In today's post, we look at creating our own Investment company, that specializes in IPOs!
Let's say you are the fund manager of an investment company and your strategy is to only invest in IPOs.
First, we need to understand the IPO investment process in detail. So let's take a look at the step-by-step process.
Allotment process
Very rarely do we have IPOs that are subscribed at exactly what the founders ask for.
When we apply for an IPO that is not so popular, it usually goes undersubscribed, and a popular IPO is likely to get over-subscribed. It can be oversubscribed as much as 50 to 100 times the asking amount!
The rate of subscription of an IPO will affect an investor directly.
How?
If the IPO is undersubscribed then the investor will get all the lots, which he/she has applied for.
What if the IPO gets oversubscribed?
It has a different procedure for the allotment based on the category.
1) Retail Category
SEBI or Securities and Exchange Board of India mandates that at least one lot should be allotted to every individual who has applied.
Assume that there are 5 lakh shares offered to the investors and the minimum lot size is 50. Then the maximum number of investors who will get at least one lot is = 5 lakh/50 = 10,000
Thus, 10,000 investors will be allotted at least one lot.
If the no of investors is more than 10,000 then they will be allotted the shares based on a computerized lottery system, and some investors won't get any lots.
2) HNI Category (Application >= Rs 200000)
This is the lot under which you will apply (as you are working on a large scale).
Allotment in the HNI category works on a proportional basis.
Let's say IPO is oversubscribed by 10 times then you will get the shares worth (the amount you have applied/no of time oversubscription).
Ex. You have applied for a 10 lakh rupee and IPO subscribed 10 times then you will get shares worth 10 Lakh/10=1 lakh rupee.
Paying for the IPO: Funding your investment
Retail investors, need to pay upfront (block the amount in the account using ASBA) and then get their money back (Unblocked the same amount) if they don't get the allotment. They usually use their savings or Block some money on the debit/credit cards to get the allotment.
But for your venture, you have multiple options to get the funding for IPO investment. As a fund manager, you will have a certain amount of money from your investors which is your equity funding. On top of that, you can decide to take a loan as debt funding.
You will get 90% of the application amount as funding from NBFCs. The interest rate charged is around 10-12% annually. IPO funding is generally taken for a week. The whole process is usually completed in a week and you'll pay the bank back.
Let's say you want to apply for 1 Cr. You will need 10 lakh from your investment fund and the rest you will get from NBFCs.
The NBFC will charge 12% annually for a week.
Now we will explore the various scenarios of IPO listing price.
Assumptions for the calculation:-
We are applying for IPO worth 1 Cr. Out of which 90 Lakhs of funding we are taking it from NBFCs for a week.
Rest 10 Lakhs we are putting as the amount invested from the personal account.
So, For a week cost of funding is: INR 90,00,000 * 12% * 7/365 = INR 20712
So you know your unit economics now. Your cost of funding in a single IPO is just Rs 20k. You need your 1Cr investment to return just 20k (0.2% return) to make money. Sounds easy?
Let's look at the model at scale.
Investing at scale
Below are the three scenarios of gain and loss. We have assumed different cases of oversubscription as well which is the norm today.
1) Listing day Gain/loss=+-15%
Win Rate is the ratio of winner IPOs (ie 15% gain) vs loser IPOs (ie. 15% loss) on listing day.
So, if the subscription of the IPO is 50 times and listing day gain/loss is +/- 15% then you should be right 9 out of 10 times to just breakeven.
2) Listing day Gain=30% and Loss=-20%
Win rate is lowered as our numbers change, ie. 30% listing day profit vs 20% loss.
3) Listing day Gain=50% and Loss=-20%
And if we take more comfortable numbers like 50% gain on listing day for winners vs 20% loss for losers then the numbers get better,
Result
Even in the most comfortable scenario, you need a win rate of at least 33% to 50% for breakeven! In the long term, this is a very high number.
IPOs look rosy based on listing day gain but the numbers are saying something different!! Let's take a look at the historical win rate for IPOs.
Here is a database from Chittorgarh that tells us the date-wise listing gains/losses for the recent IPOs.
We could gather the following observations:
1. Most IPOs that give significant gains have a very high oversubscription rate (~80X). And those that don't do well or give losses are oversubscribed by only 10X-15X.
2. Average win rate for winners is 50%, and if you remove the top 3 IPOs then it falls to 33%. The average loss rate for losers is ~10%.
3. The biggest risk is that a few bad bets will ruin your profits completely in the case of leveraged IPOs. The top 5 losers have a loss rate of 25%.
Final recommendation: The win rate required is quite high and difficult to maintain in the long term.
Follow a structured process and manage your risk by adjusting position sizing. Keep enough money for a large number of continuous bad bets.
If you do decide to go for such an investment firm, do let us know how it turns out! All the best.
Further Reading
If you want to understand the relation between the pay-off ratio and win rate then the expectancy curve is the best place to learn. Click here on the Link for the article on the expectancy curve.
