The Hindu Business Line : Making IPOs retail-friendly

Initial public offerings are variously seen as an indicator of expected industrial growth and the confidence level of investors in the equity market. These are the result of the efforts of the market regulator, strong corporate ethics, and healthy economic trends.

The Securities and Exchange Board of India has been striving continuously to increase the transparency and efficiency of the primary market, as also to improve disclosure norms to rationalise the allotment . This has had an impact, and IPOs (initial public offerings) have played an effective role in funds mobilisation, though their share in the total capital raised has fluctuated considerably.

Thus, in 1999-2000 IPOs accounted for nearly 39 per cent of the total capital raised, but in 2001-02 only 15.6 per cent and in 2003-04, 14.8 per cent after rising in 2002-03 to 25.5 per cent. In 2004-05, IPOs garnered Rs 74,000 crore, or more than 48 per cent of all capital raised. Over 1999/2000-2004/05, IPOs accounted for nearly 43 per cent of the capital raised.

Yet, this stupendous performance has not been without faults in the system, which need correction. Free pricing was introduced with the idea that the market forces of demand and supply would determine the price of equity shares. In reality, free price is a fixed one in terms of price determined by the issuer and his merchant banker within the price band specified by them. No one authenticates the quality of such a price band. The investors take that price as a given, and purchase shares allotted to them at a fixed price. It is a situation where issuers come one at a time but buyers are in their thousands. Despite the many market reforms, the IPO is still influenced by a manipulated secondary market and the spiralling boom supported by heavy inflows of foreign institutional investments. A look at the way funds are raised.

Book-building pricing

Almost all IPOs now use the book-building route. After making firm allotments to employees, depositors, bondholders and subscribers associated with the issuer company, offer is made to qualified institutional buyers (QIBs; 50 per cent), retail investors (35 per cent) and high net worth individuals (HNIs; 15 per cent).

Of interest is the treatment to retail investors. The pro-rata system of allotment favours investors who bid for relatively large numbers of shares. Perhaps, the process should be changed such that those applying up to 1,000 shares are allotted in full and beyond this number on pro-rata basis.

Book-building is preferred because the allotment of shares is generally done at a price determined by the lead merchant banker and issuer within the price band. Since QIBs are the dominant players and bid at somewhat higher prices within the band, the issuer and merchant banker fix the price at the higher end such that retail investors have to accept it. Thus, investors chipping in 35 per cent of the capital have little role in price discovery. As a matter of fact, the IPO demand curve is skewed by differing demands at different prices by various bidders. This indicates the need to use multiple pricing for allotment.

The Dutch auction

The Dutch auction can also be used to protect the interest of retail investors. In this system, auctioneering begins at a high price, which can be lowered up to the lower limit of the price band. All participants pay the last price. This mechanism does not discriminate against small investors. This is also favourable for other investors, QIBs or HNIs. A weighted average price can also be thought of for retail investors; that is, the weighted average of the retail investor category bids is accepted as the cut-off price.

The recent IPO scam has exposed the allotment procedure, which has been exploited by capital market intermediaries. Though SEBI identified the culprits and took action, the punishment was not stringent enough.

The regulator should ban more than three multiple joint accounts with depositories, whatever the combination. The name of one shareholder or bidder for allotment should not appear more than thrice including joint holdings. It is surprising that rather than correct the system, the Government should think of abolishing the retail investors' quota itself to stop allotment scams..

SEBI can also issue clear guidelines/clarifications on offer documents to build confidence among investors. For instance, on `offer documents', SEBI indicates `observation issued'. It should make an unambiguous statement if it has approved the offer document and permitted the company to make an offer to the public. If the equity investor population is to grow, the regulator will have act quickly and decisively.

(The author is a former Economic Advisor to SEBI.)