By the book

The Indian primary market's brief honeymoon with discretionary allotments for qualified institutional investors has ended.

The practice had been a thorny one right from its inception, with market commentators pointing to the abuse of the system by lead managers. The system was used to build hype around an issue by so-called "over-subscriptions" within minutes of its opening, to allot prized stock to cronies, and to mislead retail investors.

Since institutional investors did not have to put money upfront along with their bids, bids were often frivolous, especially since they could always be revised later. And since the book running lead manager had the discretion to allot stock, he could reserve a hot issue for friends, creating a shortage in the market and helping them to make a killing.

Several solutions to the problem have been mooted, some of them by Sebi-appointed committees. Some called for making QIBs pay their money up front, just like the high net worth and retail investors have to do. Others wanted QIBs to pay margins on the bids they made.

Yet another suggestion was that a proportional allotment system should be made applicable to QIBs, in the same manner as for other investors. Sebi has now decided that QIBs should pay a 10 per cent margin up front, and that proportional allotment would also be applicable to them.

This will prevent frivolous bidding, and ensure that every institutional investor who bids will get a share of the issue.

At the same time, by reserving 5 per cent of the issue for mutual funds, the market regulator has opened up another investment option for the retail investor, who can now participate in IPOs through the mutual fund route, and not just by directly applying for shares.

But in the almost universal condemnation of the discretionary allotment system, it's worth remembering that discretionary allotment by book- running lead managers is normal business practice elsewhere. Lead managers have a responsibility to ensure that the post-issue market is managed properly, which is why they ensure that stock is allotted only to quality investors.

Under proportionate allotment, on the other hand, there is a possibility that most of the issue could end up in the hands of momentum players like hedge funds, and this could lead to volatility in the after-market.

In the present system, institutional investors have an incentive not to indulge in irresponsible behaviour, since that could prevent them from gaining allotments in other IPOs""under proportional allotment, there's no such incentive.

There's also the more fundamental argument that the entire purpose of the book-building process is price discovery, and that it is the institutional bidder who is supposed to discover the price for the retail investor.

Now that they have to pay their money upfront, institutional investors will delay their bids till the last minute, depriving retail investors of the chance to gauge appetite for the issue. Sebi's decision makes it clear, however, that the market regulator is unimpressed by these arguments; it has probably been influenced by the obvious abuse of the book-building system.

So far as the decision to ensure a free float of at least 25 per cent is concerned, while the intention is laudable it is imperative that progress on the matter is by consensus. The market regulator must ensure that its desire for a larger free float does not lead to a deluge of shares in the market, which will adversely impact investors.