QIBs and QIPs

Role of QIB (Qualified Institutional Buyer) in the Indian Capital Market for the last 6 years

A] Who are the Qualified Institutional Buyers?

Qualified Institutional Buyers (QIBs), as defined under sub-clause (v) of clause 2.2.2B of the SEBI (DIP) Guidelines, can be one of the following:
1. A Public Financial Institution as defined in Section 4-A of the Companies Act.
2. A Bank
3. FII (Foreign Institutional Investors) that are registered with SEBI
4. Development Financial Institutional, both multilateral and bilateral
5. VCF (Venture Capital Funds) registered with SEBI
6. SIDC (State Industrial Development Corporations)
7. Insurance Companies registered with the IRDA (Insurance Regulatory and Development Authority)
8. Provident and Pension Funds with minimum corpus of 25 crores.

Such QIBs shall not be promoters or related to promoters of the issuer, either directly or indirectly. Besides, QIBs cannot have either veto rights or the right to appoint any nominee director to the board because that would also be considered to be related to the promoter.

The QIBs (especially the Mutual Funds and FIIs) play a very important role in the stock price movements. QIBs play an important role by bringing in the necessary funds needed by the equity stock market. The FIIs, though volatile and essentially market driven, facilitate significantly to the foreign funds inflow. QIBs are generally believed to bring in more efficiency and liquidity in the system.


B] Changes brought in by SEBI that impacted QIB role in the recent years

Earlier, in the book building route for public issue, 50% was reserved for QIBs, 15% for HNI and 35% for Retail investors. Even without this reservation for QIBs, the merchant bankers had the discretion alot shares to QIBs in any manner they liked. SEBI brought about the following major changes in the Primary Market in the last 6 years which impacted the role of QIBs in a big way:

(a) QIBs now have to bid with margin money of 10% of the application value of the issue. Earlier they did not have to give any margin money. This was an attempt to discourage manipulation of issue oversubscription by forming a cartel of QIBs.
(b) The merchant banks’ discretionary quota to the QIB is done away with. The allotment of the shares to the QIB will be on a proportionate basis.
(c) Mutual funds get at least 5% of the overall 50% reservation for QIBs.
(d) All listed companies must have a minimum public holding of 25% of its shares on a continuous basis.
All these changes are for the benefit of the small investor and improve liquidity of the stocks.


C] QIBs and price discovery – How effective were the QIB in discovering a realistic price in recent years?

QIBs are those who have the financial muscle and necessary expertise to make informed investment decisions. QIBs are expected to play an important role in the price discovery in the book-building mechanism. Theoretically, the QIBs can sober down the prices of the issue to realistic levels but practically, that seldom happens as seen by the recent bursting of the IPO bubble. The companies were quoting a hefty premium over similar stocks in the secondary market but the QIBs had little choice. If they wanted to participate in the offer, they had to do so in the exorbitant price band range dictated by the company and because of excess liquidity in the market and stiff competition, they generally bid at the upper end of the price band, thereby debunking the theory of book-building resulting in real price discovery. So, in reality, the QIBs did nothing to sober the prices of the fresh issues during the IPO bubble.

D] QIB vs the Retail Investors in the last 6 years

An article in Economic Times (4th Jan, 2007) [8], using the data for the last couple of months during that period, mentions that in IPOs, where QIBs are entitled for upto 50% of the issue size, gets subscribed upto 28 times while the retail portion gets subscribed for only upto 6 times on an average. Companies like to share forward-looking sensitive information with the QIBs which is typically not available to retail investors (they mostly rely on the company grading) which gives these QIBs a clear advantage over the retail investors. Also, the retail investors generally look at the subscription levels of the QIB portion of the offer to get an idea about the image of the company in the market. The SEBI guidelines amendment in September 2005 allowed at least 5% of the QIB’s reserved portion to go to Mutual Funds which gave an opportunity for the retail investor to get a bigger share of the pie through the Mutual Funds.




