ARTICLE –

“INITIAL PUBLIC OFFER GRADING”

About of the author –

This article is prepared by :-

1. Rupa Agarwal

2. Anubha Singh

Both the author are 5th year students of “Hidayatullah National University, Raipur”

About the publication –

This article is published in “Corporate Law Advisory magazine”, volume 83.Its published in the
year 2008.

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Reasons for selecting the Article –

First it is the era of globalization and then Industrialization which made a boom in the birth of
new companies as well as financial opportunities in the form of IPO (Initial Public Offer),and
then the idea of grading such IPO’s came into picture, later it was made compulsory by SEBI.

This new concept become successful in the financial market as it guided many investors
to the right investments and now the faith of investors are safeguarded by SEBI too. It is very
important for us to be familiar with all the process, concepts, and grades and how to understand
them along with the demerits of this new concept. This topic gives us the detailed information
about everything relating to ‘IPOgrading’ which an investor needs to know before investing as
per IPO grades. It’s also important for us to explore new possibilities into this new concept and
to keep on making necessary amendments from time to time to save the investor’s faith.
Thus, this article can be very useful for anyone who wants to look behind the creamy layer of
IPO grading.

Background information of the Article –

This article written by Rupa agarwal and Anubha Singh on Initial public offer grading
refers to the gradation or ranking given to different IPOs in a share market based on their
performance and repayment capacities. In such a wide financial market, it is difficult for an
investor to know about different companies and then to decide which company will be better for
their investment for a secure return.

Thus, to solve these problems of investors, the separate agencies called as CRISIL,
CARE, ICRA etc, came with the idea to give different rates in numerical form ranging from 1 to
5. These ratings are given to a company for its IPO after making a detailed research on all the
vital sectors of the concerned company. The numbers from 1 to 5 allotted are known as IPO
grades.

This article deals with some basic information about IPO grading and how it is done
from research to final allotment of grades. It also gives us the amended rules that SEBI has
issued in regard of IPO grading process. The article also points out the merits of having such

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grades which helps in reducing the risk and saving of time of the investors. In short, this article
contains all the details to understand the concept of IPO grading.

Contents of the article -

In the article above mentioned, the authors have discussed a new emerging issue of
‘Initial public offer grading”, of which many people or investors are not aware of and does not
possess detailed information about the whole grading process and how it can help them in
finding a suitable IPO for a safe investment. As per the author the Indian markets have seen a
tremendous growth in the formation of new companies, which resulted in floating of new IPOs
in the share market.

The need for the IPO grading is discussed as it can help the prospective investor to make
a right investment decision, Moreover accruing a good grade for an issuing company gives it
command a better premium on their offer and issuers having underlying strength can also
protect themselves in a better way to their prospective investors.

The authors has out lined the true concept of grading which involves an independent
agency that is free from bias and with available tools for assessing the investment attractiveness
of an equity security. This has caused India to be amongst one of the most transparent and
effective capital markets in the world. The idea is that IPO grading will help the investors to
better appreciate the meaning of the disclosure in the issue documents, collapsing all of the
complex information into one single digit.

The authors have explained the whole procedure of grading in detail with the name and
work done by these grading agencies. There are mainly four credit rating agencies in India viz:-

1. CRISIL ( Credit Rating Information Services of India Limited )

2. CARE ( Credit analysis and research limited )

3. ICRA ( Investment information & credit rating agency of India limited )

4. FITCH India rating agency.

The grades given by such agencies do not have any ongoing validity.

The steps taken by a company to get itself rated by such agencies are:-

Step 1. The company needs to first contact one of the grading agencies and mandate it for the
grading exercise.

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Step 2. The CAR would then follow the process to seek information required for grading from
the issuing company. Then such information and reports collected are sent to the concerned
committee which discusses all relevant issues and assign a grade. It takes 3 – 4 weeks ideally to
complete the process.

Credit rating agencies have to forward the names and details of the IPOs graded by them
on the monthly basis to SEBI/stock exchanges for uploading on their web sites for the public
information. A company which has opted for IPO grading, does not have a choice in accepting or
rejecting the grade, however they can further go in for a new grade with the grading given to
them previously in their prospectus.

