Electronic copy available at: http://ssrn.com/abstract=1609817 CREDIBILITY OF THE IPO GRADING: TIME TO RETHINK
Initial Public Offer (hereinafter as ‘IPO’) in the new regime (which started as an innovation) has to be mandatorily graded by a Credit Rating Agency (hereinafter as ‘CRA’). This optimization of the IPO by the Securities and Exchange Board of India (hereinafter as ‘SEBI’) has been seen as a market innovation to ensure the credibility of the offer and to protect and guide the investor. The motivation for the proposal of the mandatory IPO Grading by SEBI lies in the legal mandate of ‘investor protection’ cast upon it under Sections 11 and 11A of the SEBI Act, 1992.1 This step of investor protection if carried out effectively would make India as one of the most transparent and efficient capital markets of the world. However with the results produced, this is truly not the case.
Part I analyses the meaning and various dimensions of IPO grading. Part II critically examines the concept of IPO grading with respect to CRA’s, including the various arguments which the analysts hold against it and that of the authors. In Part III, the authors brings forth the analysis by exhibiting the inconsistency in the results of the grading system and the final part is the conclusion.
I. IPO Grading –Meaning and Importance
SEBI is the first market regulator to introduce the concept of IPO grading. From being an optional process at its inception it has become a mandatory process from May 2007. IPO grading is a service that provides an ‘independent’ assessment of fundamentals regarding quality of 1 Tarun Jain & Raghav Sharma, Mandatory IPO Grading: Reflections from the Indian Capital Markets, ICFAI Journal of Corporate and Securities Law, Vol. 5, No. 4, pp. 8-22, November 2008. Electronic copy available at: http://ssrn.com/abstract=1609817 equity shares offered to aid comparative assessment that would prove useful as an information and investment tool for investors.2 This assessment is carried out as already mentioned, by the independent credit rating agencies. Moreover, such a service is 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.3 This way the investor, by placing reliance on the IPO grading, can decide whether the particular offer has potential to bring him returns or not. The grades assigned represent a relative appraisal of the ‘fundamentals’ of that issue in relation to the universe of other listed equity securities in India.
The grade, reflective of the ‘issue quality’, is based on an indeterminate and non-quantifiable concept of ‘fundamentals of the issuer’ and is an outcome of the assessment of factors which are in turn only qualitative guides to the security being graded.4 This grade also helps in determination of the price of the IPO. The factors on which the grades are being based upon is however, not exhaustive as the market is a fluid concept. So providing an exhaustive list of factors which are influential in assigning the grades is a task too tedious and impractical, but an estimation of the underlying strength of the security requiring gradation has to be based on certain core factors which are pragmatic to be identified.
The factors identified by SEBI5 in this regard are; (1) business prospects and competitive position of the company; (2) risks and prospects of new projects; (3) company’s financial position; (4) quality of management; (5) corporate governance practices; and (6) compliance and litigation history. While growth prospects of the industry and financial strength are some of the quantitative parameters, qualitative parameters such as management capability also provide critical input in determining a grade.6 Furthermore, this grade will not be a recommendation to invest in or sell- off or hold onto a security7 which is a security-specific...
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