The Hindu Business Line : Why IPOs have turned too risky for comfort

The very notion that retail investors can rely on institutional buyers to decide whether to invest in an IPO appears to be flawed. Their risk appetite and return objectives may be completely different from retail investors.

Some recent IPOs were from businesses in such a nascent stage that they would be better suited to private equity or venture capital investors.

Aarati Krishnan

If retail investors in India have shown a decided partiality for initial public offerings (IPOs) in the past, it’s not too difficult to understand why. Who wouldn’t like to unearth a future Bharti Airtel from today’s stock market debutants! Investors who invested Rs 45 a share in Bharti’s IPO in 2002 have seen its value shoot up to nearly Rs 680 (adjusted) today, multiplying their money 14 times.

However, Business Line’s analysis of IPO performance shows that cases such as Bharti’s have been the exception rather than the rule. Bunching up of offers in super-heated markets, stiff asking prices and the risky nature of businesses now seeking IPO funds combine to make the IPO market a potential minefield for retail investors.

Let’s start with the timing aspect first. In recent years, companies seeking funds for projects have mostly waited for buoyant market conditions to launch IPOs. Roughly a third of all IPOs in the past seven years made their debut between January 2007 and January 2008, the last leg of the previous bull market.

Companies cannot be blamed for timing their offers so that they can obtain the best price; but this practice has proved severely detrimental to investors. Not only do IPO investors end up betting large lump-sums on stocks during the market’s most euphoric phases; they end up doing so at bloated valuations that can’t be sustained in more sober market conditions.

Scaling up risk

To make matters worse, the very nature of companies tapping the IPO market has undergone a sea change in recent years. Some of the IPOs in recent years have come from businesses that are in such a nascent stage that they would be better suited to private equity or venture capital investors, rather than retail investment.

In the offer boom of the early 1990s, investors were taken in by companies that painted an overly bright picture of their prospects using fancy profit projections; regulatory intervention put an end to that. But IPO investors of today grapple with precisely the opposite problem; too little visibility on the business or prospects of the issuer.

Quite a few of the high-profile IPOs of the past three years have come from companies seeking to fund high-risk or long-gestation projects that are to come up years into the future. There is also little by way of an existing business or financial record for the issuer.

Evaluating such offers entails making five- or ten-year projections of revenues, cash flows and earnings — surely, a tall order for retail investors. When Reliance Power made its mega-IPO in January 2008, it was to part-fund power generation capacities of about 7000 MW that were still largely on the drawing board. The projects were to generate their first cash-flows in 2010-11 and go onstream in phases until 2016.

Pipavav Shipyard recently made an IPO to fund working capital requirements for its ship-building business which commenced operations only in April this year. Offers such as these can be directly traced to the popularity of book-built IPOs, where regulations allow the issuer to raise money without the requisite three-year profit record or net worth criteria that are mandated for other offers.

While lowering the quality bar on book-built IPOs, it was hoped that institutional participation in the book-building process would protect the interests of retail investors.

QIBs don’t help

Qualified institutional buyers (QIBs), with their reserved quotas in book-built offers, were supposed to vote out issuers with dubious quality or extortionate pricing. But experience with the book-built offers of 2007 and 2008 provides hardly any evidence that institutional investors indeed fulfilled this role.

Retail investors who went by massive QIB responses to bet on some of the 2007-08 offers have only losses to show for it today. Future Capital Holdings, much-fancied by institutional investors, with the QIB portion subscribed 180 times, has seen its IPO investors lose two-thirds of their capital till date!

In fact, the very notion that retail investors can rely on QIBs to decide whether to invest in an IPO appears to be flawed. For one, institutional investors are not immune to broader market sentiment or errors of judgement. They are as likely as retail investors to take on big risks under euphoric market conditions. Two, and more important, both the return expectations and risk-taking abilities of institutional investors are likely to be vastly different from that of a retail investor.

A venture capital fund, when buying into an IPO, may be quite willing to assume the risks of a nascent business with sizeable execution challenges. A hedge fund buying into an IPO as an ‘anchor investor’ may simply be looking to make the best of market momentum by exiting the stock soon after listing. Yet, such strategies can hardly be recommended to retail investors.

Vetting QIBs

It is also unrealistic to expect a lay investor to vet the credentials of the QIBs subscribing to an offer, to gauge if he should follow suit. For instance, the fact that “anchor investors” such as Copthall Mauritius Investment, Nomura India Stock Mother Fund and Indea Capital bought into the Indiabulls Power IPO can hardly mean much to the retail investor, as he is in no position to judge whether these are, in fact, long-term or short-term players.

As the IPO season begins again in right earnest, analysis suggests that it is best for retail investors to take a cautious stance on IPOs and leave the frenzied bidding to institutional investors. As the risks of participating in bull market IPOs appear to far outweigh the returns likely from them, they appear to be a strict no-no for first-time investors. Even seasoned investors may do well by being extremely selective in their choices. As a rule, it is best to rely on your own homework and give stiffly priced offers a go by.

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