The ‘grading’ is given in an overall assessment of fundamentals on five point scale from
grade 5 to grade 1. These grades are explained as:-

IPO grade 1: poor performance.

IPO grade 2: Below average fundamentals.

IPO grade 3: Average Fundamentals.

IPO grade 4: Above strong fundamentals.

IPO grade 5: strong fundamentals.

The author through this article pointed some important SEBI guidelines regarding IPO
grading which are made by SEBI (disclosure and investor protection) guidelines, 2000 were
amended with SEBI circular no. SEBI/CFO/DIL/DIP/21/2006/24/4 dated 24th April, 2006.

These amendments are summaries up as:-

• Pre-issue obligation in case of IPO grading – An unlimited company making an IPO of

any security which may later be converted into equity shares may opt to obtain grading.

• Contents of the prospectus – the company opted for grading must show all its grades
obtained in its prospectus even if it’s unaccepted once.

Benefits of IPO grading – the author in this article pointed out some very interesting
benefits of having an IPO graded. They are as following:-

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• Professional and independent appraisal – IPO grading will create awareness about the
fundamentals of the company’s IPO and will provide focused company information as a
key input to the prospective investors that will be helpful in taking an investment
decision.

• Removal of information burden – when disclosures of issues are large and complex, the
grading process can make it quickly cutting through the clutter. Thus, IPO grading will
particularly be helpful for the small investors as it will serve as a guide for them of the
new company coming out with the issue.

• Impediment for weak companies – companies which are fundamentally not very strong
will be impeded in building speculative demand among investors, such weak companies
will need to offer pricing, which will adequately compensate investor’s risk.IPO grading
provides disincentives for weak companies to come to the market for easy finance.

• Improved investors sophistication - It can help an investor in making his mind as CRAs
do not force an investor to buy but it provides scientific reasons for the investor to take a
concrete decision based on the IPO grading.

In the concluding sentences the author has summarized the whole article into
few lines stating that IPO grading only focus on assisting the investors, particularly retail
individual investors, to take an informed investment decision about the IPO before
putting in money. Grading of IPO is a tricky affair as it could give a false sense of
security to the public. However, there is close watch of SEBI on safeguarding the
investor’s interest by increasing disclosure levels.

For a fact there are certain investors who do not read the whole offer document
or even if read, not aware of all the disclosures made in the document by the issuing
company. Even in such a case, the IPO grading can save some investors from suffering
losses from a bad issue. An IPO grading is merely a snapshot of the fundamentals of the
company issuing.

The helping hand provided by SEBI to investors by making IPO grading

mandatory for equity shares does not leave any boundaries for an investor to stop

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 investing in any company. The author in the last lines also pointed out the need of some
separate body to regulate and control such CRAs, because SEBI is an independent body
and has nothing to do with the CRAs along with introduction of some penalty for the
breach of conduct by these agencies. As per the IPO grading is concerned it is only to
help an investor in making his decision but the final call is with the investor only to go
with such grades or to relay on his independent research.

Reviews of the article –

Grading of IPOs in terms of their fundamental quality will be enable investors

steer clear of unsound offers. Grading of IPOs of shares by the companies was something
necessity for the Indian market. Thus, it was made mandatory by SEBI for every issuing
company to opt for grading process. What has always ailed the IPO market in India in the
predominance of poor quality IPO’s and their mixing of with bad ones. Hence, if the good
quality can be segregated from the bad once then it would be a real help for the investors. The
subscribers to IPOs have suffered huge losses in those cases where they UN knowingly
purchased poor quality, bogus or even fraudulent issues. There was no determined punishment
to the fraudsters, given our weak legal system. The IPO grading system tackles these problems.

The article above give is a very brief introduction about the IPOs and its grading
process. The author has focused in covering up all the complex information about the IPO
grading concept through this article. However, there are some important information and points
of argument which are neglected in this article. In my review, I have tried to cover up all the

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loopholes of this article. The author has given a very good introduction about the IPO grading
and its needs with its procedure and process. But one of the points of argument is:-

The IPO grades given are from 1 to 5.if the investor wants to invest in a two
companies and both the companies gives the same return, he is confused and he takes the help of
IPO grading to find out that both the companies are having a same grade (e.g. IPO grade 5).
Then how will the investor decide on which neither IPO to invest for, nor the grading can help
him in making is mind. So the IPO grading may sometimes fail to convince the investor and it is
the investor’s final call on decision to choose between the two investments. This condition is an
exception to IPOS grading.

