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December 15, 1999


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Devangshu Datta

Is book-building a boon or bane?

In 1996, when the MS-Shoes scandal broke, the primary market went down the tube. Over the next four years, only banks and financial institutions that were attempting to meet capital adequacy or net worth requirements made equity issues. Private promoters waited for a more propitious moment.

Over that period, scam after scam surfaced in the primary market. Companies didn't exist, their promoters were untraceable, some of the promoters had shut down the business and run away, others didn't bother to file their results and were summarily delisted. To even assess the magnitude of losses is impossible.

One good side-effect of the IPO collapse was that investment was redirected into mutual funds. Small IPO investors who don't play the secondary market on principle subscribed to mutual funds. That meant an explosion of competing schemes. As a result, transparency in that sector, as well as the number of alternatives available to the small investor improved massively.

After that four year hiatus, the IPO market now shows signs of revival. The last three months have seen several good issues. Most have been in the favoured IT sector. Most IT issues -- such as Hughes Software and HCL Tech -- have been over-subscribed with HCL setting a record. But the systemic problems that led to the collapse still remain. And there is a new trend that is slightly alarming.

Pre-Sebi, in the days of the Controller of Capital Issues, IPOs were always under-priced, assuming that the company was worth anything at all. Allotments were on lottery basis and this led to a simple scam. Entire families would make applications from multiple bank accounts and multiple addresses. Every allotment was grist to the mill of the thriving grey market. Companies liked this because it meant cheap working capital in the form of over-subscription in the days before Stockinvest.

After the CCI was abolished, issues tended to be wildly mispriced for a while. But that is really an analytical problem for the lead manager, issuer and investors. The new Sebi system of proportional allotment was fairer although it is somewhat skewed in favour of the big investor. The big problem was that Sebi developed no checks on basic matters like the company's actual existence. Investors will live with the possibility of buying a dog but it is too much to expect them to live with outright fraud. Literally hundreds of those 1994-96 IPOs have disappeared.

Anyway, Sebi brought in a requirement that the company must show three years worth of profits before it could apply. This alleviates the fraud problem but it leaves fast-growth industries like IT in the lurch, since nobody in the fast-track can wait that long for capital infusion. As a result, every Indian dotcom is seeking listing abroad. If Sebi relaxes the norms for dotcoms as it well may, then every shady operator will promptly make an Internet IPO. Already the name-changing game with companies randomly adding an "Infotech" or "Infosystem" or "software" to their names has reached absurd proportions. In the long run, the regulator will have to enforce regulations. There is no way of getting around that.

A new two-edged trend in the IPO market is the book building process. This is an adoption of the standard US procedure. There, the book-building is done at the institutional level and retail allotment is done by the allottees to their retail clientele. Here the book-building procedure has been applied to all comers in the Hughes and HCL issues. This has certain disadvantages.

Book-building creates a reliable price-discovery curve. The IPO issuer and runner both know exactly how much they can raise. Book-building does however lead to cosy relationships between bidders, runners, and issuers. Both the price-discovery mechanism and the allotment process can be manipulated easily and opaquely. It isn't criminal to guarantee somebody a large allotment in a book-building issue. In USA, book-building is carried out by a bunch of big institutions, who can force each other to stay in line. Also the retail investor doesn't get shafted because a method exists for them to participate.

Here too, the book-building process effectively cuts individual investors completely out of the price-discovery loop. Institutions bid in such volumes as to totally dominate all points of the curve. This, in itself, is not so bad. After all, the traditional system offers no price-flexibility either. But book-building also leads to a completely opaque allotment process. And Indian institutions will not pass on allotments to retail investors. In fact, a method for passing allotments onwards at the retail IPO level does not exist. So the individual investor can also be completely cut out of the allotment process.

This is a system that could easily encourage crony capitalism and it contains the seeds of unfairness where the allotment process is concerned. Please note that I'm not saying that such a thing happened in either of the above issues. But it could have. It would not be criminal and you would never know. Any allotment process that is necessarily discretionary could also be discriminatory. In the Indian context, it will almost certainly head that way.

To make it less discretionary we must either create a system of retail allotment akin to that in the US. Alternately, after the price-discovery curve is plotted, individual investors should re-bid for allotments at the now-fixed price. And then proportionate allotment should be made on the basis of the new bids.

Isn't this a little too complicated? Is it necessary? Frankly, I haven't worked out why companies can't make IPOs at a fixed price anyhow. If they are hot, they should seek subscription at the upper end of the band. The marginal loss of a price-discovery mechanism could be compensated partially by a greenshoe option. Perhaps flexibility in issued capital could be allowed. That is, if a company suspects that it has under-priced its IPO, it could promptly issue more stock at the prevailing secondary market price.

The other interesting problem in a book-building process is post-bid devolution. This has actually been known to happen abroad because secondary market conditions have changed for the worse between bid and allotment. If the bidder is short of the cash required to take delivery, there is a messy default. Then the issuer ends up with less money that expected, the runner ends up with egg on its face, and the bidder sells his allotment in desperation. This is more difficult to cope with than a vanilla under-subscription for a vanilla IPO.

Devangshu Datta

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