Is Greed Killing The IPO Market In India?

In January, the Indian primary equity market was chalking up new records. Now, suddenly, there are hardly any takers for new corporate paper.

The first casualty of the Indian IPO bubble was, ironically enough, a hospital. On February 7, Wockhardt Hospital pulled out its Rs. 676 crore ($178 million) IPO. It had exhibited all the signs of a patient on his last legs. The price band of the book-built issue was lowered from Rs. 280-310 ($7-$8) to Rs. 225-260 ($6-$7). The last date for subscription was extended.

But qualified institutional buyers, including foreign investors, mutual funds and hedge funds, applied for only 0.06% of their quota in the Wockhardt issue. The non-institutional portion (mainly for high net-worth individuals or HNIs) was subscribed 0.0048 times. Even the retail part saw demand for barely more than half the pie. It was an unmitigated disaster and the first time in recent memory that an IPO from a respected business house has flopped in India.

Close on its heels, real estate company Emaar MGF, a joint venture between the Dubai-based Emaar group and MGF Development of New Delhi, also had to withdraw its IPO in the face of low demand. The Rs. 6,500 crore ($1.7 billion) issue started with a price band of Rs. 610-690 ($16-$18). It was brought down to Rs. 530-630 ($14-$16.50) in two tranches. The last date of subscription was extended by three days, but to no avail.

“We are clearly a victim of the (secondary) market,” says Emaar MGF managing director Shravan Gupta. Along with other markets around the globe, the Indian stock markets, too, have had a torrid run the past few weeks. The Bombay Stock Exchange Sensitive Index, Sensex, touched 21,207 on January 10, an all-time high. Barely a month later, on February 10, it fell to 16,608, a five-month low.

Wockhardt and Emaar MGF were bad enough for investor sentiment; more issues are being withdrawn or postponed. But the massively-hyped Reliance Power IPO was the most high profile casualty. This was an issue from the Ambani stable; word on the street is that the Ambanis have always made money for their investors. At Rs. 11,500 crore ($3.025 billion), it was India’s largest-ever IPO.

The Reliance Power IPO was subscribed one minute after it opened. It was eventually oversubscribed 73 times and raised $190 billion. Some $100 billion of this came from foreign funds. This constitutes one-and-a-half times the total foreign institutional investor (FII) money coming into the country since 1992. “When Reliance Power lists early February, it will be among the 10 top listed companies in India,” Anil Ambani, the younger son of Reliance founder the late Dhirubhai Ambani, told a press conference shortly after the IPO closed. “If we assume it lists at the issue price of Rs. 450 ($12), the market capitalization for the group will be around $100 billion.”

It was not to be. Reliance Power ended its first day on the markets at Rs. 372 ($9.80). Millions lost money. The Sensex dropped 863 points in sympathy. The myth of Ambani invincibility was shaken. The Financial Times of London wrote: “It’s only when the tide goes out… that you discover who has been swimming naked. Few are caught in quite such an alarming state of undress as Reliance Power.”

Clearly, it didn’t help the Reliance Power IPO that the Sensex lost more than a fifth of its market capitalization between January and February. Wharton management professor Saikat Chaudhuri sees nothing wholly unexpected in these developments. “The market periodically has to adjust,” he says. “If there is a bull run, the market usually pulls back to an extent, especially now because there is so much uncertainty surrounding the credit crunch.”

The Hole in the Credit Barrel

Chaudhuri points to the continuing flow of “bad news on the credit crunch, particularly from banks,” and says that several private equity deals are also stuck. He doesn’t see any respite until some clarity emerges on the actual size of the credit crisis. “Until this is resolved – say (for example) people know that the top 10 banks will take a $50 billion hit – the market will continue to be jittery,” he says. “Short-term investors are very nervous. They are not sure if the problems associated with the credit crunch have been adequately addressed and if the market has all the information it needs.”

Fears about a possible U.S. recession are also stoking the uncertainty in the Indian markets, says Chaudhuri. “If the U.S. is headed for a recession, then of course a lot of growing firms in India, particularly those in the IT sector, are going to take a bit of a hit because they are still very heavily dependent on the U.S. market.”

Franklin Allen, a finance professor at Wharton, says primary markets will continue to be “tricky” until the markets settle down. “When you have so much volatility [in the secondary market] – it’s up 2% one day and coming down 2% the next day – it is very difficult to do these primary market operations; that is the underlying problem,” he says. “This happens also in developed markets when there is volatility.”

