Usefulness

IPO Grading and Its (Draft Report)

Nov-2011

IPO

Under guidance of, By R Sucharita (1226110132), RP Eashwar Singh (1226110129), Ram Kandelwal (1226110131), Sayan Das (1226110134), Sailesh (1226110133),
GITAM School of International Business (Formerly GITAM Institute of Foreign Trade) Visakhapatnam- 530045

Introduction: Grading of Initial Public Offerings (IPOs) is a service aimed at facilitating assessment of equity issues offered to the public. The Grade assigned to any individual IPO is a symbolic representation of assessment of the fundamentals of the issuer concerned relative to other listed securities. IPO Grades are assigned on a five-point point scale, where IPO Grade 5 indicates the highest grading and IPO Grade 1 indicates the lowest grading, i.e a higher score indicates stronger fundamentals. An IPO Grade is not an opinion on the price of the issue, pre- or post-listing. IPO grade 1: Poor fundamentals IPO grade 2: Below-average fundamentals IPO grade 3: Average fundamentals IPO grade 4: Above-average fundamentals IPO grade 5: Strong fundamentals IPO grading has been introduced as an endeavor to make additional information available for the investors in order to facilitate their assessment of equity issues offered through an IPO. The IPO grading process is expected to take into account the prospects of the industry in which the company operates, the competitive strengths of the company that would allow it to address the risks inherent in the business and capitalize on the opportunities available, as well as the companys financial position. IPO Grading: Conceptual Issues IPO grading is a service intended to facilitate the assessment of equity issues offered by unlisted companies to public. The grade assigned to any individual issue may represent a relative appraisal of the fundamentals of that issue in relation to the universe of other listed equity securities in India. In fact, IPO grading is positioned as a service that provides an independent assessment of fundamentals to assist comparative assessment that would prove useful as an information and investment tool for prospective investors. The methodology of such grading is to

consider five-point scale with a higher score indicating stronger fundamentals. While investment recommendations are expressed as buy, hold or sell securities and are based on a security specific comparison of its assessed fundamental business strength (such as business prospects, financial position etc.) and market factors (liquidity, demand supply etc.) to its price, IPO grading is expressed on a five-point scale as stated earlier. In other words, it is a relative comparison of the assessed fundamentals of the graded issue to other listed equity securities in India. The cost of IPO grading shall be borne from investor protection funds administered by stock exchanges or from Investor Education and Protection Fund (IEPF) administered by the Ministry of Companies Affairs. SEBI would finalize necessary procedural aspects in consultation with Stock Exchanges IPO grading covers both internal and external aspects of a company seeking to make an IPO in general. The internal factors include competence and effectiveness of the management, profile of promoters, marketing strategies, size and growth of revenues, competitive edge, technology, operating efficiency, liquidity and financial flexibility, asset quality, accounting quality, profitability and hedging of risks. Among external factors, the key one is the industry and economic/business environment for the issuer. Here, it is important to note that internationally, the global rating agencies such as Standard & Poors and Moodys do not perform grading of 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 acquired another rating agency Dun & Bradstreet in 2000) also does not grade IPOs as yet. Why IPO Grading? Sometimes a company may not know whether it is performing well or not. In such a Situation, getting a grading by an independent rating agency would come in handy and may be very much valuable to companies. IPO grading is supposed to be useful particularly for assessing the offerings of companies accessing the equity markets for the first time where there is no track record of their market performance. There is no denying the fact that IPO grading will be helpful to the unlisted issuing companies provided CRAs prescribe a higher score indicating stronger fundamentals. As stated earlier, the IPO grade assigned to any issue may represent a relative assessment of the fundamentals of that issue in relation to the universe of other listed equity securities in India. This grading can help the prospective investor to make a right investment

