There have been fairly extensive discussions on pre-IPO (initial public offering) placements in various circles, such as, TV programmes, Security and Exchange Commission, and traders and brokers in the stock market. SEC has been prompted to take some actions. It has been made out in the media that the recent stock market decline had been due to the fairly active pre-IPO placement activities. I may be alone in my opinion but I believe that the worry is misplaced, and the actions taken are ill conceived and very harmful from an economic perspective. I also object to the steps that sweepingly benefit one group (especially a small group that is interested in gambling), hurting the group that is supplying long-term capital embracing significant risk and uncertainty in building plants, buying machinery and equipment, setting up an operating system, and bringing actual production and utilities in the economy. Once this major uncertainty and risk (whether there will be an actual economic unit) is removed and after economic activity is ensured, the stock is placed in the stock market, the value of the company can be ascertained in terms of its productivity, profitability, and generation of cash flows.
Let us first see what pre-IPO placement does. I want to discuss this because, in all the deliberations, the discussion on this is missing. Pre-IPO placement has been presented as a villain completely ignoring the crucial purpose it serves. If a proposed company needs to raise 100 Crore taka, it will typically raise at least 50 Crore taka from investors who are willing to risk their money even before the factory is built, even before there is a history of business, even before there is a proof of profit. This relieves the burden on the merchant bankers who must ensure that necessary amount is raised. There are not a lot of people who can commit several crore takas without any expectation of getting any return on the money, but with the full possibility of losing all the money committed.This is a process that ensures that an IPO will not be undersubscribed. If you point out that IPOs are typically oversubscribed, let me point out that (1) the number of issues offered to the public is significantly lower because pre-IPO investors have already taken up a large number of shares, reducing the supply, (2) the commitment in the pre-IPO raises the confidence of likely ordinary shareholders in the potential of the company, and (3) risk element whether the company will engage in actual business is mitigated.
If you just consider the above paragraph, you will realise the magnitude of risk undertaken by pre-IPO shareholders and the risk undertaken by ordinary shareholders post-IPO involves only market volatility and noise. Ordinary long-term shareholders have earned an average annual return of 30 per cent and above in the stock market in a time span of 1999 to 2018. Given the risk taken by the pre-IPO investors, the expected return on pre-IPO placements will naturally and theoretically be higher. The risk undertaken by ordinary shareholders is anywhere near what pre-IPO investors do.
There is no justification to expect the stock market to relentless go up without limit. Sometimes, the stock market will decline. That is the nature of the stock market. The stock market showed sign of life after the national election, but it could not maintain the upward trajectory. It is not that unusual. When a market declines by ten per cent, the market is thought to be in the correction phase, and the market goes through correction phases not that infrequently. It is very common right after a significant run-up, like the one we had in January 2019.
I am not saying that there is nothing to be concerned about the decline in the stock market. But, the concern has been misplaced. When a market goes through these phases, it is customary and fashionable to say that this was due to market manipulation, some devilish machination, some syndicates, some dark forces behind the screen of the stock market, and so on. This time, somehow, pre-IPO placements got the most bum rap. I suspect, some influential player in the market unexpectedly lost some money because their game did not turn out exactly the way they hoped. That is supposed to happen once in a while and the regulators should not react to just about any complaint if this comes from the “influential” group.
Consider the DSEX index for last one year. The peak was on January 24, 2019. The stock market rise was somewhat euphoric right after the election and it started running out of juice in February. The index value had shown a gain of over 14 per cent in just about a month and expecting that trend to continue unabated is not realistic. On an annual basis, that rise was 168 per cent. Nobody was unhappy then and it sort of spoiled the players. The technical charts
goaded traders to bet more often and more, thinking there was no end to good times. But in the stock market, good times always end. The rapid rise gave way to a correction. If you estimate the one year return from June 18 to May 19, it came to a negative 1 per cent. The algorithm of DSEX index does not capture cash dividend. If you consider the cash dividend paid out which is normally around 4-6 per cent, long-term diversified investors actually had a gain of 3-5 per cent over this time frame. In Bangladesh stock market, if you play long, it is reasonable to expect 30 per cent annual return in spite of all the ups and downs. But if you want to get rich by trading on a daily basis, and form your investment strategy by remaining fixed on the computer screen, you should be ready for some loss once in a while and 1 per cent negative return does not really count as a loss. I have a difficult time understanding why there was such a hue and cry for just a 1 per cent negative return in one random year. Should you really be trading in the stock market if you cannot stomach a 1 per cent drop in the value of your portfolio? I am more concerned about the fact that the stock market, relative to the historical average, did not produce very good returns over the last few years. If you look at the chart above, the index has remained basically flat over this time phase, and has remained fairly flat for last three years.In the Working Paper 95 by Centre for Policy Dialogue, Moazzem and Rahman (2012) list several questionable activities that make certain stocks move. They mentioned bull cartel and serial trading to lure (I am reluctant to say innocent) market participants into buying stocks at unreasonably high prices, only to see the price drop. I suspect that happens and I am going to blame the SEC and DSE from promoting technical analysis. They teach you how to do technical analysis, and inadvertently, create conditions for setting up these traps. People relying on technical analysis are much more likely to fall in their trap than those who make diversified investment for the long-term based on fundamental analysis. Instead, I would like SEC to develop capabilities to identify bull cartels and serial trading. That would be much better than creating wrong-headed suicidal rules.
