Public offers for Steel Authority of India Ltd. (SAIL) and Coal India Ltd. in the near future will go a long way in determining the success of the Indian government’s efforts to raise billions of dollars through disinvestment this fiscal year. Various news organizations reported this week that Coal India would try to raise US$2.9 billion in a share sale in August. Preparations were already under way for a US$3.6 billion SAIL issue.

Each of the offers would constitute around a third of the US$9 billion that Finance Minister Pranab Mukherjee proposed to raise through disinvestment in his budget announced in February. The first few issues of 2010 had been disappointing, mainly because the government overpriced them, some industry observers say. The Steel Authority offer would try to entice retail investors with a 5% discount to what institutional buyers would have to pay.

India’s recent history of big public-sector offers — both initial public offerings (IPOs) like Coal India’s and follow-on public offerings (FPOs) like the Steel Authority’s — has involved the significant participation of another government organization, the Life Insurance Corporation of India (LIC). In the US$2.2 billion follow-on offer of NMDC (formerly known as National Mineral Development Corp.), LIC saved the day. While high-net-worth individuals and retail investors bid for only about a fifth of their allotments, and the interest of foreign institutional investors was nominal, LIC bid more than US$1.5 billion. The issue, which closed March 12, was subscribed 1.4 times. In early February, LIC pumped in US$950 million in the US$1.9 billion IPO of electricity generator NTPC.

Critics question whether the exercise can truly be called disinvestment. “The government has achieved its objective of getting the money,” says Arun Kejriwal, director of Kejriwal Investment & Research Services, who advises potential subscribers to public offers. “But has there been a price discovery? Has the ownership become wider?” About LIC’s role, Kejriwal says: “It is not in anybody’s interest to have such a large holding in one entity.” He notes that in the one issue that gave a substantial return on listing — the follow-on offer of Rural Electrification Corp. (REC) — LIC came away without a share because it underbid.

The ‘Pretense’ of an FPO

“Why make the pretense of having an FPO?” asks business daily The Financial Express. “All that the government needed to do was place the shares with LIC, which could then have gradually offloaded the shares into the market. Because ultimately, LIC has ended with the biggest chunk of NMDC stock, and that’s what it will have to do.”

The government, meanwhile, says it has no role in LIC’s decisions. “LIC makes its decision based on commercial factors,” disinvestment secretary Sumit Bose told The Economic Times. “It bid for REC as well, but it was outbid by other institutions. LIC’s equity drive is not just for public sector companies. LIC is also looking at dispersed ownership and expanding its portfolio. It is a big investor in IPOs of private companies as well.” According to Bose, there has been no government arm-twisting in LIC’s bids. Kejriwal counters, “Does anybody ever admit to arm-twisting? But actions and outcomes speak for themselves.”

Public-sector issues for 2009-2010 took in just shy of the government’s US$5.4 billion target. But the Union Budget hiked the goal for the current fiscal year. (See “Prudent and Progressive’: Why India’s New Budget Gets More Cheers than Jeers.”) If the response is poor and issues list below their offer price, reaching the target could be difficult. The government’s objectives should be more than merely balancing its books, Kejriwal says. Recent IPOs by private-sector companies such as Persistent Systems and DQ Entertainment have been oversubscribed and have listed at significant premiums to their issue price. “They were attractively priced,” he notes. Adds Ajay Parmar, institutional equities head at Emkay Global Financial Services: “It is always advisable to leave something on the table for investors.”

So has the government been too greedy? “I think I partly agree that the issues are being priced aggressively,” Parmar says. “The argument for aggressive pricing is that the investment is good for the long term and one can get a decent return in a three- to five-year horizon. But a wise investor would not be encouraged to buy the stock after knowing that it is likely to get listed below issue price. For a large global fund, however, it makes sense to invest even at higher prices. First, this kind of participation gives them ownership in companies that are sometimes monopolies or preferred vendors for the government. Second, global fund managers are normally required to put a sizable amount of money in any company, and acquiring such shares from the secondary market would mean a significant impact” on market prices.

Traditionally, some degree of underpricing has been the norm in many countries. In the United States, the average first-day return on IPOs was 7% in the 1980s, according to a paper by U.S. academics Tim Loughran and Jay R. Ritter. Returns doubled to almost 15% for most of the 1990s before jumping to 65% during the Internet bubble years of 1999 and 2000. From 2001 to 2003, it reverted to 12%. “We attribute much of the higher underpricing during the bubble period to a changing issuer objective function,” the researchers noted in their 2003 study. “The reason that IPOs are underpriced varies depending upon the environment.”

