Investment decisions in IPOs are becoming increasingly difficult, given the flurry of public offers that hit the market these days. Differentiating a good offer from a bad one, assessing the company fundamentals and verifying the credentials are becoming more complex. In this backdrop, the Securities and Exchange Board of India's decision to make IPOs (initial public offers) grading by credit rating agencies mandatory, is likely to provide some respite to retail investors. However, the rating is unlikely to throw much light for short-term investors or traders seeking to make a quick buck from the `listing gains'.
We take a look at what the grading system proposes to do and what changes, if any, it is likely to bring in.
In a move, which does not appear to have any precedence elsewhere in the world of capital markets, the SEBI has introduced compulsory grading of initial public offers that will hit the market from now on. Credit rating agencies such as the CRISIL and ICRA will grade the various forthcoming IPOs on a five-point scale from grade 5 (indicating strong fundamentals) to grade 1 (indicating poor fundamentals).
This grading, which will be based on the agencies' assessment of company fundamentals, will consider the following five parameters — earnings per share, financial risks, accounting quality, corporate governance and management quality. Thus, the rating awarded to an IPO will mirror the company's general health in terms of these qualitative and quantitative factors. The IPO pricing, however, is not factored in for the purpose of rating.
These ratings, apart from being available in the respective offer documents of the companies, can also be viewed on the respective rating agency's Web site.
Grade 1
For instance, a company X decides to tap the primary market for raising capital. The rating agencies will now be required to grade the company. This process will include market checks, plant visits and practice of due diligence apart from studying the other already-specified macro factors. At the end of the process, say, X is awarded grade 1 (indicating poor fundamentals). This would mean that the company is fundamentally weak and investments in that company could be risky. However, the rating does not go on to say whether such an offer is to be avoided or not.
In a similar manner, if X gets a grade 5 (the highest one possible), it does not mean a blanket approval from the rating agency to invest in the public offer. It only means that X is fundamentally sound on the basis of metrics used by the rating agency.
Thus, in general, the grading process that has been introduced is meant to make the retail investors aware of the health of the company's business. It cannot be interpreted as a recommendation to invest or avoid any offer that is so rated.
Advantages
IPO grading, a hitherto optional exercise, has been made compulsory to encourage only serious companies.
Over the longterm, it is likely to help SEBI regulate the IPO market by helping it protect the investors from cases of vanishing companies. The rating will also facilitate the not-so-well known companies in tapping the primary market for capital.
Retail investors, on the other hand, stand to benefit the most. The grading system that purports to give a professional perspective of the company's fundamentals, is likely to help investors establish the credentials of the company they plan to invest in.
Neutral agencies can be more objective in their evaluation of a public offer compared to other market participants.
This apart, it is likely to help investors weed out companies with poor fundamentals or those with a spurious background at the preliminary stage itself.
Disadvantages
More often than not, the pricing of any IPO is what influences the decision of any investor. The rating agencies, in this case, will not talk about ``what price'' and ``what time'' aspects of the offer.
Given that the decision to invest or avoid investments in any IPO is most often a function of the pricing, the lack of this aspect in the present IPO grading system could make the whole process an unfinished task.
Also, rating agencies (experienced in debt rating) could face trouble with rating the equities, which, unlike debt rating, is more dynamic and cannot be standardised. Further, IPO grading mechanism is a globally-unique initiative; it could increase the cost of raising capital in India and urge companies to seek capital overseas.
Markets, in the short term, can be price-driven and not purely motivated by company fundamentals. That is to say that, at times, even good companies at a higher price could be a bad investment choice, while the not-as-good ones could be a steal at lower prices.
Despite having disclaimers, a higher graded IPO may well tempt small investors into falsely believing that a high premium would come about on listing.
Similarly, investors may get deluded by a low-graded IPO, which could become a `missed opportunity' in the future. The purpose of introducing grading, thus, might get defeated if it leads to a false sense of buoyancy or alarm among investors.
Till such time the utility of the IPO grading system is unravelled, it is advisable for investors to use the grades only as an additional input to make an informed decision.
Investors need to be convinced about the business potential, pricing and valuations of an IPO, together with the grading, to make a final choice.