Shobhana Subramanian: Book building

The system is working well, though the retail investor does not always seem to be participating in the price discovery process.

Investors who bought into initial public offerings (IPOs) and public issues in the past two years should be delighted. Most of the issues have given them good returns.

The issuers, including the government, too, should be pleased having mopped up more than Rs 30,000 crore. After a long hiatus of almost 10 years, retail investors are flocking back to the primary market.

The number of applications per issue has grown multifold "" from about 2.85 lakh applications for the Maruti IPO in June 2003 to over 8 lakh for the Oil and Natural Gas Corporation (ONGC) issue and further to over 14.7 lakh applications for the National Thermal Power Corporation (NTPC) issue.

With India being the flavour of the season, bids from Qualified Institutional Buyers (QIBs), too, have trebled from around 100 for Maruti to around 300 for NTPC.

Says S Ramesh, executive director, Kotak Mahindra Capital, "Book building has helped issuers to get a good price and most issues have been priced at the top end of the band."

Indeed, both issuers and lead managers are now convinced that the era of fixed pricing is over. Observes Ramesh, "It would be risky to do an issue, especially, a big one at a fixed price, given the long gap of over a month between the time the price is fixed and the issue hits the market."

Much of the success of these issues, especially, the bigger ones, say merchant bankers, is because the price discovery has taken place through a book building exercise. This allows investors to bid at what they feel is an appropriate price within a band or at/above a floor price.

The overwhelming response has seen most issues priced at the top end. However, as Ranganath Char of Enam Financial observes, in some instances an issue has been priced just below the equilibrium price (the price at which there is a demand for the total number of shares to be allotted), so that some demand is left unsatiated and the price is sustained in the secondary market.

The fact that most book-built issues have resulted in good returns for investors proves that the pricing has not been too aggressive. Ravi Menon, co-head , investment banking, HSBC, thinks that the system has worked well and is fair to all participants.

He believes that the retail investor, who invests a sum of up to Rs 50,000, needs to be given some preference. "Since they hardly have any access to research, book building, gives them some idea of what the response to the issue is," he observes.

The system today is more transparent and retail-friendly than it is overseas. For example:

In India, the book is built directly, in the West the lead underwriter takes the shares on his books and then allots them to investors.

In the US, book building is done confidentially, not transparently on the screen as it is here.

Abroad, the book can be opened and closed anytime. In India, the book has to be kept open for a minimum of five days; the period can be extended to 13 days if the price band is revised.

In India, 50 per cent of the book is reserved for high net worth and retail individuals (25 per cent each), the allotment being proportional to the bid. The allotment to QIBs is discretionary. Overseas, all allotments are discretionary and there are no reservations. Retail investors account for barely 15 per cent of the issue.

Overseas, the price band is often a soft band, in the sense that the underwriter is allowed to bid at a price outside the band; in India, we have a rigid price band, though it can be revised.

Retail investors here have to put in a cheque for the full amount, although QIBs pay no margins. Overseas, neither segment pays a margin.

(Click for the table on "The Indian new issue market")

The system is particularly friendly towards retail players. For example, they can withdraw a bid even after the bids have closed but before the allotment happens. Moreover, they are allowed to bid at a cut-off price whereas high net worth individuals (HNIs) and QIBs need to indicate a specific price.

Any investor can scan the stock exchange screens for an update on the book. Although there is no category-wise break-up, he can see the number of shares demanded and the corresponding prices.

From this he can gauge the price levels at which there is maximum demand. However, Menon points out that the software used by the exchanges could result in duplication of bids submitted at various prices. This is called the "dirty book" and can often be misleading.

Regulators believe that retail investors should participate in price discovery since one-fourth of the issue is reserved for them. In fact, there is a proposal to increase the quota from 25 per cent to 35 per cent.

But, are retail investors actually participating in the price discovery process? On the face of it, it would appear that in most cases they are not. Empirical evidence shows that they are simply opting for the cut-off price.

In other words, the investor is willing to accept whatever price is discovered, and pays up for the shares at the top end of the band. Observes Char, "In most of the issues, more than 90 per cent of retail investors opt for the cut-off price, so it's clearly the QIBs that are deciding the price."

Again when a floor price has been indicated, as has been the case with some issues such as Indian Petrochemicals Corporation Ltd or IBP, the maximum bids have come in at the floor price or slightly above the floor as happened with CMC.

According to Char, this again would imply that retail investors are simply following institutional investors. There was, of course, the instance of the Bharti Televentures IPO when retail investors did not take a cue from institutional investors and the retail portion remained under-subscribed.

Those who bid, did so at the lower end of the price band. The issue, however, was ultimately priced at the top end and the QIBs' portion was oversubscribed.

Merchant bankers say that was a time when the markets were not in great shape and many investors had burnt their fingers and so were wary of investing.

Char suggests that an indicative price, rather than a band might work better. In such a situation, buyers would be compelled to decide on a price.

According to Menon, if the retail investor is to participate in the pricing, it might be better not to allow the option of a cut-off. In fact, the cut-off had been withdrawn for a few issues but was re-introduced with the Maruti IPO, ostensibly because it would make it easier for the small investors.

Menon suggests that the bidding system could be modified by allowing retail investors to go through brokers who could consolidate the bids and submit them to the lead managers. Brokers could then advise investors on the pricing.

Perhaps the system could do with some modifications to help small investors find their voice. For the present though, with the markets on fire, no one's complaining. Not the issuer, the merchant banker nor the investor.