83) What pricked the IPO bubble

The prospects for the business apart, returns on stocks offered through IPOs are subject to whether the market is in a bullish or bearish mood.

For those who have just begun to invest in initial public offers (IPOs), events of the last few weeks are bound to be bewildering and probably even upsetting. Offers said to be of good quality were withdrawn and an offer that was ‘certain’ to list at a premium disappointed. Isn’t book building supposed to result in efficient pricing of IPOs at all times? Just a few weeks ago, every IPO seemed to have rosy prospects. How could things change so quickly? It has everything to do with sentiment.

IPOs in bull markets

The prospects for the business apart, returns on stocks offered through IPOs are subject to whether the markets are in a bullish or bearish mood. In a bull market, IPOs tend to be aggressively priced and the book-building process that is designed to enable ‘price discovery’ too may be influenced by the overall mood of investors.
As you know, a company, in consultation with its investment bankers, decides the price band of the issue. A price band stipulates a floor price and a cap price and the price range cannot be more than 20 per cent.

In a book building process, it is left to investors to ‘discover’ the actual price of the offer, by bidding for shares at a price within that band. Qualified institutional buyers or QIBs, for whom 50 per cent of the shares on offer are reserved, play a key role in determining the price for the offer, given their professional investment expertise. Retail investors have the freedom to bid for shares at the cut-off price, which is the price ultimately determined by the company and the lead managers, based on the outcome of the bidding process.

Retail investors take cues from the subscription levels of the QIB portion of the offer. If the response from QIBs is strong, it is considered a vote of confidence in the company. By bidding at the cut-off price, retail investors ensure they are eligible for allotment.

In a bull market, this system is less than perfect. It becomes easier to justify stiff valuations because excess liquidity ensures overwhelming demand for the shares on offer. The pricing, therefore, gets distorted.

Over the past year, several offers were made at valuations that were at a considerable premium to similar stocks available in the secondary market.

But instead of shying away from these expensive offers, markets simply re-rated or bid up the price of existing listed players. Brokerage stocks were re-rated when Religare first tapped the market, as was Unitech when DLF went public. Let’s not forget the rush for power stocks upon the announcement of Reliance Power’s IPO.

Under these conditions, QIBs who wish to participate in a quality offer may be forced to bid within this exorbitant price band, even though they might, under different circumstances or in a different market, view the offer as expensive. Second, because of this IPO rush, QIBs too bid for shares at the upper end of the price band to guarantee their allotment.

This meant that you rarely had the benefit of obtaining shares at the lower end of the price band and improving your chances for listing gains. So much for price discovery!

Third, as more offers list at fancy premium, more short-term investors enter the primary market. This is not restricted to retail investors alone.

There could be some QIBs who enter the IPO game for listing gains alone. Which is why you need to view the over-subscription in the QIB portion with some caution, as it is not always indicative of the quality of the offer.

What went wrong?

So long as the bubble continues to expand, investors continue to make money from IPOs. But when sentiment takes a turn for the worse, the anomalies in the system manifest themselves quickly. This is precisely what happened in the recent offers.

As global developments rapidly unravelled, stock markets across the world tumbled. Foreign institutional investors who were facing the heat back at home became more risk-averse and were unwilling to pay high prices any longer. Weak response from QIBs forced some companies to lower the price band of their offer.

Companies are allowed to revise their price bands during the offer period; the floor of the price band can move up or down to the extent of 20 per cent. But in a market where stocks were being steeply de-rated, even a 20 per cent cut in valuations may not have been enough. Sentiment changed so quickly that investors withdrew their bids at the last minute, as in the case of the Emaar MGF IPO.

Poor responses to offers have resulted in some of them being withdrawn. This has robbed the sheen off IPOs and has dampened the performance of companies on listing.

Recent offers such as IRB Constructions and Shriram EPC have fixed the cut-off price at or closer to the lower end of the price band, an attempt to provide some room for listing gains.

The good news is that, for now, markets might shun offers where fundamentals are not in place. The bad news is that in their extreme pessimism, investors might avoid good quality offers as well.

All this makes you want to re-think investing in IPOs, doesn’t it?

Investing in IPOs
Actually, if market players have learnt their lessons from these events, you, as a retail investor, may be at a better advantage from now on when it comes to investing in IPOs. Offers might be more realistically priced, subscribers might be of better quality and chances of securing allotment are likely to be higher. This is why you should probably not give a fundamentally sound offer a miss, irrespective of secondary market conditions.

There is still no guarantee of listing gains. In fact, there is a need to moderate our return expectations from IPOs al together. But something has to be said for the lure of investing in a great company right from the time it opens itself to the public. Be a long-term investor and reap the gains.

Shanthi Venkataraman