INTRODUCTION:

Indian capital market has witnessed a drastic development as a result of economic liberalization in the country since 1991. This includes abolishing the regulated regime under the Controller of Capital Issues (CCI) and establishing the Securities and Exchange Board of India (SEBI) as the market monitor in 1992. The technological advancements in the stock market, improved trading process, strict regulatory controls, enlarged investor base has brought a new environment of stock investment in India, likely to develop in the future also. Investors perceive Indian capital market, whether local or global, as a new investment opportunity to earn high returns. The research statistics have proven that in the Indian financial markets, equity instruments provide higher returns in long period as compared to other traditional forms of investments such as fixed deposits and gold etc.

Thus there has been a continuous increase in the tendency of investors to make investments in equity by taking more risk in order to earn superior returns from the stock market. Capital market is considered as the best opportunity to fulfill the dreams of retail investors. As the Indian economy is considered as one of the highest developing economy in the world, the investors expect the good returns in view of that. The funds from different class of investors including Foreign Institutional Investors, qualified institutional investors and retail investors is expected to increase in the future in the Indian stock market.

Along with the developments in the secondary market, the primary market has also shown the tremendous improvement in recent years. Initial public offering (IPO), also referred to simply as a "public offering", “going public” or "flotation" is when a company issues equity shares to the public for the first time. They are often issued by smaller, younger companies seeking capital to expand, but can also be done by large privately owned companies looking to become publicly traded. For the individual investor, although it is tough to predict what the stock or shares will do on its initial day of trading and in the near future since there is often little historical data with which to analyze the company, yet they are very popular among the investors. In last few years a large number of IPOs have come in the market and have been successful in attracting the investor’s attention and funds. The history of IPO under pricing in Indian stock market made IPO investment at the time of issue relatively safer for the investors also the companies perceive it as a reasonably reliable source of raising of funds in a scenario of highly volatile interest rates in the economy. At the end, the both entities are seems to be in the win-win position.

For the first time in the world, the Indian stock market regulator, Securities and Exchange Board of India (SEBI), introduced the system of IPO grading and made it mandatory for the companies going public since May 2007. This is done in order to decrease the information asymmetry between the retail investors and qualified institutional buyers (QIBs) and to protect the wealth of retail investors from the investments in low quality Initial Public Offerings (IPOs). IPO grades, which are based on the fundamentals of the companies and are supposed to indicate quality signals about the future prospects of the company’s performance and hence ensure better returns from the investments in quality IPOs. This is done to help the majority of investors so that they can make wise investments.

The need for IPO grading stems from the fact that Indian stock markets, which is still evolving, has many problems such as the relatively low rate of financial literacy of retail investors and lack of any system to differentiate the quality of entrepreneurs which has the potential to wash out the wealth of the retail investors. Moreover, there have been several instances of IPOs in the past, where companies have vanished prowling several millions of public funds. In the background of numerous instances of ‘fly-by-night’ entrepreneurs and the fear of its re-emergence, there has been a demand from some investor groups to introduce ratings for IPOs. The initial decision of IPO grading was launched as an optional one by Mr. M. Damodaran, the then Chairman of SEBI. In Dec 2005, he had announced that it would be solely at the discretion of the issuer company to grade the IPO, which would essentially be a comment on the investment-worthiness of the company, and that the regulator shall not certify the assessment made by the grading agency. It was also laid down that the cost incurred on grading the IPO can be met by the exchanges, or out of the corpus of the Investor Education and Protection Fund, the details of which were to be finalized by the regulator in consultation with the exchanges. In April 2006, subsequent amendments were made in the SEBI (Disclosure and Investor Protection) Guidelines, and it was specifically underlined that an IPO grade obtained has to be necessarily disclosed in the prospectus.

However, despite more than 40 IPOs expected to hit the market in the first half of 2006, only four companies approached the agencies for their rating. Incidentally, they did not accept the ratings awarded to them as the same did not match their expectations. Additionally, there was no incentive for the companies to rate their IPOs, leading to the emergence of a tricky situation wherein a good company did not approach a Credit Rating Agency (CRA) to get its IPO rated for the fear of getting a sub-standard rating, which they would have to incidentally mention in their prospectus. As a result, the issue might suffer, despite the strong fundamentals of the company. Also, a company with weak fundamentals would never seek to get its IPO rated for the fear that its cover ups might get exposed with a poor rating. Hence, with the purpose of bringing additional transparency to the market, the requirement was further changed to a mandatory one.

