In today's Finshots, we explain the concept of IPO financing and why the Reserve Bank of India (RBI) reprimanded JM Financial.
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The history
Introduce. The IPO market is red hot. A new company goes public every other day. And the increase in the share price on the trading day is insane. Anyone who invests earns a lot of money.
But the desire to earn even more money arises. People are not happy with sacks. They want truckloads of money. So they resort to leverage, or in simpler terms, they start borrowing money to invest. They want to invest large sums of money to maximize their absolute profit.
And they don't usually go to the bank and apply for a personal loan. Instead, they turn to their wealth manager or a non-banking financial company (NBFC) that offers this niche service. This is so-called IPO financing.
If you want to see this in action, all you have to do is look at the HNI (High Net Worth Individual) segment of popular IPOs. You will often find that this segment is oversubscribed by hundreds of times or more. And that's usually thanks to the loans they receive. For example, in July 2021, there were a number of IPOs that attempted to raise a total of ₹18,400 Crores. But people are offering a gigantic sum of ₹8.86 Lakh Crores! And around 98% of that money came from these loans tied to the IPO!
Remember the Ashneer Grover vs. Kotak Wealth Management dispute in 2021?
Well, that was due to a dispute over IPO financing. Or the lack thereof.
Nykaa, the beauty and fashion startup, was preparing to go public. And everyone was excited. It was a profitable startup, which was pretty rare. And investors expected a huge boost from the listing. Now Grover wanted Kotak to lend him a whopping 500 Crores to participate in the IPO. And he says Kotak resigned at the last moment and missed the opportunity to make some money.
But wait…how can these companies even lend such large sums of money to these HNIs?
Well, they usually don't have that much money lying around. Therefore, they first have to borrow money. This is done by issuing a so-called commercial paper (CP). Think of this as an extremely short-term bond that must be paid back in about seven days.
So they launch the CP, companies like liquid mutual funds buy it and the money then goes into funding these IPO bets for the HNI risk takers.
And all of this IPO financing can be very lucrative.
Look, no one guarantees full allotment in an IPO. It's a lottery. It all depends on how much people are interested in the IPO and subscribe to it. The larger the subscription, the less chances investors have of getting what they wanted. And while the NBFC or asset manager pays an annual interest rate of around 5% on the CP, they charge quite high interest rates on these IPO loans – up to 20%. That's quite a spread.
Also, it doesn't matter whether the HNI gets an allotment or not, it still has to pay interest on the entire amount borrowed. *
So yeah, when the IPO market is booming, it's a pretty fun time for these IPO financiers.
Okay, but isn't this a risky venture for the NBFC, you ask? At the end of the day, huge sums of money are involved. And there is no collateral or security attached to the loan.
Ah, so here the NBFC could do something different. They expect the investor to trade on their terms. This means that they obtain a Power of Attorney (POA) for the demat account and bank account of the investors. They control the entire process – from granting a loan to the bank account, submitting the IPO application, selling the shares, to pocketing the profit or absorbing a loss. Everything. This reduces the risk somewhat.
And that finally brings us to today.
The Reserve Bank of India (RBI) has raised a company that was a big fish in the IPO funding pool – JM Financial.
Why, though?
Well, according to RBI, there seem to be a few glaring problems. Apparently JM Financial provided the IPO financing at low margins. This means it gave customers excessive leverage. Also, RBI seems to have a problem with the POA practice as JM Financial controls customers' bank accounts.
RBI says JM Financial is violating regulatory guidelines. And then he even mentioned the dreaded G word – governance issues.
So the regulator laid down the gauntlet and told JM Financial that, among many other things, it could no longer engage in IPO financing.
Now, we don't know exactly what went wrong as other NBFCs are also resorting to POA and meager funding margins. However, there is speculation that NBFCs like JM Financial have violated an RBI rule.
Around the time of the Nykaa IPO, the RBI became concerned about the huge amounts of money at stake. Therefore, they issued a diktat stating that no customer can borrow more than ₹1 crore to fund an IPO application. Gone were the days of the Ashneer Grover-like ₹500 crore loan.
But Moneycontrol says NBFCs have ignored the rules and are lending more. Could JM Financial have done the same?
Another rumor doing the rounds, according to Economic Times, is that JM Financial has also increased the number of IPO subscriptions.
What do we mean?
Okay, during the IPO process, companies can easily file false applications. For example, there could be multiple details listed on the PAN card, which would ultimately lead to rejection of the application. But it will still be reported as a subscription during the IPO and may keep things looking rosy.
And perhaps by showing public interest in the IPO to HNIs, the NBFC could even encourage investors to rely on IPO funding to participate.
Yes, it's a pretty dubious practice.
Now JM Financial has categorically denied all of these allegations. They also claim to have clean corporate governance.
But the RBI doesn't believe in it. Perhaps even the Securities and Exchange Board of India (SEBI) has something to say on the matter. And who knows, every other NBFC involved in IPO funding will be nervous about what's to come.
See you then…
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*If the HNI borrows money for an IPO, it will be deposited into his bank account. When they file the IPO application, the money is blocked for this purpose but remains in the bank account and continues to earn interest.
PS: Last night, SEBI banned JM Financial from managing certain bond issues due to irregularities.
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