IPO Financing Volumes Set To Grow Despite Lower

Margins

Analytical contact
Umesh Nihalani
Manager, Financial Sector Ratings
Tel.: 91-22- 3342 3025, Email: unihalani@crisil.com

Gourav Gupta
Manager, Financial Sector Ratings
Tel.: 91-22- 3342 3172, Email: gogupta@crisil.com

Executive Summary

India’s equity markets continue to see growth in initial public offer (IPO) financing, driven by
increasing issuances in 2010-11 (refers to financial year, April 1 to March 31). Market
participants, however, face increasing margin pressure on account of growing competition in
the business, reduced deployment tenure and IPO cycle time, and rising costs of borrowing.
Players also face challenges owing to the limited funding avenues available for short-term
deployment.

Players in IPO financing are, however, expected to remain in business, the reduced
profitability notwithstanding. Their moderate spreads may be partly offset by likely increase
in volumes. Moreover, IPO financing is a useful offering to players’ high net worth (HNI)
clients, and therefore important for the private wealth management business; it also has
benefits for the investment banking franchisee. Market participants will, however, need to
ensure that their risk and liquidity management practices are adequate for increasing volumes
in the business.

Equity capital markets revive, despite inherent volatility

Clearly, increasing activity in the primary market has translated into gradual revival in the
IPO finance market. India’s equity markets revived considerably in 2009-10 and 2010-11,
following a sharp slowdown in 2008-09. The quantum of capital mobilised through IPOs or
follow-on public offerings increased to Rs.467.4 billion in 2009-10 from a low of Rs.20.8
billion in 2008-09. If current trends and the applications pending with the regulator are any
indication, the capital mobilised in 2010-11 will be even larger.
CRISIL’s rated non-banking finance companies (NBFCs) have witnessed significant growth
in short-term episodic borrowings for IPO financing over the first two quarters of the current
financial year. This trend may intensify in the second half of the year, given plans for some
large IPO floats by the public and private sectors. While large IPO financing opportunities
may arise, particularly for those public sector issues linked to the Rs.400 billion disinvestment
plan of the Government of India, CRISIL believes that the volatility inherent to equity
markets has potential to adversely affect the IPO pipeline, and therefore, the prospects in the
IPO finance market.

IPO financing has traditionally been an attractive value proposition for the financier and
investor. To the financier, it offers good yield (ranging from 12 to 17 per cent) and
opportunity to earn fund-based income at low risk, given the self-liquidatory nature of the
transaction. It also enables investors to apply for a large number of shares, and thus, to book
gains if demand for the stocks is high when the shares are listed.

Box 1: How IPO financing works

IPO financing is a short-term credit facility provided by the NBFC arm of broking firms and
banks typically to HNIs, for the purpose of subscribing to IPOs. The investor initially makes
an upfront payment of the margin amount (as specified by the NBFC, based on the
assessment of subscription levels) and an interest payment for the specified number of days.
The NBFC finances the remaining amount at an agreed rate of interest. The interest rate
varies, but is usually in the band of 12 to 17 per cent per annum. These loans are usually for
the period between the closing date of the issue and the date of refund (or listing), which is an
average of seven days. The financiers have a lien on shares allotted in the IPO which act as
collateral.

The NBFC financier typically raises the required quantum of funds through short-term debt
instruments; the repayment is proposed to be made entirely from the refund proceeds if the
margins taken are aligned with final oversubscription levels. In case of a shortfall, leading to
non-payment by the borrower, the financed shares available as collateral can be liquidated to
bridge the gap. The credit and liquidity risks faced by the financier are, therefore, largely
mitigated through such a mechanism.

Players in the IPO financing segment are facing margin pressures

Lenders, primarily NBFCs, in the IPO finance segment have, however, witnessed shrinking
margins over the past two years. Shirinking margins are primarily the result of:

• Growing competition in this segment with entry of new players—largely NBFC arms
of domestic brokerage firms willing to work for lower spreads with a larger objective
to strengthen their capital market franchise.

