In many ways it was an initial public offering (IPO) with a difference. When Mahindra & Mahindra Financial Services Ltd tapped the primary market last fortnight with a Rs 400-crore issue, it was the first issue by a non-banking finance company (NBFC) in a long, long time. If NBFCs haven't approached the markets in the past so many years, it's because the industry has only recently succeeded in exorcising the ghost of one C.R. Bhansali, who left millions of depositors high and dry in the nineties. Perhaps that may be one reason why M&M Financial has been pretty liberal with its NPA (non-performing assets) provisioning. For instance, in the first nine months (April-December) of fiscal 2005-06, as per Reserve Bank regulations, M&M Financial would have had to make a provision of just Rs 93.68 crore. Instead the company chose to make an NPA provisioning of Rs 146.28 crore. So any fears of the pricing of M&M's 12-year-old NBFC getting distorted were in a sense belied with that show of transparency.

Yet, in one way though M&M Financial's IPO wasn't too different from all the other offerings that flooded the ongoing bull market. Like many of its predecessors, the tractor maker's NBFC too had placed a chunk of its shares with a private equity player at the pre-IPO stage. One-and-a-half-month before the bidding for sale of shares actually started, Copa Cabana, a Mauritius-based wholly owned investment arm of Chrysalis Capital, made an entry into the Rs 400 crore M&M subsidiary by buying out 4 per cent equity at a price of Rs 190 per share. When the issue did finally hit the market, guess what was the price band 'discovered' by lead managers Kotak Mahindra Capital Co. and ABN Amro Securities (India), via the much-touted book-building process? Rs 170-200 it was, making the ChyrsCap subsidiary's entry price the beacon for pricing of M&M Financial's IPO.

Six Things You Never Knew About Ipo Pricing

» A private equity player, hedge fund or FII enters at a pre-IPO stage. » The entry is six months or a maximum one year before the IPO. » The entry is either direct or through a merchant bank. » In some cases, the merchant banker discovers the 'price' with an understanding that an IPO will follow. » The company hits the market with an IPO. » Price band for the issue, via 'book-building', is rarely lower than the pre-IPO price (determined by the merchant banker), and most often higher.

Did Somebody Mumble "Book-building?"

Welcome to the primary market's best kept secret pertaining to IPO pricing: Price discovery actually takes place a couple of months before the book-building process. And it hasn't been that way just in the case of M&M Financial. As the table above indicates (see Pre-IPO Placement: A Case Of Perfect Timing), a host of companies has been relying on private equity players or foreign investors to determine the pricing for their IPOs, which is invariably higher than the initial placement price. Textbooks will tell you that private equity players typically enter companies at an early stage, bringing to the table the capital required for growth. Textbooks also tell us that these investors tend to stick around for at least three to four years before exiting, often via an IPO. These days, though, with the stock market indices hitting new highs on a daily basis, the private equity tribe isn't thinking twice about investing in mature companies, with an exit route always available in such boom times.

"I don't think any price discovery is taking place in book-building issues because a (broad) 20-30 per cent band is attached to the price" Prithvi Haldea Founder/Prime Database

From the point of view of the company doing the IPO, this is clearly a great way to extract a maximum valuation in the primary market. As Girish Nadkarni, Chief Operating Officer (Investment Banking & Institutional Equity) at il&fs Investsmart, puts it: "The entry of a private equity player does not influence the IPO price, but definitely helps in bringing about some amount of confidence in the company." IL&FS Investsmart incidentally had made a placement to FIIs (foreign institutional investors) at Rs 54 per share in January 2005, and duly IPO-ED in July 2005 at Rs 125 per share. In private, bankers will tell you that the premium an IPO price commands is often proportional to the pedigree of the private equity player. An IPO that has as an investor a high-profile player like Aranda Investments (Mauritius), a wholly owned subsidiary of Temasek Holdings, would command a higher premium (to the placement price) than most offerings. For instance, the Temasek subsidiary acquired shares in Gateway Distriparks at Rs 32 per share. The IPO price: Rs 72 per share.

To be sure, it's not just private equity players who are gatecrashing the pre-IPO pricing party. A number of hedge funds like Farallon Capital Partners, Tiger Management LLC, Och-Ziff Capital Management and TPG Axon have been aggressively sniffing for pre-IPO deals. Farallon, for example, bought into Indiabulls Financial Services at just under Rs 25 per share. The company is perhaps the only one in recent times to IPO under that price, in the Rs 16-19 band. That Indiabulls zipped away to stratospheric levels after that (an all-time high of Rs 257 per share, 14 months after its listing) is of course another story.

Against a backdrop of such heady pricing-pre-IPO, at IPO, and post-IPO-the question that needs to be asked is: Is there any price discovery taking place at all in the much-hyped book-building process, which replaced the fixed pricing model seven years ago? Primary market tracker Prithvi Haldea of Prime Database is fairly clear it's a hoax. "I don't think any price discovery is taking place in book-building issues because a (broad) 20-30 per cent band is attached to the price." Gagan Banga, Executive Director, Indiabulls, points out that pre-IPO pricing is completely different in nature from that during book-building. "The valuation in a private equity deal pre-IPO stage is based on a longer term horizon whereas price discovery in book-building takes into account the demand and supply at a particular price point."

"An entry of a private equity player doesn't influence the IPO price, but it definitely helps in bringing some amount of confidence in the company" Girish Nadkarni COO (Investment Banking & Institutional Equity)/IL&FS

Interestingly, market sources reveal the sudden spurt in pre-IPO deals may be because institutional investors can no longer take advantage of discretionary allotments, which were done away with by SEBI last August. The market watchdog's investigations had apparently revealed that investment banks were making "irregular" allotments to a clutch of preferred FIIs. Since the window to "favourable" allotments has been shut, institutional investors are now taking the pre-IPO route to get a good price and a preferred quantity. In the Suzlon IPO, not only did the FII, T. Rowe Price get in at an attractive price relative to the IPO-Rs 425 as against the public offer price of Rs 510-it also succeeded in mopping up a huge quantity of shares, all of 37,50,000 (or 1.44 per cent of the company's equity). Had T. Rowe Price waited till IPO, it probably wouldn't have got the same price, and certainly not the same quantity of shares. With the markets looking fairly valued, it won't be long before the private investors begin scouting for exit routes. At the same time, though, the grapevine is crackling with tales of private equity investors and FIIs directly approaching unlisted companies-bypassing the merchant banker-that have a listing in the pipeline to work out a price. Whilst such investors may not be flouting any guidelines via this modus operandi, what it does is make a mockery of the venerated book-building system. Haldea of Prime Database would rather prefer an "auction method" for pricing IPOs where the bidder pays the highest price. "The retail portion could be priced by taking into account the average of the institutional price," suggests Haldea. The Economic Survey of 2006 also makes a mention of "shifting away from a system of quotas to a non-discretionary price discovery through a unified auction," although this is more in the context of the recent multiple bids for IPO subscriptions by scrupulous investors in the retail quota. Till something of that nature happens, promoters, institutional investors and merchant bankers will continue to run amok. As long as the bull run shows little signs of losing steam, the pre-IPO pricing party will rage on.