IPOs - The Good, the Bad and the Ugly!

This Article was originally published in The Global Analyst

Primary markets the world over are buzzing with activity, driven by abundant liquidity, which in turn is led by massive stimulus programs raised by governments in major economies, notably the west, as well as investors’ quest for superir returns. However, there is word of caution: IPOs may not always turn out to be a winning bet, or so a string of negative or low listing gains shows

Bulls are busier than ever before, courtesy record Initial Public Offerings (IPOs) that have hit the global markets so far this year. On the back of robust liquidity, global primary markets hit a whopping $140 bn-mark in total capital raised, with 670 IPOs hitting the markets in the first five months of the year. For a record, this is the second largest amount raised via primary markets, after year 2000, and is four times bigger than the amount raised in 2020.

The Indian story is no different. Already, close to two dozen companies, or 22 to be precise, have mopped up nearly $2.5 bn in the first quarter of 2021, while another 20-odd companies are reportedly in the pipeline, having filed the Draft Red Herrings Prospectus (DRHP). Thirty private equity-backed companies are also planning exits.

While FY 2017-18 marked the highest, 2021 will probably eclipse the previous year going by the current trend. If global liquidity scenario is any indication, there is a lot of money floating around, some of which (may be a significant part of it) could find its way into emerging markets, notably India. The optimism stems from the sterling performances by the recent issuances in the Indian primary market, creating a frenzy which was unheard of so far. Given that, prospects of similar performances could see investors jump at every offering!

In the first five months of 2021, 17 firms hit the primary market. In contrast, only 15 firms raised funds via primary market issuances in whole of 2020. During both these years, financials dominated the proceedings. Besides, most IPOs were in the mid- and small-cap space, accounting for more than 95% of total issuances. Further, barring three (Kalyan Jewellers, Suryoday Small Finance Bank and Indian Railway Finance Corporation), all the other issues produced positive returns, ranging from a high of 292% (Nureca) to a low of 2.7% (Home First Finance).

Last year too proved to be equallyv good for the primary market, notwithstanding several-weeks long nationwide lockdown, with a majority of IPOs turning in handsome returns. In fact four of them even generated triple-digit return on listing.

This may lead one to believe IPOs are all about making some real quick gains. However, there is a word of caution: before considering investing in the primary market, one must keep in mind the following before taking the plunge:

Pricing and valuation: Unlike secondary market, where valuation is determined by market price through the interplay of demand and supply, IPO pricing is normally established through a book-building process by investment banks based on the feedback they get during roadshows. At best it is a guestimate and is aimed to extract the best value from investors. Of course, the need to walk to fine line in terms of optimally pricing the issue is always there. Huge oversubscriptions often indicate significant listing gains and viceversa. However, this may not always turn true.

Pro-cyclicality: As alluded before, primary market issuances peak during bull markets as the probability of success improves from an issuers point of view. Though it also makes it risky from investors’ standpoint. Promoters of bad business or promoters with bad intent can collude with investment banks to take advantage of bull market frenzy and can mop up money only to disappear a little while later. The Indian IPO landscape is laden with thousands of such stories.

Purpose: There can be multiple reasons for a promoter to take the company public. The often-cited reason is capex followed by working-capital needs. However, we also notice reduction of debt as another reason which can reduce interest burden and improve net income. However, exit of current investors/divestment can be a problematic reason.

Lottery: The biggest hurdle for retail investors, especially high net worth, is the upper limit of subscription at 2 lakhs per issue. For heavily subscribed issues, the allotment turns out to be a lottery. In my personal experience, many times I received four shares, while I may have applied for 200 shares. The strike rate can be so poor. While in percentage terms, the profit can be handsome, in absolute terms it can be so small that one is left wondering whether it is worth going through the hassle!

Information availability: Even for a listed company, research from analysts builds up only gradually. Till that point, the only source of information happens to be annual reports and quarterly updates, which mostly provide information after the fact. In the case of IPOs, information availability is even sparse, restricting our ability to take informed decision. We can only see what is shown, not necessarily what is required.

New asset classes: The arrival of Real Estate Investment Trusts (REITs) and Infrastructure Investment Trusts (InvITs) has changed the landscape of IPOs in India. However, these new asset classes have different risk-return profile compared to regular stocks. They are modelled more on the lines of predictable income distribution in the form of dividends and hence cannot be a capital appreciation play. Hence, investing in them during IPO is as good as investing in them say a year later.

IPOs or listed stocks? Take your call Suitably

As Indian stock market breached $3 tn in market cap (a landmark event indeed), IPOs have an important role to play. Be it the new digital India or the traditional basic chemicals industry, IPOs provide investment opportunities. However, for the size of the Indian economy or the stock market, the existing issuances are far and few. Hence, one can only expect more action in the years to come. However, given the lottery nature of allotment, it may not merit investor time and effort to subscribe during the IPO. For good issuances with solid business model, they are worth picking up in desired quantity post-issuance when they offer good entry points. But then, is that not true for all the other listed stocks that are traded regularly?

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