RBI’s One-Cap Rule on IPO Financing – Should it be for All?

[Mehak Jain and Aditi Ghosh]

The authors are students of Hidayatullah National Law University, Raipur.

Introduction

Post Covid-19, there has been a regime shift in terms of investing in IPOs because of the frenzy created by newer investors in the market. IPO financing is a tool majorly used by High Networth Individuals (‘HNIs’) to leverage funds for a short-period of time for the purpose of investing in IPOs.

The systemic risks posed by NBFCs have prominently been a concerning topic for the country’s financial regulators ever since their exponential growth in the sector. Amongst the issues, unregulated IPO financing by (‘NBFCs’)  has been viewed as a significant problem majorly due to concerns of market volatility caused by it. With the aim of regulating this practice, the RBI through its Scale Based Regulations (‘SBR’) declared a cap limiting IPO financing by NBFCs at a value of Rs. 1 crore per investor.

Understanding IPO Financing

In IPO financing, NBFCs take a nominal margin amount (i.e., a collateral amount that the borrower themselves put in) from the HNIs in advance in exchange for providing funding for the purposes of investing in an IPO. The borrower is the one with the highest exposure, who repays the loan by realising their allotted shares post listing gains, which happens in a span of around 6 days from the close of the IPO. In cases where the closing price is less than the listing price, thereby resulting in a loss, HNIs are nevertheless personally liable for repayment of the borrowed funds with interest.

In the HNI category, there are no limits on the amount one can bid and the shares are allocated proportionately. Thus, the entire process of investing large funds into this category results in huge profits for both the investors and the NBFCs. Taking advantage of this, funds in the range of hundreds of crores are loaned per investor under IPO financing with the NBFCs contributing around 90 times the amount being invested by the investors.

Evidently, this leads to concerns of market volatility and financial instability in the market, along with jeopardizing the interests of genuine long-term investors and hindering fair price discovery. Accordingly, RBI by virtue of the SBR has capped IPO financing to Rs. 1 crore per borrower with the intent of preventing abuse of the system.

  1. Benefit to the NBFC sector: Smaller NBFCs set to gain

By virtue of the capping on IPO financing, smaller players are set to gain and penetrate the Rs. 80,000 crore short-term funding market.

For NBFCs, the financing options for on-lending to individuals for applying to IPOs are limited. Banks are prohibited from financing NBFCs for further lending to HNIs for the purposes of IPO financing. NBFCs resort to obtaining the requisite capital either via commercial papers or via Non-Chequable Debentures.

Prior to the capping, individuals have sought as much as Rs. 250 crore for applying for one IPO (such as in the case of Nykaa), and financing such a large amount is something that smaller players are not equipped with to do. Until recently, wealthy investors borrowed huge sums of money from large and established NBFCs who in return charged higher rates of interest depending on demand.

With a capping of Rs. 1 crore now set in place, would not have to compete with larger NBFCs for exorbitant amounts of funding. Additionally, smaller NBFCs with expertise and dedicated focus in capital markets shall be more likely to get in and expect increased business in this regard.

Concomitantly, it is relevant to note that problems of fund mobilisation and rapid increase in the number of borrowers can pose an issue. Fund raising can be a major hiccup given that the costs for raising the same shall be higher than for bigger NBFCs such as IIFL and Bajaj Finance face. Increased number of borrowers also might pose operational risks. Thus, while the capping is inclusive in nature, addressal of these concerns is pertinent for observing substantial benefit to the sector.

  1. Benefit to the HNI investor sector: Long-term genuine HNIs set to gain

Just as the capping benefits a part of the NBFC sector, it also benefits a part of HNI investors. For the ones bidding genuinely for amounts less than Rs. 50 lakhs, and with an aim of generating long-term wealth, they now have a better chance of allocations in the absence of obscene values of bidding.

