IPO grading was initially introduced on optional basis in April 2006 for public issues that come to raise money from the market. But in May 2007, the Securities and Exchange Board of India (Sebi) made it mandatory for all IPOs to be graded by rating agencies. This was done to help investors take informed decisions. However, after six years and several questions over the effectiveness of IPO grading, the Sebi now seems convinced to scrap the exercise.
?IPO grading has not served the purpose that it was supposed to,? UK Sinha, chairman Sebi, told The Indian Express in an interview. ?I think we need to have more and more dialogue with people and then come to a solution,? he said.
A review seems necessary, and Sebi seems to be thinking on the right path. While pricing remains the key component of an IPO, it is one of the critical factor for retail investors to see whether they should invest in an IPO or not, IPO grading does not take pricing into account while grading an issue.
A leading investment banker said that it should be called IPO corporate governance grading or IPO fundamental grading rather than IPO grading as it is not a grading on the issue which includes pricing too.
It may not be a bad idea considering that the name IPO grading suggests a grading on the issue while it does not incorporate the most essential aspect ? the pricing of the issue.
Why was it introduced?
In December 2005, Sebi board agreed to introduce IPO grading on optional basis to help retail investors take better IPO investment decisions. Sebi had then clarified that the cost of grading was to be borne by Investor Education and Protection Fund (IEPF) of MCA or Investor Protection Funds (IPF) of stock exchanges.
IPO grading was supposed to cover the business prospect, competitive position, financial position, corporate governance practices, management quality and compliance and litigation history of the company.
The rating agency after assessing the same would provide a grade between 1 and 5 with 5 denoting strong fundamentals on all these grounds.
?The grading would be a one-time exercise and would only focus on assisting the investor particularly Retail Individual investors, in taking an informed investment decision,? said Sebi statement after the board meeting on 30, 2005.
Later, after a presentation by R Ravimohan, the then MD and CEO of Crisil in March 2007 and further discussions, Sebi made it a mandatory requirement for all draft offer documents filed on and after May 1, 2007. It was also decided that the cost of grading would be borne by the issuers which means that ultimately it would be paid by the subscribers of the issue.
Crisil also called for the need to have critical mass of graded issues from a range of companies so as to develop a universe which would enable investors to compare while taking an investment decisions.
Why a bad idea now?
Ever since its introduction as a mandatory requirement for a public issue, voices against IPO grading have been growing louder. With six years of history and performance of the issues that have been graded, relevance of IPO grading without incorporating a view on pricing is in question.
Even the IPOs, over the last few years, that have got high grading from credit rating agencies have not been able to generate positive return for the investors.
If we look into the performance of 97 IPOs that have hit the market since January 2010, 75 of them are trading below their issue price.
While 58 of the 97 issues received an IPO grading of 3 or above (3 – average fundamental, 4 – above average fundamental and 5 – strong fundamental), 41 of them are trading below their issue price even now. This means that 70 per cent of the issues that received higher grading have not been able to generate returns for the investor.
The situation is even worse at the top. Out of the 26 issues that received a grading of 4 and 5, 19 are trading below their issue price which means 73 per cent of those issues have not been able to generate positive returns.
?There is a catch 22 situation. If the issue gets a higher grading then there is a higher chance that the pricing of the issue is aggressive and there is a risk for the investor to lose money,? said the head of a leading investment banker who did not wish to be named.
He added that issues graded 3 often end up with attractive pricing as the promoter is scared and tries to make up for the average fundamentals.
?Equity is a moving object while grades are one-time and that too based supposedly only on fundamentals. IPO grading becomes even more redundant as it does not factor pricing. In fact, high grades can prompt issuers to price themselves even more aggressively,? said Prithvi Haldea, managing director, Prime Database.
?Gradings are often determined by size of the company and profile of the promoters, and most large issues are assigned high grades, and often these are the ones which have given the maximum losses,? he said.
The data clearly shows that the higher ratings of fundamentals does not necessarily mean a better performance at the stock market and hence it has hardly been of any help to retail investors who may think of it as a grading for the issue.
How much for a grade?
While IPO Red Herring Prospectus remains silent on the fee that is paid to rating agencies, sources in rating agencies and at investment banks say that it depends on the size of the issue and the bargaining power of the company.
While small issues of around Rs 50 crore generally pay a fee of between Rs 5-10 lakh, the price may go up to Rs 20-25 lakh for large issues.
?While the IPO market is very weak, it is also very competitive. As a result the price being charged for issues is on a decline,? said an official with a rating agency, who did not wish to be named.
How to read IPO gradings?
While questions are being raised over the relevance of IPO grading, the Sebi chairman said that there are strong views against IPO price being included in the grading criteria.
Retail investors must clearly understand that grading is just a recognition of the corporate governance practices and the fundamentals of the company and it has nothing to do with the pricing of the issue. So rather than taking it as a grading on the issue, it should be seen as grading of the company?s fundamentals.
An IPO grade of 5 only assures of a good corporate governance and good fundamental, and if the pricing is aggressive, it may not be a good idea to invest in the issue.
sandeep.singh@expressindia.com