21 January, 2021

Side Bet Is An Unborn IPO

Pre-IPO trades, with its inherent uncertainty, is a grey area where individual buyers must tread with caution

Side Bet Is An Unborn IPO

Despite huge gains in the Indian stock markets, small investors are frustrated today. They are exhilarated, but agitated and ann­oyed too. As the Sensex boomed from under 26,000 in late-March this year to over 44,000, they missed the opportunities to rake in the riches. Now, the renowned listed stocks are overpriced and beyond their reach. They are wary of the smaller shares, which may be decimated by COVID-19 disruptions. There is too much uncertainty about their future.

Sadly, this option seems like a dead-end too. The promising Initial Public Offerings (IPOs) are hugely oversubscribed, i.e. the potential buyers seek more shares than the available quantity. In Mazagon Dock, investors applied for shares that were 157.41 times the numbers sold. The figures for Happiest Minds and Chemcon Specialty were 150.98 and 149.3 times, respectively. In such cases, people like you and I either don’t get the allotments, or manage a minuscule percentage of what we desired.

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Neel Shah, a CA from Palghar (Maharashtra), applied for nine IPOs this year, and got allotment in only one, SBI Cards. A Mumbai-based trader-investor, 31-year-old Monic Shah managed to get only 44 shares in Chemcon Specialty. Although he sold them at a profit of 115 per cent, his returns were a mere Rs 17,160. Pritesh Jain, who has invested in IPOs for 13 years, had to buy extra shares from the market as he did not get the full allotment on his application for Happiest Minds this year.

Hence, tens of thousands of angry, embittered, yet ambitious investors are playing a new game in town—pre-IPO trade. It is dangerous and riskier than the dealings in IPOs and listed stocks. It is largely unregulated, partially unofficial (possibly illegal), and few laws govern the dealings. SEBI, the market regulator, brokers, traders, and financial intermediaries are unclear about the rules of the play. Rest assured that the chances to lose your savings and shirts are higher.

Photograph by Dinesh Parab

Let us add relevant caveats. The business isn’t illegal. But it is un-monitored, especially when shares are sold to small investors. The prices are decided unilaterally. Investors have no legal recourse if they lose money. There are no guarantees that the firms will launch their IPOs; they may not do it or delay them. People can be stuck with the stocks, or forced to hold them for years.

Pre-IPO trade is unmonitored. Prices are decided unilaterally; there’s no legal recourse if one loses money. And there is no guarantee that firms will launch their IPOs.

Outlook spoke to dozens of market players to piece together the details of this dodgy business, which has the making of a scandal. SEBI did not respond to our emails and phone calls. One of its officials spoke on a background basis, and abruptly asked us to send written queries, which went unanswered. If you have purchased pre-IPO shares, read further to know the implications of the actions. If you haven’t, go through this piece to understand the tricky traps that await you.

Pre-IPO trades, in simple terms, imply the purchases of shares in firms that are not listed on the exchanges. Ideally, and in normal circumstances, these are private deals between owners and buyers. They happen offline and off-market, and are akin to cases when you buy a laptop, phone or washing machine from either a friend, or someone who knows someone who wishes to sell. SEBI, or any other government agency, isn’t involved in, or bothered about, these dealings.

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In frenzied times like these the scenario changes as desperate investors wildly grope for profits. It is serious when private deals become public, and brokers openly offer such shares through ads and YouTube videos to gullible buyers. It is murky when the trade continue after the firms have either received SEBI permissions to launch their IPOs, or filed relevant documents with the regulator. These trades happen in the name of upcoming IPOs, which fall within the ambit of SEBI.

Photograph by Dinesh Parab

“To maximise gains, one has to be smart, and be timely if one wishes to invest in pre-IPOs. There has to be an IPO for official prices to be triggered on the exchanges, followed by listing, which has to be at a higher price. If these two events don’t happen, the buyer is saddled with losses,” says a trader who buys and sells in the pre-IPO market.

The game begins before an unlisted firm has thought of an IPO. The existing shareholders, including promoters, employees and angel investors, sell their holdings to cash out. They flog them to the brokers, intermediaries, and dedicated pre-IPO funds. The latter offload them to those who wish to invest Rs 20,000 to Rs 1,00,000 each. “If you wish to buy and sell unlisted shares, you have to involve the brokers,” says the MD of a firm that tracks IPOs and corporate databases.

Outlook procured a list of 93 stocks prepared by an intermediary. Most were touted as shares of companies whose IPOs were imminent, or pre-IPO stocks. A search revealed that at least two dozen hadn’t announced plans for IPOs. The intermediary had star-rated the stocks on a scale of 1 to 5, with 5-star indicating “strong buy” and 4-star “buy”. The prices and marketable lots were included, and the minimum buying price (price multiplied by minimum lot) ranged from Rs 30,000 to Rs 1,50,000.