IPO financing for HNIs works differently than for retail investors. In cases of over-subscription, while allotment for retail investors follows a lottery system ensuring allocation of at least one slot, HNI’s are allotted proportionately to the amounts they bid. This results in excessive oversubscription, where IPOs are subscribed hundreds of times of the actual IPO size. For instance, the Paras Defence IPO was over-subscribed a whopping 928 times in the NII/HNI category.

Owing to the capping, genuine investors shall have better chances at availing of allotment thus leading to the creation of long-term wealth, which is something that was amiss till now given the concentration of IPO funding.

  1. Reduction of oversubscription leading to fair price discovery

The objective behind IPO financing is not to “invest” per se and reap investment returns, but to book hefty short-term gains by leveraging available funds and having a quick means of “entry” and “exit”. This leads to the concentration of funds in the hands of a few, with the IPO allotment process being turned in favour of these short-term players. Such extreme concentration leads to market volatility, which hinders fair price discovery. Given that IPO financing happens in a way where the investor is funded multiple times than what (s)he is putting in, there is huge leverage which inevitably leads to huge risk that is capable of leading to a downfall of the NBFC sector. Accordingly, IPO capping by reducing the oversubscription numbers shall be beneficial in determining the actual IPO price.

Recommendations

The business of IPO financing is a lucrative one for both the NBFC and the investor given the short listing period of IPOs. The general practice followed by NBFCs in this process indeed pose some serious risks to the systemic stability of the financial sector. However, capping the leverage at an unreasonably low value of Rs. 1 crore for all investors alike is likely to become a hurdle in gaining significant benefits through it by both the lender and the borrower. In order to mitigate these issues, while maintaining the intent of the RBI behind placing such a limit, we propose the following alternatives to a one-cap-all rule.

  1. Increasing margin requirements

A widely observed pattern in IPO financing has been the practice of keeping smaller margins that may go as low as 1-2% while leveraging 80-100 times that amount. For instance, an HNI investor investing 100 crores in an IPO would actually be contributing only 1-2 crores of their own funds into such bid, while the rest comes from the NBFC. A preferable course of action to would be to increase such margin requirements to the range of 40-50%, ensuring greater security in these transactions.

  1. Exemption of NBFC-BL from the capping

RBI has classified NBFCs into 4 categories (base, middle, upper, and top) on the basis of their risk profiles and accordingly prescribes progressive levels of compliance from NBFC-Base Layer (‘NBFC-BL’) to NBFC-Top Layer (NBFC-TL). Greater the risk, higher would be the requirement for supervision by regulatory bodies. This makes the NBFC-BL a more secured option for IPO financing than the others in terms of ‘systemic significance’.

Accordingly, we suggest that NBFC-BL be exempted from the stipulation of a limit on IPO financing, which aligns with what was originally proposed in RBI’s discussion paper as well. This would be in the interest of the investors and a majority of the NBFCs (>97%) while keeping the risk to a minimum.

  1. Exemption of Accredited Investors from the capping

Accredited investors are those who are financially sophisticated[1] and can make larger investments with higher risks. In December 2021, SEBI came out with the concept of accredited investors in India who are recognised based on their net income. As per the guidelines issued, an individual, HUF, family trust or sole proprietorship, can be an accredited investor if their annual income is at least 2 crore or net worth is at least 7.50 crore, with at least half of it in financial assets.”

Given the secured nature of such investors, it is proposed that they be exempted from the RBI capping.

Conclusion

Post the IF&LS and the DHFL crisis, RBI’s Scale-Based Regulations and particularly the capping of Rs. 1 crore on IPO financing for NBFCs is key to restore the lost trust in the NBFC sector. An impact-based analysis makes it evident that in sum, despite potential hits to profitability and capital generation for NBFCs, the capping shall be beneficial in the long run by securing financial stability in the NBFC sector, promoting interests of genuine investors, aiding fair price discovery and reducing system risks in the NBFC sector. However, the present rule of a blanket capping should be modified in a way to ensure that the IPO financing sector still remains lucrative to secured investors and majority NBFCs. The sector has also been provided with adequate time to ensure compliance with the Regulations and the authors look forward to the effects of the same post its implementation in April 2022.

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