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What is Margin Funding? How Has it Affected BharatPe and Kotak Mahindra Bank?

Jan 11, 2022 10:37 AM 5 min read

The Indian social media found some fresh fodder last week when rumours of a prominent startup founder abusing and threatening a bank employee went viral.

The founder in question is Ashneer Grover who is also the managing director of BharatPe, a fintech company that offers a range of products including UPI payments, micro financing etc. 

Mr. Grover, along with his wife, Madhuri Grover, is reported to have sent a legal notice to Kotak Mahindra Bank on October 31st 2021 for failing to provide financing in Nykaa's IPO

Interestingly, earlier on January 5th 2022, an anonymous clip landed online which revealed a phone conversation between Mr. Grover and a Kotak Mahindra Bank employee. It showed the former being upset about missing out on Nykaa shares in its IPO and hence taking out his frustration on the bank and its employee, allegedly so

Kotak Mahindra Bank is now threatening to sue Mr. Grover for the use of "inappropriate language". 

Besides the drama and the apparent high-handedness of the rich on ordinary professionals, these events also raise questions about the process and merits of IPO financing. We bring you an explainer on how the process works and what are the nuances involved. 

Mo' Money Mo' IPOs

Let's take a cue from the current example. Mr. And Mrs. Grover say that they had each proposed to apply for the subscription to the shares of FSN (Nykaa's parent company) worth ₹250cr ($33.7m) each. To that end, they availed the services of Kotak Mahindra Bank as the broker. 

The bank's job was to arrange for (and finance) the allotment of the above shares before the issue closed or it will be liable to compensate the Grovers for losing out on gains they would have made otherwise. 

Now, how would the bank arrange for this financing? Through a process called margin funding. 


What is Margin Funding?

In the world of finance, "margin" is effectively the collateral that an investor has to deposit with his broker or an exchange to cover the credit risk that he poses for them. 

Basically, the idea of buying something on a margin involves buying a financial asset by borrowing the balance from a broker (usually a bank or NBFC). 

Let's say X wishes to execute a trade but he doesn't have sufficient funds to do it. At this point, X's broker can lend him the remaining sum so that the trade can go through. This is called margin funding (in some cases, margin trading). Think of it as a short-term loan with a pre-decided interest rate. Lately, it has become a very effective tool in IPO financing.


How Does it Work?

Most brokerages require the investor to provide 50% margin in order to avail margin funding from them. This means that if the shares of a company are priced at ₹1,000 ($13.5) then the investor has to present ₹500 ($6.75) to the brokerage for them to cover the other half of the investment. 

The funds are provided for a short duration, usually for a week (6-8 trading days). If the funding in question is for an IPO, then the duration is usually from the day the subscription closes until the listing day.

In some cases, the investor can also use the shares in his demat account as collateral instead of hard cash or bank balance to avail funding. 

If you're thinking what do the brokerages get out of it, the answer is this - interest income and a boost in trading volumes. Most brokerages in India charge around 15-18% interest on margins which varies depending on their relationship with the client. Large capital investors usually get cheaper rates.


What are the Downsides?

Investing with borrowed money is a risky proposition anyday. In case the actual listing premium is lower than expected or the listing price is below the issue price of an IPO, then investors don't make money. And since there are interest costs they have to pay, they are compelled to sell the stocks at a loss. 

In case the investor wants to wait until the listing price hits his desired target, he would have to hold on to the investment, and that means arranging for additional funds to repay the loan. 

Margin financing in IPOs are often tricky bets, particularly for the NII (Non-Institutional Investor) portion of the issue in which share allotment takes place somewhat differently than the retail portion.

In the retail segment, all valid applicants get at least one market lot. But in the NII segment, it is done on a proportionate basis which means that the number of shares allotted depends on the extent of subscription. 

In India, the NII portion of an IPO is open to resident Indians, NRIs, trusts, corporates and other institutions provided they apply for more than ₹2L ($2,700) worth of shares in the issue. Over the years, HNIs (High Net Worth Individuals) have come to dominate this segment with their presence.

There is a cyclical connection between oversubscription and listing losses, particularly in the NII segment. HNIs who fear that they won't be awarded their desired lot in the issue usually tend to oversubscribe in an effort to boost their chances of a higher final allotment. But that means the final amount of allotted shares (per capita) is lower. This leads to net losses if there isn't a significant listing premium or if the stock is listed below its issue price. 

So, essentially, the margin funding route delivers good returns in an IPO only if the stock receives moderate subscription and then makes a strong listing gain.


Return of the IPO Financing

During the times when the markets are flush with liquidity and interest rates are low, the IPO financing rush becomes more pronounced. In 2021, a large portion of IPO financing has come from NBFCs who, by virtue of the regulatory leniency accorded to them, tend to use their margin financing abilities leading to mispricing of shares.

IPO listing gain is a largely demand-supply game. Unlike retail investors, HNIs and institutions have no limit on the number of shares or the amount they can bid for in an IPO. Currently, HNIs, with money borrowed from NBFCs, can pay only 1% of the margin money to bid for the entire portion reserved for the category. This means that in a ₹1,000cr ($135m) IPO, 50% of which is reserved for the HNIs, these investors can pay just ₹5cr ($675,119) to bid for shares worth ₹500cr ($67.5m). 

This shows how disproportionately the HNIs can leverage their bids at the cost of other investors (and their financiers). Excessive leverage, if allowed to go unchecked, could lead to the market crashing. It is also detrimental to the overall investment climate seeing as high oversubscription numbers may mislead the investors into thinking that the company is doing exceptionally well, shares are highly valued and hence demand is booming. Post-listing, however, the shares slide leading to huge losses. 

In light of this, RBI's new rules on capping IPO financing per investor to ₹1cr ($135,024) by an NBFC, are highly opportune. This is likely to reduce the increasing trend of oversubscription and listing day exits and thus help in the price discovery process. 

And perhaps, it will also lessen the practice of HNIs crying foul over missing out on allotments (like the Grovers) and the resulting spectacle. The spike in investor interest in IPOs leading to a spike in financing leading to easy availability of funds in the market leading to increasing market liquidity finally leading to a boom in capital markets (i.e. More IPOs) is thus a cyclical swell, one that merits closer regulation to avoid a splash down. 


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