Why is the Securities and Exchange Board of India (Sebi) finding it so difficult to mandate a pro-rata allotment of shares in the institutional segment of public issues?
The simple answer is: because of the enormous clout of these institutional investors and their investment bankers.
Primary market investors know that the institutional segment of public offerings, which accounts for nearly 50 per cent of the issue, is often over-subscribed within minutes of the offer opening for subscription because institutional investors agree to make large applications, which they don’t have to pay for the shares until actual allotment. What they gain in return is a decent discretionary allotment.
It is also no secret that an over-subscription in the institutional segment is drummed up in order to send a bullish signal to retail investors and lure them into making larger, often leveraged applications. In recent few months, this has led to the unhealthy re-emergence of the illegal grey market in issues such as Provogue, even public sector bank shares were not immune to the machinations of market manipulators.
At a recent board meeting, the members Sebi has empowered Chairman M Damodaran to scrap the discretionary allotment to Qualified Institutional Buyers (QIBs) made by investment bankers, but it gave him the choice to time its implementation. Sebi too is keen on ending discretion, it is mulling over the possible consequences.
For instance, some say that an end to discretionary allotment won’t end the practice of making large and frivolous bids to mislead investors and that such a move must be necessarily accompanied by an imposition of margin on their applications. Ideally, margins are the best antidote to frivolous bidding. And the SMILE Task Force and the Primary Market Advisory Committee (PMAC) had both recommended the imposition of margins on institutional applications to public issues. The recommendations were ignored because outraged institutions pointed to the ‘international practice’ of discretionary allotment by Lead Managers. However, this ignores the fact that internationally, retail and institutional investors are never part of a single book-built process.
Even when the Google IPO successfully shunned the standard formula and made a success of its unusual Dutch auction process that allowed direct bidding by retail investors, very few companies followed its lead. The reasons are not far to seek. The Google issue was mired in controversy for months before it opened as Wall Street ganged up against its young promoters and their path-breaking practices. It was criticised for everything — from its valuation to an ill-timed interview, which came in for scrutiny and generated negative publicity.
Under the auction process, which leads to a sort of pro-rata allotment, investment bankers lost the opportunity to strike sweetheart deals with favoured clients and probably earned just half the usual underwriting fees. So they ensured that few companies were brave enough to follow the Google path, even though the issue had opened at an 18 per cent premium on listing and is now quoting far above its listing price. An eye-opening article on July 7 of the Asian Wall Street Journal (AWSJ) proves the clout of the global investment banking community, which is now firmly entrenched in the Indian capital market.
It says, Morningstar Inc. asked its investment bankers Morgan Stanley about using the electronic auction route to sell its Initial Public Offering (IPO) last fall. Morgan Stanley is the firm that had handled the Google IPO, and its initial response was positive. However, when Morningstar got serious about using this route, a senior Morgan Stanley executive flew-in to warn the company that the electronic auction route carried a high risk of an ‘adverse outcome’.
When Morningstar persisted, says the report, Morgan Stanley threatened to withdraw from the IPO. When the company seemed adamant about its decision, it carried out its threat and resigned as lead underwriter. Interestingly, Morningstar’s electronic auction was also a success, but Wall Street continues to insist that electronic auctions are ‘dangerous’.
The news report says that the popular book-building route, that has been embraced by India’s investment banking community offers a hefty 7 per cent fee to lead managers abroad, in addition to the opportunity to favour their best clients through discretionary allotments. That way, the chosen clients stand to benefit when trading opens at a premium and the favour is returned in other issues. In India, institutional investors return the favour and create a profit opportunity for themselves by drumming up investor interest in the issue.
The AWSJ goes on to illustrate how other companies were discouraged from using the electronic auction route and some, like Overstock.com Inc. were even cautioned that they would become a ‘‘pariah on Wall Street’’. Morgan Stanley reportedly warned Morningstar that the electronic auction could lead to insufficient bids or that ‘‘over-exuberant individual investors might overpay and then get burned’’.
The article has some uncanny parallels with the Indian situation. The regulator is worried that powerful investment bankers and institutional investors could sabotage issues, especially of public sector companies, if its decision is not carefully timed.
Clearly, it has in mind the furore of March 2004 when Disinvestment Minister Arun Shourie openly accused the Lead Managers to these issues of trying to jeopardise the disinvestment process. Sebi itself would recognise a pattern in the angry protests against the reverse book-building process, by companies who want to delist their shares. Here too, investment bankers want the pricing power to remain with them and have falsely argued that individual investors will either bid too low or demand too high a price.
Sebi needs to stop vacillating and act quickly to end discretionary allotment for institutional investors. If they persist with frivolous bids to distort the subscription process, it should go ahead and mandate a tiny margin on institutional bids. The Indian regulator needs to worry about safeguarding retail investor interest in an over-heated primary market rather than be pressured by what is clearly international malpractice. It must also immediately implement the recommendations of the SMILE taskforce to streamline the application process and eliminate the possibility of procedural glitches in the application and refund process.