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116 The Chartered Accountant July 2006

B a n k i n g a n d F i n a n c e

SEBI’s Initiative To Safeguard Investors’

Interest Through IPO Grading

As part o a series o initiatives to protectinvestors’ interest, the market regulatorSecurities and Exchange Board o India

(SEBI) has granted in principle approval orintroduction o ‘optional grading’ o public issueso those companies which are not listed withthe stock exchanges [viz. Initial Public Oerings(IPOs)]. IPO grading service is provided by somecredit rating agencies (CRAs), including ICRA,CRISIL, Fitch Ratings India and CARE, registeredwith SEBI. According to SEBI, IPO grading wouldnot be mandatory and would be solely at theoption o the issuer company. SEBI will notcertiy the assessment made by the gradingagency.

The main objective o such IPO grading is toenable investors to have an independent opinionrom credible entities about the equity issue

o an unlisted company. Though it is optionalor companies to seek an opinion, it would bemandatory or them to state the grading symbolon the oer document i they have opted to getthemselves graded. However, SEBI has clearlysaid that the grading exercise would restrict

itsel to assessing the ‘undamental businessstrength’ o the company (such as businessprospects and nancial position), and wouldnot be an ‘investment recommendation’ as such.SEBI has also said: “As the IPO grading does nottake cognizance o the price o the security, itis not an investment recommendation. Rather,it is one o the inputs or the investor to aid inthe decision making process. All other thingsremaining equal, a security with strongerundamentals would command a higher marketprice”. SEBI will probably be the rst regulatorin the world to implement rating/grading o IPOs. Currently, only debt issues are rated aheado oers. According to SEBI, “There are somevariants o the product in other markets, orpre-sale equity reports done by equity brokinghouses. However, no regulator has initiatedrating o IPOs in any part o the world.”

IPO Grading: Conceptual Issues

IPO grading is a service intended to acilitatethe assessment o equity issues oered byunlisted companies to public. The gradeassigned to any individual issue may representa relative appraisal o the ‘undamentals’ o thatissue in relation to the universe o other listedequity securities in India. In act, IPO gradingis positioned as a service that provides ‘an

independent assessment o undamentals’ toassist comparative assessment that would prove

IPO grading is a service intended to acilitate the appraisal o equity issues oeredby unlisted companies to public. The grade, assigned by some credit rating agencies,including ICRA, CRISIL, Fitch Ratings India and CARE, registered with SEBI to any indi-vidual issue, may represent a relative appraisal o the ‘undamentals’ o that issue inrelation to the universe o other listed equity securities in India. However, IPO grad-ing may provide ‘an independent assessment o undamentals’ to assist comparativeassessment that would prove to be a useul investment tool or prospective investors.The methodology o such grading is to consider a fve-point scale with a higher scoreindicating stronger undamentals. In this perspective, this article provides an over-view on IPO grading in India.

(The author is a Senior Lecturer of Ac-counting & Finance at St. Xavier’s Col-

lege, Kolkata, West Bengal. He can be reached at [email protected])

- Dr. Siddhartha Sankar Saha

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The Chartered Accountant 117July 2006


useul as an inormation and investment tool or

prospective investors. The methodology o suchgrading is to consider ve-point scale with a

higher score indicating stronger undamentals.

While investment recommendations areexpressed as buy, hold or sell securities andare based on a security specic comparison o

its assessed ‘undamental business strength’

(such as business prospects, nancial position

etc.) and ‘market actors’ (liquidity, demand

supply etc.) to its price, IPO grading is expressedon a ve-point scale as stated earlier. In other

words, it is a relative comparison o the assessed

undamentals o the graded issue to other

listed equity securities in India. The cost o IPOgrading shall be borne rom investor protectionunds administered by stock exchanges or rom

Investor Education and Protection Fund (IEPF)

administered by the Ministry o Companies

Aairs. SEBI would nalise necessary proceduralaspects in consultation with Stock Exchanges.

IPO grading covers both internal and external

aspects o a company seeking to make an IPO in

general. The internal actors include competence

and eectiveness o the management, prole

o promoters, marketing strategies, sizeand growth o revenues, competitive edge,

technology, operating eciency, liquidity and

nancial fexibility, asset quality, accounting

quality, protability and hedging o risks. Amongexternal actors, the key one is the industry and

economic/business environment or the issuer.

Here, it is important to note that internationally,

the global rating agencies such as Standard &

Poors and Moodys do not perorm grading o IPOs at all. While Standard & Poors is the majority

stakeholder in CRISIL Ltd, Moodys is the single

biggest stakeholder in ICRA Ltd. Similarly, the

third global player Fitch IBCA (which acquiredanother rating agency Dun & Bradstreet in 2000)

also does not grade IPOs as yet.

Why IPO Grading?

