Book Building Process Mukesh Kr.

Singh

Introduction To keep pace with the globalization and liberalization process, the government o f India was very keen to bring the capital market in line with international pra ctices through gradual deregulation of the economy. It led to liberalization of capital market in the country with more expectations from primary market to meet the growing needs for funds for investment in trade and industry. Therefore, th ere was a vital need to strengthen the capital market which, it felt, could only be achieved through structural modifications, introducing new mechanism and ins truments, and by taking steps for safeguarding the interest of the investors thr ough more disclosures and transparency. As such, an important mechanism named as Book building in the system of initial public offerings (IPOs) was recognized b y SEBI in India after having the recommendations of the committee under the chai rmanship of Y. H. Malegam in October, 1995. SEBI guidelines recognized book buil ding as an alternative mechanism of pricing. Under this approach, a portion of t he issue is reserved for institutional and corporate investors. SEBI guidelines, 1995 defines book building as a process undertaken by which a demand for the sec urities proposed to be issued by a body corporate is elicited and built up and t he price for such securities is assessed for the determination of the quantum of such securities to be issued by means of a notice, circular, advertisement, doc ument or information memoranda or offer document. Book building process is a comm on practice used in most developed countries for marketing a public offer of equ ity shares of a company. However, book building is a transparent and flexible pr ice discovery method of initial public offerings (IPOs) in which price of securi ties is fixed by the issuer company along with the Book Running Lead Manager (BR LM) on the basis of feedback received from investors as well as market intermedi aries during a certain period. mukesha.kr@indiatimes.com

Need of Book Building The abolition of the Capital Issue Control Act, 1947 has brought a new era in th e primary capital markets in India. Controls over the pricing of the issues, des igning and tenure of the capital issues were abolished. The issuers, at present, are free to make the price of the issues. Before establishment of SEBI in 1992, the quality of disclosures in the offer documents was very poor. SEBI has also formulated and prescribed stringent disclosure norms in conformity to global sta ndards. The main drawback of free pricing was the process of pricing of issues. The issue price was determined around 60-70 days before the opening of the issue and the issuer had no clear idea about the market perception of the price deter mined. The traditional fixed price method of tapping individual investors suffer ed from two defects: (a) delays in the IPO process and (b) under-pricing of issu e. In fixed price method, public offers do not have any flexibility in terms of price as well as number of issues. From experience it can be stated that a major ity of the public issues coming through the fixed price method are either underpriced or over-priced. Individual investors (i.e. retail investors), as such, ar e unable to distinguish good issues from bad one. This is because the issuer Com pany and the merchant banker as lead manager do not have the exact idea on the f ixed pricing of public issues. Thus it is required to find out a new mechanism f or fair price discovery and to help the least informed investors. Thats why, Book Building mechanism, a new process of price discovery, has been introduced to ov ercome this limitation and determine issue price effectively. Public offers in f ixed price method involve a pre issue cost of 2-3% and carry the risk of failure if it does not receive 90% of the total subscription. In Book Building such cos t and risks can be avoided because the issuer company can withdraw from the mark et if demand for the security does not exist. mukesha.kr@indiatimes.com

Malegam Panels Recommendations: The introduction of book-building in India in 1995 was on account of the recomme ndations of an expert committee appointed by SEBI under Chairmanship of YH Maleg am to review the (then) existing disclosure requirements in offer documents. Two o f the terms of reference being the basis of pricing the issue and whether substanti al reduction was possible in the time taken for processing applications by SEBI. The committee has submitted its report with several recommendations and the SEBI accepted the same in November 1995. The book-building route should be open to i ssuer companies, subject to certain terms and conditions. Some of them are prese nted below: 1. The option should be available only to issues exceeding Rs. 100 c rore; 2. The book-building issuer companies could either reserve the securities for firm allotment or avail themselves of the book-building process; 3. Draft pr ospectus to be submitted to SEBI could exclude information about the offer price ; 4. A book runner to be nominated from among the lead merchant bankers, charged with specific responsibilities and the name is to be submitted to the SEBIs appr oval 5. The requirement of 25 percent of the securities to be offered to the pub lic will be continued. There have been several amendments/revisions to the above guidelines; the first one in December 1996 made available the option of book-bu ilding to all corporate bodies which were otherwise eligible to make an issue of capital to the public, and in case of under subscription, the spill-over from t he public portion could be permitted to the placement area and vice-versa. In 19 97, the restriction of the facility to 75 % of the issue was thought to severely constrain the benefits arising out of price and demand discovery, and the facil ity was extended to 100 percent of the issue, available only if the issue amount was Rs. 100 crore and above, compulsorily offering an additional 10 percent of the issue to the public through prospectus, and reserving at least 15 percent of the issue size to individual investors applying up to ten tradable lots. Furthe r, audited financial ratios had to be disclosed, namely, EPS, P/E, average retur n on net worth for the last three years and net mukesha.kr@indiatimes.com

