Legal Briefing

Grading of initial public offerings

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Corporate & Commercial | 04 June 2011

The concept of grading of initial public offerings (IPOs) in India was first introduced by the securities market regulator, the Securities and Exchange Board of India (SEBI) in 2006 under the erstwhile SEBI (Disclosure and Investor Protection) Guidelines 2000. It provided issuers with an option to get their proposed IPO graded by SEBI-registered credit rating agencies and disclose the IPO grading assigned in its offer documents.

ASSESSMENT OF COMPANY FUNDAMENTALS

An IPO grading is essentially a certification assigned by an independent credit rating agency that entails an assessment of the quality of securities offered by an unlisted company and the quality of the IPO itself. The grade represents a relative assessment of the fundamentals of the issue in relation to the other listed equity securities in India. In addition, the grading is intended to provide an investor with an informed, objective and unbiased opinion expressed by an independent body of professionals that are not connected with the offering or with the issuer company.

In other words, an IPO grading is a simple, objective indicator to a potential investor of the relative fundamental position of the issue company vis-à-vis other listed companies in similar businesses.1 While it is akin to a credit rating of a debt security, the criterion for assessment of an IPO grade is entirely different from rating debt securities.2

REGULATORY REGIME: SHIFT FROM OPTIONAL TO MANDATORY GRADING PROCESSES

In May 2007 IPO grading was made mandatory by SEBI for all first time issuers of securities by way of a public offering and these new requirements specified the disclosure of the IPO grading along with the scope and rationale for the grading as a compulsory process for any unlisted company seeking to raise funds from the public.

This unique change in the legal regime was perhaps precipitated by SEBI’s perception that IPO grading would provide investors, particularly retail investors, with additional information to facilitate an independent assessment of an IPO. It is also a part of the initiatives adopted by SEBI to improve transparency and efficiency in the securities markets by ensuring that an investor has access to meaningful information about the issuer company, along with the viability and prospects of the equity shares proposed to be listed. This is particularly relevant in the case of smaller and lesser known companies or companies without any established track record. An IPO grading can help an investor by providing access to material information about the company and its business prospects on parameters that are simple and easy to understand, since disclosures in most offer documents tend to be technical and financial in nature, and may not always be easily understood by the average retail investor.

Recent studies by credit rating agencies also suggest that IPOs receiving higher grades from rating agencies continue to enjoy higher price-to-earnings multiples (P/E).3 This reaffirms the importance of the IPO grading process and further justifies the regulatory regime.

GRADING CRITERIA AND METHODOLOGY

SEBI has identified six fundamental factors on the basis of which an issuer company is awarded an IPO grade, namely:

  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.4

The methodology adopted by any credit rating agency typically involves an in-depth study of various quantitative and qualitative parameters of the issuer based on the criteria set forth above. While growth prospects of the industry, business prospects, company prospects, financial strength and operating performance of the issuer are some of the quantitative parameters analysed for an IPO grade, qualitative parameters such as management vision, their credibility and competence, coupled with their ability to handle uncertainty in terms of capitalising on future business opportunity and mitigating the impact of contingencies, promoter dynamism, accounting policies, corporate governance practices although subjective, provide a critical input in determining an issuer’s fundamentals. The IPO grading process is expected to take into account the prospects of the industry of the issuer company and competitive strengths of the company that would allow it to address the risks inherent in the businesses and capitalise on the opportunities available, as well as the company’s financial position. Independent financial forecasting of the issuer is done and key parameters that influence valuations, earnings per shares, profit after tax, return on investments, return on net worth and growth in revenues.

Using the aforesaid criteria, an IPO grading is finally assigned on a five-point scale with a higher score (grade 5) indicating ‘strong fundamentals’ and the lowest score (grade 1) indicating ‘poor fundamentals’. Grades 4 and 3 indicate ‘above average fundamentals’ and ‘average fundamentals’, while grade 2 reflects ‘below average fundamentals’.5

The grading is a one-time assessment required to be done prior to registering the Red Herring Prospectus with the Registrar of Companies. It is pertinent to note that, in India, the issuer company is required to appoint a SEBI-registered credit rating agency to obtain the IPO grading and is required to bear the expenses for such grading. Further, the grade obtained, along with the rationale for such grading, has to be disclosed in the offer document regardless of whether the issuer agrees to accept such a grading or not, since grading once issued cannot be rejected. Under the current legal regime, an issuer company also has the option of appointing more than one credit rating agency to issue an IPO grade. However, the SEBI (Issue of Capital and Disclosure Requirements) Regulations 2009 make it mandatory for every unlisted company to disclose all the grades obtained, along with the rationale furnished by the credit rating agency for each of the grades in all the offer documents and issue advertisements.

