Effective and reliable IPO grading is difficult due to the nature of equity cash flows
Last week,Sebi Chairman U.K. Sinha said that the practice of grading IPOs has not served the purpose that it was supposed to. IPO grading,mandated by Sebi from May 2007,was expected to provide investors with an easy-to-interpret objective assessment of every IPO. It was touted as a unique certification to safeguard retail investors from the perils of IPOs and boost IPO pricing efficiency. The grade was expected to reflect on five factors relating to issuer fundamentals industry prospects,financial position,management quality,risks and prospects of new projects,and its regulatory compliance. This led to higher grades,expectedly,for the larger,relatively low-levered and profitable issuers. We found there is evidence of relatively strong demand for high-graded IPOs and relatively weak demand for low-graded IPOs. While it may be tempting to support IPO grading on the evidence of grades consistent with the firm fundamentals impacting the demand pattern,these are insufficient to prove any significant gains from its introduction. Rather,the real test for IPO grading is its ability to improve pricing efficiency and offer protection for investors wealth.
If grading helps the retail segment to make more informed IPO investments,such a role would mirror in their bidding behaviour. A positive influence could be granted if more retail investors aided by the IPO grade put in their bids with a price indication. Still better if retail investors are able to sharply distinguish future performers from their poor cousins at the IPO stage itself. Our findings from a recent study of the IPO grades suggest the following. First,the proportion of retail investors bidding for IPOs without a price indication is no different between graded and ungraded IPOs. About 62 per cent of retail investors continue to bid at the cut-off price. Second,their share of investments in poorly performing IPOs remains the same as before. These findings suggest that the retail does not display a sharper IPO picking skill owing to IPO grading.
The role of grading on its stiffer test pricing efficiency is also doubtful. Pricing efficiency is popularly measured as the discount offered in the issue price relative to its price on listing. Grading was expected to put more information into the hands of investors in a ready-to-use format. This would lead to a stronger agreement between the issuer and investors on the price,thereby reducing the need for heavy discounts on IPOs. Further,a riskier or fundamentally weak IPO,as indicated by a lower grade,may be priced at a greater discount to compensate for its incremental risk. Our findings are as follows. First,the graded issues,which are expected to have lower information problems,do not have lower discounts as compared to ungraded issues. Second,high-graded issues do not enjoy lower discounts relative to their low-graded counterparts. It appears that high graded issues,which experience stronger demand,leave more money on the table by way of discounting. Further,if grading acts as a certification for underlying issuer quality,this role would be more evident in the case of small firms and those from the nascent industries,as these firms could suffer from greater information problems in the market. Again,there is no evidence of a significant role.
It is common to argue that irrational investor demand is behind the price pop. In the face of the irrational demand argument,a key test for the role of IPO grading is whether grading helps rational investors to better prevail over the irrationals. Unfortunately,we find little evidence of this. This insignificant role of grading on IPO pricing suggests that grading has not performed its expected role as an easy-to-use certification of issue quality.
It is evident that effective and reliable IPO grading is tough due to the residual nature of equity cash flows. Inherently volatile cash flows leave IPO grading without a reliable benchmark,unlike in the case of credit ratings. This presents two inter-related problems. First,an objective grading that encompasses the issue pricing is hard to achieve. Without a comment on the issue price,IPO grading has little relevance in the Indian market. Second,the tractability of IPO grading becomes weak. Whereas the failure of credit rating can be easily spotted by defaults,post-issue IPO performance is not easy to judge,due to the volatile nature of equity. This makes it difficult to ascertain the veracity of IPO grades,and poor grading may not cause much reputational damage to the agencies. The lack of tractability may not sufficiently incentivise them to objectively assign the grades. There are wider questions on the conflicts of interest involved with an issuer-pay model,which are also reported to surround credit ratings.
The writers teach at IIM-Ahmedabad