Effort is made in the study to investigate the relevance of IPO grading on the under pricing, long term returns, liquidity and the P/E ratio of the companies. For the purpose of the study, 83 IPOs are selected, which came after May 2007 through National Stock Exchange (NSE) and possess IPO grades at the time of issue. The IPO’s of different IPO grades have been analyzed in terms of under pricing, liquidity, P/E ratio and long term returns using t-test and regression analysis. The results indicate that the QIBs consider IPO grading significantly and hence also affects the overall subscription of the IPO. The listing day liquidity of higher graded IPOs is low but commands better liquidity in the long term. Long term performance of the higher graded IPO is better than lower graded IPO’s. However, the IPO Grading in not relevant in explaining the Listing Day returns. Also the IPO grading has no impact on the subscription behavior of retail investors.

LITERATURE REVIEW:

Poudyal (2008) analyzes the efficacy of IPO grading, through regression analysis study of a total of 63 IPOs that have been graded. It found that securities with higher IPO grades tend to exhibit under pricing to a lesser extent. He also found that, with higher IPO grades, the subscription rate of the IPOs improves across all class of investors, including retail investors. IPO grades are inversely related to the short term liquidity of the IPOs, i.e. at least in the short term, higher graded IPOs don’t exhibit high turnover ratio. He further found that that the IPO grade fails to explain with any significance the subsequent market performance of the issues in terms of capital gains.

Khurshed et al in their paper examined the certification role of various signals in the book built Indian IPOs they found that IPOs in India which are handled by more prestigious underwriters do not leave more money on the table than the non prestigious ones. This does not support the results of Loughran and Ritter (2001) and Ritter and Welch (2002) for US IPOs. Secondly, Indian IPOs which have VC presence have higher first day under pricing in consonance with the results of Lee and Wahal (2004). Given this positive certification by the Venture Capitalists they proceeded to investigate if the recently introduced IPO Grading process in India is able to reduce the ex-ante uncertainty and hence the first day returns. Their results suggest that as of now the IPO Grading process is not significantly able to reduce the ex-ante uncertainty and therefore there is no significant drop in the first day returns of Indian IPOs after the introduction of Grading. Further they investigated whether any of the three investor groups is making use of the Grades and found that the more informed QIB investors do invest more in IPOs with higher Grades. Their results suggest that older firms are associated with IPOs of higher grades but contrary to popular perception higher size issues are not necessarily associated with better Grades, controlling for other factors.

Carter and Manaster (1990) and Carter, Dark and Singh (1998) find that more reputed underwriters are associated with lower underpriced IPOs. Megginson and Weiss (1991) demonstrate that presence of VCs in IPOs results in reduced under pricing as well as reduced underwriting costs. Booth and Smith (1986) while postulating the certification hypothesis said that the underwriter with a reputation to protect can “certify” whether the issue price of the new security to be issued better reflects the available inside information. In the absence of such a certification, due to the potential information asymmetry between insiders having private information and the outsiders who may be over-estimating cash flows, can result in market failure as identified by Akerlof (1970). There are three tests to determine whether the certification is believable (Megginson and Weiss, 1991). First the certifying agent should have reputation at stake, second this stake should be greater than one time side payment which can be made to certify falsely and above all it should be costly for the issuer to purchase the services of the certifying agent. The cost of the certifying agent is therefore an increasing function of the importance that the issuing firm places to the resolution of information asymmetry

DATA:

For the purpose of the study, 83 IPOs are selected, which come after May 2007 through National Stock Exchange (NSE) and possess IPO grades at the time of issue.

FINDINGS AND DISCUSSIONS:

The frequency distribution of the companies with their IPO Grading is shown in Table 1. The frequency distribution indicates that most of the companies have the IPO Grade three (44.6 percent) followed by 28.9 percent of the companies having grade two and 19.3 percent of the companies with grade four and companies with grade one is lowest in number (7.2 percent).

