In today’s Finshots, we explain the concept of IPO financing and why the Reserve Bank of India (RBI) has reprimanded JM Financial.

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The Story

Imagine. The IPO market is red-hot. There’s a new company that’s going public every other day. And the share price pop on the listing day is insane. People who invest are making sacks of money.

But the desire to make even more money sets in. People aren’t happy with just sacks. They want money by the truckload. So they turn to leverage, or in simple words, they begin to borrow money to invest. They want to invest huge sums of money to maximise their absolute gains.

And they don’t typically go to a bank and ask for a personal loan. Rather, they turn to their wealth manager or a Non-Banking Financial Company (NBFC) that offers this niche service. It’s something called IPO financing.

If you want to see this in action, you just need to look at the HNI (high net worth individual) segment of popular IPOs. You’ll often see that segment getting oversubscribed by 100 times and more. And that’s usually thanks to these loans they get. For instance, in July 2021, there were a bunch of IPOs trying to raise a total of ₹18,400 crores. But people bid a gargantuan sum of ₹8.86 lakh crores! And around 98% of that money came from these IPO-linked loans!

Heck, do you remember the spat between Ashneer Grover and Kotak Wealth Management from 2021?

Well, that was due to a tussle regarding IPO financing. Or the lack of it.

Nykaa, the beauty and fashion startup, was preparing to go public. And everyone was excited. It was a profitable startup which was quite rare. And investors anticipated a huge pop on listing. Now Grover wanted Kotak to loan him a whopping ₹500 crores to take part in the IPO. And he says Kotak backed out at the last moment and he lost the opportunity to make a killing.

But wait…how do these entities even have that kind of large sums of money to lend out to these HNIs?

Well, they usually don’t have that much money just lying around. So they have to resort to borrowing the money first. They do this by issuing something called a Commercial Paper (CP). Think of this as an extremely short-term bond that they have to repay in about 7 days.

So they launch the CP, entities such as liquid mutual funds buy it, and that money then goes into financing these IPO bets for the HNI risk-takers.

And this entire exercise of IPO financing can be quite lucrative.

See, no one’s guaranteed a full allotment in an IPO. It’s a lottery. It all depends on how much people are interested in the IPO and subscribe to it. The greater the subscription, the lesser the chances of investors getting what they wanted. And while the NBFC or wealth manager pays an annualised interest of around 5% on the CP, they charge quite a hefty interest on these IPO loans — up to 20%. That’s quite a spread.

Also, it doesn’t matter whether the HNI gets an allotment or not, they will still need to pay interest on the entire amount borrowed. *

So yeah, when the IPO market booms, it’s quite a jolly time for these IPO financers.

Okay, but isn’t this a risky proposition for the NBFC, you ask? There are massive sums of money involved at the end of the day. And there’s no collateral or security involved in the loan.

Ah, so this is where the NBFC might do something else. They expect the investor to operate on their terms. This means they take a power of attorney (POA) for the demat account and the bank account of the investors. They control the whole process — right from lending money into the bank account, making the IPO application, selling the stock, pocketing the gain or taking a loss. Everything. That reduces the risk a bit.

And this finally brings us to today.

The Reserve Bank of India (RBI) has pulled up an entity that was a big fish in the IPO financing pond — JM Financial.

Why though?

Well, there seems to be a few glaring issues as per the RBI. Apparently, JM Financial doled out IPO financing against meagre margins. Meaning that it gave clients excessive leverage. Also, the RBI seems to have a problem with the POA practice since JM Financial controls the bank accounts of customers.

The RBI says that JM Financial is in violation of regulatory guidelines. And then even mentioned the dreaded G-word — governance issues.

So the regulator laid down the gauntlet and told JM Financial that it can’t indulge in IPO financing anymore amongst a bunch of other stuff.

Now we don’t know exactly what went wrong because other NBFCs also resort to a POA and meagre financing margins. But one speculation is that NBFCs like JM Financial have flouted an RBI rule.

Around the time of the Nykaa IPO, the RBI was getting worried about the massive amounts of money at play here. So they issued a diktat saying that no customer can borrow more than ₹1 crore to finance an IPO application. Gone were the days of the Ashneer Grover-type ₹500 crore loan.

But Moneycontrol says that NBFCs have ignored the rules and are lending out more. Could JM Financial have done that too?

Another rumour doing the rounds as per the Economic Times is that JM Financial has also been inflating the IPO subscription numbers.

What do we mean?

Okay, so during the IPO, entities can simply submit incorrect applications. For instance, it might mention multiple PAN card details which will eventually lead to the application being rejected. But it will still reflect as a subscription during the IPO period and can make things look rosy.

And maybe by showing HNIs the public interest in the IPO, the NBFC could even nudge the investors into relying on IPO financing to participate.

Yeah, it’s quite a dubious practice.

Now JM Financial has categorically refuted all these allegations. They claim clean corporate governance too.

But the RBI doesn’t think so. Also, maybe even the Securities and Exchange Board of India (SEBI) will have something to say about this matter. And who knows, every other NBFC involved in IPO financing will be jittery about what’s to come.

Until then…

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*When the HNI borrows money for an IPO, it’s deposited into their bank account. When they make the IPO application, the money is blocked for this purpose but still remains in the bank account and continues to earn a bit of interest.

PS: Last evening, SEBI barred JM Financial from managing certain bond-related issuances due to irregularities.

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