The risky game of IPO financing

Dizzying debuts in the IPO market, as in the case of D-Mart that listed with a spectacular gain of over 100 per cent on the day of listing, has no doubt piqued investor interest. The recent frenzy, after a hiatus of nearly six years, has led to a significant jump in the quantum of capital mobilised through IPOs. In 2016-17, main-board IPOs collectively raised around ₹28,000 crore, double the amount raised in the previous year. With piping hot IPOs such as NSE, SBI Life and HUDCO lined up for the coming year, capital raising could hit a crescendo.

But who is financing Indian retail investors’ latest fling with IPOs? The NBFC arm of broking firms, it appears, have been funding high networth individuals, to own a piece of the IPO action. Up until now, the credit mechanism has kept risks for lenders at bay. But a couple of disastrous IPOs can throw assumptions awry and lead to liquidity and operational risk for lenders.

IPO financing is a short-term credit provided by the NBFC arm of broking firms, typically to HNIs. The investor is required to make an upfront payment of the margin amount, which can vary across NBFCs and IPO issues. An interest rate of about 10-11 per cent (per annum) is charged for the loan which is usually extended for the period between the close of the IPO and the date of listing, that is, six days. NBFCs typically raise the required quantum of funds through issue of short-term debt instruments of, say, seven days.

By design, the structure of IPO financing mitigates the risk. For one, NBFCs take an upfront interest payment on the loans. NBFCs, having a lien on the shares allotted in the IPO, also have their backs covered. ASBA (applications supported by blocked amount), a boon for retail investors, has also kept the credit machinery of NBFCs for IPO financing well-oiled. Under ASBA, only the amount corresponding to the actual allotment of shares under an issue is deducted from the account; the rest is unblocked. What gives additional comfort is the fact that the account of the investor is operated by the lender (NBFC in this case).

Also, NBFCs demand an upfront payment of the margin amount based on the assessment of subscription levels. Say, for instance, the IPO issue is expected to oversubscribe 10 times; the NBFC would ask for a 10 per cent margin. If the issue does oversubscribe 10 times, then of the 100 shares an investor applied for, he would be allotted 10, against which the NBFC holds a lien and can liquidate the shares if need be, to recover its money. As most of the lending to HNI investors happens on the last day, after the extent of subscription is fairly known, the magical ‘100’ figure, is yet to fail. If the issue oversubscribes more than the expected amount, the lender is more than covered with the excess margin amount.

Mutual funds that have exposure to CPs for IPO Financing also receive their dues in time. In short, everyone is happy.

But what happens if the rug is pulled out from under these spectacular IPOs some day? In the above example, let us assume that the IPO issue is subscribed only twice. This implies that the investor would get allotted 50 shares (against a margin of 10 shares), subjecting NBFCs to market price risk of the underlying shares. The shortfall in margin can be made good by the NBFCs by selling off the collateral. But what if the stock fetches a price way below the offer price in the market? NBFCs could in turn default on their obligations to mutual funds.

Certain operational hitches can crop up too. The allotment of shares usually happens six days after the close of the issue. Unforeseen delays, though not seen yet, can leave NBFCs in a lurch to honour their payments to debt funds.

According to data on the website of ICRA, recent issuances (for which ratings have been assigned) run into a few thousand crores of rupees. These are much higher than the debt raised by these NBFCs for normal business operations. What’s more, multiple NBFCs under a particular group appear to raise bonds at the same time, possibly to fund a particular IPO. For instance, the Edelweiss group through its various NBFCs — Edelweiss Financial Services, Edelweiss Commodities Services Limited, and Edelweiss Finance & Investments Limited — all put together have an outstanding rating on CPs totalling over ₹10,000 crore in value as of March end. India Infoline as a group on the other hand had an outstanding rating for CPs of over ₹15,000 crore last month.

Possible operational and liquidity risks call for attention.

Given that NBFCs have to maintain a total capital adequacy of 15 per cent, their leverage is usually around 5-6 times. This may shoot up temporarily when issuances peak. If NBFCs are unable to recover the loans extended to investors, overleverage can cost them dear, particularly in the case of small players without the necessary capital bandwidth to absorb losses.

By putting in place a more stringent regulatory norm around the capital and financial performance of NBFCs involved in IPO financing, the regulator can help contain some of these risks. This will ensure that only the financially sound NBFCs with large networth undertake such activity in the first place. Rating agencies also need to be more selective, limiting ratings to large NBFCs with deep pockets.

NBFCs also need to have adequate liquidity buffer to tackle cash flow mismatches due to delay in IPO refunds. Rather than cutting it too close and issuing bonds only for seven days, NBFCs will have to choose the right tenure of borrowings to avoid mismatches. However, this may come at a cost.

While mutual fund schemes’ exposure to a single issuer is restricted to 10 per cent of the NAV, multiple schemes can take exposure to the same bonds, indirectly exposing the entire fund house to the vagaries of a single IPO issue. Imposing a limit at the fund house level towards exposure to bonds issued for IPO financing can avoid large default risks.

For now, none of the worst scenarios have played out. But risks could well intensify. All it would take is for one neatly placed domino to knock the next one over.