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Rating of initial public offering: moving into uncharted territory

SEBI's new measures to protect investor interests

OF THE three major decisions taken by the Securities and Exchange Board of India on March 21 to further investor interests, the one making rating compulsory for all initial public offerings (IPOs) is intriguing and has evoked a fair amount of controversy. The other two — permitting short selling by institutional investors and insisting on greater disclosures by real estate companies entering the market — however meet specific needs of the market and in a sense are overdue.

The decision to ask for IPO rating has to be viewed against the fact that unlike debt instruments, equity (practically all new public offerings are equities) does not lend itself to easy or transparent rating methodologies. As the SEBI chairman claimed after the board meeting, the move is unprecedented in the history of capital market regulation .No developed market, in fact, has such a provision, which is bound to add to the cost of raising capital in India.

Issuers to pay

A strong case exists for reducing issue expenses drastically right from the preparation of the offer document (prospectus) to the allotment stage. Regulatory measures since the advent of SEBI in the early 1990s have in fact taken note of the disproportionately large bill that issuers of capital have to meet. At the same time, insistence on fuller disclosures, a key area of regulation, cannot be wished away.

Simplification of the offer document and incorporating its key provisions in an easy-to-read format in the application form have been major steps forward. But it is difficult to see how a rated IPO will enhance investor protection further.

However, it appears that all major investor associations have pitched for equity ratings. Initial opposition, according to them, is mainly from merchant bankers and others who are now directly involved with the public issue. Their role could be threatened by the new development.

A rating exercise is specific to a scheme or instrument. The company issuing the security is not rated. Its fixed deposit schemes, debentures and other debt instruments are. It will be wrong to read larger meanings applicable to the whole company from the rating for any of its schemes.

Debt instruments are more amenable to rating. Safety of the money invested in a particular scheme and correspondingly the company's ability to repay the debt are two of the key factors covered by the rating exercise.

Different exercise

Though by no means fool proof, rating agencies have over time acquitted themselves creditably in rating debt instruments. Although it was regulatory rules that provided the impetus for the rating of debt instruments, the fact is that the rating symbols given — triple A, double A and so on — are now easily recognised by investors.

Rating agencies will naturally have to go through the learning curve before they get a handle on rating equities. Starting with the IPO, rating of a company's equity issue is likely to be a continuous affair. Hence secondary market investors too can use the rating in their decisions.

Even granted that rating agencies can equip themselves soon, the question remains whether (a) a rating so arrived at is of much relevance to investors and (b) they will not induce a sense of false complacency among investors.

There is no way that a rating symbol will obviate the need for looking at the offer document and the various disclosures, especially in issues by new promoters. For blue chip issues, there will be no need to look at either the disclosures or the rating.

Realty sector

SEBI is on much stronger ground in asking real estate companies accessing the capital market to disclose more about the land they claim to possess. Land banks, as they are called, have been the key determinants in valuation of these companies. There has been considerable opacity about the professed extent of land holding as also the nature of ownership.

Often real estate developers include in the prospectus agreements to buy as proof of ownership. In most cases, they are at best part owners. From now on, real estate companies will be forced to disclose full details of such agreements. These will presumably be included as material contracts and open to public inspection.

One should not forget the larger picture. SEBI is already applying the brakes on some real estate companies' unrealistic valuations as the property market in the big metros is showing signs of a bubble. The Reserve Bank of India has for long been cautioning banks against reckless lending to the real estate sector. It has also asked them to treat lending to special economic zones as exposure to commercial property and incorporate more onerous terms in loan agreements.

Short selling

Short selling by institutions is an idea whose time has come. Institutions can go short if they are convinced that the price of a particular share will go down.

At lower levels, they can buy the share and square the position. This is of course the opposite of what an investor does when he is betting on a higher price: he will borrow money, take a position and hopefully come out when the price is right.

SEBI has made it mandatory for short-sellers to back their actual action by borrowing the relevant shares. That presupposes the existence of a vibrant stock lending mechanism to be operated by a depository or a custodian. Beneficial owners of the shares will of course be compensated.

Institutional short selling, according to its critics, will aggravate, not minimise, volatility and will further tighten the hold institutions have in today's share market. Like many other recent moves of SEBI, this one too will need to be examined in detail. Conceptually, however, it looks extremely sound.

C. R. L. NARASIMHAN

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