Examining SEBI’s Edict: Mandatory to Voluntary IPO Grading

Abstract

A major landmark that took place in the history of India was Securities and Exchange Board of India’s (SEBI) resolution to make IPO grading mandatory with effect from 1 May 2007. But SEBI’s decision to make IPO grading voluntary with effect from 4 February 2014 has made researchers reexamine the impact of this verdict on underpricing. Multivariate regression analysis run on the data collected from 164 graded initial public offerings (IPOs), which are issued during mandatory grading regime (from 1 May 2007 to 4 February 2014) in the Indian capital market, reveals the efficacy of IPO grading in lowering underpricing. The implication for the naive investors is that the assessment tool dispensed by the market regulator to make splendid investor choice was actually proving its worth for them as well as for the issuer company in lowering the anomaly they face in the form of underpricing. It was concluded that graded IPOs faced lesser underpricing, thereby making quizzical SEBI’s verdict.

Keywords

Initial public offering (IPO)grading underpricing Securities and Exchange Board of India (SEBI)

Introduction

A major predicament that a company encounters when it makes itself publicly visible through an initial public offering (hereafter IPO) is the high cost of raising capital through underpricing. The issuer company makes effort in order to get rid of this phantom following it in the form of underpricing. The company going public resorts to sending quality signals and for this, many certification mechanisms are adopted including underwriter reputation (Carter, Dark & Singh, 1998), presence of venture capitalists (Megginson & Weiss, 1991), quality of board of directors (Certo, Daily & Dalton, 2001) and credit rating among others (Jacob & Aggarwalla, 2012). Credit rating, a certification mechanism very close to IPO grading, is also reported to reduce underpricing in the US market (An & Chan, 2008).

1 May 2007 witnessed a landmark in the history of Indian capital market, at the introduction of mandatory IPO grading by Securities and Exchange Board of India (SEBI), the Indian market regulator, to assist the ingenuous and unapprised investors of India, to provide an information tool in their hands and to assess the quality of offering and demarcate the poor quality IPOs from the good ones. This entire lengthy process of assessment is undertaken by experts, that is, credit rating agencies (CRA), and the cost is borne by the issuer company (Saha, 2006). Currently, there are five CRAs operating in India—CRISIL, ICRA, FITCH, CARE and BRICKWORK. Companies can opt for grading from more than one CRA but all the grades (whether acceptable to them or not) need to be disclosed in the offer document. Aim of investor protection vis-à-vis an effort to ensure rationale investment decision instead of flooding the market with useless information seems to be the underlying principle for IPO grading (Khurshed, Paleari, Pande & Vismara, 2008).

Jain and Sharma (2008) remarked IPO grading as a fruitful exercise aimed at reducing information asymmetry and information overload. It assists the amateurish retail investors by providing unbiased analysis in the form of a single letter and guarding the markets against unviable securities. Given the limited analytical ability, poor financial literacy and dearth of information available to unacquainted retail investors in Indian market, IPO grading encloses them in a shield cover against capricious promoters (Mittal, Gupta & Sharma, 2012).

Dissimilar to the above views, many critics hold IPO grading a wasteful exercise since it is not an investment recommendation for a layman (Mahajan & Anand, 2009). Lack of a standardized methodology, high subjectivity, non-accountability of CRAs, oligopoly of CRAs, non-consideration to issue price, biasness and financial burden on the issue company are some of the latent loopholes in practical implication of IPO grading (Jain & Sharma, 2008; Krishnamurti, Thong & Vishwanath, 2009). Unlike rating of debt instruments, grading of equity is much more complicated as uncertainty about the future cash flows surrounds equity offerings (Mittal et al., 2012). Small and medium enterprises (SMEs) are discouraged to float an IPO as they are destined to receive poor grades as compared to well-established and publically known large-scale enterprises (Deb & Marisetty, 2010). As reported by Mahajan and Anand (2009), IPOs with higher grades underperform than those with lower grades, hence calling for amendments in the grading process to improve its worth to be used as a barometer by investors to dump the bad IPOs and accept the good quality IPOs. Considering all the above-stated facets, SEBI took a move to transmute IPO grading from mandatory into a voluntary exercise w.e.f. 4 February 2014. The current study tries to re-examine SEBI’s verdict whether grading is a wasteful exercise, if it were so it will not result in reducing underpricing. For this purpose, the impact of grading on underpricing during mandatory grading regime is discerned in the current study.