The author has also mentioned the merits of IPO grading for an issuing company
as it gives better command on premium for their new issues. But this merit of company may turn
harmful for the investors as an issuing company with a good IPO grade can ask for a higher rate
of premium which the investors are forced to pay if they are looking for a better investment
option. In this way an issuing company which has a good IPO grade can exploit the investors
through higher rate of premium on their shares. Moreover, there are some questions which are
not answered and information omitted or not covered in this article. Inclusion of this information
makes the article more informative and clears any doubts arising in the mind of readers.

These points are:

1. How is IPO grading different from an investment recommendation?

Investment recommendations are expressed as ‘buy’, ‘hold’ or ‘sell’ and are based on an
assessment of the fundamental factors, the current pricing of the security and the likely
appreciation on price over a specific time horizon. Thus, investment recommendations carry out
a detailed evaluation of the ‘market factors’ (liquidity, demand supply, valuation etc.) as well. On
the other hand, IPO grading is a relative comparison of the assessed fundamentals of the graded
issue and does not take cognizance of the price of the security, its valuation compared to peers or
the possible gains over a specified time period. Rather, it is designed to be only an additional
input to the investor in his decision making process.

2. If the IPO Grading is not commenting on the price or valuation, how

Does it help the investor?

The IPO grading is a comment on the “fundamentals” of the company being graded. All other
things remaining equal, an entity with stronger fundamentals and better growth prospects should
be able to generate higher shareholder returns related indicators in the long run.

3. For how long would the assigned grade be valid?

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The assigned grade would be a onetime 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. ICRA however reserves the right to change the grading
after the same has been assigned should the circumstances so warrant.

4. What are the deliverables of the Grading exercise?

For the IPO Grading exercise, the deliverables are the Grade itself and a rationale (which is
published) highlighting ICRA’s key observations against each of the parameters listed in the
section 6 above. The IPO Grading along with the rationale will be disclosed in the Red Herring
Prospectus (RHP). Accordingly, the company is required to obtain the grading prior to filing of
RHP with Registrar of Companies and disclosure of the same has to be ensured in the RHP.

5. I am an issuer. By when am I required to obtain the grade for the IPO?

IPO grading can be done either before filing the draft offer documents with SEBI or thereafter.
However, the Prospectus/Red Herring Prospectus, as the case may be, must contain the grade/s
given to the IPO by all CRAs approached by the company for grading such IPO. Further
information regarding the grading process may be obtained from the Credit Rating Agencies.

6. Who bears the cost of the IPO grading process?

The company desirous of making the IPO is required to bear the expenses incurred for grading such
IPO.

7. Is grading optional?

No, IPO grading is not optional. A company which has filed the draft offer document for its IPO
with SEBI, on or after 1st May, 2007, is required to obtain a grade for the IPO from at least one
CRA.

8. Will IPO grading delay the process of issue?

IPO grading is intended to run parallel to the filing of offer document with SEBI and the
consequent issuance of observations. Since issuance of observation by SEBI and the grading
process, function independently, IPO grading is not expected to delay the issue process.

9. Does IPO grading consider the price at which the shares are offered in the issue?

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No. IPO grading is done without taking into account the price at which the security is offered in
the IPO. Since IPO grading does not consider the issue price, the investor needs to make an
independent judgment regarding the price at which to bid for/subscribe to the shares offered
through the IPO.

10. Where can I find the grades obtained for the IPO and details of the grading process?

All grades obtained for the IPO along with a description of the grades can be found in the
Prospectus. Abridged Prospectus, issue advertisement or any other place where the issuer
company is making advertisement for its issue. Further the Grading letter of the Credit Rating
Agency which contains the detailed rationale for assigning the particular grade will be included
among the Material Documents available for Inspection.

11. Does an IPO grade, which indicates ‘above average or strong fundamentals’ Mean I
could subscribe safely to the issue?

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.

12. What is the role of SEBI in IPO grading exercise?

SEBI does not play any role in the assessment made by the grading agency. The grading is
intended to be an independent and unbiased opinion of that agency.

