Unicorns are strange creatures: formed in private markets, they are now roiling public markets. Almost every loss-making Unicorn that has listed in the recent past is quoting below its listing price. The only exception is Nykaa started by an ex-investment banker.
Unicorns are firms that “realise” their billion dollar-plus valuations through flipping of shares among a cozy club of private equity investors. A few investors flipping shares between each other to raise the value of each other’s portfolios is a time-tested technique to raise valuation with every round. This is possible in private markets but if these investors were to do the same in public markets, it would be called circular trading or market manipulation. Such an activity is specifically prohibited and considered fraudulent in public markets. This dichotomy in what is encouraged or accepted as practice in private markets and banned or frowned upon in public markets is what Unicorns, its promoters and shareholders need to understand.
Private equity investors, when they take these shares public, ultimately flip these to retail investors, who are ultimately left holding the can. Again this time-tested technique, called the “greater fool theory,” has been honed to perfection by merchant bankers, promoters and private equity investors.
Varun Sood, a journalist, recently tweeted, “On 22 Dec, Morgan Stanley’s research arm put out an overweight rating on Paytm, giving a target price of Rs 1875. In the quarter ended Dec, Morgan Stanely (sic), which was the lead banker & an anchor investor, sells the max number of Paytm shares. On 22 Jan, Paytm is at Rs 959 a share.” While the research arm claims it is independent of the merchant banking unit, the fact of the matter is that they all seem to be involved in cheerleading the price of the IPO.
The old warning of buyer beware or caveat emptor is often raised in defence of this practice. Yes, the buyer has to beware and the IPO draft red herring prospectus (DRHP) does provide information. However, each DHRP runs into 700-1000 pages in tiny, hard-to-read fonts, drafted by clever merchant bankers. As happens with verbose documents, this deluge of information does not explain or clarify and only confuses the retail investor.
Moreover, “buyer beware” is a loose interpretation to justify the absence of proactive regulation. It basically gives a license to some smart alec to fool the retail investors, and take protection under the argument that fools allow themselves to be fooled, and it’s up to the retail investor not to be fooled in the flipping game.
This does not mean that the valuation has to be determined by the regulator. It only means that the regulators should approach IPOs through their mandated lens of consumer protection – not only should the buyer beware, but the seller too has to ensure that a reasonably educated and intelligent person can take a reasoned call on the product/service being sold.
Another way is to insist that those determining the valuation should have more skin in the game. Beginning with the merchant bankers, who are part of the team that defines the IPO’s book building. The fees of these merchant banking firms may be paid through shares of the company with a lock-in of six months to a year. This will ensure that they are more careful about how they price the stock. If merchant banking firms also want their employees to be sincere, they can even pay them bonuses through stock options. This will ensure that the skin in the game is complete right up to the last merchant banker’s employee.
Second stage is the pre-IPO placement. This is where the justification for the price band is ensured by asking ‘friends’ in institution investment firms to put in money. “Blue blood institutional investors are wooed by merchant bankers, promising high listing gains, and creating an artificial demand” for the shares. The claimed rationale is to stabilise the price band, but this is outright rigging. This stage demands far greater scrutiny and transparency and supervision.
Especially, if any mutual funds are putting in money at this stage. The mutual fund manager has to see it as an exceptional decision because any loss or profit has to be docked at the AMC (asset management company) level instead of just at the fund level. Once the AMC is involved in the fund manager’s decision, their stake in this decision will be higher and frivolous investment will be shunned. Moreover, institutional investors should not be allowed to leverage any pre-IPO through borrowings.
Merchant banks, which are part of an NBFC, actually work out easy financing schemes for institutional investors, pushing them towards large investments in the pre-IPO allotment stage. Even if they don’t, there is enough easy money sloshed around in the system to be borrowed for funding the pre-IPO placement or even the IPO itself. This is what the BharatPe founder was arguing about with the Kotak employee on that celebrated audio clip that Kotak did not fund his investment for the IPO up to the tune of Rs 500 crore.
What is Conflict of Interest in Public Markets
Recently, the issuer companies have been using the proceeds from the IPO to acquire other loss-making internet companies. There is nothing wrong with the acquisition per-se, if that is the purpose of the IPO and is disclosed properly. But, very often, the promoters of these newly listed companies are also angel investors in the acquired companies. Such an acquisition is a clear conflict of interest in public markets and is seen inimical to public shareholders. It is akin to promoters doing front running by acquiring stock in a target listed company, clearly a fraudulent exercise and punishable under SEBI’s regulations.
New-age companies are used to overturning traditional self-regulatory practices. But such conflicts show poor corporate governance. This may not matter in the private markets, but it does in public companies.
Role of Credit Rating Agencies
SEBI in its revised norms issued in December 2021 has said that credit rating agencies will monitor the end use of IPO proceeds for a period of one year. In the past too, credit rating agencies have been maligned because of the conflict of interest that arises when they are paid by a client who they are supposed to monitor. This conflict of interest can be avoided if credit rating agencies are paid from the investor protection fund under the aegis of SEBI or from such a fund maintained by the stock exchanges. They will then maybe have more interest in ensuring that the proceeds of the IPO funds are monitored more closely.
Second, the credit rating agencies can be paid from the investor protection fund to also issue a rating on the risk that they perceive about the valuation of loss-making companies. This will ensure that the retail investors are at least warned about the risk in advance and merchant bankers also know that too high a valuation may invite a riskier rating.
There has been criticism of SEBI’s revised norms as harking back to CCI price control days of ‘80s. This is a misplaced judgement as markets can only function best if the retail investors remain invested. If retail investors walk away from primary issues, it will do more harm than good to fund raising. Balance between protection and development is a role a regulator has to play; it can’t veer towards the development side too much at the cost of retail investors. Plus there are enough stakeholders out there interested in developing the market, SEBI is the only entity protecting retail investors’ interest.
The author is CEO, Center for Innovation in Public Policy. The views expressed in this article are those of the author and do not represent the stand of this publication.
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