“Now, if I were an investor, I don’t think something like Reliance Power should have taken a hit,” says Chaudhuri, pointing out that India is power-deficient and its infrastructure sector is “growing very well. In the worst case, if India’s growth needs were to come down a notch, its power needs will still have to be met.”

While the fall in the Sensex and the air of pessimism hurt the Reliance Power listing, many people point to high valuations as a reason for the IPO market going bust. “The bull frenzy led to unsustainable valuations,” says Prithvi Haldea, chairman and managing director of Prime Database, which tracks IPOs. “Retail investors feel they have been cheated,” says Kirit Somaiya, president of the Investors’ Grievance Forum (IGF).

“It’s just a question of timing,” says Chaudhuri. “It is fine to be greedy, but you have to do that when the market is rising. I am not making a value judgment, but everybody is always trying to extract the most that they can at any point in time. That’s their natural quest.” He says it may have been a good idea for some promoters to postpone their IPOs until things got clearer on the credit contraction front.

Sudip Gupta, professor of finance at the Hyderabad-based Indian School of Business (ISB), says, “What is interesting and important is what to expect now when things look relatively bad worldwide. The informational cascade effect comes in here.” He explains that the first few investors in an IPO bring in bad news, forcing a price cut, scaring away potential investors, and “thus generating an informational cascade.”

Gupta says that if the IPO’s price cut is “too much,” investors may start to wonder “why the firm is so desperate for cash.” In other words, he says price cuts don’t necessarily work. Gupta of Emaar MGF says the company will come back to the market in three to six months, when he hopes it will be less volatile.

Reliance Power’s Make-Good Gesture

In a post-listing development, Reliance Power has announced that it will issue bonus shares to its investors; however, the promoter group will not be entitled to these shares. Reliance Power has since risen to more than Rs. 400 ($10.50). But analysts read into the bonus proposal a tacit admission that the pricing was indeed too “aggressive” in the first place.

“The pricing of an IPO is dependent on three factors – the state of the capital markets, sector fundamentals and company performance,” says S. Ramesh, chief operating officer at Kotak, one of the leading investment bankers in India. “One needs the tailwinds of all these three to achieve good IPO response and post-listing performance.” He says what is important is a stable market; if you are on a rollercoaster ride, all bets are off.

Most merchant bankers agree. And there is no disputing the fact that, if the market hadn’t tanked, all these issues would have done very well on listing. The reason why so many were disappointed in the performance of Reliance Power was its showing in the gray market in several cities of the western state of Gujarat. This unofficial and illegal market trades in shares even before the IPO and allotment. (The final settlement is when the scrip lists.)

Reliance Power changed hands at Rs. 900 in January. When the market fell in February, it came down to Rs. 600 ($24). Even at this reduced rate, it commanded a premium of Rs. 150 ($4) over the issue price of Rs. 450 ($12). When it listed at less than Rs. 400 ($10.50), these investors – mainly high-net-worth individuals – ran up huge losses.

Many investors had borrowed at high interest rates to buy Reliance Power shares. A back-of-the-envelope calculation shows that the share would have to list at Rs. 600 ($24) for them to break even. What happened was a disaster for these speculators. Many are refusing to pay up. And there is turmoil in the illegal betting shops in cities like Rajkot and Baroda.

Irrational Exuberance,

Indian Flavor

Promoters are a shade more candid. “It takes two hands to clap,” says Ravi Ramu, chief financial officer of Puravankara Projects, a real estate developer in Bangalore. “If you ask about the greed of merchant bankers and promoters, you should also talk about the irrational exuberance of investors. Do they rush to invest in an issue simply because it rained harder that day? In the euphoria, they forget to look at the fundamentals.”

Ramu and Puravankara must have a feeling of déjà vu. When Puravankara floated its IPO last August, the ripples of the U.S. subprime crisis were hitting Indian shores. Puravankara had to reduce the price band by 20% from Rs. 500-525 to Rs. 400-450 and extend the issue by three days. It finally did garner adequate subscription. But on the day it listed, it closed at Rs. 362.80 against the issue price of Rs. 400 ($10).

Puravankara is not a typical case. Most IPOs have been listing way above the issue price. Power Grid closed its first day at Rs. 100.70 (against an issue price of Rs. 52). Other such runaway examples include Mundra Port Rs. 440 (Rs. 961.70 issue price) and Power Finance Rs. 85 (Rs. 112.60 issue price).

