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IPO investing: Rolling a loaded dice
IiAS’ analysis shows that returns from investing in IPOs have been dismal over the past 10 years. ~60% of investors lost money, and on the whole investors were better placed investing their money in fixed deposits. High valuations are solely responsible for the anaemic state of the IPO market. While regulators can ease the process of listing – and have periodically done so, only the market participants can bring rationality to the valuations. Investment bankers need to be firm regarding the issue price and companies need to listen to them and consciously leave money on the table. Investors are craving for genuine price discovery and if this is not offered, regulators will have no choice but to draw a hard line on the issue price to help the IPO market survive.

Investing in IPOs (initial public offering) is like a game of chance – information on the track record of the company is limited, the correctness of valuations is questionable (See IiAS Report: Valuations – the Emperor’s New Clothes ), and expectation of performance is almost crystal-ball gazing. Historically IPOs have had good participation from retail investors, with most issues being oversubscribed. But the IPO fever has abated as the poor post-IPO price performance has caught up. This is a worry for corporates that plan to grow or those that want to correct their capital structure by raising equity, as it is for a government, which has budgeted on divestments to meet its fiscal needs.

The performance of IPOs over the past 10 years does not inspire investor confidence.IPO valuations have been far away from being ‘fair.’ IiAS’ analysis shows that in almost ~60% of the IPOs over the past 10 years, investors would have lost money had they subscribed to the IPO (See Table 1 below).

If one is to go by past trends, there is more than a two-third chance that investors will have made higher returns by investing in fixed deposits rather than in IPOs. IiAS’ analysis of 394 IPOs made between 1 April 2003 and 31 July 2014 (See Chart 1 below) shows that only 164 companies are currently trading above the offer price (See Table 1 below), which is 42% of the total IPOs – one is more likely to get a higher success rate by flipping a coin 394 times.

Further, of the 164 companies that are currently trading above the offer price, the returns are not significant: in 20% of this set of companies, investors would have made higher post-tax returns by investing in fixed deposits2 rather thanthese IPOs.

This analysis is being made during a bull run – markets have moved up 30% in the past one year. Were this analysis based on market prices a year ago (with 16 January 2014 price data instead of 16 January 2015 data), 245 (or 70%) companies would have been quoting below their offer price.

Two other factors discourage participation in IPOs: One is that shares of 25 companies (6%) that raised money through IPOs between 2004 and 2013 have been suspended for either procedural lapses or as a penal action.

Two, and more worrying, is that over 70% of the companies reported lower net profit margins and return on equity ratios than in the financial year in which the shares listed. This would have more likely lowered their valuations, independent of any market run-up, and leads one to question the motivation behind the IPO itself.

Can the success of an IPO be predicted?

Size is possibly the only factor that correlates to the success (returns) of an IPO.
We have dividedcompanies into four quartiles by IPO size. For the top quartile (largest issuers),53.9% of the issues gave positive returns. This proportion has steadily moved down to 50.0%, 46.1% and 35.2% for the lowest quartile. (See Chart 2 below). Seven of the 10 largest issues in the data-set quote above the issue price, and only three of 10 smallest issues do so. Unfortunately for investors, most IPOs have been of small size - of the 394 IPOs, only 20 had an issue size of greater than Rs.1bn

Although the data is not wholly confirmatory: performance of larger IPOs is relatively better – though not convincingly so. Yet,there is still a case for a higher minimum IPO threshold. Larger companies tend to have a higher threshold to absorb shocks and have also reached a certain business level before raising capital through the IPO route.There is a virtuous circle around large IPOs. These are also more likely to attract institutional investors, because they can take a larger bite. The larger size also implies that it pays brokerages to write research. The larger size and more research begets liquidity.

IPOs of government owned companies (PSUs) have outperformed private sector IPOs. Of the 20 PSUs that listed themselves during the period, 75% generated positive returns. On the other hand, only 40% (149 of the remaining 374) of private sector IPOs generated positive returns.Two factors possibly account for the PSU IPOs’ performance:one, that government has cherry-picked the PSUs to be listed, and two, fiscal pressures meant that there was limited flexibility with regard to timing, resulting in shares being sold even in the midst of a bear market.