decision. Thus, IPO grading is additional investor information and investment assistance device to enable more realistic pricing of shares and assist investors make an informed decision. Truly speaking, if investors respond better to a graded IPO, it would prove an incentive for promoters to opt for grading in future. Needless to mention, acquiring a high grading symbol could enable issuing companies command a better premium on their offer and Issuers having underlying strength can also project themselves in a better way to their prospective investors. There are various positive sides of an IPO grading. The most significant factors that go in favor of IPO grading are: (a) Professional and independent appraisal, (b) Removal of information overload, (c) impediment for weak companies, (d) improving investors sophistication. It is worthwhile to have a brief description of these issues so as to understand the objectives of IPO grading. (a) Professional and Independent Appraisal: IPO grading will create awareness about the fundamentals of the companys IPO and will provide focused company information as a key input to prospective investors that will be helpful in taking an investment decision, in a manner similar to what a credit rating is for debt investors.(b) Removal of Information Burden: Where disclosures of issues are large and complex, a service analysing and interpreting these disclosures independently and quickly will be extremely useful in cutting through the clutter. Thus, the usefulness of IPO grading would be particularly high for small investors as it will serve as a guide about the company coming out with the issue.(c) Impediment for Weak Companies: While fundamentally sound companies will gain from the market, companies whose fundamentals are not very strong will be impeded in building up speculative demand among investors. Such weak companies will need to offer pricing, which will adequately compensate investors for the risks they take. Therefore, IPO grading provides disincentives for weak companies planning to come to the market to raise easy capital.(d) Improved Investors Sophistication: It is perceived that an independent and informed opinion on the fundamental quality of the company will bring about greater level of investor sophistication in a scientific manner. In fact, investors may take investment decisions in a better way on the basis of opinion of CRAs regarding IPO grading. However, the assessment is not a recommendation to buy or not buy a stock. It is, instead, a powerful tool to assist the investors in making up their mind about the quality of a company proposing to offer an IPO investment option.SEBI Guidelines Regarding IPO Grading In exercise of the powers conferred under sub-section (1) of Section 11 of the Securities and Exchange Board of India Act, 1992, it had been decided to amend the SEBI (DIP) Guidelines,

2000. The amendment regarding IPO grading had been made on 24th April, 2006 (vide SEBI Circular No. SEBI/CFD/DIL/DIP/21/2006/24/4 dated April 24, 2006) and came into force with immediate effect. SEBI has also circulated the following amendments of IPO grading to all merchant bankers (who perform as lead managers/ intermediary in management of capital issues of primary capital market in India) as well as stock exchanges. These amendments are summed up as below: (1) Pre-Issue obligations in case of IPO grading: An unlisted company making an IPO of equity shares or any other security, which may be converted into or exchanged with equity shares at a later date may opt to obtain grading for such an IPO from one or more credit rating agencies. Where an issuer opts to obtain IPO grading, it shall disclose all grades so obtained by it, including unaccepted grades, in the prospectus and abridged prospectus.(2) Contents of the prospectus: Statement indicating whether IPO grading has been opted for. If yes, disclosure of all grades so obtained, including unaccepted grades and reference of the page number where details of IPO grading, as mentioned below, are given.(i) Name of the credit rating agency from which grading has been obtained for the proposed IPO of equity shares or any other security which may be converted into or exchanged with equity shares at a later date and the grading so obtained, including unaccepted grades. ii) If grading has been obtained from more than one credit rating agency, disclosure shall be made of all the grades so obtained, including unaccepted grades. (iii) The rationale/description of the grading/s so obtained, as furnished by the credit rating agency/ies. Factors Consider for IPO grading While the actual factors considered for grading may not be identical or limited to the following, the areas listed below are generally looked into by the rating agencies, while arriving at an IPO grade Business Prospects and Competitive Position Industry Prospects Company Prospects

The alignment between industry opportunities, the company strategy and objectives
Financial Position:

 Forward looking assessment of key financial Position, indicators such as RoE, ES, P/E, growth in profit, relevant or a equity investor.

Management Quality:

An evaluation of the ability of the management to handle uncertainty in terms of capitalizing on future business opportunity and mitigating the impact of contingencies.
Corporate Governance Practices:

An evaluation of the companys governance architecture to determine if it is structured such that the risks and rewards of business are equally available to all shareholders. Compliance and Litigation History New ProjectsRisks and Prospects IPO grading covers both internal and external aspects of a company seeking to make an IPO in general. The internal factors include competence and effectiveness of the management, profile of promoters, marketing strategies, size and growth of revenues, competitive edge, technology, operating efficiency, liquidity and financial flexibility, asset quality, accounting quality, profitability and hedging of risks. Among external factors, the key one is the industry and economic/business environment for the issuer. It may be noted that the above is only indicative of some of the factors considered in the IPO grading process and may vary on a case to case basis. IPO Grade is not: A recommendation to invest or not to invest in the graded instrument A comment on the issue price of the shares being offered, likely listing price or likely movement of price post listing. A valuation of the equity offering. An assessment of the market risk associated with equity investments. An audit of the issuer. A forensic exercise that can detect fraud.

