The Great Indian IPO Gamble: Regulators Could Do More To Curb The Froth In The Primary Market

Starting financial year 2023, India's stockmarket regulator SEBI overhauled the allotment rules for high networth individuals (HNIs) when they applied for shares from companies’ Initial Public Offerings (IPOs). Shifting away from the pro-rata allocation system, where shares were distributed based on the amount staked by HNIs, SEBI introduced a flat allocation of shares worth Rs 10 lakh for applicants chosen via a lottery system. Additionally, the HNI category was bifurcated into ‘small HNIs’ (entitled to 1/3rd of the total shares otherwise reserved for HNIs) and ‘big HNIs’. The former were eligible for a lottery-determined allocation of Rs 2 lakh worth of shares, whilst the latter could similarly get Rs 10 lakh's worth.

In another move related to IPOs, the RBI capped the lending that NBFCs could extend to HNIs for their IPO share bids at Rs 1 crore, a significant change from the previous situation of short-term loans worth hundreds of crores. RBI's move was aimed at curbing the excessively exuberant bids for IPO shares among HNIs, with oversubscription ratios in IPOs often topping 500.

SEBI Chairperson Madhabi Puri Buch revealed in December 2023 that the earlier pro-rata allocation system for HNIs had impeded genuine price discovery of an IPO's shares. The HNI quotas were often oversubscribed by several hundred times, since investors anticipated receiving at least one lot of shares through pro-rata allocation, even if they did not get the several hundred that their bid amounts indicated. The publicly reported oversubscription rates in an IPO’s open period also functioned like a miniature stock exchange, attracting further bids for shares as the 3 typical days of an open IPO issue rolled by.

While the lottery allocation rule has certainly curbed extreme oversubscription, IPOs still witness high demand, and are often oversubscribed by several multiples of 10. Yet, as Buch noted, “it is a free country”, begging the question as to why speculation in IPOs is attractive and almost systemic. Reports suggest that 25 per cent of HNI applications continue to be backed by leverage, with the saving grace that - due to the lottery allocation - big-HNIs' bids now stand uniformly at Rs 10 lakh and no more.

The Economics Remain Enticing

Even at a 24 per cent annual interest rate, a mere Rs 4,000 serves as the entry ticket to participate in this IPO lottery by borrowing Rs 8 lakhs and bidding as a big-HNI within a pool where more shares are available. What is the prize though ? The ‘grey market premium’ (GMP) – the anticipated listing day gains, exemplified by the 80 per cent premium for Tata Technologies’ November 2023 issue.

The 62x oversubscription in the big-HNI segment for this IPO translated to a 1.6 per cent chance of being allotted shares which could yield Rs 8 lakh on the listing day, and could also be retained by the HNI for further appreciation. In several IPOs, the GMP could pleasantly surprise as well, as evidenced by the same IPO where the metric topped out at 80 per cent just prior to listing day, but the premium that IPO investors could demand reached 140 per cent on that day.

The practice of 'flipping', or selling shares off on listing day or immediately after, is also all too common: 3/4ths of HNIs offloaded within the first month as per SEBI figures (the fraction selling in the first week is only slightly lower).

Anecdotal evidence suggests that HNIs now employ multiple PANs, including close family and trusts, to maximize their chances of being allotted shares. This potentially increases their allocation odds in a blockbuster IPO from a meagre 1-2 per cent to a respectable 8-10per cent. However, since the beneficial owner of shares remains the same HNI, the RBI could curb this froth further and tighten the IPO financing cap down to a modest Rs 6 lakhs: i.e. a loan-to-value ratio of 60 per cent for any subscriber who wants to participate and bag share allocations in the big-HNI pool.

The GMP’s reliability as a signal is complicated by the involvement of Qualified Institutional Buyers (QIBs), a category of sophisticated bidders whose allocation in an IPO continues to be pro rata. QIBs often overbid to maintain the chance of receiving a given block of shares that their portfolio calculations have targeted.

This way, these ratios unwittingly distort price discovery for HNIs and retail investors via the unofficial GMP signal. For instance, the QIB oversubscription in Tata Technologies stood at a staggering 203 times (much more than HNIs). Though the shares acquired make for only a small fraction of a QIB’s portfolio, listing day gains are also a bonus to a QIB's fund managers for whom the broader stock index is a benchmark.