Let us consider the damage the proposed measures will do to the market development and industrialisation of the country. We can currently about 12 good IPOs per year and the desire is to raise that to about 18 in the near future. Let us work with the following simple assumptions:
1. There will be 12 companies per year making initial public offers.
2. Each company needs Tk 100 crore.
3. 50 per cent of the money will be raised through pre-IPO placements (within one year of IPO), and half of that (25 per cent) will be through controlled IPO (that is pre-IPO lock in for one year).
In this scenario, pre-IPO investors will shell Tk 600 crore to ensure the viability of business, and reduce the supply of open issue to hold a reasonable price of the IPOs. If you lower this proportion to 25 per cent, you better be certain that there will be buyers to supply the necessary Tk 300 crore to take up the open issue shares without causing a drag on the opening price. You will probably be also jeopardising the viability of the new business.
It is well-known that Bangladesh has severe shortage of capital. Bangladesh also has severe shortage of business entrepreneurs and risk-takers. Nearly $6 billion is laundered out of the country every year, which otherwise could have been available for investment in the country. You disrupt the system to reward those who seek profit on a daily basis and punish those who risk money with all returns on hold for at least one year, you had better be sure that is the right thing to do. The proposal to limit pre-IPO placement limit to 25 per cent will be a desirable goal in the future, but at this point, this comes with the presumption that the balance can be raised assuredly from our weak capital market without putting any pressure on the possible open price.
A suggestion to enforce a lock-in for pre-IPO placements for three years is plain crazy. It is not easy to get people to lock in Tk 600 crore per year without any guarantee of any return after a year. A three year lock in will raise the amount to Tk 1,800 crore and the pre-IPO investors will see no return for three years. It will be a pipe-dream to think that, in the present capital market, we will be able to raise that kind of money knowing that it will remain tied up for three years generating no benefit at all. Bank FDR and laundering money out of the country will clearly look more desirable. This is to “guarantee” that traders in the stock market (a very small percentage of the population and a small bit player in industrialisation) have handsome profits on a regular basis with no tax on capital gain to pay. It is a strange logic that day traders’ profits matter more than who are risking money to build productive facilities without any return for a long stretch of time. The proposed change to a three year lock in will throttle this process of capital formation.
The off-loading is essential in supplying capital for the growing economy of Bangladesh and it is suicidal to try to make it unavailable. Off-loading allows capital to be recycled for new businesses, makes larger amounts available for next cycle of investment, and it also provides a mechanism where common shareholders can participate in the good fortune of a company once the initial risk, uncertainty, and errors in evaluation is behind. Traders in the stock exchanges will never provide capital to companies at the stage where possibilities of fraud, uncertainty, and evaluation errors are at the highest. Without the investment by pre-IPO investors, these opportunities will not be created for common risk-averse investors, and yes, traders who are sure that they can predict the stock price for the next day. The mechanism looks something like the following figure. If you break the process, you eliminate a reliable source of capital for new investments.
And what benefit will it provide to delay off-loading by two years. If the off-loading truly has any significant effect on stock prices (it actually does, but the market must reward the risk-takers), this will be delayed by two years. The effect will not be eliminated and we will eventually have to go through the off-loading process and a prospect of a hit on the particular stock price. The secondary market is supposed to allow off-loading of shares so that money is freed for new investments. The secondary market does not assume any risk at the development stage of a firm, the sponsors and pre-IPO investors do. Given the magnitude of risk and shortage of capital, it is only natural that they will reap higher return than the 30 percent annual return long-term diversified investors are getting from the capital market.
The off-loading process actually brings a discipline to the market. It curbs the appetite for increasingly higher price not backed by fundamentals. Pre-IPO investors are not likely to off-load shares if they feel that they are not getting fair price. If the price falls below the intrinsic value, new buyers should enter the market based on fundamentals. The intrinsic value at this point is much clearer and that should set the price in the market, not market rumour or technical analysis. SEC can play a role here. It is there job to ensure the fundamentals of the company are disseminated in the market in very clear term, without any ambiguity, any hidden but significant information. They have to ensure that directors do not sell more than what they are allowed to and the market is notified of their intentions. They have to keep an eye on earnings management. SEC must also encourage listed companies to maintain decent websites and archive of financial reports.
Here are my final words for this article. A three year lock-in period is suicidal for industrial development and the capital market. Don’t do it. Do things that help build trust in the market, not destroy it.
The author is a professor of finance and the Director of Graduate Studies, North South University.