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IPO Grading in India: Does it add value to the bookbuilding process?

Arif Khurshed Manchester Business School

University of Manchester (arif.khurshed@mbs.ac.uk)

Stefano Paleari

University of Bergamo (Stefano.paleari@unibg.it)

Alok Pande

Indian Institute of Management Bangalore (alokp05@iimb.ernet.in)

Silvio Vismara

University of Bergamo (silvio.vismara@unibg.it)

Abstract

India has the unique distinction of demonstrating its IPO bookbuilding process to investors. In the context of this backdrop, we analyze the certification role of the newly introduced mechanism of Grading, for bookbuilt IPOs in India. We find that, Grading does not affect the underpricing of bookbuilt IPOs. We test other certification mechanisms like reputation of investment banker and presence of Venture Capitalists and find that although reputation of investment banker does not matter in India, the presence of Venture Capitalists is mildly associated with higher underpricing. We also find that while Grading was meant for the retail investors, it is being made use of by the informed institutional investors in India. We conclude that the transparency of the bookbuilding process offers a much stronger signal to the retail investors as compared to that provided by Grading1.

JEL Classification: G11, G15, G18

Key words: Grading, certification, IPOs, bookbuilding, underpricing

1 The authors thank officers of Securities and Exchange Board of India (SEBI), Vidhu Shekhar and Sunil Gawde (National Stock Exchange of India), Saurabh Vijayvergia, Abhishek Goel and Aseem Goel (DSP Merrill Lynch), Kaushal Shah and Prateek Diwan (Kotak Investment Banking), Arun Panicker (CRISIL), Prithvi Haldea (PRIME Database) and M.T. Raju (Indian Institute of Capital Markets) for their help with details of the institutional features of the Indian IPOs. Alok Pande wishes to acknowledge the financial support received from the University of Bergamo.

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1. Introduction

While debt grading is a universally pervasive concept in the world of finance, equity

grading is a relatively unknown concept which has not been tried anywhere, to the

best of our knowledge. In this paper, we analyze the possibly first application of

equity grading. A number of agencies in the private domain carry out equity ratings

and provide buy, hold, sell recommendations to investors. However a Grade which

just signifies the “fundamentals” of the firm with respect to the listed peers without

any investment recommendation and is carried out compulsorily, by an independent

agency, is a unique feature of the Indian regulatory set up. In India, the Initial Public

Offerings (IPOs) coming to the market are compulsorily graded on a scale of 1 to 5

by regulation with 1 signifying poor fundamentals and 5 signifying very strong

fundamentals. The rating agencies in India claim that the grade is not a

recommendation on the “price” of the IPO or a buy, hold, sell recommendation. We

try to find out whether this unique concept of grading adds any value to the issuers,

investors and the regulators for book built IPOs.

Historically, India was a regulated economy and there were no Institutional players

in the capital markets. This was because the economy was tightly controlled by the

Government and there was little incentive for the private sector to set up banks,

mutual funds and other financial institutions. In such a scenario, the retail investors

were the only source of funds for firms who wanted to go public. Gradually as the

economy liberalized, and the Institutional players became important, there were

some compulsory allocations to be made to Institutional players. However the retail

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investors continued to receive the attention of the regulators in terms of protection of

their interests. Recently, the IPO Grading exercise is also an attempt to ensure that

the retail investors have some “information” about the fundamentals of the firms

going public. We discuss in detail the Institutional features of Indian IPOs in section

2. Testing for certification by grading in India is also motivated because of the

absence of underwriter discretion in the allotment of shares. The absence of

underwriter discretion theoretically means that the informed investors (Institutional

investors) cannot get any favourable allocation from the underwriters. Therefore

there is no incentive for them to reveal their private information about the pricing of

the IPO. However there is another regulatory feature unique to the Indian IPO

market. The Indian bookbuilding process is transparent and each category of

investors can see the demand patterns of other category of investors. Therefore if the

informed investors do not invest in an IPO so can the uninformed investors and

hence the IPO could fail. Surprisingly, though, there are very few IPOs that have

failed in India before the adverse market conditions of 2008 set in. This implies that

the institutional investors see some merit in investing in Indian IPOs. It is therefore

important to investigate whether the certification provided by IPO grades is

important for the investors or not.

