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Hype On No Issue

IPO grading is flawed in concept and an inconclusive verdict on whether or not to invest in an initial issue

I have never seen any SEBI proposal facing so much criticism as its plan to introduce compulsory grading for IPOs. Every single article and editorial has condemned the idea. This criticism is now being challenged on the ground that analysts lack understanding of the concept. Well, no rationale for grading was ever put out and hence surely people would interpret it in their own ways. Nevertheless, the reality is that almost all critics have got it right, clearly understanding what grading encompasses.

I still cannot put my finger on who thought of or what led to the IPO grading. This was a concept that was previously rejected by the ministry of company affairs. There also is no body of research, no global experience, no concept paper, no invitation for public comments. Worse, the voluntary grading exercise - which did not see any company volunteer and 19 small firms were then arm-twisted into doing so - has left much to be desired, and nothing justifies the move towards mandating grading.

Having made grading compulsory, many explanations in support are now being given by the regulator to the media. It is being said IPO grading has been introduced because small investors have asked for it, there has been a deluge of bad IPOs, because of fear of yet another vanishing companies' scam and because small investors deserve a crispier version of the voluminous offer document. None make sense.

Small investors have asked for it
Who would not like free actionable investment advice from experts? This is the logic given for introduction of IPO grading when several investor associations unanimously voted for it. This is too simplistic. Instead of doing any diligence himself, if you ask any person on the street, he would obviously wish that someone else, and especially if it were the reputed rating agencies, gives him guidance on investment decisions. But is he even aware of how dissimilar it is from rating of debt instruments and of the several pitfalls in the IPO grading concept? The small investors are not even remotely aware of the underlying value of the grades, the inexperience of the rating agencies in this area and what will be delivered is a subjective opinion on an IPO, and that too incomplete.

A deluge of bad IPOs may lead to yet another vanishing companies' scam
First, I do not know what a deluge is. What I know is that an average of seven IPOs in a month, that too for a country of our size and amid an economic bull run, is not deluge. Regarding quality, entry norms have become tighter, there is better vetting of issues by stock exchanges and by Sebi, and there is compulsory participation of 50 per cent in an issue by QIBs (qualified institutional buyers), who are more discerning and better informed and their response to an issue holds cues for small investors. In any case, bad IPOs are rejected by Sebi and if some pass through, then by the market; more than 15 IPOs have met such fate. The fear of another vanishing companies' scam is totally unfounded. Every single company that has come out with an IPO has been an existing company, in business for several years. There has not been even one IPO for a new project from an unknown promoter.

For sure, misuse of issue funds is a continuing threat to our system but the regulators have failed to device any mechanisms to stem this. And grading is no solution to post-issue misuse of funds. Significantly, misuse of funds in the 90s was perpetrated not by small firms but by large well-known companies, and too in most cases legally by obtaining shareholders' approval to undertake an activity different from what was stated in the prospectus! On another front, it is also amazing that in the scheme of things, even if a company gets the lowest grade of 1, it can still make its issue. If its fundamentals are judged to be so bad, why doesn't Sebi stall the issue?

Interestingly, some IPOs are now being called bad in case they are now quoting below their offer prices, the accusation being of overpricing. Several IPOs made in the last couple of years surely have gone below their offer prices. What we fail to understand is that there is no such thing as overpricing; it can at best be a statement made in hindsight. If an issue finds a huge demand leading to over-subscription and then lists at a premium to its offer price, how can anyone accuse it of overpricing? That several IPOs are quoting at a discount to issue price is a function of the market. Thousands of secondary market stocks have fallen, but no one is crying hoarse about them. Once IPOs become listed stocks, these should be treated likewise. Anyway, IPO grading is of no use, as it completely ignores price. And we know that even a good company at the wrong price is a bad investment. If post-listing prices are manipulated, Sebi needs to address that as a surveillance measure.

Investors need crispier information
The offer document is beyond the capabilities of small investors and a grading is supposed to offer a "crisp summary of the voluminous offer document". This concern is totally valid, but the solution is flawed. First, the small investors do not get the voluminous offer document, what they get is the abridged prospectus. On the other hand, the objective of providing crisp summary has been totally defeated. Take a look at the grading rationale put out for the 19 IPO offer documents graded so far. What we have is only a two-para unstructured rationale for the grade awarded. The real need is to revisit the contents and format of the abridged prospectus, which small investors use. Redesign the risk factors, which were introduced to highlight the negatives, but have become a joke. After this, a further condensed version of two to three pages would still be welcome. And that should be the task assigned to the rating agencies, and not of grading. Grades influences investment decision directly, a condensed summary does not as it would help in giving a basic sense whether the investor should drop or pursue that IPO.