The state of the QIP (Qualified Institutional Placement) since it’s inception in 2006

QIPs are a quick and cost effective method of raising funds by way of private placement of securities or convertible bonds with QIBs. Before the introduction of Chapter XIII -A in the SEBI DIP Guidelines, an Indian listed company intending to raise further capital from the public markets in India had the option of doing so by offering securities through a follow-on public offering or preferential allotments. In May, 2006, SEBI came out with it’s guidelines for raising funds through the QIP route. Since then, a lot many companies have gone this route.

The intention of SEBI behind allowing QIP Scheme, is to promote the domestic private placement which is generally considered to have two prime advantages over FCCBs (Foreign Currency Convertible Bonds) and GDRs (Global Depository Receipts), i.e. keeping liquidity in the same market and faster way to get approvals. Through QIP guidelines, SEBI has opened a window for Indian companies to raise funds domestically instead of exporting the private placement market out of India. QIP has certainly emerged as a preferred instrument for entities to raise funds as it involves lesser disclosures and does not require a pre-issue filing with SEBI. Sebi guidelines say only QIBs can participate in QIPs.


A] QIP providing a level playing field.

These new guidelines have been hailed as a significant step for the Indian Capital Market. Through QIP, the equity private placement markets are expected to come onshore. Also, the Indian Mutual Funds – who are becoming comparable to FIIs, will get an opportunity to participate in these issuances. These guidelines are likely to create a more level playing field and removed a substantial aberration from the marketplace [1].

B] QIP and it’s impact on Retail Investor

The view that the QIP has made the primary market out of bounds for the retail investors by allowing only the QIBs to participate in it has been doing the rounds for quite some time now. The Retail investor share in an IPO process is typically 35% and QIP route dictates that potentially no portion of the follow-up issue reaches the retail investor directly because it bypasses them altogether. Indirectly though, the retails investor can participate in QIP through Mutual funds.

C] QIP vs Preferential Issue

As compared to a preferential issue, a QIP does not involve a lock-in and hence it offers an opportunity for liquidity, if an investor wants to exit.


D] QIPs in the US vs in India – Key differences [2]

US Securities & Exchange Commission’s (SEC) Rule 144A (came into effect in 1990) is for the QIP in the US while the SEBI’s QIP Scheme is for the Indian Capital Market. The intention of both regulations is to encourage private placements in the domestic markets of the US and India, respectively.

There are some key differences between the SEC’s QIP and the SEBI QIP Scheme such as the SEBI pricing guidelines and the US rule that a private placement under Rule 144A must be a resale and not a direct issue by the issuer. Under Rule 144A, transactions must actually involve an initial sale from the issuer to the underwriter and then a resale from the underwriters to the QIBs. A QIB is defined under Rule 144A as having investment discretion of at least $100 million and includes institutions such as insurance agencies, investment companies, banks, etc.

In addition, the target audience of both regulations is different -while the impetus behind Rule 144A was to encourage non-US issuers to undertake US private placements, the impetus behind the SEBI QIP Scheme was to encourage domestic Indian issuers to undertake domestic Indian private placements.

E] Key features of QIP
Pursuant to the QIP Scheme, the Securities may be issued by the issuer at a price that shall be no lower than the higher of the average of the weekly high and low of the closing prices of the related shares quoted on the stock exchange (i) during the preceding six months; or (ii) the preceding two weeks.
The issuing company may issue the Securities only on the basis of a placement document and a merchant banker needs to be appointed for such purpose. There are certain obligations which are to be undertaken by the merchant banker.
The minimum number of QIP allottees shall not be less than two when the aggregate issue size is less than or equal to Rs 250 crore; and not less than five, where the issue size is greater than Rs 250 crore. However, no single allottee shall be allotted more than 50 per cent of the aggregate issue size.
The aggregate of proposed placement under the QIP Scheme and all previous placements made in the same financial year by the company shall not exceed five times the net worth of the issuer as per the audited balance sheet of the previous financial year.
The Securities allotted pursuant to the QIP Scheme shall not be sold by the allottees for a period of one year from the date of allotment, except on a recognized stock exchange. This provision allows the allottees an exit mechanism on the stock exchange without having to wait for a minimum period of one year, which would have been the lock–in period had they subscribed to such shares pursuant to a preferential allotment.
Companies should be listed at least for a year to be eligible for making qualified institutional placement, according to the SEBI's new guidelines.