Table 1. Frequency Distributions of the IPO Grading of the Companies

IPO Grading	Frequency	Percentage
1	6	7.2 %
2	24	28.9 %
3	37	44.6 %
4	16	19.3 %

Fig.1: Frequency Distributions of the IPO Grading of the Companies

Relating the IPO Grades with the average age of the company, it is found that in general the older companies have better IPO Grades, as shown in table 2. This is due to the reason that most of the older companies are well established and command better reputation in the market and have better IPO grades due to having good fundamentals

Table 2: IPO Grades and the Age of the Companies

IPO Grading	Average Age of the Company
1	11.83
2	14.50
3	17.11
4	18

IPO Grading and Category wise Subscription:

In Indian stock market one of the common phenomenons that exist among different category of investors is the problem of information asymmetry. As a result of this, the retail investors lose their hard earned money due to wrong selection of stocks in their portfolio. One of the important objectives of introducing the IPO Grading system in Indian stock market is to reduce the information asymmetry between the retail investors and comparatively better informed Qualified Institutional Investors and to protect the wealth of retail investors from the wrong investments in the IPOs. Hence it is necessary to analyze the response behavior of investors towards the companies coming out with IPOs with different grades. Surprisingly the response of retail investor is found to be indifferent for all the companies with different IPO Grades. The subscription of retail investors is more or less same for the companies with different IPO Grades. The purpose of IPO Grading is not completely fulfilled with respect to retail investor behavior. On the other hand the QIB subscription is increasing significantly with increase in IPO grades. To some extent same is the case with high net worth non institutional investors. The details of subscription of different categories of investors to the companies with different IPO grades are shown in Table 3.

IPO grading and the under pricing (short term returns of IPOs):

Under pricing is one of the common anomalies found in most of the countries in case of IPOs. This is due to the difference in the valuations done by the company (price band decided by the companies) and the price at which market as a whole ready to pay for buying the company’s share on the listing day. As IPO grading indicates the long term fundamentals associated with the company, it should not have any relations with short term returns. The details of listing day returns (without and with adjustment of market return) with respect to different IPO grades are shown in Table 4.

The results as shown in table 4, supports the irrelevance of IPO grading with respect to under pricing. The results indicate that IPO grading has no impact on the listing day returns. Analyzing the under pricing expressed by the discrete average returns and the market adjusted average returns provided by the companies with different IPO grades, it is found that the under pricing is same for the IPOs with different Grades. This is due to the reason the IPO grades represents the fundamentals of the company. The company with higher IPO grades has better fundamentals. Hence short term higher returns cannot be expected from them.

Fig.2 IPO grading and subscription in different categories of investors

3 Fig: IPO Grading and the Listing Day Returns.

Table 4.: IPO Grading and the Listing Day Returns.

IPO Grading	Returns on the Listing day	Market Adjusted Underpricing
1	1.29	7.04
2	8.85	8.46
3	6.85	8.05
4	8.66	8.76

IPO grading and the long term performance of IPOs:

IPO Grades indicates the strength of the fundamentals associated with the company. Hence these IPO grades can be considered as a signal for the long term investments. It is expected that the companies with better IPO grades should provide good long term returns as compared to the companies with lower IPO grading. The details of the long term returns provided by the company along with the standard deviation are shown in Table 5. The results indicate that the companies with better IPO grades definitely provide better returns in long term as compared to the companies with Poor IPO grades. Also the variations in the returns are less in case of IPOs with higher grades as compared to the companies with lower grades. These results support the relevance of IPO grading system in India.

Table 5: IPO Grading and Long term returns.

IPO Grading	Long Term Returns	Standard deviation of the Returns
1	-9.65	125.86
2	14.41	93.54
3	27.84	81.28
4	21.93	36.14

Fig 4. IPO Grading and Long term returns.

