A popular tactic used by Indian brokerages to raise money for rich clients is likely to be banned by the central bank's move to curb unregulated lending, potentially crimping funding for a long pipeline of planned IPOs.
India's central bank this month proposed to stop borrowers from issuing non-convertible debt with a maturity of less than 90 days, part of a broader effort to remove excess liquidity as overseas funds pour into its markets.
Brokerages have made such borrowings mostly from mutual funds, typically at twice the commercial paper market rate, and then turned around and loaned the funds to rich clients. The wealthy investors, in turn, used the cash to invest in a recent slew of IPOs, fuelling aggressive valuations.
The Reserve Bank of India is afraid of asset bubbles, said Alex Mathews, head of research at Geojit BNP Paribas Financial Services. This will definitely be a hindrance for brokerages.
Analysts say the move will increase the costs associated with IPO fundraising in India, as brokers used the financing tactic to work around regulations and avoid hefty stamp duty.
Brokers would issue a one-year secured non-convertible debenture (NCD) with a put/call option exercisable before 89 days. Under Indian law, a company has 90 days in which to place security for the paper or pay a higher stamp duty.
The new rule, which is expected to take effect by the end of the month, eliminates that loophole.
It was a profitable business. People have made a good amount of money, said an official at a local brokerage based in Mumbai, who declined to be identified and said his firm had made a few such deals.
However, it is a cycle that forms. Now that recent IPOs have not been performing well, sentiment has gone sour. So people will anyway not come to us with big demands for funds, he added.
The central bank move comes in the wake of recent heavily subscribed IPOs of state-run firms NHPC and Oil India, which together raised $1.8 billion for the government.
Despite strong subscription levels, NHPC and private sector firms Adani Power and Indiabulls Power made muted IPO debuts in recent months, with analysts blaming high valuations fueled in part by the unregulated IPO financing.
Indian IPOs expected in the coming months include a $1.1 billion issue from power company Sterlite Energy, a unit of Sterlite Industries, and a $900 million sale by Reliance Infratel, an arm of Reliance Communications.
The intention of the Reserve Bank is to make IPO funding more scarce, said Arun Kejriwal, whose investment firm advises wealthy clients.
Heavy oversubscription has not resulted in strong market performance, as investors who took on leverage to subscribe to new listings sold shares quickly in order to repay their loans.
Oil India, which was priced at a discount to its peers, is the only big recent Indian IPO now trading above its offer price.
For the NHPC offering, the 10 percent of shares allotted to wealthy investors was oversubscribed 57 times. Fund managers said roughly $2.5 billion worth of NHPC IPO applications was funded through the soon-to-be-outlawed practice.
Other short-term funding options for brokers, such as commercial paper and bank loans, are less attractive because they are governed by stringent guidelines and have longer maturities.
When compared with a daily put/call instrument, (brokers) don't really have an alternative, said Kaustubh Kulkarni, director of capital markets at Standard Chartered in Mumbai.
CPs (commercial paper) have a minimum maturity and certain eligibility criteria, which will mean an increase in costs of borrowing. Corporates' access to cheap short-end funds will reduce, he said.
The rule change is expected to lower margins for brokers and their clients and decrease the availability of IPO funding.
The RBI is being vigilant. This may help bring down IPO valuations, which anyway needed to go down, said Geojit's Mathews.
Analysts say lower valuations could stoke larger retail subscription for planned IPOs. The removal of a key funding source, however, could cut down on subscription levels from high net-worth individuals.
The crackdown comes as India readies a series of stake sales in government firms as Asia's third-largest economy looks to help finance its stimulus plan without adding to its fiscal deficit.
Meanwhile, easy money in the financial system due to government stimulus measures has led to froth in the market and the fear that asset bubbles could derail the recovery.
At its monetary policy review in October, India's central bank left key policy rates unchanged but tightened credit to the commercial property sector and lifted its inflation forecast.
It also said there were signs excess liquidity is seeping into asset prices.
(Editing by Tony Munroe and Muralikumar Anantharaman)