October 28, 2012

unwise safety net for ips

A month ago, a proposed safety net for IPOs was in the news. 

I wrote about it then in an editorial for the newspaper I work for. I share it below.

A net full of holes
The proposed safety net framework for IPOs is not a good idea

There is no dearth of props in the financial system and more so in the current economic situation fuelled by the government's pursuit of high growth, aggressively cheerlead by financial market players. Yet another one is being sought to be given to them. This time, the capital market regulator, Securities and Exchange Board, has moved ahead in its earlier consideration of a mandatory safety net mechanism for initial public offers in the capital market. 

This new measure aims to protect retail investors from a large dip in the price of an IPO in the first three months after its listing. Not only is the idea of a price protection regressive in modern financial markets as it distorts the natural price discovery process in the market, the convoluted nature of Sebi's proposed safety net mechanism will make the distortions only more worse.

In the past couple of months, the primary market advisory committee followed by the Sebi board have given their approval for the safety net measure and after formalising its broad framework Sebi, late last week, made public a discussion paper on it  on their website inviting comments from investors and other parties in the capital market before October 31. The discussion paper is just three and a half pages long and while length need not be an issue, for a measure which will be the first of its kind for primary market issues in the last 20 years. 

Earlier, before the 1991-92 financial market reforms abolished the Controller of Capital Issues, the central government had administrative control over price and premium of shares in IPOs. It was direct and full price management then and now, under the proposed new safety net measure, it will be indirect and partial. If, and only if, a couple of conditions are met will small retail investors be eligible for the safety net. In all of the three months immediately after the listing of IPO-issuing company's shares, the volume-weighted price has to be more than 20 per cent lower than the issue price and the gap between this fall in the company's price and that in the fall of either of the broad market indices, S&P CNX 500 and BSE 500, is also more than 20 percentage points. 

Effectively, it means the fall in the post-listing price fall should be at least 20 per cent and 20 percentage points over and above the general fall in the market. Once this  happens, then as per the other complex conditions set out by Sebi's proposed safety net framework, the actual cost for the promoters will range from just 1 to 7 per cent of the issue size. To make matters worse, as per yet more conditions, eligible retail investors could see only one-seventh of their allotted shares receive the benefit of price protection.

The convulated conditions will ensure that the final objective of restoring the diminishing confidence of primary market investors on account of fall in post-listing prices of IPOs is never met. Sebi and the finance ministry who is subtly applying pressure on Sebi to do this would do a better job of protecting investors' interests if they empower the retail investors with the discerning ability to choose the right IPO for investments. IPOs thrive only when secondary market is in a bull run and their pricing is inflated since most secondary market share prices are also inflated. 

Hefty commissions paid to lead managers and distributors during IPOs are the root cause of badly timed, aggressive mis-selling of IPOs at inflated levels. Coming down hard on these commission levels would automatically lead to retail investors being left alone to choose the right IPO.

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