As LIC prepares for its initial public offering (IPO), many investors who are completely new to the market are looking to apply. Here’s what you need to know about how such offers work in order to place a winning bid.
type of offer
When companies controlled by the promoter decide to enter public markets, they first decide the type of offering they want to make. Companies that need money to expand issue new shares. Companies like LIC, where the promoter wants to sell their shares to the public, make offers to sell (or OFS). SEBI regulations also allow companies to launch either a fixed-price IPO (subject to a few conditions) or a book-built IPO.
Fixed-price IPOs are straightforward because the company sells shares at a price that it sets. Book-built offerings offer investors a “price range” and conduct an auction to “discover” the final price for their shares. The IPO of LIC is an offer to sell by the Government of India taking the book-built route.
When companies go public, SEBI regulations require that they share extensive information with their new investors about their history, operations, finances, management, and the risk factors they face in their business. This information will be packaged into the company’s prospectus, which will first be submitted to SEBI for comment. Companies conducting book-built IPOs file a Draft Red Herring Prospectus, or DRHP (so-called because it contains all the details except for the pricing of the shares), which is available on SEBI’s website pending approval.
Because DRHPs tend to be voluminous, it’s worth reading them yourself on the SEBI website at the draft stage to get acquainted with the business. Once approved, you can find it on the company’s website and the lead manager for the issue. Companies may also hold conference calls with analysts and media ahead of the offering. You can tune in to get clarifications on the gray areas or risk factors for the company.
As the offering is being prepared, companies are undertaking roadshows with global and local institutional investors to assess their appetites and the prices at which they are likely to subscribe to the offering.
The quota system
In the Indian context, small investors often burn their fingers when bidding on exorbitantly expensive IPOs from dubious issuers. To ensure they have a better experience, SEBI rules require all companies conducting IPOs to carve out significant portions of their shares to institutional investors such as pension funds, insurance companies, mutual funds, foreign portfolio investors, etc. These investors are referred to as QIBs (Qualified Institutional Bidders). Most of the shares sold in a book-built IPO are reserved for QIBs, followed by retail investors and NIIs. Retail investors are individuals bidding on shares up to 2 lakh per application. Non-Institutional Investors (NIIs) are individuals who bid more than ₹2 lakh per application.
For profitable companies that meet certain criteria, 50% of shares sold are reserved for QIBs, 35% for retail investors, and 15% for NIIs. In non-profitable companies, the QIB rate is set higher at 75%, with 15% for NIIs and 10% for retail employees. The quota system is designed to ensure that an IPO fails if it doesn’t receive enough bids from the big players. Retail investors can also look to the price at which QIBs are bidding to gauge appetite for the offering. In addition to these categories, SEBI also allows IPO-bound companies to allot shares to QIBs who register as “anchor investors” before the bookbuilding process begins. In theory, the enthusiasm shown by QIBs and anchor investors for an IPO should help retail investors gauge whether an IPO is worthwhile. But the reality is that even institutional investors can get carried away by euphoric markets and the prospect of quick profits from an IPO, so QIB or anchor subscriptions may not be a good indicator of a company’s quality.
This is how the auction works
An auction procedure decides at what price you receive contingents in a book-built offer. Based on its roadshows, the IPO-linked company sets a price band for the issue that sets the lower and upper bounds on the price at which it is willing to accept bids. The price range will be announced at least five days before the offer opens. Companies typically set a lot size for IPO bids, which may consist of a minimum number of shares.
Book-built offers are generally open for five days and are conducted electronically. Once the offer is open, different categories of investors bid for the number of shares they want to buy and the price (within the range) at which they want to take the shares. Book-built listings in India use the Dutch auction method to determine the final price. That is, the offer is valued at the highest level at which all shares can be sold. This price is referred to as the “cutoff” price. While QIBs and NIIs are required to bid within the price range, as a retail investor you can simply bid at the ‘marginal price’ that is finally determined by the auction. Once the auction window closes, all investors bidding at prices equal to or higher than the cutoff price will be eligible for allocations.
When IPOs are in high demand during bull markets, bidding alone may not guarantee you an allocation. Whether you actually receive shares depends on the extent to which the retail quota is oversubscribed at the time of the IPO.
To ensure retail investors aren’t turned away too often in IPOs, SEBI rules require companies to allocate at least one lot of shares to each retail bidder. However, such allocations are only possible where IPOs have retail quotas that are not fully subscribed or are slightly oversubscribed.
When IPOs are heavily oversubscribed, issuers find that there are not enough shares to allocate even one lot to all of their retail investors. In such cases, they choose the people who get lot by lot. In this case, despite a large application size, you may not receive any shares at all or you may only be allocated one lot. To top this, some investors are making multiple applications with family members’ Demat accounts. But luck still plays a big part in deciding whether or not you can participate in coveted IPOs.