IPO Funding via Financial Institution loans
Not a Very Healthy Practice
By Santosh Pandey
The most recent incident of oversubscription of shares during Initial Public Offering (IPO) was that of Siddhartha Bank Limited. If one goes only by the number of applications and the subscription amount which was over 17 times more than what was asked for, one would hardly believe that the Nepali economy is on a slowdown; people are still prepared and keen to invest. Now that the stock is already listed and with trading already started, one can see that the face value was indeed well below the price and hence the rush for the Initial Public Offering (IPO). Good performance of IPOs in the short-run has become a norm in other countries as well. This has been well-documented in many of the journal articles published across the globe.
Unlike many developed capital markets, the Nepali stock market is still far from perfect. One of the criteria for a market to be perfect is that all investors should have information about the stocks they would like to invest in; in other words, there should be free and fair trade for all the investors. With loans given to investors by financial institutions to invest in IPOs, there are a few issues that need to be looked into. Some of my concerns are; is there a level playing field for all the investors? Does this phenomenon help in perfecting the stock market? What could be the possible adverse consequences?
An IPO issue is meant to be for all investors in the market, be it big or small. With provision of share issuance at no more than Rs 100 as par value, most of the stocks in IPO, especially those of financial institutions are well below their actual values (under Sharpe's Capital Asset Pricing Model). In other words, companies leave a handsome sum of money on the table for the investors whether these companies like it or not. With more than 70 per cent of market capitalisation belonging to the financial institutions in the NEPSE, it is natural for investors to rush for IPOs of such institutions and hence a recent rush for the Siddartha Bank IPO is no different. With the first day trading price of around Rs 300, a 200 per cent net return on investment (capital gain) in less than half a year, anyone who is rational and knows the stock market would go and place applications for the primary issues of Siddhartha Bank Limited and there would be no dearth of speculators trying to win as many allotments as possible. However, post-issuance and post-allotment, has anyone looked into who gets the major chunk of the IPO? The answer would probably be negative. With some financial institutions disbursing loans to investors to fund IPOs, it is necessary to see the consequences that these loans would have on investors, especially those who are less informed and/or small and also the consequences that these loans could have on financial institutions.
Impact of financial institution loans for IPO funding:
Well informed and speculating investors, when they know that the shares being floated are highly underpriced, approach various financial institutions for loans to place their share applications. Banks tend to be reluctant to offer small sized loans for IPOs, especially when they have bigger players approaching them. Investors especially the bigger players can avail of loans from such financial institutions and apply for a larger number of shares. So it is also possible that the big players may avail of loans from financial institutions in the names of their relatives, friends and families and make more than one application thus increasing the possibility of allotment for more shares to enjoy the short run over-performance of IPOs. Uninformed investors and small players, who also want to enjoy some benefits of the IPOs rarely approach financial institutions for funding and even if they do so, the possibility of these players being funded is low mainly due to their lack of relationship with such financial institutions (relationship banking being the type prevalent in Nepal) and their not-too-big funding requirements. As a consequence, most shares are allotted to a handful of big investors though in different names and lesser shares are allotted to smaller investors. In this way, bigger players tend to enjoy more from IPOs than smaller players, which go against the principles of stock market where investors need to have a level playing field. <Also, in line with Akerlof's (1971) market mechanism theory due to asymmetric information, there exists a market for lemons even here where more of speculators get attracted towards IPO and financial institution loan resulting to adverse selection on part of the financial institution.
IPOs are also supposed to signal the health of companies making the IPOs. There are two ways in which IPOs, after being announced, provide important signals about the company; one when they are announced and the other at the start of trading. Oversubscription of IPOs after announcement signals a reasonably good health of the company and underpricing of shares as more and more investors try and take benefit of IPO. However, due to availability of loans from financial institutions, the true picture of the company may no longer prevail. This could be due to asymmetric information as even those who know little about stock valuation (primarily speculators rather than rational investors) may approach financial institutions for loans so that they could enjoy more from a short run performance of IPOs. Besides, with more shares being allotted to bigger players in the market, informal buy-sell deals happen even before the start of trading. With shares being sold to lesser informed investors before the start of trading (because they could not win allotment during IPO), the price generally paid by these investors is more and at the start of trading day, we could well observe that the share prices are more than normally expected and unrealistic (for instance, the shares of Siddhartha Bank Ltd. on the first day hovered around Rs 300 per share). This renders the possibility of signaling a huge underpricing when actually the underpricing may be lower.
Also, when bigger players can access financial institutions for loans and increase the possibility of being allotted more shares, smaller investors tend to stay away from IPOs mainly due to their impression that they would not win allotment (less incentive) thus reducing the breadth and depth of the market, which happens to be one of the most important prerequisites for proper functioning of capital market.
There could be one more important adverse repercussion of financial institutions funding the IPOs for investors. I take a small case to explain this. Let us suppose a financial institution disburses loans for 100,000 shares to one of the customers. Let us then assume the application amount to be 100 per cent. The margin requirement by the financial institution is assumed at 20 per cent. Thus, the application amount for subscription of 100,000 shares amounts at Rs 10 million, the margin amounts to Rs 2 million, and the loan amounts to Rs 8 million. Let us assume that the investor is allotted 100 per cent of the subscription. In that case, the investor has to repay the loan to the bank which is Rs 8 million plus interest. In case the investor is not able to repay the loan and interest amount, the shares will have to be acquired in its own name and sold to compensate for the loan amount and interest. In case the shares are that of financial institution, which is normally the case for oversubscription, the financial institution which makes the loan will be acquiring and selling shares of another financial institution as investment, which is, as defined by the central bank norm a prohibited transaction. Therefore, in this way, it is theoretically possible for financial institutions to conduct prohibited transaction.
Thus, it can be seen that funding of IPOs by investors through financial institution loans does not yield much benefits from the financial market point of view.
(Pandey is a free-lancer writer on financial management issues)
