The Indian government’s chief economic advisor V Anantha Nageswaran recently expressed dissatisfaction over a trend in the initial public offering (IPO) market.
He said: “India’s equity markets have grown impressively, but initial public offerings have increasingly become exit vehicles for early investors, rather than mechanisms for raising long-term capital. This undermines the spirit of public markets”.
Catalyst for stock market reform
Nageswaran’s view is intriguing, more so because it comes from an important official of the union finance ministry. The context here is the catalytic role that this ministry played three decades ago in pushing Indian equity market to leapfrog a few stages.
In the space of less than a decade India went from a state where neither buyer nor seller could be certain of the date of completion of the transaction or the authenticity of the stock certificate to one where these problems didn’t exist.
India’s largest stock exchange of the time, Bombay Stock Exchange, could occasionally come to a halt when brokers were in the grip of panic about counterparty solvency. Moreover, cases of duplicate shares making their way into the system were common.
Contract notes issued by brokers then were valid only for specified regions, making the equity market a fragmented one.
After the Harshad Mehta problem, the finance ministry took the lead in not just pushing legislative reform, but in also promoting National Stock Exchange to catalyse change through the introduction of nationwide online trading. Soon, a clearing house to provide counterparty guarantee and a depository to dematerialise shares followed. In less than a decade after the Mehta issue, the nature of the equity market, both IPOs and secondary market, changed dramatically.
It was Nageswaran’s ministry that played the lead role in bringing about these changes because there was never any conceptual confusion about the role for the market in raising long-term capital.
We don’t have the same wants
Trade between individuals is a natural phenomenon because people don’t have the same wants at the same time. It’s this difference that leads to a trade as individuals try to satisfy an immediate need by giving up something relatively unimportant. That leads to a market.
In one of the most striking examples of the creation of markets in the most inhospitable of conditions, RA Radford, a British economist, wrote about the evolution of a market in the camp where he was prisoner during World War II. Cigarettes were used in place of money to carry out transactions as POWs tried to better their existence.
IPOs and risk appetite
A healthy equity market will have investors with enormous diversity in the risk appetite, capacity to hold and the ability to understand a business.
For example, LIC’s risk tolerance and holding period will necessarily be different from that of a venture capital. Individuals are another set of investors altogether.
Without this diversity, it’s not possible for a liquid market to evolve.
Exit=entry
If early stage investors choose to exit with an IPO, it means their place has been taken by another set of investors with a different outlook.
Without this exit option, it’s unlikely that there would be early stage investment.
It doesn’t make sense to complain about exits because a listed company can always approach the market later to raise more capital. A mechanism to raise long-term capital is not contingent on the identity of the investors remaining unchanged. Long-term capital requires a market that allows easy entry and exit because a company’s evolutionary trajectory cannot always attract the same kind of investor.
If early stage investors are using the IPO to exit, we should be delighted. It means that they are more likely to recycle their returns as they look for the next big idea or entrepreneur.
India’s IPO market is doing the job it’s meant to do.
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