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Book-building: Then and now…

Jul 1, 2003

Maruti Udyog Ltd., India’s largest passenger car manufacturer, has been in the news recently. The government, which had a majority stake in the company, divested a part of its stake in the company. But instead of taking the traditional IPO issue route, it opted for the (now in vogue) ‘book-building’ route. However, it is not the first company to do so. Some companies, which adopted the book-building route in the recent past, include Hughes Software, Mukta Arts, Creative Eye, HCL Technologies, Bharti Televentures and i-flex. So what exactly is this book-building? The concept:
Book building is a comparatively new concept for the Indian investors as compared to their peers in the US or the UK, where it is a very common practice. It is a process wherein various bids are collected from investors and the entries made in a book. It must be noted here that book building is just another form of an IPO wherein investors, retail and institutional, can participate in the process and acquire shares of the company up for divestment or whose equity is at sale.

Why book building?
Why does a company choose to go through the book-building route when the conventional method (IPO) is still prevalent? The most apparent reason for this could be the price discovery mechanism, which is inherent in this process. Since institutional and retail investors have the option to bid for the equity, at or above a particular floor price, decided by the company in consultation with the merchant bankers, it helps the company realise the true value for its equity, or simply put, what the investors perceive the value (or rather intrinsic value) of the company to be. It also gives the company an insight into its credibility factor amongst the investors, which could be gauged by the demand generated for the purchase of equity up for sale. Also, through this route, the company saves on cost and time required to complete the issue.

But, how exactly is the book built and the price decided?
The entire book building process is illustrated in the chart below:

Price discovery is basically a function of the demand for the stock at various prices. A weighted average of all the bids received is calculated to arrive at the final price. Sometimes, the pricing and allocation also takes into consideration the fact that the allotment should be made in such a way so as to leave some craving for the stock post its listing on the bourses, which would provide the support needed for the stock in its early days of trading.

However, though India has adopted the US book building procedure, there is a difference in the process of the two countries. The difference lies, primarily, in the way the shares are acquired. In the US, the process is carried out at the institutional level, who in turn allot shares to their retail clients. But in India, direct retail participation is given importance. A good indication of this is the recent amendment in norms by Securities Exchange Board of India (SEBI) for equity allocation via the book building route.

The amendments:
In its recent amendments, SEBI has reduced the allocation of equity to Qualified Institutional Buyers (QIBs), which includes financial Institutions, banks and the newly added insurance companies, and increased the share of retail investors. Prior to the amendments, QIB's could be allotted 'upto 60%' shares, which now stands reduced to 'upto 50%'. Also, another change was the definition of retail investors, which previously meant those investors who bid for less than 1,000 shares. However, the definition now stands changed to an investor who bids for shares less than worth Rs 50,000.

Earlier norms…
New norms…

Another positive step taken by SEBI is the setting up of a price band, which will assist the retail participants in placing their bids. This would act as a good guidance for the retail investor in placing the bid, as the previous method had a flaw in the sense that a floor price was fixed below which the bidder was not allowed to bid while there was no upper limit to the bid price. This would often leave an investor guessing as to what should be the price at which he should be placing his bid so as to get a pie of the allotment. However, this shortcoming is taken care of. Now the investor knows the upper limit and can place the bid at the upper end of the price band if he finds the same as value for him. Therefore, the risk that he has overpriced his bid is reduced to some extent.

Another change made by SEBI in the rules governing primary market issues is that institutional bidders cannot withdraw their bids. This move is again in the interest of retail investors as the current ‘avtaar’ of book building could be misused to take small investors for a ride. Prior to this change, institutional bidders could tie-up with the lead book running managers and submit inflated bids thus creating an artificial demand and price for the issue. This would attract the ignorant and innocent retail investors into subscribing for the issue and then the institutional bidder could easily withdraw its bid, leaving the small investors in the lurch. However, now it makes it rather impossible for the institutions to take retail investors for a ride.

A couple of other changes include the introduction of a 15% greenshoe option for IPOs adopting the book building route in case of an oversubscription of the issue. The greenshoe option, basically, gives the issuer company a right to allot an additional 15% of equity. This right will be exercised by the company, but naturally, in the case of extra demand due to oversubscription of the issue. This would, thus, help reduce price volatility post listing of the security. Moreover, the decision to reduce the listing period interval from 15 days to 6 days post the date of allotment ensures that the investor’s finances do not remain locked in for a longer period of time. This move is more in line with the international practice.

Another welcome change in order to safeguard investor interests includes making the board of the company more responsible towards what they state in the book building document. Also, the CFO of the company has to authenticate the financial statements stated with this document. Bottomline, the chief executive officer or the chief financial officer of a company will certify the disclosures in the offer document. Thus, the recent amendments announced by SEBI, aim at strengthening investor confidence.

Going forward, since this is a relatively new concept for the Indian markets, it will take some time for an average investor to grasp all the nitty-gritty’s involved in the book building process. But then, one must remember, that Indian investors tend to adapt themselves quickly to changing systems and scenarios. To cite a couple of examples, the change from the traditional Badla system to derivatives (futures & options) and the upgradation from the T+5 trading system to the current T+2 system (US and UK still follow the T+3 system of trading). Indian investors are now ready to accept change for the betterment of the capital markets. Always remember, an aware investor always has an edge. Happy investing!

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