Fault lines in the Indian IPO market

Our current stock market is a study in contrasts and contradictions. As a nation we save around 34 per cent of our disposable income -- much more than most of the developing economies except Malaysia that has a comparable rate and China where the aggregate marginal propensity to save exceeds 50 per cent.

The European Union has a rate that hovers around 11 per cent. The savings rate of the UK is only two per cent.

But despite our high savings rate, which is contributed largely by the household sector, only half of it goes into financial savings like cash, bank deposits, small savings, provident and pension funds, LIC and private sector insurance premium.

Only a minuscule part of it goes in shares and debentures and the other half into physical assets like gold and land.

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There may be marginal shifts in the structure of the investment patterns of financial savings over the years, but the share of the stocks and debentures in the household sector's financial savings has not improved to more than five per #162 if at all, it has worsened. This is where the contradiction lies.

We boast of a "vibrant" stock market. We look for the sustained growth of our stock market indices, take pride in how the stock market is growing wealth and churning out billionaires.

Pessimism engulfs us when the indices are on a slippery slope, we yearn for foreign portfolio flows and when the tap shows signs of drying up because of global imbalances in capital flows, we rush to take measures in the hope that the flows are sustained.

At one time not many years ago, our stock market was a single product market, trading only in equities with an account period settlement system. Now it is a multi-product market, with a T+2 rolling settlement.

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The market capitalisation of listed companies as a percentage of GDP is comparable to many developing countries. It was around 93 per cent in 2010, according to a World Bank report released in 2011.

After mega public issues such as Coal India the ratio grew to 132 per cent last year. The market microstructure and the regulatory architecture on which our stock market is now predicated has grown more sophisticated over the past two decades, following the efforts of the Securities and Exchange Board of India (Sebi) and the stock exchanges, especially the National Stock Exchange.

But despite all these efforts, India's household sector has consistently demonstrated that it has very little confidence in the stock market. Our domestic institutional investor segment has not grown.

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The mutual funds sector was weak, last year it weakened further and consequently pulled down the share of financial savings in shares and debentures to - 0.4 per cent.

That the secondary market has to depend on the foreign portfolio flows to sustain itself despite the country's high savings rate and good regulatory architecture is another contradiction of sorts.

The primary market brings much-needed new blood in the system. Without institutional support and lack of retail enthusiasm our primary market has been in the doldrums, except for certain bouts of brightness brought about by purportedly over-subscribed issues.

"Purportedly" because the recent Sebi orders against seven companies, their promoters, directors and the lead merchant bankers showed that what was seen as sunshine turned out to be moonshine.

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The orders of the regulator were ample proof of the brazenness with which the companies and merchant bankers dare to rip off investors. Issuers and intermediaries have tried to take advantage of the market several times and raise funds and use them for purposes other than what has been stated in the prospectuses.

This happened in the first bout of "mega issues" that came to the market in and around 1988; it happened with a vengeance immediately after liberalisation between 1994 and 1997; it was repeated in 2000, 2006 and 2007.

During these years several efforts were made to enhance disclosures, simplify issue procedures, reduce the time lag between issue closure and listing and introduce the book building process, with qualified institutional buyers (QIBs) being allowed to subscribe first to help price discovery for retail investors.

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But as the Sebi orders show, the companies and the merchant bankers and those who qualified as QIBs were able to audaciously game the system. Fault lines again.

The orders also showed that it is possible for companies that are not so well known, without strong balance sheets and with below-average ratings to quote a price that is at least seven or eight times the par value and get oversubscribed.

All these companies have filled up 100 pages of offer documents and followed the due process of 100 per cent book building. Interestingly, the book building process that we adopt is far more transparent than in the US and other developed markets.

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Yet all these issues had a very interesting common feature -- the stock prices fell sharply almost immediately after or a few days after listing and are now trading below the issue price. An examination of other IPOs would show that several issues also have similar characteristics.

Among the violations listed in the orders are siphoning off the issue proceeds through transactions among a web of companies, misuse of the funds and wrong disclosures.

There are several checks and balances, there is the credit rating, the book building process, the responsibility of the lead manager, there is a 100-page offer document -- but in the face of all this violations occur with impunity. Clearly these are signs of fault lines.

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For a mature market, it is important to repair the fault lines. A good place to start is to review and simplify the prospectus. From a four-page document in 1988 in small fonts that could not be read at all, it has now grown to a 100-page document with enormous details that cannot be comprehended and correlated by an ordinary investor.

There is much scope to eliminate redundancy in the prospectus and make it simpler and comprehensible. The orders of the seven IPOs, and perhaps of others, show that a careful watch needs to be kept on the behaviour of the stock after listing. The stock exchanges perhaps are best equipped to carry out this vigilance.

There is confusion about the appropriate roles of various participants in the IPO market – the merchant bankers, lead managers -- about the extent of disclosures necessary for investors.

We need to find the right balance again, guard against excessive disclosures, rationalise the offer document; and hopefully we will.

The author is former executive director of Sebi and is currently associated with the IFC's Global Corporate Governance Forum of the International Finance Corporation and the World Bank. These views are personal.