asset value based on last years balance sheet. However, there were no takers for the 100 percent book-building facility. Based on suggestions made by leading mer chant bankers, the following amendments were made to the guidelines in 1999: 1. The issuer may be allowed to disclose either the issue size or the number of sec urities to be offered to the public; 2. Allotment should be in demat mode only; and 3. Reservation of 15 percent of issue amount for individual investors need t o the public at a fixed price. Some of the earliest mega issues through the book -building route were those of Larsen & Toubro, ICICI, TISCO and others. Book Building and Fixed Price Option in the IPOs A company may raise capital in the primary capital market through initial public offers (IPOs), rights issues and private placement. IPOs, the largest sources o f funds in the primary capital market, to the company are basically an invitatio n by a company to the public to subscribe to its securities offered through pros pectus. In fixed price process in IPOs, allotments of shares to all investors ar e made on proportionate basis. Institutional investors normally are not interest ed to participate in fixed price public issues due to uncertainty of allotment a nd lack of opportunity cost. On the other, they like to participate largely in b ook built transactions as in this process the costs of public issue and the time taken for the completion of the entire process are much lesser than the fixed p rice issues. In Book Building the price is determined on the basis of demand rec eived or at price above or equal to the floor price whereas in fixed price optio n the price of issues is fixed first and then the securities are offered to the investors. In case of Book Building process book is built by Book Runner Lead Ma nager (BRLM) to know the everyday demand whereas in case of fixed price of publi c issues, the demand is known at the close of the issue. mukesha.kr@indiatimes.com

How is Book Built in India? The main parties who are directly associated with book building process are the issuer company, the Book Runner Lead Manager (BRLM) and the syndicate members. T he Book Runner Lead Manager (i.e. merchant banker) and the syndicate members who are the intermediaries are both eligible to act as underwriters. The steps whic h are usually followed in the book building process can be summarized below: 1. The issuer company proposing an IPO appoints a lead merchant banker as a BRLM. 2 . Initially, the issuer company consults with the BRLM in drawing up a draft pro spectus (i.e. offer document) which does not mention the price of the issues, bu t includes other details about the size of the issue, past history of the compan y, and a price band. The securities available to the public are separately ident ified as net offer to the public. 3. The draft prospectus is filed with SEBI which gives it a legal standing. 4. A definite period is fixed as the bid period and BRLM conducts awareness campaigns like advertisement, road shows etc. 5. The BRL M appoints a syndicate member, a SEBI registered intermediary to underwrite the issues to the extent of net offer to the public. 6. The BRLM is entitled to remune ration for conducting the Book Building process. 7. The copy of the draft prospe ctus may be circulated by the BRLM to the institutional investors as well as to the syndicate members. 8. The syndicate members create demand and ask each inves tor for the number of shares and the offer price. 9. The BRLM receives the feedb ack about the investors bids through syndicate members. 10. The prospective inves tors may revise their bids at any time during the bid period. 11. The BRLM on re ceipts of the feedback from the syndicate members about the bid price and the qu antity of shares applied has to build up an order book showing the demand for th e shares of the company at various prices. The syndicate members must also maint ain a record book for orders received from institutional investors for subscribi ng to the issue out of the placement portion. mukesha.kr@indiatimes.com

