How Important Is It To Consider The Grade Before Investing In An Initial Public Offering IPO

First, we read about an Initial Public Offer (IPO) being launched, next we hear that the issue got oversubscribed. So what gives investors, retail or institutional, enough confidence to park their money in this financial instrument? Apart from the credentials of a company bringing out the IPO, investors take into account its credit worthiness, which is denoted by its grades. So how effective are these grades in deciding the quality of an issue, let's find out.

What is IPO grading?

Before investing in an IPO, investors must know the quality of an issue as the market is awash with many poor quality and even fraudulent IPOs. IPO grade is supposed to be a measure of the strength of the fundamentals of a company. The Securities and Exchange Board of India (SEBI) introduced this grading system to protect interests of marginal investors and also to encourage research by them before investing, making full use of the disclosures made by the company at the time of IPO.

Earlier grading was optional for companies but after seeing their unwillingness to get graded, and that too at no additional cost, SEBI made grading compulsory for all IPOs from April 2007.

Salient features of SEBI decision

• IPO grading has to be carried out by a recognised credit rating agency.
• The issuing company is free to choose a rating agency to grade its IPO.
• A 5-point scale will be used for the grading, with 1 being the lowest grade and 5, the highest.
• The grading will not take into consideration the price of the issue.

How grading is done?

As of now, SEBI has four credit rating agencies registered with it – Credit Analysis & Research Ltd (CARE), ICRA Limited, CRISIL and Fitch Ratings. These agencies employ different methods or techniques and look at different parameters to grade IPOs. They consider various aspects of a company like business model, expansion plans, certainty of funding sources, market position, industry attractiveness, promoter background, corporate governance and visibility of cash flows.

Grades are then decided by comparing these aspects with those of listed companies. The grades are from 1 to 5, with each grade indicating a particular level of fundamental strength. The different grades and their indications are tabulated below:

Does a grade reflect the future performance of an IPO?

The rating agencies do not evaluate an IPO from investment point of view. Since an IPO grade does not take into consideration the price at which the company is proposing to issue its shares, it does not comment on the returns that an investor would be able to generate by investing in the issue. The IPO grading system is designed to prevent 'fly by night' operators from running away with the investors' money. We will now take a look at the performance of some of the last few public issues that have come in the market.

Table: Performance of Recent IPOs against Their Credit Ratings

As it is clearly visible from the table, there is a large variation between the returns generated by IPOs with the same grades. For example, both NHPC and OIL India earned a grade of 4 from the same rating agency Crisil, but as on Oct 28, 2009, Oil India has given a return of 7.85 while NHPC is struggling with a negative return of 14.17.

Good grades, however, seem to have ensured at least a full subscription for an issue. We can say that a better than average grade is likely to ensure high levels of oversubscription for the issue. This can be useful for retail investors for estimation of the amount that they should invest in the issue. For an issue graded 4 or 5, an investor should put in an application closer to 2-3 times the amount of exposure that he actually desires (within the maximum application amount of Rs 1 lakh for retail investors).

Bottom line

On its web site SEBI says, "An IPO grade is NOT a suggestion or recommendation as to whether one should subscribe to the IPO or not. IPO grade needs to be read together with the disclosures made in the prospectus including the risk factors as well as the price at which the shares are offered in the issue." The general perception is 'the higher the grade, the better is the IPO's prospects'. But this is not the case. This year, despite their good grades many public issues incurred losses on account of the slowdown. This underlines the fact that good grades may save investors from investing in bad IPOs, but they neither impact companies' performance post listing nor guarantee good returns, especially for small investors.