Is compulsory grading of IPOs a good idea?

Apart from the issue of the competence of the rating firms, what needs to be kept in mind is whether the existing system weeds out fraud firms.

Rajeev Dalal,
Partner
Ernst & Young

"While private equity firms and other large investors can do due diligence, small investors can't and this is why the rating of IPOs is useful"

IPO grading is a welcome move from the regulator of the capital market. It is going to bring better efficiency to the market. There is a challenge for the investors to arrive at an informed investment decision based on voluminous and complex disclosure documents. Small investors will be the happier lot with this decision because an independent, reliable and unbiased assessment of the fundamentals of the issuer company will facilitate an informed investment decision.

The major parameters to be considered by a rating agency for the assessment include management quality, business prospects, industry and company, financial performance, corporate governance, project related factors, compliance track record, litigation history and capital history. The grading provides the investors an independent assessment of the disclosures in the offer documents to the extent that they affect the issuer's fundamentals to take an informed decision. The grading could be particularly useful for assessing the offerings of companies accessing the equity markets for the first time where there is no track record of their market performance.

Needless to say, the rating is not intended to comment on the pricing of the issue nor would it purport to provide an assessment of the market risk associated with the investment. As in the case of rating of debt instruments, it is an additional tool available to the investors to take an informed investment decision.

The Disclosure for Investor Protection (DIP) guidelines has come a long way from the initial days of Sebi, with the present set of disclosure norms coupled with the IPO grading a decidedly positive move. The disclosures in the offer documents are as per Sebi DIP guidelines and currently there are no assessments of quality especially on the management bandwidth of the issuer. A proper assessment of the management quality is very critical for the long-term sustainability of a corporate entity in a highly competitive world. Rating agencies have the expertise to do this job.

Issuers may be worried about a lower grading than expected and also the additional cost and effort. However, this worry would not last long because the issuers will soon realise that the extra cost and effort put into grading is only going to benefit them. Getting listed is a long process; it could take up to a year or more depending upon the preparedness of the issuer. A listed company has huge responsibilities to fulfil. A better prepared issuer company could complete the IPO process faster and will be in a better position to the meet the expectations of the market. To become a successful listed company, an unlisted company should act like a listed company much before the IPO. It is better to be fully prepared before the plunge than regretting after listing and exhibiting poor performance.

The compulsory IPO grading will facilitate the issuer to become a mature corporate citizen faster. Additionally, the grading will help better quality issuers to benchmark themselves and project their underlying strength better. A perceptional change from the issuers is essential here.

Though there has been criticism initially from the intermediaries involved in the IPOs, it is a matter of time before the merchant bankers, brokers and investment advisors derive the benefits of grading. For the merchant bankers, it will give additional comfort to their due diligence responsibilities. IPO grading as an investment guidance tool is going to be accepted sooner or later. It will widen and deepen market participation and facilitate the move towards a more mature equity IPO market.

Moreover, private equity investors, strategic investors, institutional investors or any large investors can afford to conduct third party due diligence on the issuer company before taking an equity investment decision. The retail investor does not have the privilege and hence this gap could be filled up with compulsory IPO grading system.

This is a beginning and if there is a continuous effort to improve the process of grading, this new development could substantially benefit the retail investor.

Prithvi Haldea,
Managing Director
PRIME Database

"All ratings will be subjective ... but the real issue is that rank bad IPOs get rejected by Sebi and the stock exchanges, and QIBs ensure right-pricing"

No Sebi proposal has met with the kind of criticism as the mandatory IPO grading one has. There is no body of research, no world experience, no concept paper and no public debate to justify it. And even the pilot voluntary grading exercise "" which did not see any company come forward and 19 small companies were then forced to do this "" did not validate the concept in any manner. Instead of a detailed rationale even now, there are only oral justifications.

Small investors demanded it: Who in the world would not say yes to free actionable investment advice from experts? But are investor associations even aware of the pitfalls of IPO grading, and that what will be delivered is a subjective opinion, and that too incomplete. In spite of disclaimers and education, most small investors will only look at the grade digit; history tells us so. As such, they will reject a low-grade IPO and invest in a high-grade one. But if subsequently low-grade IPOs do well after listing, they will complain about missed opportunities. The fundamentals of a company can change dramatically after its IPO. IPOs are all about the future; IPO grading is all about the past. Incidentally, of the six graded IPOs that have hit the market, five low-graded ones were handsomely over-subscribed and have listed above their offer prices.

Rating agencies are supposed to assess only the fundamentals, but we know that even this is highly subjective. The rating agencies themselves differ in skill sets. Worse, there is no uniform grading methodology. Rating agencies would be learning on the job and the market would have to bear the cost of this. To avoid being seen as mark givers, rating agencies have invented the concept of relative grading. The grades are supposed to be a "relative comparison to the other listed companies". This presumes that all the three rating agencies have already graded all listed stocks (over 2,500 at the least) which they clearly have not. Are the rating agencies not misguiding investors by calling absolute marks as relative grades?

It is also interesting that grading will not get funded by the Investor Protection Fund but by the companies. If the conflict is now in-built, what use is the grading?

Vanishing companies scam: After a drought of nearly eight years, an average of seven IPOs a month in the last year is no deluge. A real potential flood has been avoided because we now have stringent entry norms, there is better vetting of issues by two national stock exchanges and by Sebi and there is a provision for public comments. Most importantly, there is compulsory participation of 50 per cent in an issue by QIBs who are more discerning and better informed and whose response to an issue holds cues for small investors. Rank bad IPOs, in any case, are rejected by stock exchanges and/or Sebi and as such cannot enter the market while overpriced IPOs are rejected by the QIBs; more than 15 IPOs have met such fate. The fear of another vanishing company scam is totally unfounded.

Investors need crispier information: The real need is to revisit the contents and format of the abridged prospectus. And redesign the risk factors, which were introduced to highlight the negatives, but have become a joke. Even after this, a further condensed version of two to three pages would be welcome. And that, in fact, should have been the task assigned to the rating agencies, not that of grading. Grades influences investment decision directly; a condensed summary does not. Rating agencies could also be asked to do a forensic audit and report instances of information gaps or wrong information (based upon which the concerned merchant bankers should be punished.). The information gathered during the grading due diligence should also be included in the offer document.

With grading, we are taking the small investor away from the stated objective of "informed decision making". Equity is risk capital, and investors should know about the company they invest in. Protecting investor interests is also to ensure that they are not guided by subjective, incomplete advice.