Literature Review and Hypothesis Development

The primary market in any part of the world faces many anomalies, the prominent being underpricing (Beatty & Ritter, 1986). Issuer companies in order to save themselves from the various glitch resort to sending signals to portray their credence to investors (Signalling theory given by Certo, 2003). Many such signals espoused are underwriter reputation (Carter et al., 1998), presence of venture capitalists (Megginson & Weiss, 1991), quality of board of directors (Certo et al., 2001) and credit rating among others (Jacob & Aggarwalla, 2012). The Indian market is no exception to this quandary, and the foremost obscurity faced by issuer is underpricing. SEBI, the Indian market regulator, in line with the other developed nations put forward a remarkable change in the market by introducing the concept of grading and finally making it obligatory for the Indian companies to get their equity offerings graded before going public.

The initiative taken by SEBI in May 2007 has been successful in solving the problem of information asymmetry resulting in lower underpricing of graded IPOs. This proposition has been documented by Poudyal (2008) who found that the level of underpricing reduced for 63 graded Indian IPOs. Deb and Marisetty (2010) also remarked grading to be a valuable exercise facilitating transparency and investor protection in the capital market by finding that graded IPOs resulted in escalated demand by retail investors and reduced underpricing. Bansal and Khanna (2013) speckled the level of underpricing during grading regime. Applying logit analysis on 142 Indian IPOs issued during January 2007 to December 2011; they found a decrease in the level of underpricing in post-grading regime as compared to pre-grading period. Manjunatha and Gopi (2012) explored through survey during April 2009 to October 2011 in Karnataka that retail investors invest more confidently in graded IPOs.

However contrary to the above findings, Khurshed et al. (2008) found inability of IPO grading to lower underpricing on a sample of 47 book built IPOs tapping the Indian market from 1999 to 2008. They further concluded that qualified institutional buyers (QIB) benefit more from grading and invest prudently in high-quality IPOs than the uninformed retail investors. Book building itself was found to serve as a platform for enhancing transparency and thus it substituted the usefulness to be derived from grading process. Krishnamurti et al. (2009) conducted an in depth analysis of market efficiency in the light of mandatory IPO grading acting as a certification mechanism. Their sample included 177 IPOs issued during 1 January 2006 to December 31 2008 on which multiple regression results disclosed failure of IPO grading to reduce underpricing. Many empirical studies point towards the futility of IPO grading; hence, SEBI made it voluntary w.e.f. 4 February 2014. But this study offers cynicism on this move of SEBI by depicting a significant negative relation between IPO grading and underpricing which clearly points out the utility of IPO grading and there is no point withdrawing this novelty from the Indian capital market which has witnessed many fly-by-night entrepreneurs and scams like Satyam.

There always exists information lag between the seller and the buyer. Seller generally has access to information that the buyer does not have. In a market where a large number of sellers publicize analogous offerings, the possibility of occurrence of lemon’s problem is quite high (Akerlof, 1970), due to information asymmetry and uncertainty in the minds of the buyer. In order to avoid the adverse selection problem, investors in the capital market resort to interpreting cues from the issuer company, intermediaries, peers, media and market, to make informed judgment. Such a scenario often leads to making investors more quizzical instead of decisive. The IPO grading aims at encapsulating firm fundamentals in a single letter which speaks of the quality of the offeror as well as of the offering. Investors are nowadays more concerned with the quality of the offeror while making an investment choice because if the issuer is reputed it would honour its commitment and hence the risk of default diminishes. Such reputed companies try to reduce their cost of issue so that they are saved from the major problem, that is, underpricing. Since grading is expected to resolve the information asymmetry problem for the investors, it is expected to yield a negative impact on first-day listing returns. Hence, the following hypothesis is framed:

H₁: Graded IPOs generate a negative impact on underpricing.

