NTPC follow-on throws French auction system into question

It may have enabled the Indian government to squeeze the maximum amount of money out of its 5% sell-down in India's largest power producer, but aside from that, the use of a so called "French auction" to sell the shares seems to have replaced one flawed system with another.

The final allocation has yet to be announced, but according to sources, the government will raise approximately Rs84.8 billion ($1.8 billion) from the sale of NTPC shares, which was completed last week. All the shares on offer were secondary and resulted in the government's stake in the company falling from 89.5% to 84.5%.

Aside from boosting the proceeds for the government, the French auction system, which was used for the first time in India in this transaction, was meant to give institutional investors a chance to get a larger allocation -- if they were willing to pay a bit extra -- thus making Indian bookbuildings more meaningful and more like those practiced in most international markets.

Until now, investors in Indian initial public offerings and so called further public offerings (FPOs), have been allocated shares on a pro-rata basis, which means that on popular transactions they typically receive only a small portion of the number of shares they ask for. The need to pay part of the order in cash when placing orders also limited their ability to make inflated orders to boost their chances of a larger allocation.

With the French auction system, the issuer doesn't set a price range but rather provides only a floor price. Retail investors will pay the floor price, essentially making it a fixed-price offering, while institutional investors have the opportunity to put in orders at any price at or above the floor price. Orders submitted at the highest price will be filled first, followed by the rest of the orders in descending order -- until all the shares have been distributed.

In theory it doesn't sound like a bad idea, especially since the online bookbuilding used in India means that there is maximum transparency with regard to how many shares have been ordered and at what price. This means investors know what price they need to submit in order to get their orders filled. As one banker said: "It makes investors put their money where their mouth is."

Alas, it didn't quite work like that. The company -- or more specifically a panel of government ministers -- fixed the floor price at Rs201 per share on Tuesday, the day before the three-day bookbuilding was due to start. At that time, the floor price represented a discount of 4.9% versus Monday's closing price of Rs211.3 -- not huge, but reasonable. And if the discount had stayed at that level, the deal may have been more eagerly received.

After all, NTPC is no greenfield power producer jumping on the current demand for electricity and raising capital so that it can complete its planned generation plant and start earning revenues. On the contrary, as of the end of September last year, the company had 22 plants in operation with a combined installed generating capacity of 30,644 megawatts, or approximately 18.6% of India's total installed capacity. In the fiscal year ending March 2009, it produced 28.6% of the country's total power, according to information provided in the prospectus.

However, shortly after the deal opened on Wednesday, one institutional investor put in an order large enough to cover the entire tranche of 204 million shares set aside for qualified institutional buyers (QIBs) at a price of Rs209 per share. Since this one order covered all the available institutional shares, the floor price was effectively reset to Rs209. Once this one investor -- sources say it was Life Insurance Corporation of India (LIC), the country's largest life insurer and investor -- had its order filled, there would be no more shares left for bids at lower prices.

If this had happened in a bull market, perhaps it would have worked. Other investors keen on the deal would simply have submitted their orders at Rs209 or higher. However, concerns about the debt situation in Greece and suggestions that the economic recovery may not be as strong as initially hoped led to a sharp sell-off in global equity markets last week, which dragged NTPC's share price below the now crucial Rs209 level. At the end of Thursday's session, the share price was at Rs204.3, which meant investors would have had to pay a 2.3% premium to subscribe to the NTPC follow-on. Understandably, they weren't interested in doing that.

"The French auction may work for IPOs where there is no live share price, but not for listed companies with limited trading volumes," said one banker who did not work on the transaction.

As a result, the QIB tranche was just 2.18 times covered when the deal closed on Friday. Foreign investors had asked for 18.4 million shares, representing just 9% of the total QIB tranche. The poor interest spilled over into the retail and corporate tranches, which were both undersubscribed -- even though they were priced at Rs201 per share. This meant the entire deal was only 1.2 times covered.

People close to the deal argued that a coverage ratio of 2.2 times for the QIB tranche was decent, given the size of the deal, but since only one investor accounted for most of that, it is hard to argue that the deal was particularly successful. For one, the deal did little to broaden the shareholder base of the company.

Because of the under-subscription of the 35% retail tranche and the 15% non-institutional portion, the left-over shares were reallocated to institutional investors, which, according to one source, meant that even investors who had put in orders at Rs202 were likely to get filled. In addition, 2.5% of the deal was available for mutual funds only and that portion was filled at a price below Rs209.

A breakdown of the order inflow shows that the top bid, for 50,000 shares, was placed at Rs211, followed by bids for 1.3 million shares at Rs210 and 205.7 million shares at Rs209. The second most popular price level was Rs202, which saw bids of 169.4 million shares.

The government sold a total of 408 million shares to the public as well as 4.27 million shares that were reserved for NTPC employees and offered at a discounted price of Rs191 per share.

The offering was arranged by Citi, ICICI Securities, J.P. Morgan, and Kotak Mahindra.

For now, bankers are keeping their minds open about the new system, but they say it is likely to be used on government sell-downs only, while privately-owned companies are expected to continue to set a fixed price range - even in the case of IPOs.

The government has already decided that it will use the same auction system for the next couple of sell-downs -- a 5% stake sale in Rural Electrification Corp later this month, and an 8.4% stake sale in NMDC, India's largest iron ore miner, in early March. REC, a state-owned lender to power projects, will also sell new shares and, based on yesterday's closing price, the deal may raise as much as Rs39 billion ($830 million).

While both these deals are follow-ons, observers say they may work better than NTPC, but for different reasons. NMDC has a tiny free-float of about 1.5% and consequently the market price is so volatile and unreliable that investors may not pay much attention to it, making the deal more like a re-IPO. REC, on the other hand, already has a 59% free-float, but the fact that some of the shares will be new means the company will have proceeds that it can use to extend more loans and grow its earnings. This, said one banker, should make investors more interested in buying into the deal.

However, the most important issue for both these deals will be that the secondary markets, and investor sentiment, hold up -- or the deals may struggle whatever system they use.