Explained: How HNIs invest in IPOs using borrowed money

Initial public offers (IPOs) where on one hand help companies raise capital for the long term, on the other, they give investors a chance to make big gains in a short span of time. Many non-banking financial companies (NBFCs) lend money to high net worth individuals for investing in the primary market -- such funding is called IPO funding. Currently, only NBFCs can offer margin funding to HNIs for investing in the primary market. But trying their hand at investing in an IPO through the funding route is a risky game for investors.

Most banks and financiers provide funding to HNIs for investing in IPOs. This is known as IPO funding, which helps HNIs participate in the bidding process by paying only a small portion of the actual cost of shares. Typically, HNIs take a loan of 6-8 trading days to cover the period between the completion of an IPO to the day of listing. For borrowing these funds, HNIs have to bear interest, which usually ranges from anywhere between 8 percent and 15 percent. This interest along with certain other charges is together known as funding cost.

Most banks and financiers provide funding for investing in IPOs. This facility is usually only offered to non-institutional investors (NII) such as HNIs.

Tapping this route HNIs them to increase their chances of getting allotment at little capital compared to the actual cost of shares. But there's a catch. For such investors to cover their funding costs, the shares must list at a certain premium and the portion meant for non-institutional investors must not be too oversubscribed.

So all in all, it is a risky game for HNIs.

The investor opens a funding account with an NBFC.

Along with that, the investor also sets up a Demat account. This can either be a new Demat account, or an existing one, in which case the power of attorney is granted to the NBFC under the agreement.

The investor fills out the form for margin funding along with other formalities. All necessary documentation takes place at this stage.

The investor shares details of the intended IPO investment with the lender, including the number of shares.

Once these things are sorted, the investor pays the loan margin to the lender. This is an upfront payment made to the financier under the agreement, following which the lender releases the rest of the amount required for the intended IPO application.

The lender applies for the specified quantity of shares on behalf of the investor.

The money is blocked till the completion of the allotment process.

If allotted, the shares are reflected in the Demat account and the money is deducted. The shares are typically sold after the listing.

Finally, the profit and loss account is settled on the sale of shares. The investor clears any dues. Usually, the transactions are settled within seven days of the day of allotment, but the investor has the option of doing this in a period of up to 90 days.

The IPO funding route delivers good returns only if the stock makes a strong listing following a moderately oversubscribed IPO. This is because high oversubscription and lukewarm listing raises the funding cost for the investor.

For example, high subscription in the NII segment leads to fewer shares for the investor, in turn raising the funding cost -- fewer shares will need a much higher listing price for an investor to cover funding costs. Similarly, even if a stock lists at a premium, it is no guarantee of the investor covering the funding cost.

For non-institutional investors, share allotment takes place differently compared to the retail segment. In the retail segment, all valid applicants get at least one market lot, in the NII category, it is done on a proportionate basis -- the number of shares allotted depends on the extent of subscription.

HNIs only emerge winners through the funding route of investing in IPOs in case of high allotment and bumper listing. Remember: the investor has to bear the interest on the funding amount till the finalisation of allotment. Once the allotment takes place, the unutilised amount is returned to the lender.

So the catch is, even if you get fewer shares than applied for, you must pay interest on the entire loan amount.

Sometimes HNIs even choose to hold shares after listing; they can do this by settling their funding obligations by other means after the allotment. The investor has to clear the outstanding dues or continue to pay interest according to the agreement.

Currently, HNIs are allowed to pay 1 percent margin money to bid for entire portion reserved for the NII category. For example, for a Rs 500-crore IPO 50 percent of which is reserved for HNIs, an investor can pay Rs 2.5 crore (1 percent) to bid for shares worth Rs 250 crore -- which is the entire portion.

It is because of IPO funding that sometimes subscription to an IPO exceeds investors' expectations, giving an impression that the company's shares are in high demand. This often leads to retail investors getting trapped in IPOs that are not as promising as they appear to be.