Research Methodology and Data Collection

The period under study is the ‘mandatory grading regime’ wherein SEBI made compulsory for the issuer companies to obtain IPO grades before going public. The technique of multiple regression is applied on information collected from 164 graded IPOs (reduced sample due to unavailability of data) hitting the capital market for the first time from 1 May 2007 to 3 February 2014. The data are collected on different variables which are categorized into three sub-headings:

Dependent Variable

Since the study intends to analyze the impact of grading on underpricing, it is taken as dependent variable, which is calculated as the first-day closing price minus the offer price divided by the offer price (Certo et al., 2001). The data on the offer price and the first-day closing price were collected from the website of capital market.

Independent Variables

The information on IPO grade was gathered from the first page of each offer document submitted by the issuer company before going public, which was downloaded individually for each company from SEBI’s website. In order to analyze the impact of IPO grading on underpricing, five dummy variables were introduced for the five grades assigned by the CRAs (grades 1–5).

Control Variables

Firm characteristics, such as firm age and firm size, act as signals for investors. Older companies are well established and hence investors are likely to attach lower risk to them (Pugel & White, 1988). Similarly, large size of the firm implies access to more resources which is viewed favourably by the investors and reduces uncertainty about the offering (Giudici & Rosenboom, 2006). Yet another attribute, that is, a large issue size signifies a larger company to investors, who believe more safety of their funds in such companies (Kaur & Singh, 2015). To control the effect of these variables on underpricing, it is necessary to include firm age (calculated as the difference between the date of incorporation of company and IPO open date), firm size (captured through level of total assets reported for the last financial year prior to the IPO date) and IPO size (measured as the amount in ₹ million raised by the company). These variables are expected to generate a negative impact on underpricing (Chahine & Tohme, 2009; Shah, 1995).

The greater the time gap between issue close date and listing date of securities, the greater is the degree of uncertainty and risk (Chen, Firth & Kim, 2004). A positive link between listing delay (measured through number of days between the IPO close date and date of listing on stock exchange) and underpricing is expected (Chahine & Tohme, 2009; Shah, 1995). Oversubscription is found to drive underpricing in a positive direction, as higher the demand for securities, higher is the level of underpricing (Shah, 1995). The control variables were extracted from the prospectus or from the websites of Chittorgarh (www.chittorgarh.com) or capital market (www.capitalmarket.com), which serves as a reservoir of information related to Indian IPOs.

Empirical Results

Underpricing is a commonly observed phenomenon in the capital markets all over the world (Beatty & Ritter, 1986). Indian capital market is no exception to it. Table 1 reports descriptive statistics of the companies that went public for raising money through IPO. On an average, an Indian firm hitting the capital market for the first time experiences nearly 10 per cent underpricing. Some companies face huge short-run underperformance (75 per cent underpricing) while on the other extreme some firms face 32 per cent overpricing. The average oversubscription rate of Indian IPOs is 12. Oversubscription rate ranges from 0.91 to 159.40. Normally, the securities of the Indian companies begin trading within 8 to 174 days post-issue close date. On an average, it takes them 19 days to get listed on the stock market. Indian companies raise huge amount of funds through primary market, the mean of which amounted to ₹5300 million. The mean age of Indian company to go public is 15 years (5,575 days). The mean pre-IPO assets standing to the credit of issuer company is ₹23,050 million.

Table 1.