IPO Grading and liquidity on the listing day:

Liquidity of the shares on the listing day is measured by calculating the ratio of number of shares traded on the listing day by the number of shares issued by the company. The result (as shown in table 6) indicates that the liquidity of the shares of the companies with lower grading is higher as compared to the companies with higher grading. The reason of higher liquidity in case of lower graded shares may be due to high speculation and uncertainty associated with these shares whereas the investment in shares of the companies with higher grades IPO is supposed to be long term nature, hence the liquidity on the listing day is found to be low.

The valuations of the shares, measured by the ratio of list price to the book value of the share is found to be higher in case of the companies with higher IPO grading as compared with the companies with lower IPO grades.

Table 6: IPO Grades, Liquidity and Price to book value ratio on the listing day.

IPO Grading	List Price to Book Value Ratio	Liquidity On the listing day
1	2.2908	5.5188
2	2.3014	4.2624
3	3.1396	2.6093
4	4.7959	1.0861

Fig 5 IPO grading, list price to book value ratio and liquidity on the listing day.

Impact of IPO grading on IPO performance:

Finally the regression model is applied to analyze the impact of IPO grading on the variables such as overall subscription, QIB subscription, retail subscription, market adjusting underpricing, list price to book value ratio and liquidity on the listing day. The regression results are shown in Table 7

The results of table 7 indicate that the impact of IPO grades are significant on the Overall Subscription, QIB Subscription , List Price to BV Ratio and Liquidity on the listing day whereas the impact is insignificant on the output variables such as retail subscription and market adjusting under pricing.

CRITICISM OF IPO GRADING:

Having identified the benefits arising out of IPO grading, it may be worthwhile to examine the arguments leveled against IPO grading. In Indian economy, there has been an increasing scope for SMEs looking up to the capital markets for financing their capital requirements. Equity capital has been widely accepted to be the best form of ‘growth capital’ for them. Furthermore, IPO route provides the most profitable exit option for the venture capitalists. Thus, easy access to capital markets is essential for the survival of SMEs and is necessary to keep them attractive for venture capital investments. However, mandatory disclosure requirements pertaining to IPO grading would entail a fixed compliance cost for such enterprises, in addition to the expenses on underwriting and brokerage, thereby inhibiting their ability to effectively raise equity through the IPO mechanism. Thus, the additional requirement of getting IPO graded would restrict (if not deny), the access of SMEs to the capital markets on account of the additional expense incurred, coupled with the inability to establish strong fundamentals for their securities, leading to a bias against such firms.

Given the fact that the CRAs had failed to provide a forewarning to the incidents involving failure of major corporations, including the Enron fiasco and the more recent sub-prime mortgage crisis, their credibility has suffered adversely. Moreover, in the Indian context, the oligopolistic structure of CRAs, with the presence of only four players registered with the SEBI, has its own pitfalls as witnessed in the Enron debacle. A danger of similar incidents may as well be imminent in the new field of IPO grading, as no special rules are being introduced by the SEBI to prevent such incidents. Another pitfall arises from the perceived conflict of interest of these CRAs, as they are entitled to receive professional fees from the issuing firm for grading of IPOs. In the light of growing ancillary services offered by the CRAs, grades may be compromised for selling these services. Further, there are empirical evidences that CRAs receive several incentives from the issuing firm, and that there is every chance for IPO grade to be driven by the incentive structure of the issuing firm, thus strengthening the endogeneity bias surrounding IPO grading. CRAs have time and again countered these criticisms leveled against them, citing the ‘reputational capital’ theory which essentially states that the reputation of the grading agencies crucially depend upon the accuracy and veracity of its grading, but the same do not hold much water in the light of absence of stiff competition among the CRAs and lack of empirical evidences supporting the reputational theory.

Critics have also opined that IPO grades are based on the ‘fundamentals’, i.e., the past performance of the company, while the probability of a radical change in the performance is not accounted for. Thus, the quality of an IPO which has long-term implications cannot be evaluated fairly on the basis of the past performance alone. Furthermore, the concept of grading as traditionally applicable to debt instruments cannot be imported to equity issues, given the differences in the levels of risk associated with the two segments. Such a practice may lead to improper understanding of the grades assigned to IPOs, with a higher grade inducing a false sense of security among investors by subtly concealing the inherent risk factor associated with equity capital.

