A quiver full of questions

MARKET INSIGHT: Rating initial public offerings will not make the markets any safer.

Irrational exuberance leads to asset price bubbles and market meltdowns. But irrational conservatism leads to decades of Licence Raj and Hindu rates of growth - and it doesn't prevent the occurrence of bubbles or meltdowns. On the whole, irrational exuberance is much the lesser evil.

Unfortunately, India's regulators have a fondness for irrational conservatism. The latest manifestation is the mandatory rating of initial public offerings (IPO). Last year, the Securities and Exchange Board of India (Sebi) tried this concept as a voluntary experiment. It was a waste of time and resources.

Some 15-20 issues were graded voluntarily; due diligence took over three months on several occasions; the grading (on a scale of 1-5) bore little apparent relationship with the fate of IPOs. Low-rated IPOs (such as Shree Ashtavinayak Cine Vision ( rated 2 on 5) and Cambridge Technologies(2) were oversubscribed. High-rated IPOs such as Tubeknit Fashions (3-) bombed. Apart from generating revenues for rating agencies, the process appeared to have no utility whatsoever.

Making it mandatory will just multiply problems. There are so many logical inconsistencies to the concept of grading equity that it's tough to list all. Still, here's an attempt to put some misgivings down.

Equity subscription involves risk. There is no way of guaranteeing success for a business. The IPO system includes Sebi clearances and a compulsory qualified institutional buyer (QIB) quota of 50 per cent.

Given these two hurdles, enough due diligence is embedded in the IPO system to ensure that out-and-out scamsters don't come to the market. There have been good, bad and indifferent 21st century IPOs. But there have been no scamsters of the 1994-96 class. Rating isn't going to make issues more fail-safe.

The rating methodology is (currently) opaque
Agencies don't necessarily bring the same level of skills and consistency to bear on due diligence. Can they speed up the due diligence processes to about a week per issue as is being claimed without a drop in assessment quality?

If due diligence will take longer, how long will a given issue take to ease through the pipeline?
Companies launch IPOs to further their business plans. Those plans are time-bound. The whole process could turn into a sham as rating has often taken over three months.

The insistence on reference to corporate governance and compliance with Clause 49, etc, is absurd when dealing with privately-held entities. Most of top 500 corporates are probably not Clause 49 compliant yet. No IPO will get a high score on this ground.

There is a serious danger of leakage of privileged information because of the due diligence process itself. Sebi forbids forward projections and the draft red herring excludes issue pricing. Due diligence without these nuggets would be useless. If due diligence includes these details, the circle holding privileged information spreads wider.

Will the agencies pitch competitively for grading business as each IPO application is made?
Or, will rating contracts be assigned, turn-and-turnabout by Sebi? Either way, I see vast scope for conflicts of interest. Call me a cynic if you like.

Going by the track record during the voluntary period, the rating agencies will issue a grade (a number between 1 and 5) and two or three paragraphs worth of qualitative comment.

That will tell you if they believe the pre-IPO balance sheet has sound fundamentals. So what? By definition, an IPO alters fundamentals in both scale and quality for privately-held companies (TCS was an obvious exception).

Grading ignores issue valuation. The rating agency can't make a call on this unless Sebi allows it to ask for, and assess issue-price bands. The grading also doesn't include explicit comparisons with listed peers. So it says zilch about business competitiveness. In my humble opinion, valuation and competitiveness are rather more important than Clause 49 compliance.

Most experienced retail IPO investors use two variables as proxy signals for an IPO's subscription-worthiness. One is valuation versus listed peers. The other is the QIB subscription levels. Post-rating, these will continue to be key variables.

On the macro level, if the process turns out to be too much hassle, it will induce a go-slow on the IPO front coupled with frantic behind-the-scenes lobbying to do away with the rating concept. While that closed-room drama plays out, expansion plans will be put on hold. This is not the best way to ensure a fast cyclical recovery for the economy.

Thus far, I've listed the negatives. The only positive I can think of has been mentioned earlier. May be there's an upside to the valuation of rating agencies?