Failing the test

Grading of IPOs blurred the distinction between risks and return and damaged
the primary market

By Mohan Sule

What is the best way to guide investors about the choices they are faced with: More regulations or more information? This question is once again in focus following the decision of the Securities and Exchange Board of India to scrap compulsory grading of IPOs. Failure of several highly-rated issues to appreciate significantly is hinted as a trigger. What is known is the reason for making the process mandatory in 2007. Mainly it was to distill all the information about the company into easy-to-understand ranks, which were supposed to alert the retail investor about the fate of his investment going ahead. Yet, the move did a disservice to this class of subscribers. By instituting categorisation, Sebi unwittingly equated equity investment with bonds and debentures. In one stroke, grading blurred the difference between risk capital and guaranteed-return capital. The capital gain or loss on equity is proportionate to the risk taken unlike the concern for security of capital in a debt instrument. Higher grading of debentures denoting safety of investment means the return would be modest, while low-rated junk bonds have to offer higher coupon to attract investors. Equity issuers, on the other hand, used higher grading to slap a steep premium, thereby restricting the scope for appreciation, leading to the failure of the system.

The hike in maximum investment ceiling per issue up to Rs 2 lakh was undertaken to enable small investors to bid for pricey offerings and ensure allotment in oversubscribed ones. It could also be a covert nudge by the market watchdog to contemplate the investment carefully. Hence, grading was becoming redundant as an informed class of indidual investors was making its presence felt. Also, issuers’ dependence on small investors is gradually ending as nearly 65% of the issue is reserved for institutional investors and high networth investors. A few retail investors subscribing at the maximum permissible limit can easily fill the remaining gap, thereby nudging out the very small ones. Various other steps have been initiated to make the fund-raising process quicker for issuers and relatively less risky for small investors. Private placement with qualified institutional investors is proving to be a cost-effective way to sell the issue, bypassing the expensive primary market route. Another is the buyback of shares at offer price if the post-listing price falls 20% in three months. Post September 2008 global financial-market meltdown, investors are increasingly becoming risk averse. Many mid and small caps have been impacted by the resultant economic slowdown and have failed to translate the potential seen during the IPO debut into reality. As a result, attention has shifted to large caps. These, however, enjoy rich valuation due to the interest shown by foreign investors. Thus, the primary market is more or less shut for mid and small cap issuers, with small investors shifting to fixed-income instruments. All these factors could have contributed to the regulator’s realisation that grading of IPOs has had its day.

Will the elimination of an important guide to investment deter the small investor from entering the primary market? On the contrary, the measure has to be applauded because investors will now have to study the red herring draft prospectus carefully. Those who come into the market will be aware of the pitfalls and not demand ridiculous safety nets. Investors with different views on the issue will be present. Some may want to exit on listing, while many will be in for the long haul. It will cut on the expenses of issuers and shake off the fear of small but promising firms about getting good grades. Hopefully, IPO grading will be not the last of the poorly-conceived regulations that the market watchdog will rescind. Other norms that need a rethink include proportionate allotment and delisting. Discarding the upper pricing band and retaining the floor will increase retail participation due to improved allotment. At the same time, it will solve the problem of oversubscription as well as get appropriate pricing for the issuer. It will discourage high bidding on worries about low post-listing gains. Reverse book building allowed some minority shareholders to exercise a disproportionate influence on the process. Moreover, companies can discard the discovered price, making a mockery of the objective of safeguarding the interest of the minority shareholders. In the new Companies Act, a valuer will determine the exit price. This is similar to what happens during mergers and acquisitions: the premium or discounting paid by the acquirer is a function of the outlook for the company and industry. Hopefully, the revised edition enmeshing the existing and new version will be able to aid both companies and the minority shareholders.