EFFICACY OF THE IPO GRADING SYSTEM: ADDING VALUE TO AN INVESTMENT DECISION?

While the introduction of the grading system has been argued to be a good initiative from SEBI to serve as an additional mechanism of information flow to the retail investor, the critical question is whether IPO grading has marked a fundamental difference to securities law practice in India and proved as a useful valuation tool for evaluating securities or investor education.

It can be argued that the criteria or methodology is not so rigorous or analytical a process to actually aid an investor’s decision in subscribing to an IPO. Often the rationale used by the credit rating agencies are heavily derived on the basis of analysis of the disclosures provided in the offer documents, thereby in effect providing no additional input to the investor as such. Which raises the question as to whether such an assessment is truly independent.

There are also strong arguments against whether IPO grading actually helps an investor since it takes into account future business prospects and growth strategy that is not easy to predict, and the outcomes of which do not necessarily hold true. Other factors, such as litigation history, are not a yardstick to determine the value of the security moving forward. Further, since an IPO grading does not comment on the valuation or the pricing of a security, there is no guarantee that the grading is an indicator of the performance of the equity shares post listing. In addition, since the grade is not linked to the issue price, there are instances of inconsistencies in grading results, as there is data to establish that there is no correlation between the IPO grade and the performance of the securities post listing. Accordingly, it is not necessary that a lower graded IPO would not fare well once listed or vice versa. For example, the IPO of Jubilant Foodworks Ltd, the operator of the Domino’s Pizza franchise in India, was graded 3/5 by Fitch Ratings, but post listing this security has been among the best performing securities to list in 2010 and has provided investors with significant returns on their investment, clearly establishing the shortcomings inherent in the grading process.

This concept of grading could also act as a deterrent to small entrepreneurs from entering the capital markets since an absence of a track record, in comparison to its industry peers, could result in such companies getting a lower grade. Another drawback of the existing practice is that the cost for such grading is borne by the issuer, which may result in situations of potential conflict of interest for the credit rating agency who is also in the business providing ancillary services to such companies. Therefore, there may be instances where a credit rating agency is susceptible to issue a more favourable grade to such companies. Most importantly, it may lead to a situation where retail investors are only looking at the IPO grade without making an independent assessment of the company and the proposed equity instrument being offered to the public.

CONCLUSION

The concept of IPO grading is still in its ascent stage, with the methodology and evaluation criteria not as rigorous and consistent to positively affect an investor to be able to uniformly assess the fundamentals of a company. This, coupled with the practical instances of retail investors investing in IPOs without any independent assessment and purely on the basis of the value of the IPO grade assigned, tends to defeat the very purpose of the concept of IPO grading on the whole.

SEBI should perhaps introduce amendments to address these issues to make the grading process more beneficial and useful for investors. This is particularly important since at present there seems to be no correlation between the efficiency of the grading mechanism and the performance of the equity shares, post listing.

In addition, SEBI should also introduce reforms to the SEBI (Credit Rating Agencies) Regulations 1999 to include the process of grading of IPOs into the existing regulations (which currently has an emphasis on credit rating), and introduce measures to better scrutinise the credit rating agencies.

(The views expressed are those of the authors and do not reflect the official policy or position of Amarchand Mangaldas.)

By Prashant Gupta, partner, and Aarti Joshi, principal associate, Amarchand Mangaldas.

E-mail: prashant.gupta@amarchand.com; aarti.joshi@amarchand.com.

Notes

  1. An initial public offering (IPO) grading it does not take cognisance of the price of the security, its valuation compared to industry peers and is in no manner whatsoever a comment on the likely listing price or assessment of the market risk associated with equity investments. Neither is an IPO grade a suggestion or recommendation as to whether an investor should buy, sell or hold the securities or an analysis of potential returns.
  2. A credit rating assesses factors from a debt holder’s perspective that are very different from those of a holder of equity shares. The criteria for evaluation is also undertaken to achieve distinct objectives and therefore cannot be directly compared.
  3. ‘Higher Grading Means Higher P/E Multiples for IPOs: CRISIL’, as reported in Business Standard on 28 April 2011, available at http://www.business-standard.com/india/news/high-grading-means-higher-pe-multiples-for-ipos-crisil/433740/.
  4. See Securities and Exchange Board of India (SEBI), ‘Frequently Asked Questions on IPO Grading’, available at http://www.sebi.gov.in/faq/ipograding.html.
  5. Id.