Must Be Wary

Regulators should also note that Lead managers of IPOs are big financial institutions relying on a stream of brokerage commissions from QIBs or investment banking income from the IPO firm's group companies. These lead managers have an incentive to “leave more on the table” so that the share price appreciates over a longer horizon in the secondary market rather than merely on listing day. Super-QIBs known as ‘anchor investors’ are allotted a large fraction of the shares reserved for QIBs, typically 50 per cent.

Anchors are obliged to not sell within 30 days of listing, a deadline that has been further elongated to 90 days (for part of the parcel) by SEBI in the new rules. Hence the lead manager's incentive to ensure that share prices stay high within the most-watched period of an IPO: the first 3 to 6 months. JP Morgan, which settled with the US SEC in 2003 and again in 2006 for related transgressions, had allegedly obtained assurances from institutional investors that they will purchase stock in the secondary market - to buoy its share price - in lieu of allotments in an IPO for which there was heavy competition. Closer home, it took 6 months to discover that a lead manager allotted an NCD IPO (i.e. an IPO of a debt instrument, albeit not shares) to individuals who were its own NBFC's borrowers.

Notably, a QIB deploys its cash-on-hand, or any short-term loans it has taken, as the blocked amount for an IPO, which in turn is several times the QIB's desired number of shares. The simultaneous submission of bid amounts by QIBs, HNIs, and retail investors blocks an amount in the banking system, especially during a period which hosts concurrent IPOs. The Tata Technologies IPO in November 2023 coincided with four other IPOs, resulting in bids totaling Rs 2.5 lakh crore.

RBI has in the past organized liquidity infusions (called VRRs) for reported deficits of Rs 1-1.5 lakh crore in the banking system. While banks are smart enough to realise that not all blocked IPO amounts are frozen liquidity, the aggregate sum that gets blocked is still notably high. A mutual fund ratings chief also pointed to the contrast that the staked sum for these five concurrent IPOs equaled a full two years of mutual fund SIP inflows.

There is also a structural difference in Indian IPO allocations: a recent high-profile US listing, the semiconductor design firm ARM, was 10x oversubscribed. Compare this with India where top issues are very likely to exceed 50x oversubscription even in the new SEBI regime.

The difference may lie in the share allocation scheme: In the US, IPO broker-dealers - entities who obtain a block of the shares from the lead manager of the issue - are permitted their own prioritization schemes to further divide this block among the customers who hold share accounts with them. There is risk of reputational harm for these broker-dealers if they signal an IPO as ‘premium members only’ as a matter of hype, yet the shares tank at listing or soon after.

More red flags emerged in the US in late 2022, when the self-regulatory organization FINRA scrutinized small-scale IPO issuers raising less than $25 million. Many of the firms issuing IPOs had operations in China, and their shares had been cornered by a handful of investor accounts in pump-and-dump schemes to manipulate the share price.

Surprisingly, though the pattern was detected, the IPO rules remained practically unchanged though lead managers were to put on the hook for possible allotment of shares to any suspicious investor accounts. Research outside India has found that lead managers of IPOs use their information advantage to both price and allocate shares to favored 'pre-IPO' investors, anchor investors or HNIs.

Market watchers comment on the possibility of this in jurisidictions where the roadshow process of an IPO is relatively unmonitored, e.g. India. The lead managers may also support the IPO’s share price by allocating a large fraction to their own family of mutual funds. Indeed, even in an advanced economy like the US, the record on IPOs is sobering: while average listing day gains were a spectacular 70per cent, there is a gradual 50per cent reduction from that high price over four years, indicating value destruction for those tempted to buy an IPO's shares on listing day.

As India’s IPO market continues to evolve, the regulatory overhaul of allotment rules and the attempts to curb excessive speculation are yielding results. While measures like lottery allocations and lending caps have reined in some of the frenzied bidding, the question remains as to how even a lottery allocation is consistent with true price discovery.

The involvement of sophisticated players like QIBs and potential conflicts of interest among lead managers demand scrutiny, especially in a primary market that is often swamped with IPO issues. Ultimately, fostering transparency, minimising manipulation, and aligning incentives will be crucial to sustaining investor confidence and ensuring the long-term health of both the primary  and secondary markets. The idea is to strike the right balance between enabling access and preventing excess.

(Views expressed here are personal. Mohammed Shahid Abdulla is faculty member at IIM Kozhikode. Manoshij Banerjee is an independent consultant on digital culture and workplace)