The role of certification in Initial Public Offerings (IPOs) is important because of the

information asymmetry between the issuing firm and the investors. Unless the

certification is credible, the investors are going to pay a lower price to the firm for

having an informational advantage over them. Prior literature in IPOs finds

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certification by 2 main intermediaries - Investment bankers and Venture capitalists

to be credible. 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 underpricing 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.

The role of certification mandated by regulation on the IPO pricing and allocation

process is not clear in previous literature. We demonstrate the certification role by an

unbiased entity mandated by regulation. The unique contribution of our paper is in

the demonstration of a hitherto unknown system of grading equity which is

mandated by regulation for the benefit of small investors. This is in sharp contrast to

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the IPO systems of the US and the UK where the Institutional investors are favoured

and there is no information content for retail investors to make informed investment

decisions.

In order to verify the certification role of IPO Grading in India, we first check the

certification provided by the Investment Bankers and the Venture Capitalists (VCs)

in the Indian IPO market. We find that more reputation of the Investment Banker

does not affect the underpricing levels. However firms which have VC presence at

the time of going public, experience higher first day returns in India. In contrast we

find that the IPO Grading process does not affect the first day returns in India. Our

investigation shows that this is because of the transparency of the bookbuilding

process in India which provides superior information to the investors.

2. Quality signals in raising capital

Certification in IPOs has been studied primarily for underwriters (Carter, Dark and

Singh, 1998) and Venture Capitalists (Megginson and Weiss, 1991). Carter, Dark and

Singh(1998) found that reputable underwriters lead to lower underpricing. Prior to

this, Carter and Manaster (1990) found that firms with lower risk select an

underwriter with high reputation to signal their quality, with underwriters

reputation signalled by their position in “tombstone” advertisements. Barry et al

(1990) obtain a negative correlation between Venture capitalists (VCs) ownership in

a firm, the time spent by them in the boards of firms and the number of VCs

investing in a firm with the first day returns. This leads them to conclude that VCs

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provide a good monitoring role in the firms in which they invest. While Megginson

and Weiss (1991) found that the presence of VCs reduces underpricing, Lee and

Wahal (2004) demonstrate that the presence of Venture Capitalists actually increases

underpricing. This is because of the endogeneity involved- larger underpricing in a

particular industry increases subsequent VC funding in that industry and also

increases the reputation of the VC concerned in the market. The timing of the IPOs

studied is also important. While Barry et al (1990) study IPOs in the 1978-87 period,

Megginson and Weiss (1991) do so for the 1983-87 period. In contrast, Lee and Wahal

(2004) study all IPOs between 1980 to 2000.

An analogy to the certification role of external agencies is that of the role of credit

rating agencies. A credit rating agency gives its opinion on the credit risk involved in

investing in a firm or a security. In the recent global meltdown, the role of such

agencies has come under scanner. Even earlier, the credit rating agencies continued

to rank Enron as a good credit risk company till 4 days before the company declared

bankruptcy (Securities and Exchange Commission, 2003).

(Still to be completed)

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3. Institutional features of the Indian IPO market

The Indian IPO market is regulated by Securities and Exchange Board of India (SEBI)

since 1992, when the tightly regulated economy of the country was liberalized in

response to a Balance of Payments crisis. The year 1992 stands out as the watershed

year in India’s economic history and reforms in the capital markets were a natural

part of the broader policy reform. Prior to 1992, the primary issue market was

regulated by the Controller of Capital Issues (CCI) which also determined the

pricing of the issues. In the CCI regime the new firms had to issue equity at par

whereas already existing firms with substantial reserves could issue equity at

premium. In 1992 the Capital Issues (Control) Act was abolished and therefore the

control on pricing of issues came to an end. SEBI issued the first set of Disclosure

and Investor Protection (DIP) Guidelines in 1992, subsequently the second set was

issued in 2000. The DIPs as amended from time to time spell out the regulatory

framework for the IPOs in India.

The two main exchanges in India are the National Stock Exchange (NSE) and the

Bombay Stock Exchange (BSE). There are 20 regional stock exchanges but the trading

activity in such exchanges is very low. The BSE became a fully demutualized

corporate entity on 19th August 2005. It is one of the oldest exchanges in the world

having been established in 1875 as “Native shares and stock brokers association”.

The NSE was incorporated in 1992 as a fully demutualized entity although trading in

the equity segment started only in 1994.

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3.1 The book building process in India

Currently a firm going public in India, has the option to choose either the book

building mechanism or the fixed price mechanism at the time of the IPO. Although

book building procedure started to be used in India only in 1999, it rapidly gained

popularity and presently more than 85% of the IPOs use the book building method

as shown in the table below.

