Several high-profile issues have been pulled and the biggest one is quoting below its issue price. What should you make of the IPO market? Debashis Basu analyses

Until early January 2008, initial public offerings (IPOs) were the path to a fast buck. You filled the application form, got your allotment and, on the day of listing, you sold, making a neat 50%-100% return, sometimes more. But markets have the habit of turning on a dime and leaving everyone dumbfounded. The secondary market collapse from the second week of January has torn the IPO market to shreds. The much-hyped issue of Reliance Power (at Rs11,700 crore, it was the largest Indian IPO ever), which was priced at Rs450 per share and got oversubscribed 73 times, opened to a disastrous listing on 11th February. Far from quoting at the expected Rs1,000 and allowing everybody to make tonnes of money, it tanked to as low as Rs355.05 and closed at Rs372.50 on the day of listing. Anil Ambani is now trying to rescue it with bizarre moves such as a bonus issue.

Emaar MGF had planned to raise Rs7,077 crore in what was India’s second-biggest IPO by a real estate company. Emaar, as we confirmed during our recent visit to Dubai, is truly a giant organisation, at the centre of many mega projects in Dubai including the world’s tallest building, Burj Dubai. Why it needed to raise money from the Indian public, of course, is another issue. This red-hot issue met the cold draft of the IPO market and was in trouble. Desperate to get its issue subscribed, Emaar had lowered its price band twice and extended the closing date by five days. But even the committed subscriptions evaporated and Emaar had to pull out the issue. Wockhardt Hospitals also had to abandon its grossly overpriced issue to raise Rs700 crore after it got just a 20% subscription.
SVEC Construction too shelved its IPO, even after lowering the price band and extending the closing date. There were hardly any bids from qualified institutional buyers (QIBs). Delhi-based alcohol company Globus Spirits abandoned its Rs68 crore issue. Larsen & Toubro’s IT subsidiary, L&T Infotech, has postponed its IPO indefinitely. Does all this signify the end of this particular boom cycle in the primary market? And what are we supposed to learn from the spectacular IPO fiasco of RPL?

Lesson 1: Promoters, investment bankers and regulators are not your friends
Here is a bald fact. An IPO is a window of opportunity for the company to raise money at the highest possible price from investors. They are helped in this objective by investment bankers who are supposed to take care of the regulatory aspects and also talk favourably to large investors about the attractiveness of the issue they are managing. The higher the issue price, the worse it is for investors. By definition, promoters and investment bankers are not on the side of investors because they are interested in the highest possible price. All the issues that have failed were not only hit by market climate but also by unreasonable pricing.
When promoters get too ambitious, they have to circumvent the rules framed by the Securities and Exchange Board of India (SEBI). The regulator often obliges – depending on the promoters’ connections. So, the regulator may also not turn out to be your friend.

One of the best examples of how these three elements are not on your side is the grey market. Grey market prices, freely reported by the media, exist because of the demand from high net worth individuals (HNIs), brokers, market operators, and even the pinstriped investment bankers to the issue, who try to favour their clients with allocations that they may not get through the normal allotment. Often, the lead manager calls up a grey market broker and places buy orders for shares at a premium to the possible issue price. This rate becomes the benchmark for future grey market trades. An active grey market can rarely function without the participation of the issue manager and the promoter; the benign attitude of the regulator to this illegal activity only misleads investors.

Lesson 2: IPOs are not meant to be cheap
In the secondary market, there is scope to get shares cheap. Market panics shake off weak holders and excellent stocks can suddenly become very inexpensive. There is no panicky fire sale about IPOs. The promoter and investment bankers work hard to sell shares at the highest possible price. They pick the price and the time. This is why IPOs can rarely come cheap your way. It is always a matter of luck for your IPO stock to quote higher in the secondary market. The greed of promoters and investment bankers to get ridiculously high prices is what did in Wockhardt and Reliance Power IPOs. Apollo Hospitals is available at about 24-25 times its next year’s EPS. Wockhardt Hospitals was trying to sell its stock at 80 times its forward earnings! It was more expensive than Fortis which is quoting 34% below the issue price. Even at the lower end of the price band (Rs225), Wockhardt had an enterprise value (EV) of 44 times its operating profit of FY08. This was ridiculously high compared to 20 of Apollo, when Apollo has five times the number of beds of Wockhardt. Over the last one year, Apollo has gained by 2%.

