Sebi needn’t worry about poor retail participation in IPOs

The Securities and Exchange Board of India (Sebi) is concerned about low participation by retail investors in recent initial public offerings (IPOs), according to a Business Standard report. Should the market regulator be worried?

Last week, this newspaper pointed out that although IPOs in India have been fairly good at delivering short-term returns, long-term performance has been weak. Only three in every 10 stocks deliver double-digit annual returns in the long term. In this backdrop, one may well wonder if Sebi should rather be relieved that retail investors aren’t chasing the IPO fad.

At the same time, since household investments in equities are still extremely low, it’s understandable that the low level of participation is leading to some worry. But there are many reasons why IPOs shouldn’t figure majorly in policymakers’ plans to correct this.

Research shows that the long-term performance of IPO investments is poor. Jay R. Ritter, known as ‘Mr. IPO’ for his extensive work on the subject, says in his paper, The long-run performance of initial public offerings: “In the long run, IPOs appear to be overpriced. Using a sample of 1,526 IPOs in the US, I find that in the three years after going public these firms significantly underperformed a set of comparable firms matched by size and industry.”

Ritter and three other economists have collated data and research from 52 countries (updated till mid-2015) that show similar trends. They also point out there is evidence that companies successfully time their offerings for periods when valuations are high. It’s little wonder returns mostly end up being low in the long run. There are hardly any issuances when markets are headed south and valuations get reasonable. Edward M. Miller, an economist with the US Department of Commerce, gives a reason for the underperformance in his paper Risk, uncertainty and divergence of opinion. He points out that the most optimistic investors buy an IPO, driving up prices. Matters are made worse simply because there’s no way to short-sell an IPO. Eventually, as these constraints ease, uncertainty about the future reduces and a wider variety of views get expressed, and prices revert to the mean.

Whatever the reasons, it is well established that most IPO investments perform poorly in the long run. In fact, in some cases, such as the Reliane Group’s Reliance Power Ltd issuance at the peak of the 2007-08 rally, shrewd marketing brought a number of new investors to the market, only for them to be left sourly disappointed later. Needless to say, these investors would think twice over before considering equity investments again. A better approach for retail investors is to pursue regular or systematic investments in equities or equity mutual funds. This way, they can avoid making most of their purchases when valuations are high.

In fact, Sebi could reconsider IPOs’ special quotas, where 30-35% of the issuance is reserved for retail investors and another 10-15% for other non-institutional investors. The quota is largely used to take advantage of short-term underpricing and sell IPO stocks soon after listing. It hardly serves the purpose of bringing new long-term retail investors into the market. As the article mentioned earlier points out, even though only three in 10 IPOs delivered decent long-term returns, three in every five listed at a premium of over 15% on listing day. J.R. Varma of Indian Institute of Management, Ahmedabad, has said in the past that short-term underpricing of IPOs is effectively compensation for investors who contribute to price discovery in the presence of asymmetric information. Companies tend to underprice IPOs (relative to peers and prevailing valuations) to attract investors who will contribute to the price discovery. Retail investors, he says, bring nothing to the table in the process, and earn rents without doing anything economically useful. That, according to him, is reason enough to do away with the quotas prescribed by policymakers. But now that there is ample empirical evidence that most IPOs aren’t good for long-term wealth, policymakers have even more reason to reconsider the quota system. After all, why encourage participation in a category that underperforms in the long run, and also promotes short-term speculation?

Varma says, in jest, that instead of the myriad number of risk factors mentioned in an IPO prospectus (which likely the majority don’t read), the warning for investors should be crisp, as on cigarette packs: Investing in this IPO may result in short-term gains, but has a greater chance of poor long-term risk-adjusted returns.

Even if Sebi finds all of this too pragmatic, the least it can do is to nudge investors towards making systematic or regular investments in equities. By worrying aloud about low retail participation in IPOs, it is only sending the wrong signals. Of course, on its own, it will not be able to overcome the investing community’s tendency to buy during market peaks and exit during sharp corrections. But it can certainly do its bit through effective investor education and nudging retail investors towards the right investing path.