Abstract
This case delves into market risk management in an initial public offering (IPO) investment arising due to the unexpected onset of the pandemic. The protagonist in the case is overwhelmed by the euphoria surrounding the IPO issue of SBI Cards and turns into a speculator instead of a normal investor. He makes a leveraged bet on the likely listing gains by resorting to IPO funding. After the closure of the IPO issue, the market registered very sharp declines due to a viral fever engulfing the whole world. Now, the protagonist, who has already lost heavily from the existing portfolio, has to encounter likely losses from the loan-funded IPO investment. He had to hedge the likely losses from the possible listing day losses from the IPO. For this, he needs to put in place a hedging strategy, answering the questions on the choice of derivative contract, size and expiry date of the contract.
Keywords
Introduction
Circa March 2020, the news feed from a Social Media Platform goes, ‘We have to remember that while there is no need for panic, we are dealing with an evolving situation. Currently we have 1,500 contacts of the 74 positive cases currently being monitored’, an Official from the Union Health Ministry told reporters at a press conference. Kunal is concerned only about the money he invested in an IPO and not about anything else! There is all-around uncertainty, as no one is clear about the consequences of the outbreak of the new viral fever. This uncertainty is reflected in the jitteriness of the market movements. The Nifty index, the benchmark index of NSE India, has already fallen by 14% in the last 10 days, and no one is hazarding a guess where the decline will stop. Kunal made up his mind to act firmly today by putting together a strategy to contain his losses.
Kunal completed his MBA from a leading business school in May 2016 and joined a management consultancy firm. He is based out of Chennai and is in the specialised division that advises the state and central governments on infrastructure projects. During his MBA, he majored in business policy with a minor in finance; therefore, he found his job very apt and meaningful. He joined this firm in June 2016 and is reporting to Raghav, an Associate Partner in the consultancy firm. Together, they are advising a client on ascertaining the accurate cost of construction for their six-lane highway project. Raghav is pleased with Kunal’s contributions, who is preparing the financial analysis for the road project. Occasionally, their discussions moved from the project at hand to personal investments. Kunal told Raghav that he is saving almost 60% of his salary and investing in a few blue-chip stocks in SIP mode. Kunal sought Raghav’s views on the stocks he is investing in. Raghav replied that ‘one should enter into stock investing with a long-term view and only if one is prepared to stay brave during the sharp declines in the markets’. Kunal was a little disappointed that Raghav did not give any specific observations on the choice of his stocks. But Kunal was so pleased with the performance of his portfolio, which grew at a CAGR of 12.5% during the last four years.
SBI Cards and Payment Services Limited
Enthused by the performance of his portfolio, Kunal started looking at new investment opportunities. In January 2020, he heard about an initial public offering (IPO) from SBI Cards and Payment Services Limited (henceforth SBI Cards), a leading credit card company in India. Until then, Kunal invested only in secondary markets, and his interest in the IPO grew as he already owns a credit card from SBI Cards and is satisfied with the services of the company. As he is interested in investing in the SBI Cards IPO, he wanted to learn more about the company. He started pouring over research reports on the credit card industry to know more about the credit card business in general and about SBI Cards in particular.
SBI Cards was founded in 1998. SBI Cards was a joint venture between SBI, India’s largest commercial bank, and GE Capital. Subsequently, in 2017, GE Capital exited, and the Carlyle Group acquired a part of its stake. SBI Cards made quick progress to become the second-largest credit card issuer in India. At the end of March 2019, it had a market share of 17.6% in terms of the number of credit cards outstanding and 17.1% of the total credit card spend. It offers a variety of cards to both corporations and individuals belonging to different income profiles and lifestyles. From the draft red herring prospectus 1 (DRHP), he learned about the financial performance of the company. During the period 2017–2019, the revenue increased from around ₹3,300 crores to ₹7,000 crores, recording a CAGR of around 45%, and the profits increased commensurately from ₹370 crores to ₹870 crores. Further, Return on Equity (ROE) averaged at 28% during the three-year period.
