The Death Of The Underwriter

Merchant bankers prefer private placement and bookbuilding to a business that was all the rage two years ago.

Till about two years ago underwriting debt and equity issues was big business. Since then, the market has changed so drastically that few merchant bankers are willing to even look at an underwriting proposal. And after the liquidity crunch of 1995 and 1996 underwriters have become an extinct species in the financial community.

The current liquidity overhang has not, however, changed the situation either. This year, neither of the top two IPOs of the year -- Corporation Bank and ICICI Bank -- were underwritten. Since early 1996, in fact, no IPO has been underwritten. Today, the tribe of underwriters has been substituted by risk-averse financiers.

 

Issuers, too, have become more cost conscious. Today, they are far more disinclined to pay the hefty fees charged by underwriters. That is not surprising, considering that underwriting and management fees could be as high as 11 per cent of the issue costs.

Underwriting provided a good source of business for merchant bankers when the markets were booming. This was especially true for lesser-known companies making their maiden forays in the market. Healthy markets meant the risk of devolvement was minimal. And even if the rare issue did devolve, there was always an exit option after the scrip was listed on the stock exchanges.

In a lifeless market, on the other hand, underwriting can become a risky proposition. Says T Ramabhadran, managing director of Sundaram Financial Services, "In an adverse climate, devolvements could mean heavy losses." Devolvement of large issues means holding costs, which would in turn have to be funded. Thus, while underwriting could mean a good source of non-fund based income, devolvements could convert it into a fund-based one. In a weak market, such a development could lead to severe asset-liability mismatches.

This is precisely what happened during the last two years. Many merchant bankers then took to bought-out deals - a variant of an underwriting mechanism. In this kind of deal, the financier buys out the entire IPO at a predetermined price to unload it later in the financial markets at a higher price. But bought out deals, like a devolvement, is also fund-based and not fee-based operation. It amounts to blocking off a large amount of money for an uncertain period of time.

Only large merchant bankers with very high capital adequacy were therefore in a position to resort to such deals. During 1994 when the Bombay Stock Market's sensitive index (Sensex) topped 4,500, these bankers made huge profits, sometimes as high as 40 per cent, arising from the difference between the price at which the issue was picked up and that at which it was sold in the markets.

Similar techniques were used even in the bond markets. But there was a difference. Unlike in the equity market, where there was no assured cash flow, in the bond market, the holding costs are partially compensated by the coupon flows. And in a situation where yields tend to fall sharply, this has allowed the banks to book profits. For instance, the ICICI 15 per cent bond picked up in May would be currently priced at Rs 110, giving a yield to maturity (YTM) of about 12.5 per cent. But inclusive of the single coupon flow, the effective return would be as high as 25 per cent.

In the case of the earlier series of bonds, which came at huge front end discounts of as much as three per cent, the effective returns would have been as high as 35 per cent after two coupon flows. But crucially, none of these issues were underwritten and ICICI barely managed to raise the targeted funds of Rs 500 crore each.

One reason underwriters and bought-out artists did not take advantage of such opportunities was that the liquidity position was extremely tight last year. The cost of raising funds through borrowing, mainly in the intercorporate deposits market, was over 20 per cent. Raising such funds would make sense only if there was certainty of an exit route and if yields are expected to fall for debt or prices are expected to go up in the case of equity.

Unfortunately for underwriting business, nobody was certain of the situation in the markets. Financiers could earn their spreads only if the market price is substantially higher than the price at which the securities - either debt or equity - are picked up. The current state of the market makes that impossible, nor does it provide underwriters with an easy exit route. "Getting into bought out deals now is suicidal," says Rajagopalan, vice president, SMIFS Ltd.

Today, risk-averse financiers are looking at private placements and book building whether in debt or equity. Private placement is a completely fee-based activity and there is no commitment on the merchant bankers' part to take the issue into their books.

As far as issuers are concerned private placements ensure that the costs are kept down to the barest minimum - to as low as two per cent. Take for instance the state public sector company, Gujarat Mineral Development Corporation Ltd, which is quietly raising about Rs.107 crore through a premium priced equity (Rs 10+Rs 120). The merchant bankers are targeting the mutual funds and institutional investors like UTIs for the issue.

But the key to making such private placements attractive is the pricing. Equity issuers tend to look for the highest premium component and debt issuers look at keeping the coupons to the lowest possible rate. But caution is necessary in judging the market as arbitrary pricing has extracted a number of casualties. The most recent being the IFCI issue.

IFCI had tried placing a bond issue for Rs 250 crore at a coupon of 11.5 per cent. IFCI could find no takers at this rate, since a tax free bond was already available in the markets at yields of about 9 per cent and after including the tax savings, the effective return would be about 13 per cent. And selling such a low coupon issue to provident funds was also not very successful especially since such funds are required to pay 12 per cent to their subscribers. They therefore need higher rate of returns on investment. The result of this aggressive pricing was obvious. IFCI could find no takers and the pricing had to be revised upwards by another 100 basis points.

Others like the telecom major, Mahanagar Telephone Nigam Ltd, which periodically floats bond issues on behalf of the Department of Telecommunications invites bids for bond issues. The bids are accepted on the basis of the lowest coupon and the largest amount.

And in a liquidity surplus situation, this has resulted in MTNL raising funds at some of the most competitive rates, at times as low as 13 per cent.

But issuers like HUDCO, IDBI and ICICI who together raised nearly Rs 3,000 crore during the first half of the current year adopted the book building route. This technique essentially implies inviting quotations from institutional investors. The investors commit funds at a certain price and amount.

However, this commitment, which merchant bankers are responsible for getting, does not amount to underwriting any part of the issue - accordingly for issue managers, this technically becomes a fee-based activity.

On the issuers part, there is no commitment to place the equity or the debt issue on the basis of the quotations. In fact, issuers are at liberty to reject the bids unless they conform to their own undisclosed reserve price.

And book building methods have also been employed for keeping the issue open for a longer period of time -- offers on tap. In this case the premiums in the case of equity or coupons in the case of debt could vary. But companies like the erstwhile SCICI (now merged into the ICICI), had also used a fixed coupon last year in the book building mechanism using a YTM-based pricing. This means that the bond could be placed at a premium with investors.

Others like the public sector Nuclear Power Corporation (NPC) have begun taking a leaf out of this technique. NPC in its latest bond placement of Rs 100 crore has fixed the coupon rate at 10.25 per cent. The bids are expected to be at a discount to face value to conform to the current market YTM of 13 per cent (about Rs 88.5). So while SCICI managed to rake in a premium on its 17 per cent bond issue, NPC has a deferred revenue expenditure in its books because it pays interest on the full face value of the bond only when it matures.

The advantages are significant in both methods. Although SCICI in using this method would have a high interest outflow during the life of the bond, this method of pricing was initiated to lock into higher yielding assets.

In the case of NPC the interest flows are low in the immediate period, and the costs of the funds (Rs 100-Rs 88.5=Rs 11.5) are technically back loaded, which is typical for project financing mechanisms. Back loading becomes advantageous, since the bullet expenditure would have to be borne only at the maturity of the instrument by which time the project can be expected to generate revenues. That is an advantage of the structuring method followed by the company. Even this issue is not underwritten. Clearly, as the stocks and bond markets stay uncertain, the rule of the game now is circumspection.