A Case for Aggressive Pricing

Rajesh Chakrabarti, assistant professor of finance at the Hyderabad-based Indian School of Business (ISB), agrees that IPOs and FPOs have traditionally left some money on the table to create investor interest. This is particularly needed for little-known companies. “It is not likely to be important for large PSUs (public-sector undertakings) that should be known to informed investors,” he says. “It is the retail investor who stays out unless convinced of a significant underpricing. Institutions, with or without government prodding, seem to be okay with it. For the government, underpricing an equity offer is tantamount to transferring taxpayers’ wealth to investors who constitute less than 5% of the population. It is time we stopped worrying about retail investors. Their proportion, vis-à-vis institutions, is already quite high in India as opposed to, say, the U.S.” The government needs to be aggressive in pricing public offers, Chakrabarti notes. “Massive oversubscriptions are evidence of pricing inefficiency and should not happen. Optimum pricing would indicate the issue scraping through. So, in brief, we cannot say pricing has been overly aggressive in these [public-sector] issues.”

There are vested interests in overpricing. Promoters set a fund-raising target with an objective to dilute as little of the stake as possible. Merchant bankers set an unofficial price-per-share target with the promoters. If they can get more from investors, they get part of the amount as a bonus.

For public-sector issues, the price is set by an empowered group of ministers; the bankers’ role is limited. But they, too, prefer a higher price. For such high-profile issues, bankers often forgo fees. First, they build goodwill with the government, which can help them in other ways. Second, it’s good to have such big IPOs on their CVs when they bid for private-sector new-issue assignments. Third, public-sector IPOs are tallied in end-of-year rankings. Reputation and size count in this arena. The bigger the issue, the better. So there is a bias toward higher pricing.

A Lottery Culture

In a way, the government can be blamed for building expectations, critics say. New issues have long been regarded as a gamble. In the pre-liberalization era, subsidiaries of foreign companies were forced to dilute at prices set by the Controller of Capital Issues, a post now abolished. Shares of blue-chip companies were on offer at ridiculously low prices. Anyone who got an allotment made a fortune.

The lottery culture continued when the first public-sector undertakings were disinvested. Bundles were created of shares of different companies and these were auctioned to large investors. Some of the companies paid off handsomely, others were duds. “It’s a matter of what you are used to,” Kejriwal says.

In the meantime, the Securities & Exchange Board of India (SEBI) has tweaked the rules, confusing the situation. The NTPC issue followed a French auction system, which nobody quite understood. “I think we need to see French auction from the Indian perspective,” says Emkay’s Parmar. “Let us test it for some more issuances.” But after the NTPC issue, SEBI clarified that the French auction was just a suggestion. NMDC went back to the traditional book-building route.

SEBI has also mandated that qualified institutional buyers, which include foreign institutional investors, will have to put in 100% of the bid amount on application instead of the 10% at present. While this is yet to take effect, some observers fear that liquidity problems may temper the response to IPOs. “Bringing the institutions at par with retail players in terms of application money may have a temporary impact because of liquidity issues, but it is unlikely to be a significant one,” ISB’s Chakrabarti says. But foreign institutional investors put more than US$4 billion into the Indian markets in March, so even a temporary impact could cause a change in sentiment. Overall, however, the creation of a level playing field has been welcomed — if SEBI doesn’t backtrack. “This is a great move on the part of SEBI,” Kejriwal says. “It will be good for the markets and retail investors who have been becoming more selective.”

Investors’ becoming more selective is not a purely Indian phenomenon. According to The Wall Street Journal, “despite a bullish outlook for Brazil’s economy, local companies are running an obstacle course when it comes to IPOs.” The Financial Times reports that “Beijing’s regulators have injected a few more jitters into China’s nervy but always hyperactive stock markets – taking a swipe at ‘irresponsible’ pricing of IPOs…. Media quoted an official of the China Securities Regulatory Commission as saying institutions were ‘irresponsibly driving up’ IPO prices. The remarks come amid an increasingly lackluster investor response to mainland IPOs.”

But in China and Brazil, the government budget doesn’t hang in the balance. In India, the finance minister is using disinvestment to balance his books. He has received a pat on the back from Standard & Poor’s, which has raised its outlook for India to stable. But that outlook could easily be reversed if the disinvestment plans — and the fiscal deficit — don’t meet targets.