Lesson 3: IPOs are blind bets – by everyone
It is a supreme irony that just when the possibility of post-listing gains of IPOs have dried up, commentators have suddenly started seeing structural problems with the primary markets. All this while, nobody complained about the quality of issues, let alone the IPO rules. Whether we admit it or not, this is because most ‘investors’ who furiously invest in IPOs are doing it for short-term gains. Just as many people hope that shares in the secondary market will only go up, they also hope that all IPOs will list at a massive premium. {break}

Clearly, if the issuer is trying to stick it to you at the highest price and the investment banker and brokers are helping him while the regulator looks on, IPOs can only be a blind bet to sell on listing. Most importantly, this blind betting is done as much by the retail punter in Mumbai (a driver of my colleague subscribed and got 15 shares of Reliance Power) as much as a blue-blooded institutional investor in Manhattan. Many of them clamour for shares in pre-IPO placements and bid a few billion dollars as QIBs. These blind punts/subscriptions are then used as a carrot to lure other QIBs and retail investors into an issue. Bennett & Coleman and NDTV bought pre-IPO shares of Emaar at Rs690. Apparently, Citi bought Wockhardt Hospitals before the IPO at Rs310, a stock that nobody wanted to touch at Rs225. The Wockhardt issue was being sold by Kotak Capital, ICICI Securities and Citibank. Between them, these investment banking heavyweights could barely get a 20% subscription commitment. When nobody wants to place blind bets, the game is over. The fact is QIBs and retail investors all want to flip their allotments on the day of listing or soon after.

Lesson 4: Well, everything is good at a price
Is the IPO market dead? Not at all. Chastened by the recent experience, promoters have tempered their expectations and pricing will be more reasonable now. You will be able to get good companies at a fair price. One investment banker was recently narrating the story of a promoter whose forthcoming issue he is managing. The promoter asked him what he should be doing now. The investment banker said: “Make your issue at 50% of the previous price and it will do well.” Already issues of companies like OnMobile and Rural Electrification Corporation have been readily subscribed and may list at decent prices.
It is important to know that the issues that failed were not considered cheap by the investing community. In the case of Emaar, stock exchange websites showed subscriptions dropping sharply to 43% at 3pm and further to 39.67% by 4pm on 7th February. This was caused by the withdrawal of four crore shares from the QIB category which had an allocation of 6.15 crore shares and, till that day had garnered applications for 6.10 crore shares. The HNI category had an allocation of 1.03 crore shares while the retail category had an allocation of 3.08 crore shares, of which applications for 1.44 crore shares came in. What was the new information that the QIBs obtained to scare them into pulling out four crore shares? They knew that the pricing was all wrong. There was going to be nothing on the table on listing; so they fled.

Lesson 5: IPOs come in cycles
Reliance Power set many records. It was the largest Indian IPO, attracted the largest number of applications and was oversubscribed 73 times, managing to mop up a whopping Rs12,500 crore. It also marked the end of the furious bull run since August 2007 and was followed by a severe market crash. IPOs come in cycles (explained in some detail in the Box: A Bit of IPO History). Sometimes, there is too much euphoria and, at other times, IPOs are shunned.

In the past 18 months, real estate companies raised more than Rs16,000 crore. But a name like Emaar had to withdraw. Many shady companies have sailed through in 2006 and 2007, while L&T is hesitating to list its software subsidiary. The past two years were hot for IPOs all over the world. This year is turning out to be slow. In January 2008, IPOs raised $6.3 billion from 45 issues, down from $7.5 billion from 65 issues in January last year. Some 21 global IPOs were withdrawn in January 2008. Maybe, the cycle has turned, after a five-year global bull run. If so, the fast and furious game of flipping will stop soon.

MoneyLIFE believes that investors have little to gain by investing in IPOs in general – except on rare occasions when either the price is attractive or the broader market still has a lot of steam left (which can be known only with hindsight). One of the enduring ironies of the marketplace is that when the IPO market is attractive, companies plan a huge leap over their current operations; and that, as a rule, rarely pays off. It may be Zee which, in 2000, was valued at 400 times earnings but announced a billion dollar plan several times its size, or it may be Reliance Power which will not generate any power till 2013 (until it makes an acquisition with its expensive stock) – Indian and world stock markets are littered with examples of excesses of capital-raising, including those through IPOs.

