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What’s in an IPO? Watch out for red flags

Careful study: Investors monitor share market prices at a brokerage in Kuala Lumpur. For investors, it is advisable to analyse the selling shareholders in an IPO.

THE listing of a company on a stock market is a process of selling its shares to public investors via what is typically referred to as an initial public offering (IPO). For an IPO, there are two alternatives as to how the shares are sold to the public and they are either via a public issue of new shares; or a combination of offer for sale (OFS) of existing shares and public issue of new shares. An OFS, as the name suggests, is the sale of shares by existing shareholders and hence the proceeds derived from the sale accrues directly to existing shareholders, who are typically promoters of the company too. As proceeds from a public issue accrues to the company, the company would spell out the utilisation of proceeds from the IPO in its prospectus. This normally includes utilisation of proceeds for the purposes of capital expenditure, working capital, and of course, listing expenses. In some cases, proceeds from an IPO is also used to repay bank borrowings. In an IPO, there are a few categories of investors who subscribe to the offering and this includes via application of shares that are available for subscription to the Malaysian public, subscription of shares by eligible directors and employees, private placement of shares to identified bumiputra investors approved by the Trade and Industry Ministry and, last but not least, private placements to selected investors, which include institutional investors. For retail investors, the process of application is straight forward whereby investors apply for number of shares they wish to subscribe for by paying the full sum on application. If the issue is oversubscribed, a balloting will be done to allocate the shares that were reserved for the retail investors. Successful investors will be allocated a portion of shares that they had applied for with the balance money returned to them within a certain time frame. For institutional investors, the process simply involves these investors filling up a form of application and submitting it to the investment bank(s) running the book-building process. Allocation of shares too will depend on the book-building process, which is basically a function of demand and in certain cases price too. If the demand for the new shares is strong, there is a tendency for this group of investors to over-bid their actual demand to ensure they get their intended number of shares that they want in their portfolio. For example, if an institutional investor’s actual demand is one million shares in a particular IPO and the book building process shows that the bid is already 3x covered, the institutional investor will tend to bid-up his actual demand by the same multiple, resulting in their bid rising from one million shares to three million shares, just to ensure the fund is allocated their original intended demand. Indirectly, this creates a chain reaction among other bidders and they too over-bid their actual demand, to the extent the whole process is actually artificially inflated in terms of the book-building process itself, which does not reflect the real demand. This happens as institutional investors only pay for their allocated shares after the book building process is completed and in essence, the over-bidding process that they undertake does not cost a single sen. Perhaps the authorities need to step in to ensure this process is more transparent so as to project the actual market demand of an IPO by having the institutional investors to actually fully pay for the number of shares that they are subscribing rather than just bid for the shares and make the necessary payments upon book closure and allocation. Back to the IPO, other than LEAP market listings, which are mainly sold to sophisticated investors, Bursa Malaysia has so far seen 12 IPOs this year with 10 of them being listed on the Ace market and two others on the Main Market. The table summarises the 12 IPOs this year, which includes three that are yet to be listed as their IPO was only launched recently. From the table, it can be observed that three companies so far came to market by offering on a public issue while the rest had a combination of public issue and OFS. For the nine that had some combination of OFS and public issue, the ratio of OFS ranged from as low as just 8.7% to as high as 80%. For investors, it is advisable to analyse the selling shareholders in an IPO. One thing an investor would perhaps want to avoid is to subscribe to shares where either the majority shareholders are exiting or in some cases, the selling shareholders includes key management personnel as well. This basically signals a scenario where the shareholders are cashing out to a certain extent, although they still remain as significant and major shareholders. Another point is to look at the IPO scheme which is carried out by most companies at the pre-IPO stage. In this step, the listing vehicle undertakes the IPO scheme whereby various companies are injected under the listed vehicle typically via issuance of pre-IPO shares and effectively making the vendors of these companies shareholders of the company going public. In most cases too, these pre-IPO shares are issued at a much lower price than the shares that are sold to the public, while in some cases, the shares issued to the vendors undergoes some form of capital adjustment via a share-split exercise. There are also cases whereby shareholders of the company going for IPO may have extended a lending facility to the company and these are subsequently converted into equity and at times these shares form part of OFS by the promoters of the company in the IPO. On the use of proceeds, as mentioned earlier, it is rather acceptable to see new and upcoming companies getting listed on Bursa Malaysia for the purposes of fund raising to expand their businesses, either geographically or by increase in terms of their market reach whether in terms of higher capacity of production or in some cases more service or outlets selling the company’s products. However, if the proceeds of the IPO are solely used to repay bank borrowings, it raises a question mark as to the purpose of the IPO, especially if one looks into the reason why the company ended up with some form of debt prior to the IPO. As a matter of fact, the authorities should restrict IPOs that come to the market solely to retire existing debts as this is clearly not a purpose of a company going public. There have been cases of an IPO that comes to market whereby the promoters have already cashed-out of the company via a generous dividend, perhaps a year or two before the IPO and that dividend was made possible from a borrowing facility that was obtained to partially fund the dividends. On IPO, the company uses proceeds of the public issue to retire the bank borrowings that was initially taken to partially fund the dividend. Effectively, the promoters of the company are being rewarded twice. Once, via the OFS of the shares that they are selling in the IPO and the second time via the public issue, where the proceeds are used to pare down the debts that was taken to partially fund the generous dividend. In essence, an IPO is not so straightforward and investors are advised to read the prospectus to understand not only the IPO scheme, but also the nature of the IPO in the form of OFS and public issue of shares as well as utilisation of proceeds from the IPO. Red flags are there, only if we bother to read and understand them and not get carried away by an IPO that comes to market, especially if its judged simply by its name or by the name of the promoters. Pankaj C. Kumar is a long-time investment analyst. Views expressed here are his own.

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