Why primary market has run out of steam

The Indian stock market has been particularly volatile in the past few years. The present scenario points to a dangerously shrinking investor population that has rendered the IPO market almost inactive. It has become extremely difficult for the corporate sector to raise equity capital.

At a time when the mutual funds commission structure is being widely debated, it is worthwhile to look at what ails the primary market segment.

The financial year 2010-11 saw 72 firms cancel their IPO plans, and 58 Indian companies let their regulatory approval for their IPOs lapse in the 2011-12. In the same period, 34 firms issued their IPOs but raised only Rs 5,892.88 crore, which was the second lowest since FY05, when 23 companies raised a much larger amount of Rs 14,662.32 crore. In calendar year 2012, 13 IPOs have been called off so far.

In 2007, India was in sixth position in the global list of countries in terms of funds raised by IPOs. All that has changed. In the absence of a vibrant debt market, the corporate sector is dependent on traditional bank funding and promoter capital for new investments. Due to the shrinking retail investor base and the consequent dry IPO market, even private equity players are finding it tough to exit from their investments. This is sending a wrong message to the private equity/venture capital industry.

During 2011-12, L&T Financial Holdings was the only IPO to raise more than Rs 1,000 crore, while in the previous year there were seven offerings over Rs 1,000 crore, with Coal India being the biggest with an issue size of Rs 15,000 crore.

Primary neglect

It is interesting to note that concerns and worries about the state of affairs of the mutual fund (MF) industry were raised at the highest levels, which is a welcome sign.

The recent problems of MF industry have been linked to distributor compensation. A majority of the distributors have virtually disappeared from the business scenario, except for the big names, which are able to survive due to the Asset-Under-Management (AUM)-linked trail fee, which has reached a critical mass in their case. In this context of widespread concerns about the MF industry, the problems of the IPO market assume significance.

Traditionally in India, retail investors have entered the capital market through the IPO route. Around 20 years ago, there were two major developments in the course of our transition to the modern stock market. The first was the virtual closure of regional stock exchanges, which resulted in the winding up of a few thousand member brokers of these exchanges and lakhs of sub-brokers who were active in the primary market. During this transition, the focus of regulatory reforms in the country was on the secondary market, led by Western-trained market experts, who perhaps inadvertently overlooked the primary market.

The primary market brokers were getting 1.5 percent brokerage plus the underwriting commission, which was largely managed through the layers of brokers distributing the risk of underwriting among a large number of brokers, enabling them to earn around 3 per cent commission in the distribution of IPOs. When this compensation structure disappeared and new commission structure, which is around 25 basis points, came into practice, the distribution architecture completely collapsed, leaving the IPO market distribution in the hands of a few cartels. These cartels appear when the secondary market is active, and disappear when the secondary market is inactive, rendering the corporate sector vulnerable.

Commission Structure

At present, the Prime Minister's Office is concerned about MF commissions to distributors, while the Ministry of Finance and SEBI too are discussing how to provide more incentives to the distribution network to revitalise the MF market. One must remember that it is relatively safe for an investor to place money in the hands of AMCs; the distributor gets a trail fee apart from an average 0.50 per cent upfront commission in varying forms. This commission is paid to distributors to sell a product, which is easier and safer than IPOs.

However, the primary equity market distributor faces several challenges, as he needs to make extra efforts to convince an investor to invest in a relatively riskier equity in comparison to MFs.

When the MF distributor has disappeared in spite of an average 0.50 per cent upfront commission and an average 0.50 per cent trail commission, one can well imagine the fate of the IPO distributor who gets 0.25 per cent commission if the allotment takes place.

Whither IPO distributors?

In the name of reducing the cost of an IPO for an issuer, the investment bankers offer very low and unprofitable commission to brokers, while the management fee and other costs remain same as before.

Investment bankers are able to get IPO applications through cartels operating out of a few metros, by paying higher commissions to the cartels who, in turn, sell the shares immediately after listing.

These cartels produce a large number of applications for a good issue, but they do not originate from investors in the true sense. These are IPO speculators and not IPO investors, as most of them sell on listing. These speculators appear only when the secondary market is good, and disappear when the secondary market is dull, rendering the IPO market dead for long periods.

Over the last 15 years, only few IPO investors have entered the market due to the absence of IPO brokers and sub-brokers, making the secondary market vulnerable to block transactions that originate from institutions, both foreign and domestic. The high volatility of the Indian stock market has its origin in this basic problem of lack of retail investor population and the consequent lack of depth.

Today’s IPO investors

Most IPO investors today are secondary market investors, traders and speculators. They are serviced by the stock broking network that provides this service to an investor for an estimated 0.25 per cent commission, which is similar to the secondary market brokerage. This profile of the new IPO investor is the reason for the post-listing selling spree by investors.

There will not be any significant change in the profile or in the behaviour of the IPO investor, if the problem of commission for IPOs is not addressed. The member brokers of NSE/BSE will focus only on their secondary market customers.

The financial market in general seems to be convinced about the need to increase commissions to the MF distributor, while there has not been any attempt to understand what really ails the IPO market. It's time we addressed this basic problem, even if it means that an issuer has to incur an additional 2 per cent cost for an issue in the interest of post-listing stability.

The primary market should be the focus of our reforms, and not the secondary market.

(The author is Managing Director, Geojit BNP Paribas. The views are personal.)

COMMENT NOW