Took loans for IPOs? Without listing gains, you could land in a debt trap

In this market euphoria, it is important to understand the risks in leveraged trading or borrowing to invest in IPOs.

How does IPO funding work?

IPO funding enables investors to apply for equity shares by providing a small margin, while financial institutions fund the balance amount. Some of the non-banking finance companies (NBFCs) offering loans for IPOs include ECL Finance promoted by Edelweiss, Aditya Birla Finance, JM Financial Products, and Sharekhan Financial Services. This facility grants leverage to HNIs and retail investors, so they can apply for more lots with the hope of higher allotments. For instance, Sharekhan Financial Services offers IPO financing facility to HNIs. It gives a minimum loan amount of Rs 2 lakh; Aditya Birla Finance offers a minimum loan amount of Rs 1 crore.

These are short-term loans. In most cases, they are for seven days – from the IPO closing day to the date of listing. The repayment tenor of these short-term loans is up to three months. The borrowers must pay the margin amount upfront to avail the loan.

Let’s consider two IPOs; Company ABC and XYZ. Assume you apply for 5,000 shares for both companies at an IPO offer price of Rs 100 a share. The application amount comes to Rs 5 lakh, which you wish to borrow and then invest. Typically, lenders ask you to put in some of your own money; as a token or margin money. Say, you put in Rs 20,000. The remaining- Rs 4.80 lakh- is what you end up borrowing. At an interest of 8 percent for a 7-day IPO loan, your total interest cost comes up to Rs 736. Whatever happens on listing day- and irrespective of whether you make profit or a loss- you must repay this Rs 736 interest cost.

Say, Company ABC lists at a premium of Rs 110. And you got an allotment of 500 shares. If you hadn’t take a loan, you would have made a listing day gain of Rs 10 per share. But because you have taken a loan and need to pay interest, your gain per share (listing price less interest cost per share) comes to Rs 8.53.

Say, Company XYZ, too, lists at Rs 110. Here, however, you get a much lesser allotment of just 20 shares. Now, because of a lesser allotment, your interest cost per share, and your break-even point, shoots up <see table>. Therefore here, you make a loss. Moral of the story: For IPO funding to go right, there are many things that need to go right for you. The stock has to list at a gain, significant gain and you need a good chunk of the allotment.

To derive the loan margin requirement, lenders estimate the possibility of a loss in a particular IPO. “Based on multiple assumptions and calculations, lenders come out with a margin requirement that varies from case to case. It can be anywhere between 5 and 10 percent or 12 and 15 percent; sometimes it even goes higher,” says Deepak Jasani, Head of Retail Research, HDFC Securities.

Also read: Investing in IPOs just for listing gains? Here’s how you can plan your bets carefully

Multiple charges

Recently, after a few IPOs did not get a listing premium as was originally expected, interest rates for IPO borrowing has risen. “At present, lenders are charging between 7.5 to 8.5 percent interest rate. When the possibility of loss on listing reduces, the interest rates come down to 7 to 7.5 percent,” says Jasani.

Says Shalibhadra Shah, Group CFO, Motilal Oswal Financial Services, “The interest rate depends on the liquidity position in the market, number of IPOs at any point in time, borrowing companies’ cost of funds, etc.”

Apart from interest cost, lenders also levy processing fees and the stamp duty for loan agreement made with the borrowers.

Risks involved

Investing with borrowed money is a risky proposition. “Through IPO funding, investors develop greed when the market is bullish on listing of certain stocks. You should always check your risk appetite while investing with borrowed money,” says Rishabh Parakh, a chartered accountant and founder of NRP Capitals.

In case the actual listing premium is lower than expected or the listing price is below the issue price of an IPO, then investors do not make money. Since there are interest costs to pay, investors may sell the stocks at a loss. For instance, Kalyan Jewellers saw a listing discount of 15 percent over the issue price this year. Similarly, last year, SBI Cards saw a listing discount of 13 percent over the issue price.

“When there is hype around a certain company IPO, then there is a possibility of oversubscription and you may not get too many stocks during allocation. The stock gain will get offset by the interest cost,” says Parakh. If you don’t get enough allotment, then there isn’t much profit to make via this IPO funding.

SEBI’s analysis found that in 29 IPOs between January 1, 2018 and April 30, 2021, on an average, around 60 percent of the applicants in the HNI category did not get any allotment. There were cases where applications for as large as Rs 75 lakh also could not get any allotment. SEBI has prescribed changes in allotment norms it is better to observe how the allotments work in the dynamic scenario of investors’ interest in IPOs.

“IPO funding is misleading the price of IPOs on listing day, as most of the HNI investors, through funding, invest for listing gains and sell the allotted stocks on the first day itself,” says an analyst from a broking house, requesting anonymity.

Should retail investors take part in IPO funding?

No. Investing in IPOs through borrowed money involves higher risk. “It is preferable for HNI investors, but not recommended for retail investors,” says Shah.

“Retail investors do not understand the risk involved in the IPO funding process. So, they should stay away from it,” says Jasani. They should prefer investing a part of their savings in IPOs and shouldn’t borrow. IPO funding is a different market where the calculation of interest, funding costs, oversubscription, etc. are not really in the reach of the retail investors, he adds.