and negotiations with underwrites who will provide their prospectus based on market conditions, analysis and indications of interest received. After setting the price, the sale to investors will be made at the price.              

How an investor can apply for IPO?

An investor can apply for an IPO through online as well as offline modes. In online mode: an investor has to open demat account/trading account with financial institutions that provide this facility. Most Nationalized Banks and Stock Brokers in India offer that facility. Following are the steps-

ü  An investor first has to login in his/her trading account and select the IPO he/she wishes to invest in.

ü  Transfer funds for his/her bank account to his/her trading account.

ü  Select the number of shares he/she wants to apply for and the price at what he/she wants to bid for, or use cut off option, and then press submit button.

If the investor get the allotment, the shares will be credited to his/her demat account. The remaining money will be credited to his/her bank account through ECS.

Via offline mode: an investor has to fill the details such as his/her Name, PAN number, Demat account number, bid quantity, bid price and other relevant details and submit the ASBA; Application Supported by Blocked Amount, application form to the banking branch which has been designated to act as a Self Certified Syndicate Banks; SCSB for providing ASBA service. After the submission of the application, the bank will upload the details of the application in the bidding platform.   

Risks for common investor

IPOs can be speculative investment and involves risks which are very important to take into consideration while investing in them. The risks are: offering price, market risk, market overhang, market capitalization and common stock rights. Let’s take each one at a time.

Offering price

IPO price is determined by the company in consultations and negotiation with the underwriters, taking into account market condition, analyses of possible valuations and the underwriter’s order book. The order book is a compilation of investor’s indications of interest, showing how many shares each investor would be willing to buy and at what price. It is important to understand that competing interest affects the determination or the public offering price. Underwriters thus have an incentive to price an IPO that will increase demand and enable the underwriters to sell that all the shares. Often, the market or trading price of shares that were offered in an IPO may vary dramatically from the IPO price, i.e. the market price can be higher r lower than IPO price.

Market risk

The market price of share issued in the IPO will move up or down based on various factors including macro economics conditions, government policies, prevailing interest rates, movements in the stock market and other events or developments that are specific to the company.

Market overhang

When a company does an IPO it is only registering and selling a certain number of shares. Many of the outstanding shares may be restricted from trading at the time of the IPO, with these restrictions lapsing or expiring at certain points in time, the market price may decline because of a potential increases in the supply of shares that can be sold. So it is better to read the prospectus thoroughly as the company will describe the number of its outstanding shares and the applicable restriction on the resale of these shares in the prospectus for the IPO. 

Market capitalization

Some IPO may have smaller market capitalization. A company’s market capitalization is determined by multiplying the market price of the stock by the number of outstanding shares. Stocks of small capital companies tend to be more volatile and less liquid than larger companies; this keeps them susceptible to market pressure and business failure.

Common stock rights

Some companies engaging in IPOs may create separate classes of common stocks, with one class having greater voting power than the class being sold in the IPO. This structure is often used when the current owners; family or founder, wish to continue to exercise control by retaining super voting stock. Thus, the holding of the common stock issued to the public in the IPO have little influence over management and the decisions it make.

SEBI’s grading system

IPO grading has been introduced as an endeavor to make additional information available for the investors in order to facilitate their assessment of equity issue offered through an IPO. The IPO grading is assigned by a Credit Rating Agency registered with SEBI, to the IPO of equity shares or any other security which may be converted into or exchanged with equity shares at a later date. The grade provided by Credit Rating Agency represents a relative assessment of the fundamentals of that issue in relation to the listed equity securities in India. The grading is generally assigned on a ‘five point’ point scale with higher score indicating stronger fundamentals. The grades are given as follows:

·         IPO grade 1: poor fundamentals.

·         IPO grade 2: below average fundamentals.

·         IPO grade 3: average fundamental.

·         IPO grade 4: above average fundamentals.

·         IPO grade 5: strong fundamentals.

An important point to consider – IPO grade is not a suggestion or recommendation as to whether one should subscribe to the IPO or not. This is made amply clear as SEBI has written on its website – ‘irrespective of the grade obtained by the issuer, the investor needs to make his/her own independent decision regarding investing in any issue after studying the contents of the prospectus, including risk factors, carefully.’ 

Recent developments

Finance Minister Nirmala Sitharaman relaxation on foreign portfolio investment surcharge has brought back the spooked FPI; foreign portfolio investment. The higher tax had dampened sentiments in the equity markets, as FPIs had taken out more than Rs. 12,400 crores and Rs 11,135 cores respectively in July and the August 2019. These developments had made the upcoming IPO issuers circumspect and some of them were even willing to hold the IPO launch till a later date ‘when the market is favorable.’ Now the market is once again looking up.     

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