All publications of Manish Agarwal . जयपुर , भारत

The Story - How to IPO India's Crown Jewel

The Union Budget of 2020–21 had a little surprise. The government finally announced its intention to partially sell off Life Insurance Corporation of India (LIC). And rumour has it that they’ve kicked off the whole process by hiring two pre-IPO transaction advisors already. So let’s talk about this mega IPO, shall we?

LIC is India’s largest financial institution. It manages close to ₹31 trillion in assets (out of India’s ₹40 trillion insurance industry). It sells 3 out of 4 life insurance policies sold in the country. It’s much bigger than the 23 private sector life insurance companies put together. And it is a profitable entity which has consistently delivered value to its only shareholder — the government of India.

However, when you try to go public and extract top value out of the IPO, you have to focus on other investors who might want to take part in the stake sale. Meaning you have to focus on maximising value for all parties and therein lies the first problem.

Every year, LIC generates a profit and does a little redistribution exercise. It ploughs back roughly 95% of the surplus back to policyholders and the remaining 5% to the government. This is great for LIC customers. They get the expected payout from their insurance plan and a lion’s share of the company’s profit pool. However private investors won’t be enthused with this scheme all that much. Imagine owning a part of LIC and being entitled to only 5% of the total surplus. That doesn’t bode well for you. So you need to switch it up.

Perhaps you could take a cue from private insurance companies. Those people have devised a neat little strategy to entice both policyholders and shareholders. Here's how this works. Insurance companies usually have two kinds of policies.

1. Participating policies — Where customers are entitled to a part of company profits in addition to other policy benefits.
2. Non-participating policies — Where customers get a fixed payout irrespective of the company's performance.

So in effect, they get to operate two funds. A PAR-fund, where they transfer a bulk of the profits to policyholders. And a non-PAR fund, where the entire surplus is transferred to shareholders. This way shareholders get to make more money. But LIC just has one common fund and 95% of the profits from the fund are redirected back to eligible policyholders as dividends, bonus etc. Shareholders get a pittance. So if LIC wants to get investors excited, they have to borrow some of these ideas from private companies.

However, you can’t push it too far.

Right now, LIC can offer a higher bonus on its policies because it has a structure that prioritizes the interests of policyholders above all else. If this structure is inverted, maybe LIC policies won’t be as attractive anymore. And if business prospects take a hit, shareholders won’t make a lot of money either way. So there’s a tradeoff here and you have to be very careful while you rejig the structure.

But you can’t do all of this unless you amend certain provisions of the LIC Act, 1956. Meaning the IPO is unlikely to get the green signal before parliament can come through.

But will this fundamentally alter the valuation LIC will be able to command in the market?

We can’t say for sure. Right now most insurance companies are valued based on this esoteric metric called the “Embedded value”. It takes into account all future profits you could make from the millions of active policies you’ve disbursed so far and it’s supposed to be a representation of the existing value that it adds to shareholders. But any amendments to the structure of LIC won’t change the outlook of future profits from policies you've disbursed already. The shareholders will only be entitled to the 5% surplus they were originally promised. It’s quite possible that future policies will focus on maximising shareholder value after the new amendments kick in. But right now, the company's embedded value won’t exactly blow your mind.

And the final problem — The government itself.

Even after the 10% disinvestment, the government will still own 90% of the company. So technically, LIC will continue to be a government-owned entity. Meaning it might continue to champion the cause of the people — in the name of national interest of course. Maybe LIC will continue to bail out companies. Maybe it will continue making investments that aren’t necessarily prudent. Maybe the government will still wield considerable influence and prioritize its own interest, which by the way doesn’t always align with the interests of other shareholders. So despite being the biggest, baddest insurance company in India, the company still has a few problems.

…

But you know what? It’s still LIC. It’ll probably be a blockbuster issue anyway.

The Story

One of the biggest talking points right now is the kind of economic recovery we might see, once the threat of the virus abates. But before we talk about the recovery itself, perhaps it's prudent to spend some time discussing another major variable in this equation — Uncertainty.

You see, uncertainty is a different beast altogether. On a good day, it breeds excitement. On a bad day, it breeds hysteria. But on most days, it just forestalls decision making. And this is the single biggest threat to businesses in this country right now.

Let me explain why.