One may argue that there must be an intuitive difference in the returns between IPOs issued through the book building process and fixed priced IPOs – but that rationale is not validated in IiAS’ analysis of the 394 IPOs. Returns from IPOs have been largely agnostic to how IPOs get priced: 57% of book-built issues and 65% of fixed price IPOs were trading below the offer price on 16 January 2015 (or the last available price on NSE). Of the 394 companies (in this analysis), only 51 companies chose a fixed offerprice.

Bolstering the IPO market in India

That the primary equity market is anaemic and needs a cure comes as no surprise. Despite the frequent complaint about the need for a deeper bond market,7 Measured companies have raised almost three-times more money through bond issuances than in the equity markets between 2003-04 and 2013-14.

SEBI has made changes to the primary market to protect investors - primarily retail investors. In an effort to bring independent opinion on company fundamentals, SEBI had mandated rating agencies evaluate IPOs and assign an IPO grading on a five point scale. But, there was little correlation between the offer price, the over-subscription levels and the price trajectory with the IPO grading. This does not necessarily mean that IPO grading’s were wrong – just that the offer price and the price performance may be independent of the company’s fundamentals.

SEBI has also suggested a ‘safety net’ or issuing an optionally convertible debenture. But, providing investors a safety net goes against the core of what equity investing is all about: equity investors take ‘equity’ risk. The optionally convertible debenture gives investors the needed comfort, but leaves companies vulnerable as they will be unable to plan their capital structure. A higher issue size threshold or a higher ticket size should protect the small investor – though it risks smaller companies being squeezed out and small investors being unable to participate in some attractive issues.

SEBI has also made changes to the process. Having anchor investors and a larger institutional participation bodes well for the confidence of retail investors. SEBI’s move to increase the threshold of anchor investors’ holding to 60% from 30% is in the right direction. SEBI must consider going the complete distance and take this limit to 90%, leaving just 10% for retail investors. They could also move away from proportionate allotment in the wholesale segment, which artificially bolsters the over-subscription and price expectations.

SEBI has also recently floated a discussion paper to see how start-ups can access the local market and another on setting up of alternate platforms. A few other suggestions merit closer examination, including a larger issue size, with smaller issues being left for institutional players, who then sell down to retail investors after the ‘robustness’ of the business is established.

While regulators can ease the process of listing, only the market players can bring rationality to the valuations – which is what accounts for most ills. Over the long run, the market needs to provide a consistent push-back on high valuations by compelling companies to raise capital at a more considered price.Recently, companies have had to lower the offer price for the IPO to be fully subscribed, which seems to indicate investor caution even in a bull-run. This is a strong message from both retail and institutional investorsthat market participants need to bring rationality to prices of shares brought to the primary market. Investment bankers need to be firm regarding the issue price and companies need to listen to them and consciously leave money on the table. Investors are craving for genuine price discovery and if this is not offered, regulators will have no choice but to draw a hard line on the issue price, to help the IPO market survive.

1 Where there have been multiple ‘offer’ prices, IiAS has considered the highest one for the purpose of this analysis.
2 Assuming a pre-tax coupon of 8% on fixed deposits.
3Source: PrimeDatabase; 434 companies raised capital through IPOs between 1 April 2003 and 31 July 2014, but comprehensive data was available for only 394 companies on CMIE.
4Source: CMIE Prowess; stock price as on 16 January 2015 or the last available price the National Stock Exchange.
5Source: CMIE Prowess; Offer price has been re-aligned for stock splits, bonus issues and other corporate actions, if any
6Assuming a tax rate of 30%
7 Measured as no. of outstanding shares (immediate proceeding financial year of the issue) x issue price
8Source: PrimeDatabase; includes debt raised through public and private issuances
9Source: PrimeDatabase; includes IPOs, FPOs, Rights Issues, OFS, QIPs and preferential allotments

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