The Hindu Business Line : How IPO grading can help

What has always ailed the IPO market in India is the predominance of poor quality IPOs and their mixing up with the good ones. Hence, if the good quality issues can be segregated from the bad ones, it would be a real help to investors. The IPO grading system attempts to do just that.

The subscribers to IPOs have suffered huge losses in those cases where they unknowingly purchased poor quality, bogus or even fraudulent issues. There was no deterrent punishment to the fraudsters, given our weak legal system. The IPO grading system tackles this problem.

The Securities and Exchange Board of India (SEBI) had first experimented some months back with grading of IPOs on optional basis. However, none of the promoters and lead managers voluntarily chose to be graded even at no cost to the companies concerned. This is what led SEBI to make grading of all IPOs compulsory.

Main features of SEBI decision

The important features of SEBI's decision on IPO grading are as follows:

The grading exercise will exclude the issue price from its scope;

It will be carried out by recognised credit rating agencies;

The grading will be on a 5-point scale, the lowest grade to be indicated by 1 and the highest by 5; and

The issuing company will be allowed to choose the rating agency for grading its IPO.

The main criticism voiced against SEBI's decision has been that it excludes the issue price from the scope of grading. The critics have argued that the issue price is a crucial factor in determining the worthwhileness of an IPO from the investor's viewpoint.

However, it can also be argued that the reasonableness of the price itself depends on the IPO's fundamental quality. Determining the quality is a very complex job beyond the competence of most investors. That is why so many poor quality and even bogus IPOs get subscribed. Grading of IPOs in terms of their fundamental quality will enable investors steer clear of unsound and fraudulent IPOs. Such IPOs are likely to be restrained by the grading system as they will be in the bottom grades of 1 and 2.

The qualitative analysis of IPOs has to include factors such as business prospects of the company and the industry, company's competitive strength, management's competence and integrity, quality of corporate governance, reliability of the company's accounting and audit system, etc.

Grading method

For rating agencies, the grading of IPOs is a very different cup of tea. While the technique for rating debt securities is well-established that for grading IPOs has yet to be conceptualised, then tried out and refined on the basis of experience gained over time.

To speed up this evolutionary process, the basis on which a particular grade has been assigned to an IPO should be made public. All the factors which have been taken into account and the weights attached to each should be disclosed. This will help stimulate discussion and lead to refinement of the grading method. In all likelihood, the different rating agencies will be using different methods for IPO grading. They will quickly learn from each other if all of them are required to publicly disclose the basis of grading.

However, IPO grading cannot be as finely tuned as credit rating which has lot of nuances. This is basically because credit rating tries to measure the downside risk, that is, the risk of default by the borrower.

On the other hand, the focus of IPO grading has to be primarily on the possibility of upside gain, both immediate and long term, in the form of price rise of the shares being issued.

Even while rating debt instruments, the credit rating agencies do evaluate the qualitative aspects of the businesses concerned. They have thus accumulated a wealth of data of companies rated by them across all kinds of industries.

The ready availability of such data will help in the grading of IPOs and speed up the process.

Most IPOs are like a dark horse about which very little is known. Their grading on the basis of fundamental quality will eliminate the worst of them. We can reasonably hope that IPO grading will make the primary market a more orderly, cleaner, and safer place for the investors than it has been so far.

(The author is Director and Member Secretary, Society for Capital Market Research and Development.)

More Stories on : Credit Rating | IPOs | Investor Protection

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
India, growling and grovelling

Engaging Russia

Short-circuited power reforms

The motivation disconnect

How IPO grading can help

Needed, better direction on directors

How to set up a business in China

Crises and cherries

Attrition control