In the public eye
A company which plans to go public needs to come out of its cocoon and transform itself to put its best foot forward. Sharad Rathi, Head-Marketing and Origination, Investment Banking, Almondz Global Securities talks about the process; in conversation with Katya Naidu.
What is the ideal time for a company to go in for an IPO?
When a company achieves a minimum optimal size; for instance a mid-cap or a small- cap company should achieve a turnover of around Rs 80–100 crore. That is the minimum required size for a company to achieve to take the next step which is going public. Once this size is achieved, then a minimum of Rs 50–100 crore of growth capital can be raised from public.
But it depends again from sector to sector. Such kind of top line may not be required for some sectors where the margins are very large but for particularly a manufacturing company, this kind of size is required. Same size is optimal even for pharma companies. Otherwise, one can always come out with an IPO but it would be difficult for an investor to be interested in it.
Does the age of a company have a say in the decision to go in for an IPO?
A company needs to have a track record of at least three to four years which is what the market looks at. A new company will not go well with them unless it is promoted by a very large group which is very well established and has a big name. Reliance is the best example for this. They can always promote a refinery which is a new company and they can ask for a premium. But for a smaller sized issuer, either the promoter has to be well established with a good background or the company itself needs to have a good track record. In any case, to reach that size of around Rs100 crore topline you need to have atleast three to four years of operation. The turnover in the first year cannot go to this size, it needs to be gradually scaled up.
Companies which go in for an IPO also have the likelihood of attracting Private Equity (PE). How do the benefits of an IPO measure up to that of PE?
We did the IPO of a pharma company recently but before that we were virtually on the verge of closure of the private equity deal. Problems arose when the PE asked for a majority stake in the com-pany, which the promoters did not want to part with. This was an overseas fund and the typical model is where they look for a majority stake of about 51–76 percent. They look for family owned businesses and they put professional managers in the company, grow it for two to three years and then sell it off. They are not long term players. Of course they gave a very good valuation and which is much better than the IPO pricing but yet promoters were not interested in giving away the majority stake.
But I do agree that PE is definitely possible. Typically, the time required is more or less the same for a PE transaction and an IPO. But, there are PE rights attached to this kind of transaction which most of the promoters are not really comfortable with. Frankly, what happens is that most of these companies were very closely held and have been run more like proprietary businesses. And they have to move into a corporate structure, follow corporate governance and then there are statutory guidelines and norms that they have to follow. Typically for a PE investor, these norms are more stringent and they have their involvement in policy making, decision making and one needs their conference for matters related to expenditure etc. Again, they have a right to remove their investment in case projections are not achieved and hence, the trigger is always there. For a professionally managed company, PE is a good option but not for family owned businesses which are typically in the mid-cap range. Again PE requires specialisation because they are not interested in normal API companies and formulation companies. They want someone from a contract research manufacturing on a large scale which needs a lot of capex but it has to be capital intensive.
Does going public require a lot, with respect to professionalism in the management of a company?
That requirement of professionalism to some extent is the same with companies which are looking for PE and those going public. Even for an IPO, one needs to follow all the corporate governance norms; they need an independent board wherein 50 percent of the board of directors have to be independent and professional for the respective field. It needs various committees; for instance an audit committee should have an independent director who is professionally qualified (he should be an ex-banker or a finance professional like Chartered Accountant or an MBA). Similarly, they should set-up other committees like remuneration or a shareholder grievance committee. They also need to appoint a full time company secretary. A number of norms need to be followed like the stock exchange listing norms and SEBI guidelines. Henceforth, professionalism definitely comes in. But what we have observed is that, to a large extent, it is run in the same fashion except for the compliances. After the company completes IPO, they have to regularly host board meetings and intimate the stock exchange about each and every development. These things do come in but it is not a 100 percent professionally run company. When a PE guy comes in, these requirements need to be managed professionally on a daily basis as someone is literally sitting on your head.
Given the situation, is it easy for family owned businesses to go public?
No, it is not easy. The best example is the time taken to file the Draft Red Herring Prospectus (DRHP). For a company which is professionally managed, with all its records up-to-date, it should not take more than six weeks which is the ideal time to file the document. At the maximum, it takes about eight weeks which will cover due diligence, diligence by merchant bankers, and the rating process is also initiated. In the case of family run businesses, it takes anywhere between four to six months. Because we have seen that there is no capital structure and they have haphazardly issued capital in the past. All the reconstruction takes a lot of time. Once the legal due diligence starts, it takes anywhere between one-and-a-half to two months as records are not available and there are a whole list of litigations. I do not say that it is universally applicable, but you can safely say 75 percent of these companies face these problems.