13. Will IPO Grading given by CRAs be a parameter for SEBI to issue its observations?

The grading is intended to be an independent and unbiased opinion of a rating agency. SEBI
does not pass any judgment on the quality of the issuer company. SEBI’s observations on the
IPO document are entirely independent of the IPO grading process or the grades received by the
company.

14. Will IPO Grading given by CRAs be a parameter for SEBI to issue its observations?

The grading is intended to be an independent and unbiased opinion of a rating agency. SEBI
does not pass any judgment on the quality of the issuer company. SEBI’s observations on the
IPO document are entirely independent of the IPO grading process or the grades received by the
company.

15. As on date the following four credit rating agencies are registered with SEBI?

a) Credit Analysis & Research Ltd (CARE)

http://www.careratings.com/

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4th Floor, Godrej Coliseum,

Somaiya Hospital Road,

Off Eastern Express Highway,

Sion (East),

Mumbai 400 022.

b) ICRA Limited

http://icra.in/

1105, Kailash Building 11th Floor,

26, Kasturba Gandhi Marg

New Delhi-110 001

c) CRISIL

www.crisil.com/

CRISIL House

121-122 Andheri Kurla Road

Andheri (East), Mumbai – 400093

d) FITCH Ratings

http://www.fitchindia.com/

Fitch ratings India (P) Limited

Apeejay House, 6th Floor

3, Dinshaw Vachha Road,

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Church gate, Mumbai 40002

This article also gives us information about the latest amendments made by SEBI
regarding the IPO grading through circular no. SEBI/CFD/DIL/DIP/21/2006/24/4 dated 24th
April, 2006. The article has reflected all the merits of SEBI’s amendments, but failed to mention
the critics against SEBI.

The main criticism voiced against SEBI’s decision has been that it excludes the issue
price from the scope of grading. The critics have argued that the issue price is a crucial factor in
determining the worthwhile of an IPO from the investor’s viewpoint. However, it can also argue
that the reasonability of the price itself depends on the IPO’s fundamental quality. Determining
the quality is a complex job beyond the competence of most investors. That is why so many poor
quality and even bogus IPO’s get subscribed. Grading of IPO’s in terms of their fundamental
quality will enable investors steer clear of unsound and fraudulent IPO’s. Such IPO’s are likely
to be restrained by the grading system as they will be in the bottom grade of 1 and 2.

In a recent academic paper published in “social science research network” on October 1, 2008
the authors:

1. Saikat S. Deb (Deakin University - School of Accounting, Economics and Finance)

2. Vijaya B. Marisetty (Monash University)

Had a research on “the effectiveness of IPO grading in increasing the quality of the
capital markets”. The abstract reads:

"IPO grading, similar to credit rating, is an assessment of the quality of initial equity offers in a
scale of 1 (worst) to 5 (best) by independent credit rating agencies. Indian stock market regulator
(SEBI), for the first time in the world, introduced such certification mechanism and made it
mandatory. We test the efficacy of this unique certification mechanism which is more direct
measure of IPO quality than the other proxies used in existing IPO studies. Using data of 159
IPOs, during pre and post grading period, we find that:

(1) Under pricing of IPOs is lower in the post -grading regime;

(2) Retail investors respond to the IPO grading quality: retail investors show more interest on
better quality IPOs;

(3) Post issue results indicate that high quality or better graded IPOs attract higher liquidity and
exhibit lower risk. Our findings have a useful implication: in markets where institutions are less
developed and retail participation in IPOs is more, regulators role to signal the quality of an IPO
adds value to the market welfare."

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While the role of credit rating agencies in the subprime crisis has come under fire, the results of
this study provide a more optimistic outlook as to their role in the Indian IPO markets.

GENERAL OBLIGATIONS OF CREDIT RATING AGENCIES

Code of Conduct

13. Every credit rating agency shall abide by the Code of Conduct contained in the Third
Schedule.

Agreement with the client

14. Every credit rating agency shall enter into a written agreement with each client whose
securities it proposes to rate, and every such agreement shall include the following
Provisions, namely:-

(a) The rights and liabilities of each party in respect of the rating of securities shall be defined;

(b) The fee to be charged by the credit rating agency shall be specified;

(c) The client shall agree to a periodic review of the rating by the credit rating agency during the
tenure of the rated instrument;

(d) The client shall agree to co-operate with the credit rating agency in order to enable the Latter
to arrive at, and maintain, a true and accurate rating of the client’s securities and shall In
particular provide to the latter, true, adequate and timely information for the purpose.