Sometimes a company may not knowwhether it is perorming well or not. In such asituation, getting a grading by an independent

rating agency would come in handy and may bevery much valuable to companies. IPO grading issupposed to be useul particularly or assessingthe oerings o companies accessing the equity

markets or the rst time where there is no track record o their market perormance. There is nodenying the act that IPO grading will be helpulto the unlisted issuing companies provided CRAsprescribe a higher score indicating strongerundamentals. As stated earlier, the IPO gradeassigned to any issue may represent a relativeassessment o the ‘undamentals’ o that issuein relation to the universe o other listed equitysecurities in India. This grading can help the

prospective investor to make a right investmentdecision. Thus, IPO grading is additional investorinormation and investment assistance deviceto enable more realistic pricing o shares andassist investors make an inormed decision. Trulyspeaking, i investors respond better to a gradedIPO, it would prove an incentive or promoters toopt or grading in uture. Needless to mention,acquiring a high grading symbol could enableissuing companies command a better premium

on their oer and Issuers having underlyingstrength can also project themselves in a betterway to their prospective investors.

There are various positive sides o an IPOgrading. The most signicant actors that goin avour o IPO grading are: (a) Proessionaland independent appraisal, (b) Removal o inormation overload, (c) impediment orweak companies, (d) improving investors’sophistication. It is worthwhile to have a brie

description o these issues so as to understandthe objectives o IPO grading.

(a) Proessional and Independent Appraisal:IPO grading will create awareness about theundamentals o the company’s IPO and willprovide ocused company inormation as akey input to prospective investors that willbe helpul in taking an investment decision,in a manner similar to what a credit rating isor debt investors.

(b) Removal o Inormation Burden: Wheredisclosures o issues are large and complex,

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a service analysing and interpreting thesedisclosures independently and quickly willbe extremely useul in cutting throughthe clutter. Thus, the useulness o IPO

grading would be particularly high or smallinvestors as it will serve as a guide about thecompany coming out with the issue.

(c) Impediment or Weak Companies: Whileundamentally sound companies willgain rom the market, companies whoseundamentals are not very strong willbe impeded in building up speculativedemand among investors. Such weak companies will need to oer pricing, which

will adequately compensate investors orthe risks they take. Thereore, IPO gradingprovides disincentives or weak companiesplanning to come to the market to raiseeasy capital.

(d) Improved Investors’ Sophistication: It is per-ceived that an independent and inormedopinion on the undamental quality o thecompany will bring about greater level o investor sophistication in a scientic man-ner. In act, investors may take investmentdecisions in a better way on the basis o opinion o CRAs regarding IPO grading.

However, the assessment is not a recommen-dation to buy or not buy a stock. It is, instead, apowerul tool to assist the investors in makingup their mind about the quality o a companyproposing to oer an IPO investment option.

SEBI Guidelines Regarding IPO Grading

In exercise o the powers conerred undersub-section (1) o Section 11 o the Securities andExchange Board o India Act, 1992, it had beendecided to amend the SEBI (DIP) Guidelines,2000. The amendment regarding IPO gradinghad been made on 24th April, 2006 (vide SEBICircular No. SEBI/CFD/DIL/DIP/21/2006/24/4dated April 24, 2006) and came into orce withimmediate eect. SEBI has also circulated

the ollowing amendments o IPO grading toall merchant bankers (who perorm as leadmanagers/ intermediary in management o

capital issues o primary capital market in India)as well as stock exchanges. These amendmentsare summed up as below:

(1) Pre-Issue obligations in case o IPO grading: An unlisted company making an IPO o equity shares or any other security, whichmay be converted into or exchanged withequity shares at a later date may opt toobtain grading or such an IPO rom one ormore credit rating agencies. Where an issueropts to obtain IPO grading, it shall discloseall grades so obtained by it, includingunaccepted grades, in the prospectus andabridged prospectus.

(2) Contents o the prospectus: Statementindicating whether IPO grading has beenopted or. I yes, disclosure o all grades soobtained, including unaccepted grades andreerence o the page number where detailso IPO grading, as mentioned below, aregiven.

(i) Name o the credit rating agency romwhich grading has been obtained or

the proposed IPO o equity shares orany other security which may be con-verted into or exchanged with equityshares at a later date and the gradingso obtained, including unacceptedgrades.

(ii) I grading has been obtained rom morethan one credit rating agency, disclo-sure shall be made o all the gradesso obtained, including unaccepted

grades.

(iii) The rationale/description o the grad-ing/s so obtained, as urnished by thecredit rating agency/ies.

