Watch Out! They Are Out to Get You

We are back a full circle. A dozen-odd years after the IPO (initial public offering) mania of 1992-96, the market is dead again. Ironically, the Confederation of Indian Industry (CII) is the first to kick off a discussion on how to revive the primary market. As in the 1990s, this time too the market was killed by the combined greed of companies, investment bankers and investors. However, as far as the regulatory system is concerned, the investment banker is at the centre of the IPO process and is solely responsible for every aspect of it. Section 5.1.1 of SEBI’s (Securities and Exchange Board of India) DIP (Disclosure & Investor Protection) guidelines says, “The standard of due diligence shall be such that the merchant banker shall satisfy himself about all the aspects of offering, veracity and adequacy of disclosure in the offer documents.” The rules say that the “liability of the lead manager will continue even after the completion of issue process.” This is not mere exhortation. The investment banker is required to provide a due diligence certificate with the red herring prospectus as well as the final prospectus; is also required to certify different stages of compliance before issue opening and after it has opened. These certificates, to be issued in SEBI’s prescribed format, make the investment banker specifically responsible for price justification, no-complaints certification, underwriting commitments (including a 5% underwriting obligation) and the appointment of all other intermediaries in the issue process.

So, while issuer companies, in fact, call the shots, legally the buck stops at the investment banker’s door alone. MoneyLIFE looked at the price performance of all 177 IPOs that raised money between 2006 and 2008 to see if any investment banker stood out for bringing a better quality of issues to the market. To our horror, none was even marginally better than the others. Each had its share of good IPOs and terrible ones. No one advised companies to think long term and leave some appreciation possibility on the table. They were all in a race to raise the maximum possible money from investors and at the highest price they could.

Of the 177 IPOs made in the past three years, only 68 are trading higher than their issue price. Of these, 24 are still showing a price appreciation of 100% or more (as of 21st August) while over 45 stocks are trading at less than half their issue price.

Since we now know that investment bankers operate like a herd and are only focused on their fees, we need to ask if the regulator did enough to ensure strict accountability that goes beyond gathering due diligence certificates. The picture only gets worse. The regulator did precious little when investors were being ripped-off but media reports suggest that it was conducting a ponderous investigation that could lead to penalties after the market is all but dead.

This is not good enough. As far back as in November 2006, SEBI had accused investment bankers of submitting shoddy documents and companies of failure to meet listing requirements. It even said that the two national stock exchanges were delaying in-principle listing permissions. Following specific charges by SEBI, only a few companies withdrew their issue. The rest went ahead and listed. Here is what SEBI said and how these companies have performed: KEW Industries had no business commencement certificate, nor had the promoters brought in their contribution when Chartered Capital & Investment filed the red herring prospectus on their behalf. The share is trading at a 46% discount to issue price.

SEBI suspected that the promoters of FIEM Industries were in RBI’s wilful defaulters list. The issue managed by IL&FS Investsmart is trading at a 58% discount. Transwarranty Finance is quoting at a 63% discount; it was accused of shoddy documentation and wanting to transfer issue proceeds to two brokerage firms. Gayatri Projects, also accused of shoddy documentation, is down 21%. Blue Bird (down 70%) and Celestial Labs (down 40%) were finding it tough to get in-principle listing approval from the bourses. There was no way for investors to know what the problem was. Global Broadcast News (now IBN18) had applied without completing its amalgamation scheme (it trades at a 20% discount to the issue price). Sobha Developers did not want to disclose its land bank; its investment bankers Kotak Mahindra, Enam and IL&FS Investsmart were canvassing its case (it now trades at a 56% discount). Global Vectra Helicorp (down 56%) and Ruchira Papers (down 44%) were two others on SEBI’s list. Does this indicate that the regulator failed to be tough enough even when things did not seem right? M Damodaran, former SEBI chairman, put out these details to hit back at a leading newspaper which had accused the regulator of delaying IPO clearances. Did SEBI do anything about the merchant bankers who handled these issues? No such information was put in the public domain at a time when it would have been relevant to investors. However, sometime in August, The Economic Times reported that seven investment bankers — Kotak, Enam, DSP Merrill Lynch, SBI Caps, HSBC, Keynote and Aryaman Financial are going to be penalised for shoddy work and in connection with IPOs of Yes Bank and IDFC, which were the subject of a major investigation. Apparently, in the Yes Bank case, the IPO details in the prospectus were different from those filed with the Reserve Bank of India. SEBI has found as many as 10 to 15 lapses in several prospectuses; some investment bankers have got the issuer’s capital details wrong and others have failed to check if the plant and machinery exists as claimed. What is the point in SEBI’s so-called action and investigation, once the primary market is dead? Did SEBI not learn any lesson from the mid-1990s when it was found wanting in its regulatory role? Pointless penalties and consent orders that only enrich the exchequer with fat settlement payments are cold comfort for investors who believe that the regulator is ensuring that the investment bankers are doing their job. In a few cases, stock exchanges were reluctant to grant in-principle listing permission – some of these companies eventually dropped their IPO plans, but others went ahead and listed, and are now trading at a discount. Were the bourses pressured to clear the issues? Clearly, the regulator has as much explaining to do as the investment bankers and it cannot hide behind the fig leaf of its disclaimer that it does not clear issues but only offers “comments” on the prospectus. It is common knowledge that SEBI officials spend enormous amounts of time going through offer documents with a fine toothcomb – why then do so many lapses escape their attention? Apparently, even stock exchanges miss key details in their listing approval process.