Apart from the financials, Kunal was curious to know the addressable market in India so that the company can maintain high levels of growth rates in the foreseeable future. From the DRHP, he noted two important trends: (a) India’s overall credit penetration in the economy, measured by its domestic credit as a proportion of GDP, is one of the lowest as compared to other countries. This ratio is at 72% for India, while it is 114% and 218% for Brazil and China, respectively. (b) The number of credit cards outstanding is expected to grow at a CAGR of 23.0% over the next five years, fuelled by factors like the increasing issuance of cards in smaller cities and growth in payments infrastructure. Both trends led Kunal to believe that the credit card business in India is poised to grow considerably in the next five years, and SBI Cards, with its strengths, will benefit significantly.
IPO by SBI Cards
Kunal’s investment thesis found more support from the news he was getting from the grey market and unofficial market activity. Although very volatile, it indicates what the market thinks about the public offer. The grey market premium was around ₹300/share 2 in mid-February, reflecting the bullish view of the market on this issue.
Kunal wanted to take Raghav’s view on this public issue at the earliest possible instance. On 24 February 2020, he broached the subject of grey market premium with Raghav, to which Raghav reacted a little sarcastically, saying that one should look at IPO investing as holding a part of the business but not making decisions based on grey market activity. He further said that SBI Cards is a new and unique business in India that can provide a sort of diversification benefit to a portfolio. This will be an important reason for him to invest in this stock, but not the grey market premiums.
Kunal was very happy to get an answer from Raghav on the IPO prospects and was emboldened to make a slightly bigger bet. As time passed, the complete public issue details came out. On 26 February 2020, Kunal came to know 3 that the company had revealed that equity shares worth ₹9,000 crores would be offered through the book-building route with a price band of ₹750 to ₹755. The minimum application size is for 19 shares. The issue will open on 2 March 2020 and closes on 5 March 2020. Initially, Kunal was planning to invest in around 15 lots of shares, but his broker informed him that due to heavy demand, there is a very remote possibility of getting an allocation in the retail investor category. 4 So Kunal thought of borrowing some money from his friends and making a bigger bet to increase the probability of getting his desired allocation. This is based on the assumption that the issue will be oversubscribed a large number of times, in which case he will be allocated only a fraction of what he applies for. When the company refunds the money, he can return the borrowed amount to his lender friends.
He was following the market movements, and the Nifty index (Figure 1) was fairly steady, although there is some news of the viral fever wreaking havoc in some European countries. The slight decline in the market towards the month’s end was considered a correction after the recent post-budget rally.
As he was talking to his friend about this public issue, Kunal came to know that his friend is also investing. Even though he is borrowing some money from his credit card, he is investing in the IPO just for the listing gains. Although this is fraught with risks, his friend said he wants to spin the wheel! Remembering the words of his business school professor who used to say, ‘the biggest risk is not taking any risk’, Kunal also thought that making a big bet by borrowing money and investing was the right course of action.
IPO Funding
Kunal is realising that he is slowly moving from being an investor in the SBI Cards IPO to becoming a speculator on the listing gains. Although this is fraught with risks, he is unable to control his emotions. As a caution, he thought to himself that he would closely follow the daily subscription figures for the IPO and would decide on the last day based on the oversubscription data. He was following a popular website for the information on IPOs, and the subscription data from that website over the four-day period is presented in Table 1 below. At the end of the third day, the issue was only moderately subscribed in the Non-Institutional Investor (NII 5 ) and retail segments, while it was more than 50 times oversubscribed in the Qualified Institutional Buyer (QIB) segment. On the evening of 4 March, his broker called him and inquired about his plans for the IPO investment. His broker told him that although the figures are subdued, the subscription would jump up on the last day as the NIIs will often go for IPO funding, which is why the NIIs portion of the IPOs is heavily oversubscribed. Kunal became curious about IPO funding and asked his broker whether he would also be eligible for IPO funding. His broker replied that he will send in some information about IPO funding over email, and if Kunal wants IPO funding, he has to complete the formalities as soon as possible on 5 March 2020.
Day-Wise Subscription Figures for SBI Cards IPO.
Kunal’s broker sent him a leaflet outlining the IPO funding scheme being offered by a popular bank. Almost all NBFCs and some private sector banks are now offering such schemes. The mechanism involves the investor opening a separate demat account and a bank account with power of attorney (POA) to operate the account vested with the lending bank or NBFC. The investor had to bring the margin money, varying from 10% to 50%, and the lender would provide the remaining money, called the IPO loan. These are short-term loans with tenors of around 10 days from the close date of the IPO. Sometimes the loan will be available until the allocation of the shares. The amount lent and the margin money brought in by the investor will be locked in the POA bank account. The lending charges vary from 8% to 12% P.A., and the IPO loan amount lent will vary from ₹5 lakhs to ₹25 crores. As per the existing Rules, in cases of oversubscription, NIIs will be allocated on a proportionate basis, and the issuing company will refund the excess application money into the POA bank account.
