Several initial public offerings (IPOs) made their debut in the secondary market at dizzying prices in 2019. More than 20 primary market issues are lined up for 2020, including the SBI Cards IPO and UTI Asset Management Co. IPO.
One investor segment that has shown a lot of interest in IPOs recently is non-institutional investors (NII) that include high net-worth individuals (HNIs). For instance, in the IRCTC Ltd issue, which was open from 30 September to 3 October, the retail portion was subscribed 14.4 times even as the NII segment was subscribed 354.5 times. It listed at a price of ₹644 on 14 October 2019 against an issue price of ₹320, a 101% premium. Similarly, the Ujjivan Small Finance Bank Ltd issue was subscribed 473 times in the NII segment compared to 49 times in the retail segment. The share listed on the stock exchange at ₹58 against an issue price of ₹37, a 57% premium.
Does the large subscription number and application amount translate into greater gains for HNIs?
The HNI strategy is to take advantage of the steep premium that such shares see on listing. To make the most of the opportunity, investors look at leveraging, or in simple words they borrow to apply and sell immediately on listing, to give their short-term returns a boost.
The high subscription seen in the HNI or NII segment is explained by the process of allotment. Unlike the retail segment where the allotment is made in such a way that all valid applicants get at least one market lot as far possible, allotment in the NII segment is done on a proportionate allotment basis and depends upon the extent of subscription in that segment. For example, in the CSB Bank Ltd issue in which the HNI portion was subscribed 164 times, the investors would have had to apply for 18,000 shares to receive an allotment of 110 shares—the shares applied for (18,000) divided by the subscription number (164) gives the approximate allotment (110) that the investor is likely to get. The higher the subscription in the segment, the greater is the application amount. In the CSB issue, this meant an outlay of ₹35 lakh for an allotment of 110 shares.
NBFCs such as Sharekhan BNP Paribas, JM Financial and Aditya Birla Finance provide funding for IPO application. The investor contributes the specified margin and the rest is funded by the NBFC providing the IPO funding facility.
The investor has to pay interest on the entire amount of funding, irrespective of the shares actually allotted, for the period from the date of application to allotment. Once the allotment is known, the extent of unutilized funds for shares not allotted are returned to the lender.
The loan amount on shares actually allotted, if applicable, will attract interest till the shares are listed, sold and the amount due returned to the lender. “The margin is around 1% and the period of funding is for seven days. The interest cost varies depending upon the prevalent interest rates in the market at which the financier is able to raise funds," said Shankar Vailaya, CEO, Sharekhan BNP Paribas Financial Services Ltd. Typically, investors make the application on the last day when there is greater clarity on the subscription number and limit the period for which funding is taken.
Investors can gain from the leveraging when there is a combination of high allotment and good premium on listing. But if these two don’t materialize, then the returns may be lower than expected and sometimes even lead to a loss because the break-even price for an investor who has taken funding will be higher on account of the interest paid. “HNIs assess the likely gains on listing, the extent of subscription and interest costs before making the bid. This determines whether they make or lose money. While the first two are unknown at the time of making the application, the interest cost is known," said Vailaya.
When the subscription in this segment of an IPO is very high, the number of shares allotted will be lower and, therefore, increase the funding cost that each alloted share has to bare. This limits the gain to the investor. The same will hold true if the listing price is not high enough. The percentage of gain or loss made is magnified by the leverage.
Consider an investor who applied for 18,000 shares in the CSB issue and was allotted 110 shares. The investor uses IPO funding to make the application and incurs an interest cost of ₹5,343 at 8% for seven days, an additional cost of ₹48.57 per share alloted. Given this cost, the shares have to list at a price of ₹243.57 (issue price of ₹195 plus interest cost of ₹48.57) for the investor to break even. At a lower listing price, the investor makes a loss. The shares listed at a price of ₹307 on 4 December 2019; at this price, the HNI investor would have made a return on investment of 19.80% after considering the funding costs even though the shares listed at a 57% premium over the offer price of ₹195.
Keep in mind
Investors should be wary of leveraging just on the basis of listing prices that issues have seen in the past without analyzing other factors. When subscription is of the magnitude that has been seen in recent popular IPOs, the chances of allotment are lower.
Higher gains from leveraging works in an issue that sees moderate subscription since the allotment will be higher and the break-even price will come down since the interest costs are spread over a larger number of shares allotted. Issues where the pricing is seen as conservative relative to the valuation of shares stand a chance of being listed on a higher price. The listing price also depends on the general market conditions.
While most HNIs exit on listing, some investors take a view on the prospects of the company and may choose to hold on. The funding obligations have to be settled through other means if they choose to stay invested.