I have long been convinced that not more than 0.1% of retail investors look at the (Draft Red Herring) Prospectus (the DRHP) before applying for shares in an IPO.
As a lawyer (and an Attorney) who spent 6 years drafting these documents, this has never been a happy realisation. I wrote things which nobody liked to read. This is not a good thing. This should change.
DRHP – What is?
DRHP is the first document which a company desirous of getting its shares listed on a stock exchange, files with the Securities Exchange Board of India (SEBI). It is meant to disclose clearly and honestly everything and anything which has happened or is going to happen in the past and future of the company. It covers everything from the date of incorporation of the company, description of its core business, risks involved with investing in the business and in the equity shares being offered, regulatory landscape and economic environment prevailing at the time etc.
Issue of Capital and Disclosure Requirements (ICDR Regulations) issued by SEBI deals with the disclosures which a company must make in the DRHP. To find the DRHP, RHP and the final prospectus of any listed company or of a company which is offering its shares via an IPO, you can visit SEBI’s website here.
Key Sections of the DRHP
Definitions: This naturally is the first chapter which defines all important issue and industry specific keywords used in the document.
Risk Factors: This chapter lists down the risks and uncertainties of investing in the company. The idea is to disclose every possible risk and uncertainty which the business faces and which could have a material impact on share price (post listing).
Use of Proceeds: As an investor this is the most important chapter for you to focus on. This is where the company states its reason for doing the IPO (i.e. why does the company need money?). It tells you where the company intends to use the money raised in the IPO.
Industry Description: it includes forecasts, estimates and predictions related to the industry in which the company operates.
Business Description: This is what the company does. Its core activity, i.e. this is how the company makes its money. Think of it this way – as a shareholder this is the core business in which you are investing (and hoping to make). This is what you will own a piece of.
Management: This section lays out names, qualifications and other details about the people behind the company, i.e. directors, promoters and key management personnel. In addition any litigations and criminal records as well as financial delinquency of any of these people are also stated as a risk factor if such is the case.
Financial Information: This chapter contains auditor’s reports and the financial statements of the company for the previous 5 years. To be eligible for an IPO, the company must have had net tangible assets of three crores in each of the preceding three years and must also have a track record of distributable profits in three out of the last five years.
Legal and Other Information: Contains all litigations filed against the company and / or a promoter / director thereof which are not yet settled. If you have a grievance against the company and have taken an action, you will find its mention here.
Who Makes the DRHP?
One of the most questionable aspects of the DRHP is its genuineness. While it is drafted by a team of legal counsels who are hired (independently) by the merchant bankers/ underwriters entrusted with the job of selling the securities being offered, they are all (i.e. the legal counsels and the merchant bankers) remunerated by the company. So are the auditors who compute and give opinion on the financial statements. Naturally there is an omnipresent spectre of bias in making of the DRHP and on the process of due diligence itself.
The nature of job mostly changes from – “Making honest disclosures to reveal truth about company and the issue” towards – “Creative writing to make the truth look beautiful”.
What About Wrong Disclosures in the Prospectus?
Making untrue statements of facts or omitting to state material facts in the prospectus could lead to penalties ranging from monetary fines to the merchant banker’s license being revoked. That said, in my 6 years of experience as a capital markets lawyer, I have never seen any of that play out.
Recently however SEBI has started taking actions in this regard. Recently, DLF was fined Rs. 85 crores for not disclosing certain material information and facts in its IPO document.
Should You Pay Attention to the DRHP?
I may be a little influenced when I say this but I firmly believe that if the company does not want you to find something out, YOU WILL NOT FIND IT OUT. PERIOD.
A team of genius and creative auditors, lawyers and bankers all act in concert to make the Prospectus.
Trust me when I say this – the document is complete and honest in terms of disclosure and yet it tells you very little. If it were any other way the deal team would be paid substantially lower for their work (the issue related expense and fees often run into many crores depending of course on the size of the issue).
That said there are good reasons to pay attention to some sections of the DRHP. In particular you should look at the management section which covers promoters, directors and other key people in the company. Lawyers have little room to pull the wool over your eyes about these aspects. An honest and competent management is one of the most important investment tenets you should be looking for.
Similarly, pay close attention to the chapter – Use of Proceeds. This will tell you what the company intends to do with the money they raise.
That said, keep in mind that while a committee is formulated to ensure that the proceeds are utilised for the object stated in the prospectus, it is common for companies to raise money for a certain (disclosed) object and use most or all that money for a completely different object. Imagine a situation where a company wants to raise money for a business plan which it does not want to disclose? A more compelling case for not disclosing the use of proceeds came from a company which needed money to develop a technology the success of which depended entirely upon its secrecy? Before you read this section ask yourself this – Does the company ‘really’ need money for ‘anything’?
DRHP vs. RHP vs. Final Prospectus
DRHP – The Draft Red Herring Prospectus contains all details about the company – (i.e. all sections mentioned above under the heading ‘Key Sections in a DRHP’) but does not include issue specific details like price band, issue size, number of shares being offered etc. This document is placed on the website of SEBI and the book running lead managers (i.e. the merchant bankers employed by the company) for 21 days during which time anyone can post his comments / grievance to SEBI about the document and / or the company.
In addition, a dealing officer appointed by SEBI vets the document and lists his own comments/ complaints and sends a consolidated list of such comments to the merchant bankers. Usually the process takes longer than 21 days. Once the merchant bankers clear the comments, they update the document and place it again with SEBI. In most cases a second round of public and SEBI comments follows. Once the SEBI is satisfied with all answers it issues a clearance card to the bankers.
RHP: Red Herring Prospectus is the document which is placed with SEBI after clearing all comments received from public and SEBI. The significance of this document is that that based on this; the merchant bankers can start advertising the issue. The contents of this document, as approved by SEBI can be used as publicity material by merchant bankers to sell shares being offered in the issue. Anything which does not form part of the DRHP cannot be used in road shows, commercials or in any other form of advertising.
You could think of the RHP as the SEBI approved version of the DRHP.
A Word on IPO Process in India – For an IPO to be successful – 90% of the shares being offered in the IPO must get subscribed before the closure of the issue. Further, 50% of the shares are to be mandatorily sold to Qualified Institutional Buyers (QIBs). Another 15% are to be mandatorily sold to non-institutional investors and not less than 35% are to be sold to retail investors.
Retail investors usually wait till the last day on which bid issues in the IPO close before applying for shares. The intention is to make sure that the QIB tranche of the issue is fully subscribed. Full or over subscription in the QIB tranche serves as a seal of approval from sophisticated investors who do not need the protection granted by SEBI. QIBs do their own diligence on the company and its valuations.
After filing the RHP, merchant bankers along with the company management go on marketing / road shows. They give presentations to big investors to secure their orders. Once they have reasonable surety that 50% of the IPO will be subscribed by the QIBs, they come up with a price band (Price band: 2 price figures up to 20% apart like Rs. 50-Rs. 60, between which people can place their bids for the number of shares they wish to apply for). The issue remains open for bid collection for a few days. This process is called ‘book building’. Once received, bids are matched in such a way so that the entire issue is sold at the maximum possible price. If more bids are received at the price at which the issue gets fully subscribed then allocations are made on a pro-rata basis to people who bid on that price.
Final Prospectus: After bids are received and share price is fixed, the RHP is populated with the price figures and submitted again to SEBI. The only difference between the RHP and the final prospectus is that for (i) price of share, (ii) number of shares to be issued and (iii) issue size the RHP has blanks which mostly look like this – [•]. These blanks are filled in the final prospectus.