IPO Grading Process

It is intended that IPO undamentals wouldbe graded on a ve-point scale rom grade 5(indicating strong undamentals) to grade 1(representing poor undamentals). The creditrating agencies (CRAs) would have to ax itsname beore the grading symbol. The grade

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is supposed to be assigned as: ‘rating agencyname’ IPO Grade 1 or ‘rating agency name’ IPOGrade 5 and so on (viz ICRA IPO Grade 1, CRISILIPO Grade 5 etc). Presently, CRAs including

CRISIL Limited, Fitch Ratings India PrivateLtd., ICRA Ltd., Credit Analysis & Research Ltd.(CARE) registered with SEBI will carry out IPOgrading. SEBI does not play any role in theassessment made by the grading agency. Thegrading is intended to be an independent andunbiased opinion o that agency. The assignedgrade would be a one-time assessment madeat the time o the IPO and meant to assistinvestors who are interested in investing in

the IPO. The grade will not have any ongoingvalidity. The company needs to rst contactone o the grading agencies (i.e.CRAs) andmandate it or the grading exercise. The

agency would then ollow the process: (a)Seeking inormation required or the gradingrom the issuing company, (b) On receipt o required inormation, having discussions with

the company’s management and visiting thecompany’s operating locations, i required,(c) Preparing an analytical assessment report,(c) Presenting the analysis to a committeecomprising senior executives o the concernedgrading agency. This committee would discussall relevant issues and assign a grade, (d)Communicating the grade to the companyalong with an assessment report outliningthe rationale or the grade assigned. CRAs

are supposed to take 3-6 weeks ideally orcompletion o the grading process. However,a model o IPO grading process is suggestedbelow:

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A MODEL OF IPO GRADING PROCESS

CRAs will be required to orward the namesand details o IPOs graded by them on monthlybasis to SEBI/Stock Exchanges or uploading ontheir website or public inormation. The IPOgrading given by CRAs shall orm part o theprospectus or the IPO. As such, the company,which has opted or IPO grading, does not havea choice in accepting or rejecting the grade inthis regard. I it has opted or IPO grading, thesame needs to be disclosed in the Prospectus asstated in the SEBI guidelines.

A Bird’s-Eye View o Indian primary capital

marketResource mobilisation rom the primary

market by the issuance o equity securitiesconsisting o both the ‘initial public oering’(IPO) market and the ‘seasoned equity oering’(SEO) market, witnessed considerable activity in2004 and 2005 (Table 1).

In 2005, Rs. 30,325 crore o resources wereraised rom this market, o which Rs.9,918 crorewere raised by 55 companies which were listedor the rst time (IPOs). It is evident that thenumber o IPOs per year has risen steadily rom2002 onwards (i.e. 6 to 55). Table-2 and Chart-1 and Chart-2 present a bird’s eye view o IPOsduring 2002-2005.

It is observed that many companies cameorward to oer IPOs in 2005 as compared

to 2002 (Chart-1 on next page). There was adeclining trend o total equity issues as well

as IPOs in 2005 in comparison with previousyear’s mobilisation (Chart-2 on next page). But,according to a rough estimation made in TheEconomic Times (25th April, 2006) the Indian

equity market is supposed to witness a heavyrush o IPOs during 2006, which could rake upabout Rs. 40000-50000 crore rom the marketon a cumulative basis.

IPO Grading: A Few Comments

IPO grading has been widely commentedupon by the experts in the eld.According to Mr. AmbarishMukherjee (Business Line on

20th March, 2006), “Despitemore than 40 IPOs expected tohit the market in the rst hal o 2006-07, only our companieshave approached the agenciesapproved by the SEBI or ratingo their issues. Incidentally,they too have not accepted the ratings awarded to thembecause these do not match up

to their expectations, according to rating agency ocials. This is the rst such efort anywhere in theworld and SEBI kept it optional as a test exercise.” Mr. Ambarish Mukherjee also quotes a seniorocial in one o the approved rating agenciesas saying: “Recently one construction company gave us the mandate or rating their orthcomingIPO. We did the necessary due diligence as per SEBI specications that cover both internal and external aspects. But the company did not nd our ratingup to their expectations and has not approved it. And now it would be entering the market soonwithout using our rating.”

Table 2: Details of IPOs

Year IPOs of Equity Shares

(in number)

IPOs of Equity Shares

(Rs. crore)2002 6 1,981

2003 12 1,708

2004 26 12,402

2005 55 9,918

Table 1: Primary capital market scenario

Calendar year (Rs. In crores) Types of issues 2002 2003 2004 2005

Debt Rs. 4,549 Rs. 5,284 Rs. 2,383 Rs. 66

Equity

Of which, IPOs

Rs. 2,420 Rs. 2,891 Rs. 33,475 Rs. 30,325

Rs. 1,981 Rs. 1,708 Rs. 12,402 Rs. 9,918

Number of IPOs 6 12 26 55

[Source: SEBI]

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According to Mr. Prithvi Haldea, ManagingDirector o Prime Database o the IPO market,“there are no incentives or the companies to ratetheir IPOs. First, there is no rating o IPOs anywherein the world and thus there are no models. I a company accepts a particular rating, theconcerned agency would have to report it to theSEBI and stock exchanges within the same month,which makes it public inormation. In such a case,a good company will not go or rating earing that

i it gets a bad rating its issue may sufer despitestrong undamentals. Similarly, a bad company too would not go or rating earing that its cover-ups might get exposed with a poor rating.”