Descriptive Statistics

Variables	Minimum	Maximum	Mean
Underpricing	–0.317	0.75000	0.09394
Oversubscription	0.910	159.400	11.9383
Listing delay	8.000	174.000	19.2500
Issue size (in ₹ million)	60.00	154,751	5,295.90
Age (in days)	593.0	37427.0	5575.08
Pre-IPO assets (in ₹ million)	91.72	615,008	23,048.5

Source: Authors’ own calculations.

Table 2 reports the grade assigned to the IPOs of Indian companies by CRAs. Approximately, 12 per cent IPOs have obtained grade 1, 29 per cent IPOs have been allocated grade 2, 36 per cent IPOs have been allotted grade 3, 20 per cent IPOs designated grade 4 whereas merely 3 per cent Indian IPOs were ranked with strong fundamentals. It is worth mentioning that only five companies Coal India Limited, MOIL Limited, L&T Finance Holdings Limited, Multi Commodity Exchange of India Limited and Just Dial Limited have procured grade 5. Hence, it can be concluded that majority of Indian IPOs possess average fundamentals.

Table 2.

Grade-wise Number of IPOs

Grade	Assessment	Number of IPOs
1	Poor fundamentals	20
2	Below average fundamentals	47
3	Average fundamentals	59
4	Above average fundamentals	33
5	Strong fundamentals	05
	Total	164

Source: Authors’ own calculations.

The main objective of this article is to examine the effect of IPO grading on first-day listing returns. To accomplish this objective, multivariate regression analysis is undertaken taking underpricing as dependent variable and grading, IPO-related attributes (such as oversubscription, listing delay and issue size) and firm attributes (such as firm assets and company age) as independent variables. Regression results have been procured after complying with all its assumptions.

Table 3 reports the results of regression analysis taking underpricing as dependent variable and firm and IPO attributes as independent variables in Model 1. The variables regressed explain 52 per cent variation in underpricing. Oversubscription shows positive association with underpricing at 1 per cent level of significance, as higher the demand for securities, higher is the level of underpricing (Kaur & Singh, 2015; Shah, 1995). Similar to the results of Lee et al. (1996), the model shows a negative relation between listing delay and underpricing at 10 per cent level of significance (p-value 0.08 < 0.10). Older companies are expected to correlate negatively with underpricing. The results indicate a weak negative relation with underpricing (p-value 0.47 > 0.10). Issue size and pre-IPO assets, however, reveal an insignificant relation with underpricing.

Table 3.

Multivariate Regression Analysis Taking Underpricing as Dependent Variable

Variables	Model 1			Model 2			Model 3
Variables	Coefficients	t-value	p-value	Coefficients	t-value	p-value	Coefficients	t-value	p-value
Constant	0.05	2.47	0.01	0.10	3.26	0.00	0.09	3.17	0.00
Oversubscription	0.006	13.45	0.00*	0.006	13.80	0.00*	0.006	13.78	0.00*
Listing delay	–0.001	–1.72	0.08***	–0.001	–1.89	0.06***	–0.001	–1.79	0.07***
Issue size	–7.27E-08	–1.13	0.25	–3.58E-08	–0.54	0.58	–7.64E-08	–1.13	0.26
Age (in days)	–1.52E-06	–0.71	0.47	–7.81E-07	–0.36	0.71	–8.14E-07	–0.38	0.69
Pre-IPO assets	–1.05E-08	–0.73	0.46	–7.75E-09	–0.54	0.58	–7.20E-09	–0.51	0.61
Grade				–0.02	–2.20	0.02**
Grade 2							–0.04	–1.27	0.20
Grade 3							–0.07	–2.19	0.02**
Grade 4							–0.09	–2.60	0.01*
Grade 5							0.008	0.13	0.89
Adjusted R²		0.5253			0.5366			0.5422

Source: Authors’ own calculations.

Notes: Significant at *1% level; **5% level and ***10% level.

