IPOs in search of Alpha?

Equity investing is the new gold rush. Or has been ever since BJP came to power in 2014.

Market’s thrive on volatility. Punters love it. Clueless commoners loathe it.

One profits from the others fear. The other is devoured by the one’s greed.

Modi’s BJP provides an endless supply of volatility, through systemic jolts to the economy (demonetisation, GST, LTCG on equity), and socio-political acts borne of intolerance that nevertheless vitiate the economic climate (harassing NGOs over origin of funds, steamrolling environmental objections to infrastructure projects, eroding the autonomy of national institutions, viz, the judiciary – meddling in the collegium for appointments--, and the central bank – vicious attacks on governors who did not tow the FM’s line on demonetization and rate cuts).

An environment where equity MFs have generated wealth for investors up unto 2017, fueled a new found belief in the market’s potential. SIP investments continue undeterred, although MF returns have suffered by comparison in the past two years.

In search of ‘alpha’ (market beating) returns, the ambitious retail or high-net worth individual turns to primary market offerings, aka IPOs. But can IPOs lead to wealth creation for the common man, or even the HNI?

Let’s explore the subject using the Rs 750-crore IPO of Ujjivan Small Finance Bank (USFB), which was over-subscribed by 165.6 times on average, by the third and final day of the IPO (Wed, 4th December 2019).

The retail investors portion (10%), was subscribed 48.67 times.

The non-institutional investors (NII) portion (15%) -- including HNIs-- was oversubscribed 473 times.

The qualified institutional buyers portion (75%) was oversubscribed 110.7 times.

Applications were constrained by a lot size and increment tick of 400 shares, at an issue price of Rs 37.

Retail segment customers are also constrained by a SEBI mandated maximum application value of Rs 2 lakh. That makes for a maximum application size of 13 lots ( 200,000 / (400 * 37)).

However, due to retail segment over-subscription, actual allotment is limited to a single lot, per SEBI’s mandate to accommodate the largest pool of retail customers. And that, by lottery system. Which means even assuming the share price jumps 50% (to Rs 55) on listing day, and you win the single lot lottery, your profit on selling one lot is just Rs 7200 (Rs 18 * 400).

Nope, an oversubscribed IPO doesn’t generate wealth for the retail customer.

There exists an unofficial gray-market for IPO shares. A gray-market premium indicates high demand for an IPO, and could correlate to listing day gains. Being an un-regulated market it comes with high counter-party risks, but is used as a sounding board by HNIs for investing in an IPO.

The HNI portion of an IPO sees allotment on a proportional basis. That is if the issue is over-subscribed 400 times, for every 400 shares applied, a single share will be allotted. With the knowledge of gray-market premium (which in Ujjivan SFB’s case was 50%), an HNI will commonly raise a bridge loan from his broker at a low rate of interest, for a large sum, say 1 crore, and that too on the last day of the issue. That lets him apply for 675 lots (675 * 400 * 37). However, in the end with an issue that is 400 times oversubscribed, he is allotted a single lot (1 share for every 400, makes for less than two lots of 800). Not much to make in this scenario either.

All in all, IPOs don’t seem to be major wealth creators for anyone, save sovereign funds and domestic institutional investors (AMCs) that invest in the pre-IPO phase as anchor investors to the issue.

A related issue is the viability of an IPO from a pricing and profitability point of view. An initial offer by a first time offer is likely to be much more reasonably priced than an Offer For Sale (OFS).

The former is usually to raise capital for business expansion or service debt. The latter is usually a way for Private Equity (PE) investors to cash-in on their investments in the company. And the PEs are usually marquee VC brands.

Take the example of the planned SBI Card IPO, which is an OFS by it’s PE investors. Do you think their focus would be to reasonably price the IPO for retail or on making a good return on their investment?

In the case of Ujjivan SFB, the mandate was a dilution of promoter holding (courtesy RBI), and the intended use is for Tier 1 capital adequacy augmentation of the microfinance bank. The upper band of Rs 37 was at a premium of 2.5 times to the book value (2.5 * P/BV) for 2019). Many brokerage houses hailed this as reasonable, due to potential for growth, and that explains the oversubscription and gray-market premium. But like I said earlier, IPOs are not really a wealth generator unless you're a QIB.

Caveat emptor. This is not an authoritative piece, and is basis my layman's research on IPOs as investment tools. That said, my understanding (and the math) could be faulty, and I welcome constructive criticism.