 An opinion which has an ongoing validity. Validity The assigned grade would be a one-time assessment done at the time of the IPO and meant to aid investors who are interested in investing in the IPO. While the grading itself is valid for a period of 6 months from the date of issuance, the grading letter will have a validity of 2 months from the date of issue and would need to be revalidated subsequently- there would not be any additional charges for the revalidation. All the grading is done on the basis of one basic assumption that the market is an efficient one i.e. one where frequent trading is done without much information asymmetry. Credit Agency SEBI licensed credit rating agency in India provides research-based information for Indian investors to make the most appropriate investment decisions. These authorized rating agencies are CRISIL CARE ICRA FITCH Brickwork (BWR) There are various positive sides of an IPO grading. The most significant factors that go in favor of IPO grading are:
Professional and independent appraisal:

IPO grading will create awareness about the fundamentals of the companys IPO and will provide focused company information as a key input to prospective investors that will be helpful in taking an investment decision, in a manner similar to what a credit rating is for debt investors.
Removal of information overload:

Thus, the usefulness of IPO grading would be particularly high for small investors as it will serve as a guide about the company coming out with the issue.

 Impediment for weak companies:

While fundamentally sound companies will gain from the market, companies whose fundamentals are not very strong will be impeded in building up speculative demand among investors. Such weak companies will need to offer pricing, which will adequately compensate investors for the risks they take. Therefore, IPO grading provides disincentives for weak companies planning to come to the market to raise easy capital.
Improving investors sophistication:

It is perceived that an independent and informed opinion on the fundamental quality of the company will bring about greater level of investor sophistication in a scientific manner. In fact, investors may take investment decisions in a better way on the basis of opinion of CRAs regarding IPO grading. Although IPO grading is a novel method used to safe guard retail investors it has the following potential negative aspects, apart from the criticism already discussed:
Grading discourages small entrepreneurs as they are bound to get lower grading due to

their relatively poor background.

The cost of grading is borne by the issuer. Technically SEBI has to bear the cost of

monitoring the quality of IPOs. With grading, SEBI shares these costs with the issuers and hence grading may discourage entrepreneurs to raise equity in the public market;
Grading equities, unlike debt where the cash flows and time horizon are defined, is much

difficult as the cash flows and time horizon are not certain. To initiate the process of obtaining an IPO grade, the company first contacts one of the grading agencies. The steps involved in the grading process are as follows: The issuer shares the required information with the grading team of the rating agency
Rating agency follows up with detailed management meetings with the CEO, CFO, and

board of directors, and further follows up with subsequent site visits. The grading team prepares a detailed note and grading committee assigns the grade.
Grading agency publishes a rationale outlining the reasons for the assigned grade

Grading agency sends the grading report to SEBI, stock exchanges, and to the company.

The issuing company then discloses the IPO grade on the prospectus that it files with the RoC (Registrar of Companies).

IPO Issuing Company

On receipt of required information, discussions with companys management

Contact Rating Agency for Grading

Seeking information required for the grading

Rating Agency Prepares Assessment Report

Forwarding the details of IPO graded to SEBI/ Stock Exchanges Communicating the grade along with a report outlining the rationale to the IPO Issuing

Rating Agency Assigns Grade

The entire process depicted in figure 2 above is expected to take anywhere from 3 to 6 weeks.

International rating system There are two major credit agencies serving the Canadian marketplace: Standard and Poor's and Dominion Bond Rating Service.

STANDARD AND POORS RATING SYSTEM

Preferred Shares: Credit-Enhanced Preferred Shares: Highest Quality: Good Quality: Medium Quality: Lower Quality: Poor Quality: Suspended P-1 P-2 P-3 P-4 P-5 Suspended P-1+

The term "suspended" indicates that the issuer is experiencing severe financial or operating difficulties of which the outcome is uncertain.

IPO OFFERING PROCEDURE IN US MARKET An initial public offering procedure IN NYSE is as follows:

The very first step is the company registration. All public traded companies need to register with the concerned regulatory body; in the USA it is the Securities and Exchange Commission (SEC).

The registration demands filing public offering and other legal documents. The company prospects are to be made publicly available. The prospects should include details such as present company financials, company management, stock owners, and growth potential and potential risks.

After the registration, the company needs to tie up with investment bank(s) for the distribution of their shares. The next step is the price setting. Both the company and the investment bank come together to set a price. The price can be of lowest IPO price (traditional IPO), highest price (Dutch Auctions IPO) or of a price range.

The price is set based on the company's financial stability, past performance, growth potential and market willingness. After that the stocks are made available to broker clients and are then publicly offered to retail investors/traders and institutional clients. The stock is also registered in a centralized stock exchange (like NYSE), where it is then traded publicly on demand and supply basis.