I was speaking at a recently concluded Indian capital markets conference in Mumbai, where I emphasized the need of strengthening the due diligence mechanism in an Initial Public Offering (IPO) process. My arguments were in favor of making the due diligence process more rigorous to further enhance transparency and investor confidence in the system, the benefit of which will be reflected in the capital markets, both for the issuer and the investors – a win-win situation.

The main objective for conducting due diligence is to protect investors’ interests and investments by ensuring that the investors have access to complete information – material or otherwise – so that they can take an informed decision and participate in the pricing mechanism of the underlying security being offered.

Therefore, keeping this objective in mind, a question that would usually pop-up in an investor’s head would be on the effectiveness, transparency and rigor of the entire due diligence process when a company comes up with an IPO. To answer this question, it would be better to first describe how a due diligence is conducted in a Private Equity (PE) transaction, and then compare it with the process followed when a company comes up with an IPO. This would help identify the gaps and what more could be done to strengthen the process further.

Due Diligence Process in a PE Transaction

The due diligence process is initiated by the PE investor after signing off the term sheet. When the term sheet is signed, it reflects the mutual acceptance of terms and conditions, fundamental drivers, rationale and valuations by the PE investors and the company – represented by the sell side advisors – seeking to raise funds through equity participation. The due diligence process initiated by the PE investor covers categories such as Commercial Due Diligence, Business Due Diligence, Financial Due Diligence, Technology Due Diligence, Legal Due Diligence, and, on a case-to-case basis, promoters’ background check often called as Promoters’ Reputation Due Diligence. Separate teams are deployed by the PE investor to conduct these different categories of due diligence. Since these teams are deployed by the buy-side (investor), the entire process is transparent and does not have any conflict of interests.

The basic principle followed in this process is to evaluate all the parameters that were used to arrive at the valuation / price of the equity. For instance, if at the time of signing the term sheet a company claims that the significant growth forecast in sales is due to huge future sales order pipeline having a value of INR X billion, the due diligence team would then verify the sales order pipeline and match it with what was claimed during the road show presentation. Likewise, all such parameters – financial, business, market or otherwise – that was at the core of the discussion during the road show to justify the price of the equity would get critically evaluated by the due diligence team.

After completing the due diligence process, a detailed report is prepared with a due diligence summary sheet that throws indicator flags on the parameters that were evaluated during the due diligence process. These flags are usually categorized into Red, Amber / Yellow and Green – whereby, the Red flag indicates that there is a significant gap between what was represented during the road show and what was verified during the due diligence process, thereby, underlining it as a High Risk; similarly an Amber or Yellow flag indicates that even though the gap exists, but it’s not significant, thereby highlighting it as a Moderate Risk; Green flag indicates the parameter (s) evaluated during the process is in line with (or negligible gap) what was presented during the road show, thereby indicating Low Risk. Therefore, if the due diligence report has mostly green flags and a fewer red and amber / yellow flags, the transaction goes through without any hindrance and at the price mutually agreed at the time of signing the term sheet. But, if the red and amber / yellow flags are more with very few green flags, the investors then either terminate the transaction (withdraws their offer) / calls off the deal, or they go back to the negotiation table and offer a much lower price on the equity.

Therefore, the due diligence process ensures that an investor does not pay for elements that are either not or insignificantly present, thereby making the transaction process fair, transparent, robust and realistic on the price of the equity.

Now the million dollar question is that “is it happening the same way when a company goes for an IPO”…

Due Diligence Process in an IPO

The first step for a company coming up with an IPO is to file the Draft Red Herring Prospectus (DRHP) in accordance with the SEBI Issue of Capital and Disclosure Requirements (ICDR), 2009. The ICDR lists out the disclosures that a company must make in the DRHP. At this juncture, it’s important to understand who all are involved in making the DRHP. The consortium of merchant bankers along with the legal team and auditors appointed by the company going for IPO works towards making the DRHP. Therefore, technically and fundamentally, the DRHP team represents the sell side and are remunerated by the company who appoints them.

Therefore, if the DRHP team is on the sell side, who is representing the buy side (the investors community)? Other than SEBI, which is a regulatory body and not an advisor, there is nobody else representing the investors’ community. To understand it in a better way, let’s try to evaluate each of the stages – after the DRHP is prepared – leading to the subscription of an IPO:

Stage 1: The DRHP is placed on SEBI’s website and also on the website of the merchant banker for 21 days (issue specific details such as price band, number of shares being offered, promoters’ stake, etc. are not included in the DRHP).

During this period, public at large can go through it and post its observations / comments regarding the document. Additionally, an officer appointed by SEBI also evaluates the document and records its observations / comments regarding the document. However, one should note that the public at large i.e. the retail investors may not have the skill sets to evaluate the DRHP on technical and fundamental grounds, with the exception of few who may understand the subject – this is the first loophole in the process.

Stage 2: The officer from SEBI prepares a list of questions based on the above observations – including the observations posted by the public at large – and sends it to the merchant banker that prepared the DRHP.