With regard to information gaps, if the disclosures are incomplete, the regulators should fix them, not use them as reasons to give rating agencies work. Importantly, the information gathered during the grading due diligence should also be included in the offer document.

Grading will bring turmoil
Once we have grades, in spite of disclaimers and education, most small investors will only look at this number. History tells us so. As such, they will reject a low-grade IPO and invest in a high-grade one. But if subsequently share prices of those companies -the barometer of performance - move in the opposite direction than the grades assigned to them, they will complain. If low-grade IPOs do well after listing, they will complain about missed opportunities. If they lose money in high-grade IPOs, they will say they were misled. In equity, unlike debt, it is not safety, but the attractiveness of a company at a particular price for capital appreciation that drives the investment decision. Five recent low-grade IPOs were handsomely over-subscribed and are quoting above their offer prices, despite the market crash, while the IPO that got the highest grade nose-dived. Equity assessment, by its very nature, is subjective and a moving target, which IPO grading does not acknowledge.

By introducing grading, we are taking the small investor away from the stated objective of "informed decision making". IPO grading will give small investors a false sense of security, even confuse them. Equity is risk capital, and investors should know about the company they invest in. If they do not know about it, they should not invest in it in the first place. We are going backwards, moving away from a disclosure-driven free market to one filled with controls. Protecting investor interests is also to ensure that they are not guided by subjective and incomplete advice.

According to the plan, the grades awarded would be a "relative comparison of the graded issue to the other listed companies". For this, should the rating agencies have first not graded all listed stocks or at least the peer stocks of the specific company and of past IPOs? Only with this, an investor will get a sense of relativity. What we have in effect are absolute, and subjective, marks.

Also intriguing is that for debt, where there is enough experience, Sebi insists on every issue to be rated by at least two rating agencies. However, for IPO grading, which is still a nascent idea, Sebi has rejected the two rating agency demand. The equity market works on collective wisdom. Here, one agency's views are being forced on the entire market, and that too of agencies which have no track record, here or anywhere in the world of IPO grading. Grading is aimed at small investors. Yet it will work as a constraint on the fund managers who despite positive assessment may not be able to invest in low-graded IPOs for fear of being reprimanded later.

IPO grading is bad news also for the economy and for the capital market. I fear that IPO grading, by blocking issues, will throttle entrepreneurship and growth, for which, rating agencies would not be held accountable. Why are we giving them the status of God? Rating agencies themselves differ in skill sets. In fact, if the market was asked to grade rating agencies, they would be significant differences among the agencies! There is a room for huge subjectivity in grading. Worse, there is no uniform grading methodology. Parameters being looked into differ and so do weightages to the parameters. Examples show a very high weightage given to corporate governance, which in the case of an IPO means comparing practices of a closely held company to that of listed entities at the highest standards. On the parameter of business prospects, there can only be subjectivity. (Remember how even the collective market wisdom had rejected Bharti's IPO at Rs 45, brought it down to Rs 21 post listing and the share now trades at over Rs 800!) IPO grading is surely loaded against the issuers. For a handful of weak issuers, a large number of good companies would have to undergo this unwanted process. They will also now have to get their IPO vetted four times by Sebi, by the two stock exchanges and by the rating agencies.

It is also interesting that grading will not get funded by the Investor Protection Fund but by the companies. The proponents of grading had made IPF funding the most important pre-condition for IPO grading, to avoid conflicts of interest. I am now amused by their silence on this aspect. If the conflict is now inbuilt, what use is the grading? On the operational front, too, there are several issues. There is no clarity on the timeframes. On average, issue grading took 130 days during the voluntary period, clearly an unacceptable proposition. Moreover, it is not clear how the agency designated to grade a given issue will be selected. There is also the matter of “inside information” when future projections of business prospects are being asked from companies, something expressly forbidden by Sebi. In the 1990s, small investors lost several thousands of crores investing in fixed deposits of high-rated companies. No accountability of the rating agencies ever got established. In the IPO grading arena too, the rating agencies would get away without any responsibility. This time around, however, what may happen is that IPO grading may tarnish the reputation of credit rating agencies, so assiduously built, and of Sebi.

If at all IPOs have to be graded, let it be voluntary. Let companies seek value in grading and let rating agencies demonstrate their expertise to the investors who then start rejecting non-graded issues. If the skills of the rating agencies are required to be deployed, let these be done for putting out crisp summaries on hundreds of secondary market stocks, specially the penny stocks, where small investors lose more money in a day than they lose in all IPOs of a year.

On a closing note, if rating agencies indeed are really good at grading fundamentals, their analysts would find immediate placements in our fund management industry which has a huge shortage of such skills, and which is willing to pay much higher salaries.