Sunday, October 5, 2008

The Effectiveness of IPO Grading

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?

In a recent academic paper titled Information Content of IPO Grading, the authors Saikat S. Deb and Vijaya B. Marisetty look at 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) underpricing 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."
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.

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