12. On receipts of the above information, the BRLM and the issuer company determ ine the issue price. This is known as the market-clearing price. 13. The BRLM th en closes the book in consultation with the issuer company and determine the iss ue size of (a) placement portion and (b) public offer portion. 14. Once the fina l price is determined, the allocation of securities should be made by the BRLM b ased on prior commitment, investors quality, price aggression, earliness of bids etc. The bid of an institutional bidder, even if he has paid full amount may be rejected without being assigned any reason as the Book Building portion of insti tutional investors is left entirely at the discretion of the issuer company and the BRLM. 15. The Final prospectus is filed with the registrar of companies with in 2 days of determination of issue price and receipts of acknowledgement card f rom SEBI. 16. Two different accounts for collection of application money, one fo r the private placement portion and the other for the public subscription should be opened by the issuer company. 17. The placement portion is closed a day befo re the opening of the public issue through fixed price method. The BRLM is requi red to have the application forms along with the application money from the inst itutional buyers and the underwriters to the private placement portion. 18. The allotment for the private placement portion shall be made on the 2nd day from th e closure of the issue and the private placement portion is ready to be listed. 19. The allotment and listing of issues under the public portion (i.e. fixed pri ce portion) must be as per the existing statutory requirements. 20. Finally, the SEBI has the right to inspect such records and books which are maintained by th e BRLM and other intermediaries involved in the Book Building process mukesha.kr@indiatimes.com

Book Building Process mukesha.kr@indiatimes.com

Steps involved in Book Building Process: Nominate Book Runner Form Syndicate of Brokers, Arrangers,Underwriters, Financial Institutions, etc. Submit Draft Offer Document to SEBI without mentioning Coupon Rate or Price Circulate offer Document among the Syndicate Members Ask for Bids on Price and Quality of Securities Aggregate and forward all offers to Book Runner Run the Book to maintain a record of Subscribers and their Orders Consult with Issuer and Determine the issue Price as Weighted Average of the Off ers Received Firm up Underwriting Commitments Allot Securities Among Syndicate Members Securities Issued and Listed Trading Commences on Exchanges Regulatory Framework The Book Building guidelines were first introduced by SEBI in 1995 (clarificatio n XIII, dated 12.10.95) for optimum price discovery of corporate securities. The SEBI, from time to time modifies the guidelines in order to upgrading the exist ing mechanism. The SEBI in its press release dated 7th September, 1998 prescribe d the fresh guidelines for book building mechanism after thorough modification a nd it was again modified in 2001(Circular No.2, dated 6.12.2001) and 2003(Circul ar No. 11, dated 14.08.2003).

Some of the guidelines of SEBI are: 1. In January 2000, SEBI has issued a compen dium of guidelines, circulars and instructions to merchant bankers relating to i ssue of capital, including those on the book-building mechanism. The compendium includes a model time frame for book-building: After the price has been determine d on the basis of bidding, statutory public advertisements for a continuous thre e days containing, inter alia, the price as well as a table showing the number o f securities and the amount payable by an investor, based on the price determine d, shall be issued and the interval between the advertisement and issue opening date should be a minimum of five days. 2. The draft prospectus to be circulated h as to indicate the price band within which the securities are being offered for subscription. The bids have to be within the price bands. Bidding is permissible only if an electronically- linked transparent facility is used. An issuing comp any can also fix a minimum bid size. An initial bid can be changed before the fi nal rate is determined. 3. The Prospective bidders were advised to read the Red h erring prospectus carefully. According to the Act, a Red herring prospectus means a prospectus that does not have complete particulars on the price and the quantum of securities offered. 4. The year 2000, Amendment to the Act gave legal cloak to the book-building route by allowing circulation of the information memorandum and the red herring prospectus. According to the Act, a process is to be undert aken prior to the filing of a prospectus by which a demand for the securities pr oposed to be issued by a company is elicited, the price and the terms of the iss ue of such securities are assessed by means of a notice, circular, advertisement or document. Incidentally, the working group on the Comprehensive Companies Bil l, 1997 (since lapsed) had advocated introduction of book-building. It defined t he term as an international practice that refers to collecting orders from invest ment bankers and large investors based on an indicative price range. In capital markets, with sufficient width and depth, such a pre-issue exercise often allows the issue to get a better idea of the demand and the final offer price of an in tended public offer. mukesha.kr@indiatimes.com