Importantly, SEBI hardly ever brought this up for discussion at its Primary Market Advisory Committee. Instead, it was happy to go along with corporate and investment banker lobbies to delay the IPO rating process, which has also been initiated in a half-baked manner, without really forcing issuers to publicise the ratings. Had the regulator shown more alacrity in introducing IPO grading, it would have ensured that a qualified rating agency did some of the fact checking for the regulator and the investor. Well, SEBI now has a new chairman in charge of the clean up. We expect him to act swiftly against investment bankers who colluded with companies to dump expensive shares on investors and also pull up its own officials who have been in charge of the IPO division.

Global Problem
Greedy promoters, investment bankers and regulatory gaps are a global issue. Therefore, poor performance by IPOs is a worldwide phenomenon. Jay Ritter, a finance professor at the University of Florida, is best-known among academics who have studied IPOs. He has found that IPOs underperform the market by 5.2% a year during the first five years after issuance, with the underperformance starting six months after the IPO. Even the first-day returns can be poor. During 1990-96, he found that one in 11 IPOs had a negative initial return and one in six closed on the first day at the offer price. Companies that went public between 1970 and 1993 produced an average return of just 7.9% per year for the first five years after the offering, using the first day’s closing market price as the purchase price. Ritter who compiled various global studies on IPO returns (Table above) also found that, typically, the earnings per share of companies grows rapidly in the years prior to going public and actually declines in the first few years after the IPO. This means, that fundamentals are much better before the IPO – it is another reason to be very careful about them. As John Wakeman, a portfolio manager, once said: “Don’t ever underestimate Wall Street’s ability to kill something with too much capital.”

A Brief History of IPO Excesses
Markets change, products evolve, and investors come and go; but is anything ever fundamentally new about financial markets? The recent cycle of IPOs that culminated in Reliance Power’s massively overvalued Rs11,700 crore issue is nothing new. Those who came to the party for the first time, or forgot how the previous party had ended, have only themselves to blame. A little analysis of the past would have told them that a rush of IPOs happens only when things look extremely rosy. It is then that investment bankers collude with companies to stick expensive stocks on to you.

This keeps happening in cycles. Let’s do a quick tour of the past 15 years to understand how it works. The biggest IPO mania of the past few decades occurred between mid-1994 and early 1995. Thanks to extremely lax primary and secondary market regulation, almost anybody could raise money by mis-stating facts or ramping up prices. A grey market flourished and sent wrong price signals to investors (exactly like in the Reliance Power issue). The Securities and Exchange Board of India (SEBI) under DR Mehta simply refused to see the misuse of the system, despite my pointing it out in reports, articles and personal conversations with him.

After a steady rush to raise money throughout the second half of 1994, the market reached absolute frenzy in January and February 1995. In those two months, a spate of mega issues like Reliance Capital, Essar Oil, Jindal Vijaynagar, Hindustan Petroleum, MS Shoes and others hit the market. In January 1995, 145 equity issues opened for subscription. In one frenzied week in February 1995, 78 companies hit the market, crowning a financial year (1994-95) of as many as 1,400 IPOs! Compare this with the fact that 2007, a very good year for IPOs, saw 90 issues and you begin to understand the farce of 1994-95.

After the MS Shoes issue, the primary market went bust. Until then, it was exhibiting all the symptoms of the worst IPOs: poor track record, huge asset growth, borrowings, price rigging, lack of due diligence, a manic market and poor regulation. Such were the excesses of this period that the most high-profile companies and their aggressively marketed IPOs quickly sank below their offer price and fell steadily until some had lost as much as 80% of their initial value. The market then remained dead for almost a decade. It revived in 2005 to another cycle of excess that was the dotcom bubble.

There are three things to learn from this. First, the cycles of boom and bust will keep happening. There was one IPO boom in 1988, another in 1995, then in 2005 and one in the past two years. Second, once the primary market turns bullish with initial IPO listing at a premium in a booming secondary market, we quickly move into a late-stage IPO mania that starts when investment bankers collude with company managements to plan issues that are primarily meant to enrich themselves. Projects planned at this stage of the IPO rally often propose expansion plans that are much larger than the existing business; many are shaky to begin with because due diligence tends to be lax during a euphoria. Third, investors are more willing to take chances, since they have seen prices double and treble over short periods and their neighbours and colleagues seem to have made easy money while they were left behind. Those who taste success in one IPO are also prepared to try their hand at the next hot one.

Don’t ever believe that retail investors alone are left holding the baby when the market goes bust. Large institutional investors are usually willing participants in this game causing losses to those who cautiously invest through mutual funds. The Reliance Power IPO is a good example; although many smart funds flipped on day one, many others continue to hold the shares in significant quantities. There is no better example of the greed and stupidity of global institutional investors than their rush to invest in global depository receipts (GDRs) in 1994. When the government allowed Indian companies to issue GDRs, foreign investment bankers rushed to India hunting for business. They packaged good and bad companies to look attractive and got them to float GDRs. The GDRs issued in that period include the likes of NEPC Micon, Arvind Mills, DLF Polyester, Core Parenterals and Flex Industries. Yet, they got warm reception from institutional investors in London and New York because of the marketing hype created by the best-known global investment bankers. Many of these GDR-issuers were the pick of value-destroying large Indian companies. So much for smart investing by global institutional investors and quality investment bankers. - Debashis Basu

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