Sucheta Dalal :IPO Rating: Debating half-baked information
Sucheta Dalal

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IPO Rating: Debating half-baked information  

May 13, 2004

Spoon feeding investors by offering them an IPO rating has doubtful value, especially if it is mandatory. This article appeared in Divvya Bhaskar on May 6,2004.


Rating IPOIPO Rating: Debating half-baked information


By Sucheta Dalal


Last week, senior officials of the Securities and Exchange Board of India (SEBI) said that its Primary Market Advisory Committee was discussing the concept of mandatory rating of Initial Public Offerings (IPOs).  While the issue was indeed discussed by the committee, SEBI’s announcement has kicked off a half-baked debate based on incomplete information.

Investors are bound to welcome IPO ratings. Especially those who suffered huge losses by investing in fly-by-night companies during 1992-1996, or in the mid 1980s when grey market premia published by newspapers decided the success of a public issue.

What has happened so far is that the Credit Rating and Information Services of India Ltd (CRISIL) has made a presentation to SEBI that raised plenty of questions.  Before going into that, lets consider the concept itself.

SEBI wants to give investors a tool with which to evaluate new public offerings. But many sophisticated markets frown on IPO ratings. That’s because equity, by its very concept, is risk investment. Unlike a debt issue, which is a fixed borrowing, equity investors share the good and bad fortunes of the company. CRISIL too, is not offering a precise “rating”, as it does in the debt market. It is merely offering an analysis and grading, that too with many conditions and riders.

So far, SEBI had worked hard to ensure that disclosures in the IPO prospectus are detailed and accurate. Investors were expected to read the prospectus before making investment decisions. But it is now argued that with too many IPOs crowding the market, investors neither get access to offer documents, nor are they capable of analysing them correctly; and they end up relying on brokers and friends for advice.

IPO experience of the 1980s and 1990s shows that media analysis of public offerings is also unreliable and dictated by the compulsion of getting public issue advertising. That is one reason why investor groups themselves proposed that SEBI must try and get issues rated through independent rating agencies.

This led to the presentation by CRISIL. But its proposal is full of ifs and buts. For instance, CRISIL says that it will not comment on pricing; but will merely analyse information provided in the prospectus, occasionally supplemented by queries to the promoter.

Is this enough? After all, pricing of shares is the most critical factor in evaluating IPOs—especially for book-built issues. The shares of most companies are attractive at a certain price. If the rating does not help in deciding that price, it is of limited value.

Crisil further says that it will not do a forensic audit. Or, it won’t verify whether the information provided in the prospectus is complete and correct.  That means, the rating of an issue like Data Access, which was withdrawn by SEBI at the last minute, would not have revealed if the company were hiding key information.

In that case, Crisil is only offering to do what any smart investor is capable of doing on his own. The question then is, who pays for the rating?  If companies are made to pay for the mandatory rating of IPOs, then the regulator is merely creating new business opportunities for credit rating agencies. A company planning an IPO may end up being chased by five rating agencies to bag its IPO rating business. Can such a rating be independent? It will be no different from newspapers that are constrained by advertising considerations. And, it will only add to the costs and procedural burden of companies.

Crisil too does not deny that a rating is of limited value in making immediate investment decisions. But over a period of time, CRISIL argues that it can demonstrate better performance by companies that had a higher rating.

I believe that  IPO ratings will only be meaningful under certain conditions. First, they should be independent and not paid for by companies issuing shares. Secondly, the rating agency cannot ignore the pricing factor entirely. It must at least offer a broad price band at which the offer seems worthy of investment. Without pricing indicators, the rating agencies are providing no additional value to investors.

One way to ensure independence is by having the ratings paid for by the  cash-rich Investor Education and Protection Fund (IEPF). This is a fund of over Rs 300 crore,  available with the Department of Company Affairs and is carved out of unclaimed dividends. Investor protection is the core mandate of the IEPF and rating IPO offers to ensure safer investment decisions is certainly within its domain.

Finally, IPOs must be rated only based on information provided in the prospectus and by independent sources. This will force companies to ensure complete disclosures and will provide an important evaluation tool to investors.

SEBI’s intention in attempting to provide equity ratings is noble, but it must proceed with caution to ensure a meaningful, rather than mechanical effort.

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-- Sucheta Dalal