Several brokerages and intermediaries have similar lists—some are public, and others are doled out to members. Prices are negotiable, and one can demand a discount for a larger marketable lot. A not-so-new YouTube video made by an intermediary talks ab out its unique product, which allows ‘retail investors’ with a minimum ‘ticket-size’ of Rs 25,000 to buy pre-IPO stocks at ‘discounted prices’. The punch-line: “quality stocks can be purchased in quantity”.

Market players and market-makers goad investors with statements that sales are legal and above board. Once buyer and seller confirm the quantity and price, the former sends details of her demat and bank accounts, and PAN. On trade settlement day, she transfers the amount via NEFT/RTGS/MPS. The seller tra­­nsfers the shares into the buyer’s demat acc­­ount the same day, and generates the sale note.

But the problem arises during a market boom, when small investors queue up to buy these sha­­res. They have no idea if the IPOs will mat­­erialise, or if they will take several years. They have no clue about the prices, which may be lower or higher than the official ones ann­­ounced when IPOs happen. They have no legal way to recover the money they can lose. In addition, there is a lock-in period of one to three years from the date of the listing of these shares.

“Since shares are locked up, existing shareholders hire brokers to sell them to willing buyers. The brokers market them as pre-IPO shares. But the term differs from SEBI definition, and buyers should factor risks related to reduction in prices and delays in IPOs, which may leave them with worthless paper,” explains someone who works with a renowned law firm. “Thanks to the lock-in and other restrictions, there are no SEBI regulations,” adds the CIO of a financial services firm.

The second stage of the pre-IPO trades takes place when there is certainty that an IPO is imminent. This is after a firm files a Draft Red Herring Prospectus (DRHP) with SEBI. This is a period when SEBI guidelines kick in. The sales between the filing of DRHP and actual listing of the stock on the exchanges are defined by the regulator as pre-IPO placements, subject to a few conditions.

One of them is that the final prospectus discloses them. These placements have a one-year lock-in period after listing. The disclosure norms ensure that these sales are done in consultation with the lead managers of, and bankers to, the IPO, and they set the price. The lock-in period guarantees that the buyers are long-term ones, and do not sell their shares in a hurry, just after the listing.

Institutional investors participate in such sales. There is no restriction on purcha­ses by retail investors, but there is a cap on the number of non-institutional buyers. This imp­­lies that the only other buyers in pre-IPO placements are high net-worth individuals (HNIs).

Post-DRHP placements emerged when SEBI disallowed firm allotments to institutions and HNIs during the IPOs. The former was a comfortable option for these investors, who wished to buy huge quantities, and were unsure if they would get adequate shares during the issue if it was highly oversubscribed. It was a win-win for the company and investors. The former could tout the names of the latter to gain credibility, and the latter would not have to sweat it out.

However, there is something wrong if the shares are sold to retail investors during this phase. The FAQs of the intermediaries contend that the small buyers can even wriggle out of the lock-in period, as they can get rid of the shares offline and off-market, both before and immediately after the listing. These sellers add that they will help the small investors to do so in a profitable manner. Now, this seems odd.

“Although SEBI does not specify the minimum investment, or category of investors, the pre-IPO placements are issued to qualified institutional buyers (QIBs), and are generally not sold to retail investors. There is a cap of 200 on the number of non-QIBs that can be issued shares in a financial year. Hence, sales to small investors (Rs 20,000-50,000) are not meaningful to the company,” says Ajay Saraf, Head (Investment Banking & Institutional Securities), ICICI Securities.

Venkatraghavan S, MD, Equirus Capital, explains that the aim of these pre-IPOs is to fulfil the cash needs of the company, and the proceeds are deducted from the final IPO fund target. According to pre-IPO FAQS posted on its website by Neomile Capital, “An eight-figure amount is required to invest in a pre-IPO placement.” A senior SEBI official says, “Retail investors cannot invest in pre-IPOs; they can only participate when the public issue opens.” Venkatraghavan agrees that pre-IPO placements are “not offered to everyone at large”.

What’s worse, the post-DRHP is the time when the middle-class buyers are more prone to buy pre-IPO shares. This is because of the thriving grey market, which begins to churn as soon as an IPO is officially in play, and ends before it gets listed. Daily premiums are available, and they move like the prices of the listed stocks on the exchanges. The premium is a bet on the difference between the IPO’s offer price, as per the application, and the one on the first day it is traded after listing.

A positive grey market premium means that the listing price will be higher, and a negative one the opposite. For those who trade in this grey market, a premium of Rs 100 on an offer price of Rs 100 tells the investors that the listing price is expected to be Rs 200. If the listing price is more than Rs 200, the buyer-gambler profits by the difference. If it is less, the seller-speculator gains by the margin. Despite SEBI’s lock-in, positive premiums lure people to buy pre-IPO shares, especially when told they can sell offline.