5. SEBI (Disclosure and Investor Protection) Guidelines, 2000 contains provision s for book building under chapter XI that includes guidelines for 75 per cent bo okbuilding process, 100 per cent book-building process, disclosure requirements, allocation/allotment procedure and maintenance of books and records. According to the SEBI, a public issue through Book Building route should consist of two po rtions: (a) The Book Building portion and (b) The fixed price portion. The fixed price portion is conducted like normal public issues (conventionally followed e arlier) after the book built portion during which the issue price is fixed after the bid closing date. Basically, an issuer company proposing to issue capital t hrough book building shall comply with the guidelines prescribed by SEBI. Howeve r, the main theme of SEBI guidelines regarding book building can be presented at a glance in the following manner: 1. 75% Book Building process: Under this process 25% of the issue is to be sold at a fixed price and the balance 75% through the Book Building process. TOTAL PUBLIC ISSUE (i.e.net offer to the public) BOOKBUILDING METHOD FIXED PRICE METHOD 75% of the public issue can be offered to institutional investors who had partic ipated in the bidding process. 25% of the public issue can be offered to the public through prospectus and shal l be reserved for allocation to individual investors who had not participated in the bidding process. 75% Book Building Process

2. Offer to public through Book building process: The process specifies that an issuer company may make an issue of securities to the public through prospectus in the following manner: a. 100% of the net offer to the public through book-bui lding process, or b. 75% of the net offer to the public through book-building pr ocess and 25% of the net offer to the public at the price determined through boo k building process. 100% of the net offer to the public through 100% Book Building process mukesha.kr@indiatimes.com

75% of the net offer to the public through Book Building process The net offer to the public, under this process shall be fully underwritten by t he syndicate members/book running lead managers. The syndicate members are to en ter into an underwritten agreement with the BRLMs indicating the number of secur ities which they would like to subscribe at the pre-determined price and BRLMs s hall in turn enter into an underwritten agreement with the issuer company. If th e syndicate members are not able to fulfill their underwritten obligations, the BRLMs shall be responsible for bringing in the amount involved. The bid remains open for at least five days. The date of opening as well as closing of the biddi ng, the names and addresses of BRLMs, syndicate members, bidding terminals for a ccepting the bids must be mentioned in the advertisement. mukesha.kr@indiatimes.com

Recent Changes in Book- Building Mechanism: The Securities and Exchange Board of India on March 29, 2005 announced sweeping changes in the IPO norms. They are as follows: 1. Increased allocation for retai l investors in book-built issue from 25 per cent to 35 per cent and has also cha nged the definition of the retail category. 2. The market regulator has now perm itted retail investors to apply for Rs. 1 lakh worth of shares in a book-built i ssue against Rs. 50,000 earlier. For this purpose, SEBI has redefined the retail individual investor as one who applies or bids for securities of or for a value not exceeding Rs. 1 lakh. 3. It has reduced the non institutional category, pop ularly known as high net worth individuals (HNI), allocation from 25 per cent to 15 per cent. 4. Institutional investors include foreign financial institutions (FII) banks, mutual funds and Indian financial institutions like LIC or IDBI. 5. The changes have been made in the SEBI (DIP) Guidelines, 2000 on the basis of r ecommendations made by SEBIs primary market advisory committee. 6. The new norms will be applicable to all public issues whose draft offers documents are filed w ith SEBI on or after April 4, 2005. 7. SEBI has decided to reduce the bidding pe riod from the current 5 to 10 days (including holidays) to 3 to 7 working days. 8. It has also provided more flexibility for listed companies to disclose price band/floor price for public issues one day before bid opening. 9. SEBI has decid ed to give an option to listed issuers to either disclose price band in RHP/appl ication form/abridged prospectus (current practice) or to disclose the price ban d/ floor price at least one day before bid opening. 10. It is proposed to amend the guidelines to improve contents and ensure uniformity in data display on the websites of the stock exchanges. The date will be made available for a further period of three days after the closure of the bids/issue . mukesha.kr@indiatimes.com