QIP shall be managed by a SEBI registered merchant banker who shall exercise due diligence and furnish a due diligence certificate to Stock Exchanges stating that the issue complies with all the relevant requirements. The merchant banker shall file a copy of the placement document and post issue details with SEBI within thirty days of the allotment, for record purpose.

Offering of securities through QIP is a Private Placement. As per Section 67(3) of the Companies Act, 1956 we cannot make offer to more than 49 Investors under the private placement. It means that we cannot issue an offer document inviting for subscription under the QIP placement to more than 49 Investors.

Each placement of the specified securities issued through QIP shall be on private placement basis, in compliance with the requirements of first proviso to clause (a) of sub-section (3) of Section 67 of the Companies Act, 1956. A minimum of 10% of the securities in each placement shall be allotted to Mutual Funds. For each placement, there shall be at least two allottees for an issue of size up to Rs.250 crores and at least five allottees for an issue size in excess of Rs.250 crores. Further, no single allottee shall be allotted in excess of 50 per cent of the issue size. Investors shall not be allowed to withdraw their bids / applications after closure of the issue.

The aggregate funds that can be raised through QIPs in one financial year shall not exceed five times of the net worth of the issuer at the end of its previous financial year.

Issuer shall prepare a placement document containing all the relevant and material disclosures. There will be no pre-issue filing of the placement document with SEBI. The placement document will be placed on the websites of the Stock Exchanges and the issuer, with appropriate disclaimer to the effect that the placement is meant only for QIBs on private placement basis and is not an offer to the public.

The floor price of the specified securities shall be determined on a basis similar to that for GDR / FCCB issues and shall be subject to adjustment in case of corporate actions such as stock splits, rights issue, bonus issue etc.


F] Some examples of QIP

Spentex Industries Ltd was the first QIP after the SEBI Guidelines came in May. Edelweiss managed the QIP and it was to the tune of 46.6 crores for which 75 lakh equity shares were issued to the QIBs. Sundaram Mutual Fund was the main Indian QIB subscribing to this share among some other FIIs, mainly from Mauritius.

Mahindra Gesco Developers Ltd., (MGDL) one of India's leading real estate and infrastructure developers closed its $105 million Qualified Institutional Placement (QIP), one of India's largest QIP under the new Securities Exchange Board of India's (SEBI) regulations [4].

Rs 23,400 cr were mopped up thru QIP route (41 QIPs were done in this year) in 2007 while this was 3,935.45 crore in 2006 (Only 16 QIPs were done in this year) [7]. GMR Infrastructure and Suzlon Energy, India Inc were some of the big names going for the QIP route for raising capital.


References
1. http://www.blonnet.com/2006/08/27/stories/2006082703260200.htm
2. http://www.vccircle.com/2006/12/29/legal-guest-column-demystifying-qips/
3. http://www.sebi.gov.in/circulars/2006/dipcir0506.html
4. http://www.indiaenews.com/business/20061005/24971.htm
5. http://www.businessstandard.com/common/news_article.phpleftnm=10&bKeyFlag=BO&autono=312002
6. http://www.sebi.gov.in/faq/pubissuefaq.pdf
7. http://www.blonnet.com/2008/01/06/stories/2008010651040300.htm
8. http://www.mahindrafinance.com/media/pdf_press_reports/report07_0008.pdf

Leaving Money on the Table – Good or Bad for the IPO?

What is “Money on the Table” for an IPO?

On an average, the IPOs (Initial Public Offerings) worldwide are underpriced and the underpricing is typically referred to as “Leaving Money on the Table”. The term comes from the game of Poker where a player, despite having a better hand, is bluffed by the opponent into folding the cards and thereby loosing the pot of money on the table.

Leaving money on the table has negative connotations carrying the import of a deal that is less financially beneficial than expected or possible. Most IPOs are underpriced, thereby leaving huge sums of money on the table[1].

Fixed Price offerings used to suffer from underpricing on an average and book-building mechanism of price discovery of IPOs was touted to address this problem. But evidence shows that even book-building results in a lot of money left on the table, leading to underachievement of price discovery mechanism. A lot of studies have been undertaken to understand the underpricing and it’s still a hot topic.