The impact of grading on underpricing is examined through Model 2, where grade variable is introduced whose value ranges from 1 to 5. Grading shows a significant negative relation with underpricing (p-value 0.02 < 0.05), thereby connoting that companies obtaining higher grade will depict lower underpricing on the first-day trading. Other control variables revealed similar relation with underpricing as in Model 1. The model explained 53 per cent variation in underpricing.

In Model 3, five dummy variables for IPO grade were introduced to examine the impact of grades assigned by the CRAs to the issuer companies before going public. The regression model incorporates IPO and firm attributes as control variables along with grading as independent variable, which is regressed on underpricing. Results clearly indicate that IPO with a better grade results in lesser underpricing. The level of underpricing diminishes with the assignment of a higher grade. The IPOs assigned grade 2 decreases underpricing by 4 per cent (t-value -1.27, p-value 0.20). Grade 3 IPOs lessen underpricing by 7 per cent (t-value -2.19, p-value 0.02 < 0.05). The IPOs assigned grade 4 diminish underpricing by 9 per cent (t-value -2.60, p-value 0.01). The IPOs given grade 5 fail to lower underpricing because of the very small number of companies (merely 5) in this category. The other variables, however, report similar results as in Model 1.

The results point towards the efficacy of IPO grading process as it brings substantial decrease in the level of underpricing in Indian context. A higher grade IPO, that is, grade 4 IPOs reduce underpricing more than lower-graded IPOs, that is, grades 1, 2 and 3 IPOs. These findings clearly point towards the utility provided to investors, who perceive IPO grade as a quality signal, given their limited interpretation ability, thereby making quizzical SEBI’s edict.

Conclusion

The aim of the current study is to assay SEBI’s avowal, the paradigm shift from mandatory to voluntary grading. The relevance of this move was empirically tested by examining the expediency of IPO grading in the Indian capital market. The results suggest IPO grading to be a valuable exercise which can significantly lower underpricing of Indian IPOs as Indian market is characterized by majority of uneducated retail investors who neither have the time nor the requisite analytical skills to interpret the lengthy IPO prospectus of the issuer company (Poudyal, 2008). Thus, a single digit (IPO grade) encapsulating the crux of information proves helpful for the investors to have better knowledge about the issuer company easily and precisely and assists investors in making them their own best investment advisors, as supported by the previous findings of Poudyal (2008), Deb and Marisetty (2010) and Bansal and Khanna (2013).

The financial market in any part of the world is pigeonholed by underpricing (Beatty & Ritter, 1986), due to the presence of information lag between seller and buyer. In order to make a correct investment choice, investors search for clues and grading serves to act as a quality signal for them (Signalling theory proposed by Certo et al., 2001). As evidenced by An and Chan (2008), grading was found to reduce underpricing in US economy, similarly IPO grading holds its worth in India by dwindling the major bewilderment that a company encounters while making itself visible in the public domain. A high-graded IPO generates lesser underpricing as a higher grade symbolizes quality thereby reducing uncertainty and information asymmetry problem faced by investors, hence questioning the move of SEBI to make IPO grading voluntary with effect from 4 February 2014.

The implication for the investors is that the tool they use to assess the quality of the offering actually ameliorate their judgement. The findings of the study suggest the market regulator to re-examine the verdict given the plight of naive investors who resort to grading as an assessment tool to invest in an IPO. Grading acts as a saviour for Indian investors who save them from the fly-by-night and capricious promoters.

One of the limitations of the present study is that the effect of graded IPOs on underpricing has been undertaken, as the period under study is ‘mandatory IPO grading regime’. A comparative study of graded and non-graded IPOs could depict better results. Moreover a comparison of underpricing under ‘Mandatory Grading Regime’ (from 1 May 2007 to 4 February 2014) and ‘Voluntary Grading Regime’ (from 4 February 2014 onwards) can also be undertaken as future research topic, which may provide a more vivid delineation of the utility of IPO grading. The effect of grading on only short-run performance has been examined. Further research can scrutinize the impact of IPO grading on the long-run recital of the Indian companies.

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