Limitations of Book Building Mechanism Retail investors are not free from certain disadvantages compared to institution al investors in Book Building, which does not provide an appropriate price disco very mechanism. It is the main reason why small investors have stayed away from the market. It needs changes to make it more suitable to the Indian context and the conditions prevailing in the Indian capital market. In the IPOs through the Book-Building route, it would be difficult to find dubious issues of the kind th at put off investors. The book-building system has various limitations. Some of them are as are as follows: 1. Book-building is appropriate for mega issues only . In the case of the potential investors, the companies can adjust the attribute s of the offer according to the preferences of the potential investors. It may n ot be possible in big issues since the risk-return preference of the investors c annot be estimated easily; 2. The issuer company should be fundamentally strong and well known to the investors; 3. The book-building system works very efficien tly in matured market conditions. In such circumstances, 4. The investors are aw are of the various parameters affecting the market price of the securities. But, such conditions are not commonly found in practice; 5. There is a possibility o f price rigging on listing as promoters may try to bail out syndicate members. mukesha.kr@indiatimes.com

Green Shoe Option In most of the cases, it is experienced that IPO through Book Building method in India turns out to be overpriced or underpriced after their listing of them and ultimately the small investors become a net looser. If the IPO is overpriced it creates a bad feeling in investors mind as initial returns to them may be negati ve at that point of time. On the other side, if the prices in the open market fa ll below the issue price, small investors may start selling their securities to minimize losses. Therefore, there was a vital need of a market stabilizer to smo othen the swings in the open market price of a newly listed share, after an init ial public offering. Market stabilization is the mechanism by which stabilizing agent acts on behalf of the issuer company, buys a newly issued security for the limited purpose of preventing a declining in the new securitys open market price in order to facilitate its distribution to the public. It can prevent the IPO f rom huge price fluctuations and save investors from potential loss. Such mechani sm is known as Green Shoe Option (GSO) which is an internationally recognized fo r market stabilization. So, GSO can rectify the demand and supply imbalances and can stabilize the price of the stock. It owes its origin to the Green Shoe Comp any which used this option for the first time throughout the World. ICICI Bank h as, used Green Shoe Option in first time in case of its public issue through the book building mechanism in India. As such, such important mechanism i.e. GSO in the system of initial public offerings (IPOs) using book building method was re cognized by SEBI in India through its new guidelines on 14.08.2003 (vide SEBI/CFD/DIL/DIP/Circular No.11). In case an initial public offer of equity shar es is made by an issuer company through the book building mechanism, the Green S hoe option (GSO) can be used by such company for stabilizing the post listing pr ice of its shares, subject to the guidelines prescribed by SEBI. According to SE BI guidelines, a company desirous of availing the GSO shall in the resolution of the general meeting authorizing the public issue, seek authorization also for th e possibility of allotment of further shares to the stabilizing agent (SA). The co mpany shall appoint one of the lead book runners, amongst the issue management t eam, as the stabilizing agent (SA), who will be responsible for the price stabiliz ation process, if required. The SA shall enter into an agreement with the issuer company, prior to filing of mukesha.kr@indiatimes.com

offer document with SEBI, clearly stating all the terms and conditions relating to this option including fees charged / expenses to be incurred by SA for this p urpose. The SA shall also enter into an agreement with the promoter(s) who will lend their shares, specifying the maximum number of shares that may be borrowed from the promoters, which shall not be in excess of 15% of the total issue size. The stabilization mechanism shall be available for the period disclosed by the company in the prospectus, which shall not exceed 30 days from the date when tra ding permission was given by the exchange(s). Conclusion Book Building process aims at fair pricing of the issue which is supposed to eme rge out of offers made by various investors. One question may arise whether book b uilding is the right mechanism for fair pricing discovery in IPOs? The answer may be in the negative because a floor price is fixed for the Book Building bel ow which no bid can be accepted. Since investors participate through Book Buildi ng process in making fair pricing of IPOs where there is no ceiling price, there should not be any floor price. In addition to this, unlike international market , India has not reached the stage of development of the institutional framework to experiment with the book building process because retail investors (i.e. indi vidual investors) are still now an integral part of Indian capital market. If th e interests of the small investors are not safeguarded appropriately, this may b e very dangerous to the primary capital market. Although only two book built iss ues Hughes software and HCL Technologies have given proper returns to the shareh olders in 1999 and Maruti Udyog in 2003 but the other four book built issues of Shree Rama Multitech, Cadila, Cinevista and Mascot system were trading at huge d iscounts to their issue price ranging between 35-50%. mukesha.kr@indiatimes.com