Underpricing – Deliberate loss or unintended heartburn

An underpriced IPO means that the firm and pre-IPO shareholders are shortchanged as they are getting less money for the offer than they actually deserved. Various studies show that pre-liberalization; the underpricing was more than 100% and post-liberalization, even after reduction, its still around 80% on an average which means that firms are loosing on a lot of money in IPOs on account of this imperfect price discovery. Some firms like Google[2], adopted Dutch auction path for better price discovery, thereby leaving less money on the table; but not many firms are willing to go that path. Is underpricing really bad? And why is it that pre-IPO shareholder aren’t so upset about it? This is a real puzzle regarding IPOs which this article will try to analyze.

The first question to ask here is why do people make a beeline towards the IPOs? They obviously expect a lot of money left on the table which they can profit from by first buying the shares at lower price in IPO and then selling them at higher price in the first couple of days when the stock hits the market. The underwriters frequently underprice the IPOs to help the big investors in this fashion.

Figure 1: Indian Stock Market - Levels of Underpricing evident from the performance of IPOs

Most studies of the Indian stock market confirm that on an average, the underpricing of IPOs in Indian stock markets has been higher than what we see abroad[3]. A study by Arwah shows that from a sample of 1357 IPOs declared on BSE over a period of 1989-95, 4.5% of shares were fairly priced, 10% were overpriced while whopping 85.5% were underpriced! But the report also shows that after SEBI took over the regulatory role for IPOs, in the post-liberalization era, there has been a fall in the returns to around 80% levels which is still pretty huge.

So, it’s not difficult to see why IPOs are hot amongst new and old investors that are willing to sell the stock in a very short time frame. But what happens to the long term investors and the firm itself? Aren’t they loosing money as well as control by the way of underpriced IPO? What about the underwriters, who too, loose good profits if they underprice the issue? Moreover, the firms are not getting long-term investors but greedy profiteers with leveraged positions[4] which results in fast selling leading to wild price swings in the stock price during the initial days. Considerable research has been undertaken to explain why underpricing is not necessarily a bad thing for the all the players involved.

Studies say, that managers and long-term owners of the firm not only look at the shares that they are selling in the IPO, but also the shares that they retain. In case of underpricing, the shares that they retain give a quantum jump to their wealth. Underpricing serves two fundamental purposes. The actual price of the IPO shares is generally held by some large institutional investors. Underpricing is the cost that IPO issuers pay to extract this information from underwriters and institutional investors through the book-building process. This is the “Information Extraction Theory” of underpricing as suggested by Benveniste and Spindt’s 1989 study of IPOs. Underpricing is also employed to attract the uninformed investor to participate in the IPO offer for better price discovery.

Theory and Reality bears out advantages of underpricing

Apart from the theory of Information Extraction, there are some other prominent theories that explain underpricing and bring out its advantages.

Allen and Faulhaber, in their Signaling Hypothesis theory (1989), tried to explain underpricing by suggesting that good firms like to convey their better future prospects to investors by underpricing and allowing investors to make good profit from their stock. This increases the chances of those investors paying a higher price in future offerings[5] and the underwriter getting more business in future.

Another reason for underpricing is protecting the reputation of the players by playing safe. Study by Huges and Thakor (1992) confirm this theory. If the stock price immediately falls after IPO issue, it harms the reputation of merchant bankers and underwriters alike and may also invite legal and regulatory scanning of the IPO issue. To avoid this risk, underwriters deliberately underprice the issue. Recent example of this is Empee Distilleries while an earlier similar example is Bharti Televenture IPO. The price of both stocks went down after listing and the reputation of people involved in the IPO got a severe beating. Mutual funds exposed to those stocks had to go public, explaining reasons for their investment in these stocks.

A firm gains not only from the share price at the time of IPO but also from increased volumes of trading that happens long after the IPO is over. Loughran and Litter (2003) suggested the Prospect Theory of underpricing. They tried to explain underpricing by showing that the firm’s owners expect the prospect of higher trading price when they go for heavy underpricing, resulting in an increase of their wealth. Hopefully, this increase offsets the losses that they might have incurred due to underpricing. It encourages after-market trading as well as benefits the owners for a longer duration[6].