Another reason to dislike the proposal arises from the lack of uniformity in the methodology of grading IPOs, high subjectivity of the parameters involved and gross ignorance of certain potent factors specific to the industry. Two CRAs have a theoretical possibility of arriving at different grades for the same security, which is both understandable and comparable, thereby rendering the proposal unviable. Furthermore, given the lack of empirical evidence, it cannot be said with certainty that encapsulation of all information regarding a company in the form of a grade would be able to protect the interest of the investors at bay. Given the fact that the only measure of the success of an IPO is its performance, predicting the same prior to its listing in the form of a grade may not be a worthwhile exercise.

CONCLUSION:

The Indian stock market regulator, SEBI for the first time in the world, introduced the system of IPO grading and made it mandatory for the companies going public since May 2007. IPO grades, which are based on the fundamentals of the companies are supposed to indicate quality signals about the future prospects of the company’s performance and hence ensure better returns from the investments in quality IPOs. This was done to help the majority of investors so that they can make wise investments.

The IPO grading is found to be helpful in defining the long term performance of IPOs in Indian stock market. It is also found that the QIBs consider IPO grading significantly and hence also affects the overall subscription of the IPO. The Listing day liquidity of higher graded IPOs is low but commands better liquidity in the long term. Long term performance of the higher graded IPO is better than low graded IPO’s. However, the IPO Grading is not relevant in explaining the Listing Day returns. Also the IPO grading has no impact on the subscription behavior of retail investors.

REFERENCES:

1. Poudyal. Sanjay, Grad, 2008 ing Initial Public Offerings (IPOs) in India’s Capital Markets A Globally Unique Concept, Indian Institute of Management Ahmedabad, India.

2. Khurshed .A, Paleari .S, Pande. A and Vismara .S, IPO Grading in India: Does it add value to the book building process?, UNIBG, 2003.

3. Steven D. Dolvin and Mark K. Pyles, Seasonal affective disorder and the pricing of IPOs, Review of Accounting and Finance, Vol. 6 No. 2, pp. 214-228, 2007.

4. Lee, P.M. and Wahal, S., Grandstanding, certification and the under pricing of venture capital backed IPOs, Journal of Financial Economics, Vol.73, pp.375-407, 2004.

5. Loughran, T., Ritter, J.R., Why has IPO under pricing increased over time? Unpublished working paper. University of Florida, 2001.

6. Ritter, J.R., Welch, I., A review of IPO activity, pricing and allocations, Journal of Finance 57(4), 1795-1828, 2002.

7. Akerlof, G., The Market for Lemons: Quality Uncertainty and the Market Mechanism, Quarterly Journal of Economics, Vol.84, pp.488-500, 1970.

8. Megginson, W.L. and Weiss, K., Venture capitalist certification in initial public offerings, Journal of Finance, Vol.46, pp.879-903, 1991.

9. Booth, J.R. and Smith R.L., Capital rising, underwriting and the certification hypothesis, Journal of Financial Economics, Vol. 15, pp.261-281, 1986.

10. Carter, R.B. , Dark, F. and Singh, A. Underwriter reputation, initial returns and the long-run performance of IPO stocks, Journal of Finance, Vol.53,pp.285-311, 1998.

Received on 17.05.2017 Modified on 17.06.2017

Asian J. Management; 2017; 8(4):1057-1063.

DOI: 10.5958/2321-5763.2017.00162.7

IPO Grading	QIB Subscription	Retail Investor Subscription	Overall Subscription	Non Institutional Subscription
1	1.37	2.59	2.74	7.91
2	5.83	4.24	6.69	17.17
3	17.75	4.36	12.42	14.97
4	16.03	4.13	20.63	27.60

Dependent Variable	Independent Variable	R-Square	F-Ratio	Impact
Over all Subscription	IPO Grading	6.4%	5.5	Significant
QIB Subscription	“	10.2%	9.182	Significant
Retail Subscription	“	0.1%	0.092	Insignificant
Market Adjusted Underpricing	“	0%	0.036	Insignificant
List Price to Book Value Ratio	“	14.35	11.22	Significant
Liquidity on the listing day	“	14.5%	13.39	Significant