A Bit of IPO History
In the past 20 years, we have seen IPO booms in 1986-89, in 1993-95, a short one in 2000, and now. Here is a brief snapshot of what happened during the earlier periods.

The mid-1980s: This boom started after Rajiv Gandhi came to power in 1985 and the business climate turned very upbeat. The IPO market was flooded with ambitious Indian companies and mushrooming growth of leasing companies (most of them have closed down) followed by the mega IPOs of Bindal Agro, Usha Rectifier, Larsen & Toubro and Essar Gujarat. Rajiv Gandhi lost the 1989 elections and the business climate changed for the worse under VP Singh and Chandra Shekhar. Most of the equity issuers of the late 1980s  have either disappeared or their stocks quote well below the offer price.

1993-95: The economic liberalisation of 1992-93 permitted the entry of foreign businesses into India. There was consensus among bureaucrats, businessmen, analysts and investors that the Indian Elephant would outstrip the much-admired Asian Tigers. After achieving a 7.4% growth rate in 1994, India seemed to have broken through to a high-growth path. Some projections spoke of a 9% growth. Industry had sailed over a 10% hurdle. Industry associations were projecting 12%-14% growth. To fund such ambitious growth, companies went on a capital-raising carnival.

The government allowed Indian companies to float equity issues abroad; global depository receipts (GDRs) in European markets became a matter of prestige and greed. These GDR issues are a template of IPO excesses. In 1993 and 1994, dark-suited investment bankers rushed to India, trawling the country for companies with balance sheets that could provide even a makeshift platform for a fund-raising idea. In fact, you did not even need that. A company could issue GDRs without stating why it needed money.

So, poor-quality companies decked up for road shows in which foreign investors asked dumb questions and gave them money. The well-known financial firms of London and New York were chaperoning these companies, lending them far more respectability than they enjoyed in the domestic market. Stocks like Core Parenterals, NEPC, Garden Silk Mills and Flex Industries, shunned in India, became hot picks in London. I have heard a company owner laugh derisively at foreign investors and market intermediaries, after having successfully rigged his share price to dizzy heights and then made a GDR issue. He said: “We have now seen the white skins too. They are no better than Indian investors; they are equally dumb and greedy.” His stock price shrank by 95% over the next three years!
Fund-raising overseas was so intoxicating that even companies like Bajaj Auto made a $100 million GDR issue although it had a large investment portfolio and problems of excess cash. Its last domestic issue was in 1962. But when the GDR fashion gripped corporate India, Bajaj Auto talked about a car project and raised money even as its core business was losing steam. (In 2000, it spent money buying back its own shares.) At that time, making GDR issues looked glamorous; but, in retrospect, the list of GDR-issuers included the pick of value-destroying large Indian companies.

Towards the end of the GDR boom, the domestic market for IPOs or public issues went through the roof, as if India was running out of capital. The market peaked in February 1995. In January 1995, 145 equity issues opened for subscription. In the first two months of that year, a spate of mega issues like Reliance Capital, Essar Oil, Jindal Vijayanagar, Hindustan Petroleum, MS Shoes and others hit the market. In one frenzied week in February 1995, 78 companies hit the market, crowning a financial year of 1,400 issues. In the three years between 1997 and 2000, barely 159 companies went public. Industrial Development Bank of India (IDBI) had the dubious distinction of never quoting above the issue price of Rs130 (in 1996) for the next 10 years.

1999-2000: The market was again on a bull run, the IPO market revived and capital addiction returned, as it is wont to. A series of issues from Cadila Healthcare, Glenmark, TV18, etc., were priced on their past EPS without considering what happens to the returns after the issue. Once again, investors and companies forgot the fulcrum on which long-term value creation rests: EPS growth and RoE. Most of these IPOs were destined to earn a very poor return on equity - precisely because of the IPOs! They issued equity when the market turned buoyant after a long gap; hence, valuations were skewed. Besides, all of them went public at the end of the financial year and sold their issues on the basis of current profits (then) and past net worth. Nobody noticed what the issue would do to their net worth and return ratios in the following year. It was exactly the same situation that had led to the huge value erosion after the GDR and domestic issues in 1994.