There is another, more subtle, reason for underpricing. In his study, Sherman (2005) attributes the preference of book-building over auction to the perception that book-building is less risky[7]. The fallout of the book-building process is underpricing as per Information Extraction Theory. So, it’s the price-discovery model that is dictating the underpricing, leading to a scramble for allotment that we see in the Indian stock market, with most IPOs being oversubscribed.

Now how can the firms prevent the insider trading on the launch of the IPO so that price of the shares does not take a southward dip? One way is to enter into lock-up contracts with the underwriters, insiders and big investors so that the insiders and investors can’t sell the stock within a stipulated period of time[8] and don’t indulge into flipping of IPO shares. This mechanism merely delays the inevitable i.e. when the lock-up period expires, there is likely to be downward pressure on the stock. But at least it makes the big investors think slightly long-term and stay invested in the firm for a longer period rather than walking away by picking the money left on the table as soon as possible. This helps the firm and the already existing long-term investors.

The underwriters also gain from underpricing in two ways. They can easily find big investors without incurring huge marketing costs and their brokerage arm can negotiate higher commissions from these big investors. Also, oversubscription often results in exercising the “Green Shoe” option by the underwriters which means that already an overallotment of upto 15% of original number of shares offered. This implies that due to this overallotment, the underwriters get a larger fee since a larger number of shares are involved.

Conclusion – Money on the table good for long-term health of the IPO

Keeping all these theoretical aspects in mind with corroborating real-world evidence, we can safely conclude that underpricing the IPO is beneficial for the firm and existing shareholder in the long-term. It certainly pays not to be greedy for short-term and leave something on the table for the investors.

Also, when the demand is likely to be higher, owners of the firms leave more money on the table in the hope that this will give them more gains by way of increase of their wealth long-term via their holdings in the firm than the immediate loss through underpricing. In case demand is likely to be sluggish, they negotiate aggressively on the price and leave little money on the table.

The underwriters gain indirectly from the underpricing by way of saving marketing costs and increased commissions. The retail investors anyway benefit from underpricing and carry a good impression about the company which the firm can encash in future issues. Hence overall, it seems that IPO underpricing is not necessarily a bad thing and there are certainly some not-so-obvious gains from being charitable and leaving money on the table.

Additional Notes as Cited in the blog:
[1] Money Left on the Table = Nos of Shares Issued * (First Day Market Price – IPO Offer Price)
[2] Google’s IPO was perhaps the most hyped IPO to go the Dutch auction way despite the real risk of undersubscription, where every bidder was treated with equality and no special preference was given to institutional investors. Some of the important objectives of going the Dutch auction way were: (i) avoid leaving any money on the table, (ii) get the maximum possible price of their shares from the market and (iii) get a larger number of quality retail investors who wish to stay invested long-term. Google was quite successful in all these objectives with its IPO.

[3] Indian Stock Market is different from stock market in most other countries, including US, in the sense that comparatively, a large number of retail investors (at least 25%) participate in the IPO price discovery as primarily uninformed investors.
[4] People with leveraged positions are those who are buying shares with borrowed money, in the hope of selling them soon enough, booking profits and repaying the borrowed amount.
[5] Oversubscription of IPO is not a very credible signal of underpricing but is a strong signal neverthless. This has been borne out in a study by Pande Alok and Vaidyanathan R where they considered 55 IPOs listed on NSE in the 2004-06 timeframe.
[6] There is some kind of corruption involved here as hinted in the Prospect Theory. The managers typically get the ownership of a lot of shares in the IPO and directly gain from underpricing. Because of this, they end up promoting the practice of underpricing.
[7] Auctions run the risk of undersubscription while book-building ensures enough informed investors participating in price discovery. Google was able to survive the auction path because it was a well known brand name at the time of IPO.
[8] Minimum duration is 90 days and no ceiling on the limit.

Introduction

The name is Vikrant Khanna. Software engineer, currently working for a MNC in Noida, India. Mail me at vkhanna07@gmail.com