Individual Assignment submission form

ISB PGPMAX: 2019

Final Exam – Motilal Oswal Financial Sercvices Ltd; An IPO in IndiaFile

Course Name: Capital Markets and Strategic Issues for Fund Raising

Faculty: Prof. N K Chidambaran

Submitted by: Sri Rama Murthy Battula

PG ID: 81920030
1. Motilal Oswal Financial Services Ltd has raised capital through Venture Capitalists.
Explain the role of Venture Capitalists (VCs) in the company. The case mentions that the
VCs could put back their shares to the company at a pre-specified Internal Rate of return
(IRR). Explain this feature/condition and explain the Internal Rate of return (IRR) role
assumed. What is an acceptable IRR on this put option feature?

In the case of Motilal Oswal Financial Services, Ltd has got an offer from a big institutional
foreign bank for a 76% majority stake. This has given insight into the potential of the
concept and company to the promoters. The founders realised that they need a minority
stakeholder for growth and to mitigate risk while maintaining ownership. The role of
venture capital chosen for private equity investment is crucial. Firstly, both the private
equity firms Bessemer and New Vernon were much familiarised with the company's
business. One of the members of New Vernon has a long relationship with the company.
The idea was to get a critical equity infusion through the venture capitalists and improve
the business. New Vernon's partners have experience working in top investment banks
such as Merrill Lynch and huge international markets.

Moreover, since MOFSL has a mission that benefits them in the longer term, they find
investors who match this vision. Both the venture capital firms were able to meet that
criterion. With VC's advent, the dependency cyclical transaction-based brokerage fees got
reduced. Focus on inorganic growth by acquiring smaller brokerage entities by expanding
throughout the country can happen. The opportunity of expansion of the balance sheet
before going IPO shall be the added advantage. With minority stake sales, MOFSL can
capitalise upon an ongoing market perception of stability and endurance of Indian
markets. The investor bought 9.3% equity in the form and added an unusual term in the
deal that stated that if the company does not go public in five years, the investors can put
their stock back in the company at a predetermined internal rate of return. As per
arrangement to calculate the rate of return, projected cash flows have been used. The
growth rate is used to forecast cash flows, and the internal rate of return is calculated for
each investor. This rate is the rate at which the present value of the cash flows is equal to
the current value of outflows. The IRR for Bessemer comes out to be 22%, and for New
Vernon, it is 7%.
 2006 2007 2008 2009 2010 2011 2012
$ Mill $ Mill $ Mill $ Mill $ Mill $ Mill $ Mill
Revenues 61.53 84.01 132.27
Profit After Tax 13.77 15.16 29.11 32.05 35.28 38.85 42.77
Growth Rate 10.1%
Total Equity
Offered 227
Bessmer
Bessemer Share 2.60%
Bessemer Cost is $ -63.46
Profit's Share 0.36 0.39 0.76 0.83 0.92 1.01 1.11
Cash Flows -49.69 15.16 29.11 32.05 35.28 38.85 42.77
IRR 22%
New Vernon
New Vernon Share 6.70%
New Vernon Cost is
$ -163.54
Profit's Share 0.92 1.02 1.95 2.15 2.36 2.60 2.87
Cash Flows -150 15.16 29.11 32.05 35.28 38.85 42.77
IRR 7%

2.Should MOFSL go public? Do not give a laundry list of pros and cons. Rather, prioritise.
Discuss the top reasons why or why not, and discuss how any concerns about your
decision are mitigated. For example, what is your recommended issue size?

MOFSL, considering the company's financial performance in the past few years, going
public could help the company grow. First, by going public, the private equity investors
and the employee who are currently the primary shareholders of the firm would get an
exit route. Secondly, the idea of going public would allow the company to invest more in
growth opportunities. Hence, the company's market share would gradually start to
increase as the company has more access to capital to acquire the small growing financial
service companies. Furthermore, the company would reduce its debt burden, which
means that it will be on the profit path. The increase in profits would come from the
savings that will be originated from interests. Although, there are some costs as well which
are inevitable in going public. The first is the underwriting cost paid to the investment
bank. Other than that, the regulations get more stringent once the company goes public,
and it had to comply with SEBI. But the benefits outweigh all these costs and compliance
processes. Therefore, the company should go public.

3. IPOs are usually underpriced. Explain what is meant by underpricing. Does the firm
gain or lose through underpricing? Recommend a level of expected underpricing for
MOFSL?

The initial public offerings are usually under-priced. An important reason to underprice
the IPOs is encouraging investors to participate in the IPO. This is because more investors
could be made attractive to the offering. They can benefit from the price rise that can
incur after the initial issue. The other explanation given for IPO under-pricing is the
information asymmetry that pertains to the market. The uninformed investor would bid
regardless of the quality of the IPO. They bid only on the offerings that they think will get
superior returns. That is the reason they lose money on the IPO and eventually leave the
market.

For MOFSL, the level of IPO underpricing would depend on the number of shares it intends
to issue in the market. The valuation of IPO would primarily take into account the future
profit potential. The cash flows forecasted above in the attached table can be used to
determine the firm value—the average of the two internal rates of return issued to
discount the cash flows. Now the assumption comes in. For example, MOFSL intends to
issue 500,000 new shares in the market. The present value of the firm's cash flow comes
out to be $130 Million. The under-pricing level is obtained by dividing it by the number of
shares, which is $260. This is the minimum amount as it is calculated using the internal rate
of return.
 2006 2007 2008 2009 2010 2011 2012
$ Mill $ Mill $ Mill $ Mill $ Mill $ Mill $ Mill
year 0 1 2 3 4 5 6
Level of Underpricing
Average IRR 14%
Projected Cash Flows 13.77 15.16 29.11 32.05 35.28 38.85 42.77
Present Value 13.8 13.3 22.3 21.4 20.6 19.8 19.1
Total Value 130.2

Shares Issued 5,00,000

Underpricing Level 260.49

4.Regarding the timing of the IPO. Given the information in the case regarding the P/E
multiples of companies above and below $100 M in revenues, do you think MOFSL should
go public now or hold off? Explain why

The market outlook was optimistic and Indian investors have tactfully navigated the
booms and busts of the past. In the present situation, Indian firms had to compete with
international firms and required heavy capital and mobility to utilise the same. Corporate
profits were at 5% of GDP with a price multiple of 20X. The right time to put in money in the
secondary markets, and MOFSL needed to capitalise. The price over earnings ratio for 2006
is 4, and for the next year, it is projected around 27. This is a huge incremental in the price
over earnings ratio and shows that the company's stock price could substantially increase
in the coming as the price comes in the numerator. The company can take benefit from
this P/E and should go public. In the following year, the price over earnings ratio is
projected to fell to 19. This is again a positive sign which shows that if the price remains
constant after going public, the company is expected to increase its earnings as it will have
access to more capital. IPO was the right fit with the long term plans of MOFSL to be the
largest brokerage house in India. Companies with $ 100M capitalisation trade at a
significantly higher multiple, so real benefits are going public with a more extensive
revenue base.