Thus, there is a serious reservation aboutthe practicality o IPO grading because o the number o opinions against IPO grading.Equity, by its very nature, is ‘risk investment’and ‘Caveat emptor’ holds true especially orequity investments. Ratings should not induce

investors to ignore the above dictum andshould not provoke investors to invest their hardearned money blindly. To try and capture thatinto a grading system should, or all practicalpurposes, be extremely dicult. Since pricingo shares is the most critical actor in evaluatingIPOs, the rating’s value is obviously diminishedwithout making any comment on pricing.Another signicant observation about rating isthat markets do not always take the rating on

its ace value. For instance, in the case o debtinstruments, instruments with same ratings

have dierent prices. Keeping in mind all thesematters, questions arise as to whether the CRAscan be held accountable to the prospectiveinvestors and will need to indemniy themselvesrom such investors relying thereon. Is this achallenge to the merchant bankers who doeverything or a particular issue towards theirperormance in an IPO? Or, is this an attempt toremove the demarcating line between equityand debt?

Conclusion

The Government o India was keen to set upa system to avoid any shady promoters takingadvantage o the stock market boom and raisingmoney rom the public. The IPO grading, a one-time exercise is supposed to be an independentand unbiased opinion o the concerned agency.It would only ocus on assisting the investors,particularly retail individual investors, to take an

inormed investment decision about IPOs beoreputting in money. There may be apprehensionamong companies proposing to come up withIPOs over the possible adverse impact on pricingin the event o a poor grade. In this connection,one may comment by saying that grading o IPOs might be a ‘tricky’ aair as it could give aalse sense o security to the public. However,there is no denying the act that SEBI has takena pioneering role in saeguarding investors’

interest by increasing disclosure levels by entitiesseeking to access equity markets or unding.

Chart 1 : IPOs of Equity Shares (in number) Chart 2 : IPOs of Equity Shares (Rs. in crore)

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This has caused India to be amongst one o themore transparent and ecient capital markets inthe world. Moreover, these disclosures demandairly high levels o analytical sophistication

o the reader in order to eectively achievethe goal o inormation dissemination. It isperceived that once the IPO grading processpicks up, companies would gradually realise thebenets o getting their issues graded, especiallythose that are condent o their undamentalstrengths. In act, majority o retail investors donot read the oer document and even wherethey do they may not ully comprehend theimplications o all the disclosures made in the

document. So, there is a vital need to rate equityoerings helping investors separate good foatsrom risky ones. On the other side, there is aneed to keep in mind some important issuesregarding IPO grading: Would IPO gradingshit the responsibility o bringing out goodIPOs rom the merchant bankers to the CRAsgradually? Would CRAs provide any assuranceto the investors as regards risk and return o a

particular IPO? Will investors perceive the ratingas a regulatory approval o the oering? In act,SEBI is moving away rom an approval machineryto a more transparent disclosure machinery. So,

would SEBI’s approval depend on the ratingoutcome? What would happen i the rating ismodied during or ater the IPO process? Caninvestors sue rating agencies? What wouldhappen i the rating is high but the subsequentmarket perormance o the company is poor?All ratings are subjective opinions o ratingagencies. Should the IPO process be dependenton such subjective elements? Since this conceptis untested anywhere in the world and is yet to

be ully explored in near uture, it is very hardto answer all these queries at this stage. Undersuch situation how would investors take rightdecision to buy a particular IPO through IPOgrading? However, let companies opting to ratetheir oerings adopt it and let one observe themarket experience. In act, time will say in a rightmanner whether investors’ interest will indeedbe saeguarded through IPO grading in India. r

The ICAI Logo Was Conceptualised by

Sri Aurobindo!

When the Institute was ormed in the year

1949 in the month o June/July, C. S. Shastri, anoted Chartered Accountant o Madras wentto Sri Aurobindo and requested him througha letter to give an emblem to the newlyormed Institute o which he was an electedmember rom the South… Sri Aurobindogave him the emblem with a Garuda in thecentre and a quotation rom the Upanishad:Yah esa suptesu jagarti , that person who isawake in those that sleep.

The emblem was placed at the rst meeting

o the Council o the Institute in New Delhisometime in June/July, 1949 and was acceptedamongst many other emblems placed by othermembers o the Council. So, that became theemblem o the Chartered Accountants o India.Very ew people know about it and most o theChartered Accountants do not know it.

Source: My reminiscences authored by Prasanta Mukherjee

d i d y o u k n o w

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