Should you invest in IPOs

2016 was a bumper year for Initial Public Offerings (IPOs) in India. Indian companies raised Rs 26,500 Crores by listing themselves on stock exchanges in 2016, the highest since the heydays of 2007. Most of the 2016 IPOs made positive listing gains, which, obviously was great news for subscribers (investors).

However, not all IPOs had fantastic debuts. But issues across sectors, from private banks to healthcare, were over-subscribed many times and made very profitable listings; listing gains of some IPOs ranged from 25 – 50%. Stock brokers were telling their clients that, IPO was the easiest way to make money. But is it really? In this post, we will discuss the various factors that you should consider before jumping onto the IPO bandwagon.

What is an IPO?

Let us first understand what an IPO is. There are two kinds of companies, private companies and public companies. Private companies have limited number of shareholders, restricted to the promoter of the company and some other parties (e.g. family, friends, private equity investors, venture capitalists etc) from whom the promoter can raise money to start and grow the company. The general public, like you and me, cannot be shareholders in a private company.

Public companies on the other hand have large number of shareholders and the general public, like you and me, can become the shareholder of a public company. How? Shares of public companies are listed on stock exchanges. Buying shares of public companies is very simple. All you need is a demat account.

We discussed the difference between a private company and public company, because IPO is the route through which a private company goes public. Why go public?

• By accessing the stock market, companies can raise more capital for business expansion than it can do privately, because public companies have access to much larger investor base through the stock market.


• Cost of debt is usually lower for public companies. Though the Company’s Act 2013 allows private companies to issue debentures through stock exchanges (cost of debt raised through capital markets is usually much lower than bank loans), public companies can issue debentures at a lower interest rate, since they are subject to greater regulatory scrutiny compared to private companies.


• Mergers and acquisitions are easier for public companies because deals can be done through stocks instead of cash. IPO provides an exit route for financial investors (e.g. angel investors, private equity investors, venture capitalists) in a private company.

Process of IPO

It is useful for investors to understand the process of listing of private companies. There are several steps involved:-

1. The IPO issuer approaches a merchant bank for the IPO for listing its shares on a stock exchange. Approaching a merchant bank is not mandatory and the issuer can sell shares on its own, but listing is a complex process and hence hiring a merchant or investment bank is the standard practice. This step is also known as under-writing; the under-writer (merchant bank) is, essentially, the intermediary between the seller and the investors.


2. The merchant bank prepares the offer document, also known as the Draft Red Herring Prospectus (DRHP). Filing the DRHP is a mandatory SEBI requirement for IPOs. The DRHP contains provides detailed information about the business operations and financials of the company. The SEBI reviews the DRHP and checks if all the adequate disclosures are met. The DRHP is not just meant for SEBI, but for all the prospective investors of the IPO. As an investor, you should read the DRHP carefully. The DRHP includes details about its promoters, fund raising rationale, uses of funds and the risk factors involved. You should know that the DRHP will not provide you information about the price or size of the offering.


3. Once SEBI approves the DRHP, the merchant bank goes to the Registrar of Companies (ROC) for approval of the IPO. Upon receiving the ROC approval, the merchant bank intimates the stock exchange (NSE, BSE or both) for listing, for which the stock exchanges have their own approval process.


4. During the period when the issuer and their merchant bank are waiting regulatory approvals, they embark on road-shows. In the road-shows the company officials and merchant bankers, promote the IPO with a select group of prospective investors and fund managers. Apart from promotion of the issue, the purpose of the road-shows is to get a feel for the investor interest in the issue and will help the issuer / banker in pricing the IPO.


5. There are two pricing mechanisms of an IPO – fixed price and book building. Shares of the company at inception are issued at a face value of Rs 10. At the time of the IPO the issuer decides on a premium over the face value. In a fixed price IPO, the issuer fixes a premium at which shares will be allotted. In a book building IPO, the issuer indicates a price band within which investors are allowed to bid. For example, in a fixed price IPO, the issuer may fix the premium at Rs 45 on a face value of Rs 10 per share. So the shares will be issued at Rs 55. In a book building IPO, the issuer may indicate a price range of Rs 50 – 60 and investors would bid within the range.


6. On the date mentioned in the prospectus, the shares are made available to the public for subscription. During the subscription window, the investors will fill out the application form and submit to their brokers.


7. Once the subscription window closes, the merchant banker and issuer fixes an offer price depending on the demand for the issue. If an issue is over-subscribed, i.e. demand for the IPO (from investors) is more than the supply (size of the issue in DRHP), not all subscribers will be allotted shares.


8. On listing in stock exchanges, shares will be credited to the demat account of subscribers who are allotted shared and money will be refunded to those who were not.

What about investors?

There are many examples of hugely successful IPOs in India and also numerous examples of flop IPOs. We have discussed why a private company goes public and the process of IPO, so that you, as an investor, understand the rationale and mechanics behind the whole process. The closing price on listing day and the offer price depends on a number of factors, not all of which are related to the issue. Once the shares of a company are listed on the exchange, its price will be linked to market dynamics.

You should also understand that, an IPO is nothing but a sales exercise by the company. One of the most important factors in any buying decision is the price you pay for the product versus its value. The seller will always try to maximize price realization, while the buyer will try to get maximum value relative to the price. That is how market works. Instead of bargaining with the seller, you can simply wait if you think that the share is overpriced relative to its fair value and the market mechanism will ensure that, you get it at fair price.

It is very hard to determine the fair value of a listed company with years of financial track record. Just imagine how hard it will be for IPOs, where information is very limited (the importance of reading the DRHP cannot be over-emphasized here). If your focus is short term i.e. listing gains, then IPO is a risky game because in the secondary market, price of shares are subject to demand / supply dynamics. We have stated a number of times in our blog that, equity investments should be made with a long investment horizon. The fundamental strength of a company, whether in the primary market or secondary market, is a more important factor in the long term than the offer price. You should know that, Amazon and Google were thought to be very expensively priced at the time of their IPOs, but their investors made huge wealth.

Conclusion

In this blog post, we have discussed, various factors that you should consider, when investing in IPOs. In our view, retail investors are not equipped with enough expertise or information to evaluate the long term prospects of an IPO.

Mutual fund managers, on the other hand, are better equipped to evaluate IPOs. They have the expertise and experience to analyze offer documents, attend IPO road-shows and have better understanding of market dynamics at the time of listing. Whether you invest in primary market or the secondary market, your ultimate goal is wealth creation. Unless, you have the expertise and bandwidth to evaluate stocks, it is always advisable to invest in equities through mutual funds.