(e) The credit rating agency shall disclose to the client the rating assigned to the securities of the
latter through regular methods of dissemination, irrespective of whether the rating is or is
Not accepted by the client;

(f) The client shall agree to disclose, in the offer document;-

(i) The rating assigned to the client’s listed securities by any credit rating agency during the
Last three years and

(ii) Any rating given in respect of the client’s securities by any other credit rating agency,
Which has not been accepted by the client?

(g) The client shall agree to obtain a rating from at least two different rating agencies for any
Issue of debt securities whose size are equal to or exceed rupees one hundred corers.

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Monitoring of ratings

15. (1) every credit rating agency shall, during the lifetime of securities rated by it continuously
monitor the rating of such securities.

(2) Every credit rating agency shall disseminate information regarding newly assigned ratings,
and changes in earlier rating promptly through press releases and websites, and, in the case of
securities issued by listed companies, such information shall also be provided simultaneously to
the concerned regional stock exchange and to all the stock exchanges, where the said securities
are listed.

Disclosure of Rating Definitions and Rationale

18. (1) every credit rating agency –

(A) Shall make public the definitions of the concerned rating, along with the symbol and,
(b) Shall also state that the ratings do not constitute recommendations to buy, hold or sell any
Securities

(2) Every credit rating agency shall make available to the general public information relating to
the rationale of the ratings, which shall cover an analysis of the various factors justifying a
favorable assessment, as well as factors constituting a risk.

Conclusion –
On April 30, 2007, the SEBI (Disclosure and Investor Protection) Guidelines were
amended to introduce the novel concept of IPO grading. Following the insertion of clause 2.5A,
companies going in for an IPO are required to obtain grading from at least one credit rating
agency. Further, all grades obtained are required to be disclosed in the prospectus or red herring
prospectus along with the rationale furnished by the credit rating agency.

How effective has this measure been?

Has it assisted investors in making a more informed decision while investing in IPOs?

All these questions have been discussed in this article. The quantitative of IPOs has to
include factors such as business prospects of the company and the industry, company’s
competitive strength, management’s competence and integrity. Quality of corporate
governments, reliability of the companies and audit system also adds to its fundamentals. In this
article where we have seen so much information given on IPO grading, we all neglected the role
of the merchant bankers whose primary role is to act as a bridge between the issuer company and

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the investors. The main role of a merchant banker is to increase the investor’s confidence in the
primary market as well as in the issuing company.

For rating agencies, the grading of IPOs is a very different cup of tea. While the
technique for rating debt securities is well-established that for grading IPOs has yet to be
conceptualized, then tried out and refined on the basis of experience gained over time. To speed
up this evolutionary process, the basis on which a particular grade has been assigned to an IPO
should be made public. All the factors which have been taken into account and the weights
attached to each should be disclosed. This will help stimulate discussion and lead to refinement
of the grading method. In all likelihood, the different rating agencies will be using different
methods for IPO grading. They will quickly learn from each other if all of them are required to
publicly disclose the basis of grading.

However, IPO grading cannot be as finely tuned as credit rating which has lot of nuances.
This is basically because credit rating tries to measure the downside risk, that is, the risk of
default by the borrower. On the other hand, the focus of IPO grading has to be primarily on the
possibility of upside gain, both immediate and long term, in the form of price rise of the shares
being issued. Even while rating debt instruments, the credit rating agencies do evaluate the
qualitative aspects of the businesses concerned. They have thus accumulated a wealth of data of
companies rated by them across all kinds of industries. The ready availability of such data will
help in the grading of IPOs and speed up the process.

Most IPOs are like a dark horse about which very little is known. Their grading on the
basis of fundamental quality will eliminate the worst of them. We can reasonably hope that IPO
grading will make the primary market a more orderly, cleaner, and safer place for the investors
than it has been doing so far. At last as I said earlier “it’s the final call of an investor to invest
anywhere as per his/her willingness”

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