Borrowing to invest is a bad idea

Last week, when Adani Power got listed, Ritesh Shah was hoping for substantial gains on the first day itself. Reason: The issue had been subscribed 21.52 times.

However, a 5-8 per cent listing on the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) disappointed him, especially since he had availed himself of margin funding from his broker.

Worse still, the stock closed at Rs 100.05, barely above the price band of Rs 90-100. Next day, Shah exited the stock at a loss and paid back the broker.

"Investing in an initial public offer (IPO) with borrowed money is risky. Only a seasoned investor, who is clued on and has the resources to hold on or pay back the broker, should take such chances," said Amit Rathi, managing director, Anand Rathi.

Let's look at how IPO financing works. Typically meant for high networth individuals (HNIs), there are a couple of financing options, the most common being a brokerage house lending 80 per cent or even more. The process is popularly known as margin funding. The cost: 11-14 per cent annually.

Then there are banks, which offer you personal loans. Mostly retail investors use this route, in which interest rates are much higher–anywhere between 16 per cent and 24 per cent annually, sometimes even more.

Margin funding is calculated on a host of factors. These include expectations about oversubscription (the number of times the issue may be subscribed) and tentative listing price.

For instance, the margin for NHPC IPO was 5 per cent. Meaning, the lender was funding 95 per cent.

The borrower opens an account with the non-banking finance company (NBFC) of the brokerage house (brokerages use their NBFC arms for this kind of funding). Then the entire amount is transferred there and the application is made through this account.

"The investor benefits as the borrowed money helps garner more shares due to the bigger application size," said Manish Shah, head, business strategy and new initiatives, Motial Oswal.

However, there are pitfalls as well. Investors who avail themselves of margin funding are those who want to make a quick buck. Mostly, they want to book profits and exit on the day of listing. This could be a risky venture if the stock profile drops sharply. For instance, many investors lost money in the Reliance Power IPO in January last year. The allotment was made at Rs 450 a share. Stock prices, though, fell on the listing day itself by Rs 77.5, or 17.22 per cent, on BSE.

"If the issue is not subscribed as per expectations, the investor would end up with higher number of shares. This means more losses if things go wrong," said Devendra Nevgi, an investment expert.

And it is not just about the number of times the issue is subscribed. Adani Power had 13 anchor investors for the first time, including Credit Suisse, Sundaram BNP Paribas and T Rowe Price, who cannot exit the stock within the first month. Still, the listing was well-below market expectations.

Then, there are other uncertainties like the market mood. If sentiments turn negative between subscription and listing, there is nothing that any investor can do. In such circumstances, a leveraged investor can be badly hurt.

While a lot of HNIs play the margin funding game, retail investors should stay away from borrowing to invest. For one, the logistics are complicated and there are too many variables.

It is always better to either invest your own money or buy stocks after the listing. The first keeps you away from leveraging and the second allows you to gauge if the stock really has value.