Settlement of the IPO Loan Amount
The total amount payable by the investor will be the sum of finance charges and the IPO loan. From here, the money refunded by the issuing company will be adjusted. The investor had to deposit the remaining money to settle the IPO loan; upon settlement of the IPO loan amount, the POA will be cancelled. Alternatively, the investor can advise the lender to sell the shares allocated. The sale proceeds of the shares and the money refunded from the issuing company will be used to settle the IPO loan and the associated finance charges. Any surplus money will be transferred to the investor, and if there is any shortfall, the same has to be met by the investor.
Kunal made a quick calculation of the money he needed to borrow along with the associated charges. The calculations are given in Table 2. As his intention is to get an allocation of 1,000 shares, he determined that the amount of IPO loan would be around ₹2.8510 crores (a detailed calculation is shown in Table 2). His broker informed him that if he can arrange for the margin money, the end-to-end process will be taken care of by the lending bank and can be completed in a few hours. The next morning, the Relationship Manager of the lending bank completed the entire documentation, and by evening, he got confirmation about the submission of the application. The end-of-day subscription figures showed that the issue was oversubscribed by 26 times, and the NII category was oversubscribed by around 45 times.
Determination of the Amount of IPO Loan.
Market Decline and Hedging the Market Risk
As Kunal looked at the market movements on 6 March 2020, he was concerned to note that the market opened at a loss, with the benchmark Nifty 50 index recording a loss of 326 points. The day ended with the Nifty 50 index declining by 276 points, and most commentators are attributing it to the uncertainty about the new viral fever engulfing the entire world. Kunal started panicking and cursed himself for the speculative deal he placed yesterday. He waited with bated breath for the market’s activity the next day. On 9 March 2020, the Nifty 50 index opened with another 250-point loss and ended the day with a loss of around 550 points.
Although the issue was oversubscribed by almost 26 times, the grey market premium crash does not portend good news for those who are looking for listing gains. Further, there was a strong buzz that the shares might list at a steep discount to the issue price. Kunal became anxious, and he opined that his bet was likely to go wrong. Things worsened on 12 March 2020, as the market crashed by almost 8%, with the Nifty 50 index going below 10,000 points. Market observers started giving new targets to the Nifty on the downside, and there is fear and gloom all around the market. Kunal was eager to know whether there was any way to secure himself against his likely losses. His stock portfolio also lost heavily, eroding not only all the past gains but also a part of the original capital.
Out of desperation, he reached out to Raghav and asked for his help in cutting his losses. As expected, Raghav did not give any direct answer but coldly said that Kunal can use equity derivatives that trade on the NSE. He did not elaborate on which contracts to use or what strategy Kunal had to adopt, but just gave a broad direction.
Kunal had no idea about equity derivatives and immediately started collecting information on the contracts available on the NSE website. The shares are likely to be listed on 16 March 2020, and Kunal wanted to put in place a derivatives strategy on 13 March 2020, so that he could minimise his losses.
After discussing with some of his friends, a thorough search of the hedging literature, Kunal realised that since there are no derivatives with SBI Cards as the underlying, the hedging requirements can be met using one of the following:
Nifty 50 futures Nifty bank futures Nifty financial futures Futures on SBI stock Nifty 50 options Nifty bank options Nifty financial options Options on SBI stock
Now, Kunal must resolve many questions pertaining to which derivative contract (hedge instrument) to use from the opportunity set listed above, the size of the hedge and the expiry date of the hedging instrument. He realised that answers to these questions would lead to computing the number of contracts that needed to be traded. This can be calculated as the ratio of the portfolio’s monetary value divided by the futures contract’s monetary value multiplied by the stock’s beta. Kunal also realised that past data pertaining to these contracts can be obtained from the NSE’s website.
Footnotes
Declaration of Conflicting Interests
The authors declared no potential conflicts of interest with respect to the research, authorship and/or publication of this article.
Funding
The authors received no financial support for the research, authorship and/or publication of this article.