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Rediff.com  » Business » Should IPOs be rated?

Should IPOs be rated?

By BS Smart Investor Bureau
May 10, 2004 12:29 IST
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Last week there were news reports that the Securities and Exchange Board of India is planning to introduce mandatory rating of initial public offerings, a service not available on any bourse across the world.

The proposed rating will cover promoters, management record and past performance and will stay clear of making any comments on the pricing of issues.

Companies may be asked to disclose the ratings in the prospectus or the offer document. The regulator's move aims to fill the lacunae in the current IPO process by assessing companies that are in the early stages of existence. We get two experts to debate on whether equity rating should be made mandatory.

A powerful guidance tool

Sebi's proposal to make the IPO assessment available to investors is a step in the right direction.

Though the move to make IPO assessment mandatory has drawn some critical comments, the need for a tool to help investors make better-informed decisions and judge the quality of issues hitting the market is undisputed.

An IPO assessment brings four major pluses. Firstly, it improves information content through a professional and independent assessment.

Secondly, it is relief for individual investors from information overload. Thirdly, it provides disincentives for weak companies to come to the market in the hope of raising easy capital. And fourthly, it brings about greater level of investor sophistication.

Professional and independent assessment

The public issue report, which is part of the IPO assessment will provide focused company information to investors and will create awareness about the fundamental strengths and weaknesses of the company.

Dissemination of fundamental information will help investors allocate resource better. The report will be a key input in the investment decision, in a manner similar to what a credit rating is for a debt investor.

Relief from information overload

In a situation where issues are bunched in the pursuit of optimum market timing and disclosures are voluminous and complex, a service that analyses and interprets these disclosures independently, quickly and in manner that facilitates a comparative study will be extremely useful in cutting through the clutter.

The usefulness would be particularly high for small investors as it will serve as a guide on the strengths of the company coming out with the issue.

Disincentives for weak companies

Given the improved quality of information content in the marketplace after the introduction of IPO assessments, there will be a stratification of the market on fundamental lines.

Fundamentally sound companies will command commensurate valuations, while companies whose fundamentals are not very strong will be impeded in building up speculative demand among investors, and will need to offer pricing, which will adequately compensate investors for the risks they take.

Increased investor sophistication

In today's markets, with free pricing, it is just as easy to lose money on listing as it is to make it.

An independent and informed opinion on the fundamental quality of the company, along with clear and concise information, will go a long way towards making the process far more scientific. With a clear view on the quality and risk drivers of the company the investor is getting into, he can choose the level of risk he is comfortable with.

He will then take investment decisions, which reflect his outlook on factors such as product prices and input costs and are in line with his target portfolio composition. Such analysis is today beyond all but the most sophisticated investors.

The assessment is not a recommendation to buy - or not buy - a stock. It is, instead, a powerful tool to assist the investor in making up his mind about the quality of a company offered as an IPO investment option.

Rating equity offerings: Is it an oxymoron?

If you are finding it hard to make an investment decision on the various public issues being floated in the IPO market Sebi's primary market committee may have just found the answer to your dilemma.

The committee is evolving a rating concept for mandatory grading of equity offerings. Sebi will probably be the first regulator in the world to make mandatory rating of equity offerings. At present, only debt issues are rated ahead of offers.

Need for rating

The need to rate equity offerings emerges from the fact that majority of retail investors do not read the offer document and even where they do they may not fully comprehend the implications of all the disclosures made in the document.

Ratings from independent agencies are aimed at helping investors separate good floats from risky ones.

Counter arguments

However, there are several arguments against the proposal. Equity, by its very nature, isĀ  'risk investment'. 'Caveat emptor' or 'buyer beware' hold true especially for equity investments. Ratings should at no time induce investors to forget the above dictum.

Pricing of shares is the most critical factor in evaluating IPOs. By refusing to comment on pricing, the rating's value is immediately diminished. Markets do not always take the rating on its face value. For example, in the case of debt instruments, instruments with same ratings have different prices/YTMs.

Issues that need to be addressed
Before we implement the scheme we need to address the following issues:

  • Does the rating comply with the Sebi's aim of investor protection under its DIP guidelines?

  • Will investors see the rating as a regulatory approval of the offering? In fact, Sebi is moving away from an approval mechanism to a more transparent disclosure mechanism.

  • Any rating of business prospects would tantamount to a forward-looking statement. Do we need such statements in offer documents?

  • Will Sebi's approval depend on the rating outcome?

  • Will the ratings be unchanged (except for 'force majuere' circumstances) for a period of time and if so for what is that period? Will rating agencies continue to monitor the company and the rating?

  • What happens if the rating is modified during or after the IPO process? Can investors sue rating agencies?

  • What will happen if the rating is high but the subsequent market performance of the company is poor?

  • All ratings are subjective opinions of rating agencies. Should the IPO process be dependent on such subjective elements?

  • Will rating be required for offerings of companies that are already listed on stock exchanges? (Studies have shown that a credit rating upgrade or downgrade comes long after the market captures the information in the stock price.)

  • Who will bear the rating cost? Will it be the company or the Investment Protection Fund? Apart from adding to IPO costs and making companies answerable to yet another agency, the ultimate result may be of dubious value.

Since such a concept is untested anywhere in the world and yet to be fully explored it should not be made compulsory. Let companies who wish to rate their offerings adopt it and let the results indicate whether it needs to be made mandatory.

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