The entire company needs to be restructured by the time it files the DRHP. There are lots of Know Your Customer (KYC) norms to be fulfilled for every director and key management personnel and all the documents of the company need to be scrutinised. One hotel, a family owned company, which was going for an IPO suddenly discovered during the legal due diligence, that the property was not owned by them and they have be running the hotel for almost 30 years. They realised that the land has not been transferred to them. Legal diligence goes through the land records and the title leads. By the time the process was complete all their records were updated, legal compliances were in place, board and committees were formed and they were geared up for the next phase. Once you are going public all the things need to be put in order. The updates need to be done properly. Without that, as a merchant banker once we sign the due diligence certificate, we cannot go ahead unless everything is in place with all legal compliances.
What are the legal issues that arise before a company goes in for an IPO?
What SEBI looks at it, is that full disclosure needs to be done. They are not concerned what material impact it has on the balance sheet of the company and the financials. We have to disclose them completely in the DRHP. It is important that not even a small notice should be hidden because it might snowball into a bigger issue. Once the document is ready, it is there for public inspection for almost a month. If anyone has an objection, they can file it with SEBI. SEBI will give an opportunity for the company to reply if someone has an objection to any disclosure that the company has made or if the company has not made a disclosure. The company needs to reply and they will again counter reply. This increases the time required for clearance from SEBI. The company has to satisfy SEBI that this is not litigation and it can be settled and that it is properly disclosed. However, SEBI never rejects a proposal. They will take time to clear a proposal or they will ask the merchant banker to withdraw the proposal or refile it with proper disclosures. It is not likely that they will officially reject.
What effect does litigation have on investors?
Litigations definitely have an impact on investors and the valuation. Investors may take a negative view if there are lot of litigations. But, litigations have more impact on institutional investors than retail investors. Institutional investors are the ones who read the document before making an investment. They can take a view on what impact litigations might have on financials or the operation of the company. Retail investors go by the price in the market and what it is. Retail investors do not take all these things into account and go by the herd mentality, and also by the extent of institutional substitution. As you see, retail investors come only on the last day of the issue. Institutional investors are more calculative.
How does a company decide the price band of an issue?
Price band is decided in discussion and in consul-tation with the company. We have an indicative price band in mind while framing the prospectus which we work out when we see the cost and the means of the finance of a company. Indicative price band is a very broad figure but the final price band is made after the price discovery process where we make a presentation to the institutions. Generally, industry Price to Earnings ratio is the best indicator. Of course the market sentiment is to be taken into account. And going forward, what the company plans to achieve is not a part of DRHP but there are the financial projections. Taking into consideration past track record and the future earning potential, you give a multiple based on industry PE and then the investor appetite for this particular sector. We also have to leave something on the table for the investors too so we give a discount of 10-30 percent depending on the pricing.
What is the investor appetite for the pharma industry?
There is not much interest in the pharma industry as far as stock market is concerned but I don’t think companies are making less profit as compared to any other sector in manufacturing. They are making good profits but frenzy is not there for the moment. Over the last 30 months, index must have grown by 100 percent but pharma index must have gone up by 30 percent. For the last two-and-a-half years, they have not seen any interest in the market. But you never know, the market mood goes more by sentiments rather than fundamentals. Fundamentals do have a play but goes more by sentiments. Suddenly they find a sector very hot.
What are the strategies that you adopt to push pharma stocks?
Generally, the process remains the same but the strategy is different only in terms of pricing and the marketing part of it. We might target a different set of investors for pharma stocks like maybe a healthcare fund as there are some dedicated mutual funds which invest purely in the pharma industry, StanChart which has an IPO fund, or institutions which could be interested in pharma. These segments are targeted. Pharma companies are not on the investor’s wishlist as they have not got those kind of returns. If you are a mutual fund or an institution, where you are investing someone else’s money, you need to give them returns in mind with the market. Investors are playing safe why they should invest now when they get better returns elsewhere. Hence, marketing becomes a major issue. Institution might not be interested to that extent. So it is more of a retail push that you have to do as far as pharma IPO is concerned.
What are the common mistakes that companies make while going in for an IPO?
Most importantly, wrong capital structure can severely affect the IPO. If you blow the capital too much or dilute their holding in the first stage itself can be a very big blunder.
For closely held family owned businesses, they are lot of advisors in the past who might advise a very wrong capital structure. As far as the operations are concerned, there are lot of mistakes made which we have to undo or unwind before you go in for an IPO.
If a company has a very large offering (number of shares) with a very low price band, it will severely affect the company. The capital goes up multiple times and it will become very difficult to service after the issue. If a company which is looking at continuous growth dilutes too much, it becomes an issue as they need to dilute in the future also. In the first stage itself if the public offering is very large, promoters’ holding will go down in the future stages. Pricing is also very important. Promoters always want to get the maximum they always think they are selling cheap. Investors always feel they are buying the most expensive stock. It is very difficult to manage the expectations of both.