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B. Venkatesh

THAT many companies are proposing to make public offers in the coming months is not surprising. After all, companies can offer shares at stiff premium when the secondary market is vibrant, as it is now.

But making public offers when the secondary market is doing well is, perhaps, not an optimal strategy for companies. This is because of the negative signalling effect and reputation risk that a company suffers if the price of its stock were to decline in the secondary market, post-offer.

On the other hand, raising capital when the secondary market is moving sideward, as it was in 2001-02, may have a positive effect. Here is why.

Signalling effect: Take company X, whose stock has been trading for Rs 50 for a long time. Suppose the stock later rises to Rs 250, riding the uptrend in the secondary market.

Assume that the company makes a public offer at Rs 200 per share to attract investors. The immediate effect may be a decline in the secondary market price. Why? Investors may construe the discount as a signal that the company perceives the intrinsic value of the stock to be lower than the current market price.

Note that this reasoning does not apply to rights offers, which are typically offered at a discount to the market price. Such a discount can be construed as a reward to the shareholders for staying with the company through its growth phase. But what happens if the company, to avoid the negative signalling-effect, prices the public offer at the secondary market price? It suffers reputation risk.

Reputation risk: This can be defined as the cost the company suffers because the stock price declines below the offer price, post-offer. This is more likely to happen when the company prices the offer at or near the market price when the market is trending up.

The cost is primarily intangible. Suppose the stock declines to Rs 150 because the secondary market has tanked, post-offer. The company may find it very difficult to raise capital the next time. It may have to offer shares at a substantial discount to the market price, even if the market is moving sideward. And that may lead to irate shareholders, especially those that bought the earlier offer at a higher price.

The repercussions will also be felt if the company raises debt capital. Typically, the stock market prices risk much faster than the bond market. That is one of the reasons why credit risk is priced based on the company's stock price.

If the stock price declines sharply and stays that way for a long time, the company's credit risk may be construed to be higher. And that may translate into higher coupon rate if the company were to issue bonds. This suggests that making the public offer when the secondary market is vibrant may not be beneficial to the company in the long run.

Optimal strategy: Companies may do well to raise equity when the market is typically moving sideward. That way, the downside from the offer price may be limited, while the upside may be high. Suppose company X's stock trades at Rs 150 in such a market. The company may decide to raise capital at the same price, or at a marginally higher price.

Pricing the offer this way sends strong signals that the company management believes the stock to be worth more than the current market price. Of course, such a perception will be fortified if institutional investors and/or promoters pick up a large part of the public offer.

In the event, the company's offer may be accepted, the next time it enters the capital market.

For instance, even adjusting for the differences in the industry structure, investors may be more inclined to buy i-Flex Solutions, which made its initial public offer last year when the market was moving sideward, than, say, IDBI, which made its IPO in 1995, when the secondary market was vibrant.

Besides, there will be a beneficial impact in the bond market as well, as the company can raise bonds at lower coupon for the same reasons mentioned earlier. On balance, the benefits of entering the primary market at the right time and price are likely to outweigh the costs.

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