Stage 3: The merchant banker address the comments sent by the SEBI officer and send it back to SEBI, after which the DRHP is placed again on the website for a second round of observation from the public and SEBI.

Once all the observations / comments are answered to SEBI’s satisfaction, it then allows the merchant banker to file the Red Herring Prospectus (RHP).

Stage 4: After getting the go-ahead from SEBI, the merchant banker files the RHP with SEBI. Like the DRHP, the issue specific details (as mentioned in Stage 1) are not included in RHP. RHP indicates that the contents mentioned in the DRHP has been verified and approved by SEBI, and, therefore, filing of the RHP is a nod to the merchant banker to go to market for conducting road shows and marketing campaigns.

Stage 5: The merchant bankers conduct road shows to secure the QIB (Qualified Institutional Buyers) orders – which have to be a minimum of 50% of the total issue size – and come up with a price band.

The public at large would usually wait until the QIB orders are secured, and will then place their bids within the price band.

Stage 6: After the bids are received and share price is fixed, the final prospectus becomes available having the issue specific details.

There are two key takeaways based on the above stages –

1. SEBI is the only body that evaluates the documents on behalf of the non-institutional investors; however, SEBI being a regulatory body (and not an investment advisory firm) has its own limitations on the skill sets to be deployed to a do a proper due diligence; and
2. The only silver lining in the entire process (mentioned above) is the QIB orders. Since QIB fends for itself, they deploy their own due diligence team before they subscribe. This acts as a leading indicator for the non-institutional investors that underlines the fact that a thorough diligence has been done and the price band is reflective of the post diligence exercise

Therefore, excluding the QIB orders as a lead indicator, I personally feel the traditional and rigorous due diligence process practiced in a PE transaction is missing in an IPO. But does it mean that SEBI is not effective or the merchant bankers representing the issuer are unethical and are concealing material information that may impact the price downwards – the answer to both these questions is a resounding no. While SEBI’s intention is investor protection, the FTAR principle needs to be applied i.e., the process has to be fair and transparent, and somebody has to take the full responsibility and be accountable. Having said that, such things are already in place, and, at this juncture, it would be really good to draw best practices from the developed / advanced markets to see if there are any opportunities for improvement in the current process…

…Best Practices in the Developed World

After studying the IPO process in the United States, Europe and Far-East Asia, I can safely say that the regulatory standard adopted by SEBI regarding the IPO process is at par with the developed world. However, we can derive some learning based on the practice followed by the advanced markets – Singapore, in particular. In Singapore, the regulatory requirements – for a company going for an IPO – are as follows:

1. At the time of filing the prospectus, the issue manager would have to mandatorily document comprehensive supporting materials for every statement made in the prospectus, especially the forward looking statements.
2. If the regulatory authorities – SGX (Singapore Exchange Securities Trading Ltd.) and MAS (Monetary Authority of Singapore) – decide to conduct an audit post filing of the prospectus, the supporting materials / verification documents mentioned above gets thoroughly examined by the regulators.
3. If the above supporting materials do not provide sufficient grounds for making a statement (s), it will then considered to be misleading according to the Singapore Securities and Futures Act.
4. The issue manager would also have to appoint a third party independent agency to conduct investigation and provide an investigation report about the company coming up with the IPO, its promoters, and the management.

Note: Since the third party independent agency is appointed by the issuer and not the SGX, one may argue that the third party agency is also representing the sell side and their findings could be biased. But since the regulation makes the third party agency fully accountable and responsible for the report, the submission of the investigation report would be completely fair and transparent.

So What are the Ways to Strengthen the Current IPO Due Diligence Mechanism?

The rigor of the PE transaction due diligence process needs to be adopted in the IPO process with SEBI as the watchdog for all the due diligence processes. The stages discussed earlier in the article may not be required, if the verification, audit, and diligence is conducted and all issues ironed out / corrected before the prospectus is made available in the public domain. As a suggestion, the following could be the probable steps:

1. The merchant banker files the DRHP with SEBI, which is not in public domain
2. SEBI appoints third party independent due diligence teams to conduct various categories of due diligence (the due diligence teams should be paid by SEBI, and SEBI, in turn, gets that reimbursed from the issuing company)
3. Based on the due diligence findings, SEBI to direct course corrections (after discussing the due diligence findings with the company and its merchant bankers) based on the recommendation of the due diligence team
4. Once the course correction is done, the due diligence team will verify and give its recommendation to SEBI
5. Based on the recommendation, SEBI will issue clearance to the company to put up the final prospectus for the public
6. The merchant bankers then go to market for conducting road shows and other marketing programs so that the issue is fully subscribed

In Essence…

The above recommendation will only make the process faster, efficient, robust and transparent. This will enhance the investor confidence, and the retail investors, unlike in the current process, can participate from the moment the prospectus is made available in the public domain. This is because now they know that every statement – material or otherwise – have been thoroughly verified by the professionals and the price band is reflective of that. In my opinion, this change is necessary for an inclusive participation in the capital markets.