• Significant reduction in the number of days between the closing of a public issue and
its listing, to 12 days from 22 days, shortening the tenure for which the investors need
to avail of the facility.

• Securities and Exchange Board of India (SEBI) regulations that do not currently
permit the issuance of short-term debentures of less than 90 days with daily put and
call options. This has forced lenders to issue the relatively expensive, longer-tenure
commercial paper (CP), which is for a minimum of seven days and involves a stamp
duty charge of 0.012 per cent (for 91 days). As the cash flows could be refunded over
seven to nine days, most lenders set the CP tenure conservatively, and therefore also
have a negative carry for two to three days.
 • Sharp rise in costs of CP and short-term debt due to the tightening of the monetary
environment.

IPO finance volumes, nonetheless, expected to witness growth

Despite increasing pressure on margins, CRISIL believes that established capital market
entities (CME) with an NBFC arm will continue to focus on the IPO financing business.
Evidently, although profitability has reduced, there is still a moderate spread to be made;
CRISIL’s analysis shows that NBFCs offering this product still enjoy a net interest margin of
almost 3.0 per cent, as against 5.0 per cent in 2007-08 (see Box 2). However, players expect
volumes to grow over the near term; some players have indicated a keenness to finance retail
investors, particularly with SEBI’s recent decision to increase the maximum ticket size for
retail application to Rs.0.2 million. In expectation of larger volumes, the absolute profits from
this activity can contribute materially to the overall profitability of the CMEs.

Box 2: How IPO financing margins have been hit

CRISIL estimates that the net profitability of financing Rs.10.0 billion for an IPO has reduced
by around 75 per cent in 2010-11, as compared with 2007-08.

Particulars 2007-08 2010-11

Amount Financed (Rs bn) 10 10
No. of days of financing 15 7
Gross Spread (%) 5.0 3.0
Gross Spread (Rs mn) 20.55 5.75
Operating Expenses (Rs mn) 0 1.20
Net Profit (Rs mn) 20.55 4.55

Importantly, CRISIL believes that IPO financing is an important and strategic tool for CMEs
and has significant synergies with their core businesses of equity broking, private wealth
management and investment banking. IPO financing primarily caters to HNIs who are also
broking and wealth management clients of the CMEs. The ability to provide IPO finance
clearly facilitates client retention for these entities.

IPO financing also supports the investment banking franchise of CMEs in a significant
manner. If a CME is a book-running lead manager of a large public issue, IPO financing
definitely helps generate demand for the IPO and therefore, leverage its distribution channels
in an effective way.

Risk management systems, however, need to be suitable to handle such growth

As the demand for IPO financing continues to grow, the CMEs need to ensure that their
operating systems and processes and risk management systems are adequately geared to
handle increasing volumes. While the inherent structure in IPO financing mitigates credit
risks to a large extent, the operational and liquidity risks require attention.

With the growing number of applications for IPO financing and in particular, the plans for
some CMEs to explore the retail market for such financing, the operational complexities will
increase. Lenders will, therefore, require adequate systems, processes, infrastructure and
manpower in place to take care of such load.
Furthermore, CRISIL believes that the CMEs need to have an appropriate liquidity
management framework for the IPO financing business, given the nature of borrowing and
growing size of such lending. An adequate liquidity buffer or an alternative mechanism needs
to be in place to address cash flow mismatches arising from a delay in IPO refunds if any. The
tenure of the borrowings also needs to be chosen suitably, to avoid such cash flow
mismatches.

Conclusion

In CRISIL’s opinion, CMEs with diversified businesses, strong financial risk profiles, large
net worths, and comfortable liquidity positions are well positioned to engage in IPO
financing. Smaller players undertaking such activities should ensure that they do not subject
themselves to higher operational and liquidity risks by aggressive IPO financing and
overleveraging.

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