Curious case of IPO Pricing: An untold real story

Years ago a young lad from the USA was tutored by me in accounting for a brief period whose father, a billionaire was in the process of collaborating with a well known Indian steel manufacturing company. Both partners were keen to expand market reach of the new venture and create customer base that would strengthen its position in the Indian and foreign markets. As this was the first ever joint venture of the American firm, both partners agreed to hold 40% each of the subscribed equity capital of the new company with the remaining 20% to be held by public. The new entity launched its maiden public issue in 1991 and received an overwhelming response from investors. The IPO was oversubscribed by over four thousand times.

My student had grown in Northern Ohio with a silver spoon in his mouth as his father, CEO of a Fortune 150 multinational corporation wanted his son to learn the intricacies of the Indian accounting system and also become familiar with terms like hazaar, lacs, crores etc. His father was keen to see that his son steps into his shoes at the earliest, took charge of the Indian operations and eventually the entire entity as its CEO which was set up by the boy’s great-great grandfather. He was being groomed the way his dad filled his grandfather’s shoes, and so on.

That’s how I stepped into the life of the young American boy as his accounting teacher and the mentor. My mentee followed his father’s footsteps to Phillips Andover Academy, and then to Harvard Business School. He was a very inquisitive person and would ask me millions of questions about the way businesses are run in India. He seemed perplexed over massive oversubscription of the IPO of the new venture and couldn’t make out as to why celebrations were on the house due to the oversubscription saga by having parties, passing on bonuses and offering promotions? The same incident in the US would have caused job losses for the finance honchos and sacking of Investment Bankers, he said. They would have been blamed for pricing the issue “inadequately and inappropriately” especially when the issuer is not entitled to retain the entire subscription due to regulatory restrictions, other than exercising green show options. The lost opportunity of charging higher premium leads to an in-efficient practice and adversely affects sole objective of a Financial Manager which remains “Maximization of shareholder’s wealth”.

Initial Public Offerings (IPO) of a recently concluded Happiest Minds Technologies, a Bengaluru based company garnered huge response from investors and it flew off like a rocket when its Rs. 702 crores issue was oversubscribed by the mammoth 351.46 times for non-institutional investors category and 150.39 times overall. Promoted by Ashok Soota, a veteran entrepreneur and former Vice-Chairman of Wipro India, the IPO was listed on the BSE and the NSE, and investors hit the jackpot when it opened with over 100% gain. It was Lead managed by ICICI Securities and Nomura Financial Advisory and Securities (India). This issue was followed by many others including Route Mobile, Chemcon Speciality Chemicals and Burger King IPO which gained 131 percent on its trading debut. The Burger king stock beat the first day performance of Indian Railway Catering and Tourism Corporation Limited that delivered 128% returns.

Should we consider under-pricing of IPOs as fair since they are intended to benefit lucky ones at the time of listing? Should we consider this as failure of Lead Managers to price the issue appropriately which in turn leads to oversubscription and its ills. Charging a bit higher premium might have led to lesser quantum of oversubscription but it would have definitely helped Mr Soota and his existing shareholders in many ways such as accumulation of healthy share premium reserves, better book value, lesser dilution of voting rights, lower floating stocks and others.

Many researchers have shown that when offer price of an IPO is set in advance for bidding, any public knowledge of relevant price information goes through many public eyes, which often are not linked to pure fundamental of the organization. As a result, Investment Bankers for reasons best known to them, are too afraid to set a realistic price and therefore keep the offer price “too low” which leads to several times of oversubscription. Is this a failure of the judgement on the part of Investment Bankers which costs issuers dearly? Many a times lead managers have the last laugh in these cases as they simply walk away with their fees and get their name added in the list, as per SEBI’s disclosure, with another success story to talk about.

Is under-pricing an indication of uncertain times, a case of information leakage or that the issuer is keen on collecting interest float on funds received from bids, the interest revenue reducing the costs associated with under-pricing or management fees? While SEBI is expected to be extremely tough with the latter one, shouldn’t lead managers, well before the issue is expected to hit the market, try and reduce the instances of information asymmetries, be bold and resist from under-pricing and just target at a decent oversubscription of 3-4 times?

This leads us to a question as to “What is the correct price of a product”? Correct pricing is the foundation of any business for long term success and prosperity. This being the secret of any business, including financial transactions, wrong pricing often dents businesses in a manner that makes it difficult to overcome the damage caused by the improper strategy. Warren Buffett echoes the thinking of Economists when he said “Pricing is what you pay, Value what you get”. As pricing is directly linked to value, pricing a product is perhaps the toughest thing to arrive at. It’s part science and part art. Pricing a financial product become a difficult and complex ball game as almost all factors that affect financial markets, have an impact on pricing financial products, including IPOs. While lead managers have a lot of flexibility (within norms set by SEBI) to deal with this conundrum, it is a bad news too for them. This is where the test of a good lead manager comes out in the open.

May be that young American student of mine was correct in his apprehensions that issuers or lead managers must desist from causing momentary happiness due to oversubscriptions which may not sustain in the long run. The damage it might cause can affect the overall capital structure of an organization, its associated financial costs and has the potential to destroy economic value of the organization for a long time.

While I lost touch with my mentee long back, every time IPOs get irrationally oversubscribed, I think of that young American boy. Is he now the CEO of the Fortune 500 company today? While not much could be found about the boy with curious minds, one of the articles published on the internet in 2009 mentioned that the boy was very different from others. For him, making seven figures on the Wall Street is nothing but cheap wood which burns up too fast. He needed something that burns well, is substantive and lasts for a long time. The Harvard Graduate of Class 2004 lived in a spotless luxury condo on the ocean front at Venice Beach and yet he chose to give up everything and became Police Officer in El Monte, LA. He defied Monkey Law taught by a his professor named John Quelch at Harvard and plunged into the jungle of law enforcement in a dangerous city, without a plan.

And he loved it.