“When things sell, everything sells,” says Vivek Suchanti, managing director of Concept Public Relations. ConceptWprovides public relations services for IPOs, which basically means hard selling the issue to the media.

“Bankers and promoters sell anything at any price on the story going ahead,” he continues. “Investors look at gray market prices and buy. This is also true of the ‘sophisticated’ investors such as FIIs and hedge funds.” Says Somaiya of IGF: “Emaar MGF, Wockhardt Hospitals and Reliance Power were absurdly overpriced. Euphoria was created which was not supported by fundamentals.”

Some numbers do suggest aggressive pricing. Based on the issue price, Emaar MGF would have a P/E (price/earning) ratio of 165 at the lower end of the price band against 73 for DLF and 49 for Unitech, the established leaders in the real estate sector. At the Wockhardt Hospitals P/E of close to 200, it was looking at a valuation around Rs. 2,700 crore ($710 million), when its older and larger listed peer Apollo Hospitals commands just Rs. 2,500 crore ($658 million).

Reliance Power, of course, doesn’t have a P/E; it has no earnings. As its prospectus explained: “We currently have no power plants in operation or other revenue-generating operations, and we have no significant operating history from which you can evaluate our business and future prospects and viability… Commercial operations at our first power plant – Rosa Phase I – are not scheduled to commence before December 2009…”

For many it is not overpricing that is the norm but underpricing. Gupta of ISB says that this is not just an Indian phenomenon. “One of the stylized facts about IPOs that are universally verified is initial underpricing,” he says. “What we have observed in the Indian IPO market so far is not very different.”

Gupta explains the reasons for the underpricing. “An IPO is different from a secondary offer as investors know little about the fundamental prospects of the project,” he says. “Since investors cannot distinguish bad quality projects from good quality projects, the good quality project has to be sold at a discount (underpricing) so that investors are attracted to invest in the IPO.” Gupta says the issuing firm also may not know the actual prospects of the project, and improves its understanding from institutional investors as the IPO gets listed.

Gupta says IPOs in emerging economies could be under priced by as much as 100%; this means the price doubles on the first day. “Even in the U.S., generally known to have a transparent financial market, in 1999-2000 (the Internet boom), the first-day under-pricing was 65% on an average,” he says

Adds Ramesh of Kotak: “IPOs are typically priced by leaving a discount to the realizable price at listing. It is always a good idea to leave a discount to motivate investors to subscribe.”

Regulatory Urge

Market watchers recommend other measures to regulate the behavior of investors, merchant bankers and promoters. SEBI has been looking at putting a price band on the movement of the share on listing day. But nobody is quite sure how that will help, except to stop huge volatility. All it may succeed in doing is moving the volatility from day one to week one, say some investment experts.

“I don’t think the regulator should set the price of issues,” says Allen, who has other, longer-term suggestions. “Make the markets efficient. As long as there are enough knowledgeable investors, promoters who try to overprice won’t succeed.”

Another suggestion is to make the bankers more accountable. If the bankers are made to function as underwriters, too (which means that they will have to pay out the money for the unsubscribed portion of an issue), they are likely to be more circumspect about pricing. But this means that they will always opt for caution and the promoters will never get the best deal.

There are other suggestions floating around, which many consider unworkable. The State Bank of India (SBI) has suggested to Parliament that the agencies that currently rate IPOs should be allowed to give an independent view of the pricing. But market participants don’t think anyone will give pricing a second look in a bull market, when they aren’t likely even to read the IPO ratings. In a bear market, they are not going to be investing in IPOs, anyway.

Gupta of ISB says the critical phase is now. “Although there may have been signs of investor greed in the IPO process last year, investor fear may do more damage than investor greed.”

According to Haldea of Prime, public issues may reach Rs. 75,000 crore ($19.7 billion) in 2008, a new record. This includes Rs. 60,000 crore ($15.8 billion) of IPOs and Rs. 15,000 crore ($3.9 billion) in follow-on offers. The study was done before the market went into a decline. But with a recovery in sight, the figure is unlikely to change very much. Unless, of course, the bears win back the advantage.

Fear rules today, but it’s not clear for how long. “Everyone suffers from a memory loss,” says Ramu of Puravankara. “All the investors – and new ones – will be back.” Suchanti of Concept is a little more pessimistic. “I am going on a holiday,” he says.