According to the Kotak Securities website, the grey market is a “parallel”, “unregulated mar­­k­­etplace”, and the shares are bought and sold “outside the official trading channels”. It adds, “Although grey markets are not illegal, they are not authorised or controlled in the usual way.” Hence, SEBI, stock exchanges and brokers don’t back these transactions. “There is little legal recourse available to parties if the stock tanks,” it says.

In the recent past, positive premiums became the norm. But investors, who trade in premiums or buy pre-IPO shares because of them, can get caught in a loss-making vortex. The premium on Gland Pharma was a high Rs 170 before it crashed to Rs 10. This was because the price-band decided by the company was higher than expected. Days before its listing, the premium shot back to Rs 170. On November 20, the first day of listing, the stock closed at Rs 320.45 above its offer price of Rs 1,500.

Like Gland Pharma, the premium on UTI AMC was a high Rs 150 on September 23. It slid steadily to Rs 10 by October 2. And then it ent­­ered into the negative zone, and was quoted at negative Rs 25 on October 10. On October 12, the first day of listing, the stock closed at Rs 476.6 on an offer price of Rs 554—a fall of Rs 77.4. Thus, if investors play the grey market, or grab pre-IPO shares because of them, they can be hurt.

Clearly, the brouhaha about the pre-IPO business is related to the pre-IPO discounted prices, offer prices of the IPOs, and the ones at which they are listed. As long as there are dif­­f­­erences between these three figures, with the last being the highest, investors can make pro­­fits. Of the 29 IPOs this year, 22 closed at higher-than-offer prices on the first day of tra­­ding. The difference ranged between a minuscule 0.3 per cent for Billwin Industries, and 123.5 per cent for Happiest Minds.

The story of how these IPOs moved subseque­ntly is similar. The prices of seven of them were lower on November 24, when compared to their issue prices. The worst hit was Secmark Consultancy, which fell by 63 per cent from its offer price of Rs 135 in less than two months. The IPO game, like the pre-IPO one, is fraught with too many risks. Despite what you are told, be careful, and beware of the nefarious sellers. You may win some, you may lose some, but then, what if you lose everything?  


Pritesh Jain, 34, Professional

Recently, I invested in IPOs of Route Mobile and Happiest Minds, and purchased some shares in the latter from the open market since I did not get the number of shares I desired. I have been interested in IPOs for the past 13 years, and currently bullish on consumer technology and digital themes. While Happiest Minds focuses on big data, analytics, and mobility and security, Route Mobile is a cloud communication platform provider. In the near future, the proposed public issue of the state-owned LIC will be the mother of all IPOs. It will suck out liquidity, as investors may partially sell their current holdings, and hold on to cash to apply for LIC. Apart from gold, equities are the most liquid form of investment, and they will help achieve my financial goals.

Neel Shah, 26, Chartered Accountant

I applied for nine IPOs this year, and got allotment in just one, SBI Cards, and only 15 shares. In general, IPOs this year were a mixed bag. Some, however, delivered healthy returns, and led to greater participation by the retail investors. Like many others, I look at IPOs for listing gains, i.e., the difference between the issue price and the possible higher once it is listed. But if a company has strong fundamentals, fair valuation, and bright prospects, I am not averse to holding them for the longer term. My applications were driven by the market outlook, as pharmaceutical and IT stocks seemed attractive a few months ago. Companies too are serious about public issues as it allows them to raise finances to repay debts, and fund their growth and expansion.

Monic Shah, 31, Trader-investor

The IPO I profited from was Chemcon Specialty. But because of the huge oversubscription, I got only 44 shares. Although I sold it at Rs 730, compared to the purchase price of Rs 340, my gains were a mere Rs 17,160. In another case, I earned a 35% return when I bought Zee5 at Rs 140 from the secondary market, and quickly sold it at Rs 190 in six trading days in August this year. There is little juice to be extracted from IPOs now, especially if one hopes to multiply savings by 100-300%. It is difficult to get allotments, and the profits on absolute basis are minimal. My goal is grab a sizable chunk of unlisted shares, and create wealth when they are listed on the exchanges. IPOs, in whatever form, are the real wealth creators.


The Rules Of Pre-IPO game

Invest in unlisted companies early, even before they have decided to launch IPO.

Such stocks are openly sold by brokers, intermediaries and pre-IPO funds. Sales are legal and conducted through demat and bank accounts, and PAN.

Risk factors:

Prices are opaque, market is unregulated, and there is a lock-in period and no guarantees whether the IPO will be delayed for several years, or indefinitely.

By Himali Patel With inputs from Yagnesh Kansara

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