Beyond the red herring

India's unusual laws have provoked uniquely desi business structures. You need to go beyond western norms of governance to understand these.

By Devangshu Datta | Print Edition: November 30, 2006

By the time a business can go public, it’s already achieved some success. It has a balance sheet that meets Sebi norms. And, as has already been said, the strike rate for successful IPOs has been very high since 2002.

Selling instantly on listing is called “going stag”. Since the holding period is short, even small gains can annualise into large returns.

But should you buy IPOs as businesses to be held for the long term? It is more difficult to judge the worth of an IPO. The risks are higher and many great value investors have tended to avoid IPOs. Well, we cannot advise you to ignore instruments that can create such large wealth. But we can warn you about a few risks peculiar to Indian IPOs. Indian companies carry some baggage unique to the Indian regulatory environment.

A study by Professor Amarnath Bhide of the Columbia Business School offers insights. Bhide examined small, high-growth firms in Bangalore. These are typical IPO candidates, so his findings are key. Some of them are:

  • Indian startups require large amounts of equity capital.
  • Indian businesses own real estate, whatever the business.
  • Entrepreneurs build many small companies, not one large company.
  • Unlisted group companies create conflicts of interest and affect corporate governance.

In addition to Bhide’s finding, one can add that western norms of corporate governance are not easy for Indian businesses to follow and in fact may be convenient to circumvent. What are the implications for investors?

Indian banks are reluctant to fund businesses without physical collateral. An average US startup takes $10,000 equity—an average Indian start-up takes Rs 3.75 lakh ($ 8,400). If we compare other indicators, an Indian startup should not take more than $2,000. This means skewed equity ratios.


Indian companies often have unusual structures. Analysts should look for the following in an IPO.

Indian companies raise more equity because they find it tough to raise debt.
Indian businesses tend to be highly exposed to real estate markets — up to 80% of startup capital may be invested in real estate.
Entrepreneurs build groups out of many small companies rather than creating large standalone entities.
IPOs often have many unlisted “siblings” in the same group that can create conflicts of interests for promoters and thus affect corporate governance.
Western-style corporate governance is easily circumvented by Desi-style family businesses with their extended networks of relationships.

Indian businesses are real estate plays. It’s easy to raise loans to buy land and then, to raise further loans, using the land as collateral. According to Bhide, up to 80% of start-up capital may be tied up in real estate. Expect even businesses with no apparent real estate connection to react to land prices.

Excise exemptions and smallscale industry reservations make it tax efficient to create many small companies rather than one big one. It used to be illegal for a bicycle manufacturer to make lamps or tyres. It is illegal for HLL to make “ice-cream” though it can sell “frozen dessert”. It is also easier to hire and fire if you have small, nonunionised workforces. Hence, sideways growth is common.

Unlisted group companies can be a maze for the IPO investor. These can create conflicts of interest that hurt shareholder returns. For example, brands such as Horlicks, Ariel and Oberoi were not owned by the publicly-listed Glaxo SmithKline, Proctor & Gamble and EIH, which use them respectively.

In each instance, the listed company paid licensing fees to a privately held company, which owned the brand. Even when the brand is transferred to the public entity as with Oberoi or Nirma, there may be a substantial cost to minority shareholders.

Jet Airways illustrates another type of potential conflict. Apart from the trademark, which is owned by a private company controlled by the promoter, the general sales agent is also a private company owned by the promoter. Jet pays high commissions on ticketing to the general sales agent and it has a full-fare strategy.

Suppose the promoter decides to merge unlisted companies with listed ones? You may have a mess. There’s room to fiddle the equity structure in unlisted companies and valuations may nosedive. Anybody who has followed the saga of Nalwa Sons (formerly Jindal Strips) of the O.P. Jindal Group through the Company Law Board to the Supreme Court will know how complex this is.

However, group companies may also create strong synergies. Take the Munjals, for instance. Hero Honda’s valuation is strengthened by the group companies straddling the value chain.

Most Indian companies have boards composed of friends and families. It is easy enough to find an independent director who is sympathetic to the promoter while technically independent under the definition of Clause 49 of Sebi’s Listing Agreement. You may have to go well beyond the letter of the law to judge corporate governance and this is difficult with an IPO.

So we’re not saying avoid IPOs though you can make very decent returns without ever touching one. But do focus on these hidden pitfalls before subscribing.

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