The Ellsberg Paradox

Imagine you’re in a room with two large urns. Both are covered, so you can’t see inside them. But then I tell you that the urn on the right contains 50 white marbles and 50 black marbles. I also tell you that the urn on your left has 100 marbles (only black and white), without giving you the exact distribution between the black and white marbles.

And then I ask you to draw a black marble in one pick without looking into the urns. If you pick a black marble, you win 10,000 Rupees. If you don't, you get nothing.

So which urn would you pick from, to maximize your chances of winning?

.....

Well, if you picked the urn on the right. Congratulations, you got it spot on. And most people would agree with you. Because it just feels so right, doesn't it?

But here's the kicker. Even if you'd picked the urn on the left, that would work equally as well. Because believe it or not, the likelihood of you picking a black ball from either urn is exactly the same i.e. 50% or 1/2

Point of Interest: If you are wondering how we arrived at this conclusion, here’s some math to help you out. The first urn has 50 black balls and 50 white balls. So the probability of picking a black ball is 1/2. This much ought to be intuitive. If it’s not… Fellow reader, you need divine intervention. I cannot help you.

However, figuring out the likelihood of picking a black ball from the second urn is perhaps not as intuitive. So we reduce the complexity of the problem and imagine we have 4 balls instead of 100. Then we list down every single possible event that could materialize here. And calculate the probability of each event separately.

Event 1: 0 Black 4 White balls | Probability of this event materialising (1 in 5, since there are 5 events) * Probability of picking a black ball if this happens (0 in 4, since there are 4 balls) -> 0.2*0=0

Event 2: 1 Black 3 White balls | Probability of this event materialising (1 in 5)* Probability of picking a black ball (1 in 4) -> 0.2*0.25=0.05

Event 3: 2 Black 2 White Balls | Probability of this event materialising (1 in 5)* Probability of picking a black ball (2 in 4) -> 0.2*0.5=0.1

Event 4: 3 Black 1 White Balls | Probability of this event materialising (1 in 5)* Probability of picking a black ball (3 in 4) -> 0.2*0.75=0.15

Event 5: 4 Black 0 White Balls | Probability of this event materialising (1 in 5)* Probability of picking a black ball (4 in 4 ) -> 0.2*1=0.2

Add all the probabilities and you get 0.5 or 50%. You can try doing this with 100 balls and it will still be 50%. Ergo, you have the same chance of picking a black ball from either urn. So it doesn’t matter what you choose.

In fact, when Daniel Ellsberg, an economist and military expert, ran this experiment to see how people would pick and choose between the two options, he found out that most people overwhelmingly chose to draw the ball from the urn with a known set of probabilities, rather than take a chance on the urn with an unknown ratio.

The underlying premise here is that people have a strong distaste for uncertainty and they’d much rather live in an unambiguous world, even when it doesn't affect the eventual outcome.

And this propensity to operate within less ambiguous constraints extends to the business domain as well. An entrepreneur choosing to set up a manufacturing plant in Dhanbad might just decide to put his plans on the back burner until there is more clarity. A Multi-National Corporation working with a real estate consultant in India might simply choose to end the engagement in the face of uncertainty. A newly hired intern from a business school will probably be let go, considering we can’t say for sure if we will see the curfew persist for more than 21 days.

So it’s imperative that the government communicates in no uncertain terms how we plan to emerge from the lockdown. Because, unlike what most people think, the lockdown isn’t an end unto itself. It's simply a means to an end. We are buying time so that we can prepare to enter into a new world, that will look very different from the one that we inhabited just a few days ago. So perhaps, what we really need right now is a tentative guide on how the state plans to ease the country out of this deadlock.

Now, I understand the enormity of this task. Especially considering policymakers themselves are in uncharted territory. However, they’re on a better footing than most businesses to draft an action plan. And if they keep dragging their feet and refuse to engage with the larger community, businesses will simply stall decision making and that doesn’t bode well for anybody within the ecosystem.

Time and time again we see that policy uncertainty affects investment activity, hiring decisions, and consumption patterns across the board. However, on this particular occasion, we are on a race against time. The longer the paralysis persists, the more painstaking the recovery.

So hopefully we get some clarity on how the government plans to “Unlockdown” so that businesses, entrepreneurs and other employees can chart their path to recovery before its too late.