Table1- IPO activity (using the bookbuilding mechanism) in India for the years 1999-2008(August)

Year < INR 1billion INR 1 to 5 billion > INR 5 billion Bookbuilt IPOs As a % of all IPOs

1999-00 1 3 1 5 9.8

2000-01 10 1 11 10.09

2001-02 1 1 16.67

2002-03 1 1 2 33.33

2003-04 2 4 1 7 38.89

2004-05 6 5 4 15 65.22

2005-06 25 27 3 55 70.51

2006-07 36 23 10 69 86.25

2007-08 33 27 14 74 86.05

2008(April to August) 8 3 1 12

Total 114 91 34 251

In book-built IPOs, the firm going public first selects its Investment Banker who is

also called the Book Running lead manger (BRLM). The BRLM first files a Draft

Offer document with the regulator which is called the Draft Red Herring prospectus

(DRHP). This draft document has to be filed by the firm with the regulator at least a

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month before filing it with the Registrar of Companies (ROC). If the regulator

advises certain changes in the draft document then the firm incorporates those

changes before filing the DRHP with the ROC. At the DRHP stage, the price band is

not disclosed. The firm simultaneously files a listing application with the stock

exchanges and the confirmation from the stock exchanges is needed before filing

getting the nod of the regulator on the DRHP. The BRLM and the firm then go for

road shows amongst these Institutional clients who are termed as Qualified

Institutional Buyers (QIBs) when they make their bids in the IPO. It is during the

course of these road shows, that the BRLM reaches a finality about the pricing band.

Regulations constrain that the cap of the band cannot be more than 20% of the floor.

Moreover, after the band has been finalized, the BRLM files a Red Herring

Prospectus (RHP) with the regulator. The RHP contains the price band but not the

final price. Next the BRLM forms a “syndicate” of brokers and banks/financial

service providers to carry out book building for the firm on its behalf. The three

categories of investors are the Retail investors who can bid up to 100,000INR in the

IPO , Non Institutional Investors( NIIs) who can bid for more than 100,000 INR and

the Qualified Institutional Buyers (QIBs) who are the institutional investors. While

making their bids, investors have to choose their respective category as QIB, NII or

Retail so that they can be considered for share allocation accordingly. The investors

in their bidding forms, indicate the price and the number of securities that they want

to buy at that price. The tranches for the three categories of investors are fixed as

50%, 15% and 35% of the shares for the QIB, NII and Retail categories respectively.

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The books on the BSE/NSE are mandated to be updated every half an hour by

regulation. At the end of the day the cumulative bids for shares are shown at the

prices indicated. The web sites also show how many shares against each of the

categories have been bid for and what percentage of the issue has been subscribed.

3.2 Institutional Arrangement for Grading of IPOs in India

Regulation in India requires that all firms coming to the equity markets for the first

time after 1st of May 2007 need to be graded on a scale of 1 to 5 with 1 indicating

poor fundamentals and 5 indicating strong fundamentals when compared with the

listed peers. Prior to the 1st of May 2007 the regulator had required the grading of

IPOs to be optional at the discretion of the firm going public. The grading of IPOs in

India is carried out by credit rating agencies which are registered with the regulator.

The grading is an independent opinion by an agency which is not connected with

the placement of the IPO and has still got a reputational stake. The firm going public

must get a grade from at least one of these rating agencies. This grade as well as its

rationale given by the rating agency is required to be disclosed in the draft

prospectus as well as all advertisements by the firm. The primary aim of the grading

exercise is to provide some information to the uninformed investors regarding the

fundamentals of the firm going public. The fundamentals are based on the

comparison with the listed firms in the market. The rating agencies emphasize that

the investment decisions are based on a) analysis of fundamentals, b) analysis of

returns and c) investor’s preferences. The Grading of the IPOs addresses only the

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first of these issues. Therefore a high Grade may not result in an investment decision

if the investors feel that the returns that they desire from the IPO and their

investment preferences do not match.

The costs of the Grading are to be borne by the IPO firm. Therefore there is a likely

conflict of interest between the rating agency which is supposed to grade the IPO

and the issuing firm who is bearing the costs of this grade. Just like the Investment

Bankers however there is likely to be a reputational stake for the rating agencies in

the long term. The firm cannot reject the Grade granted to it by a rating agency but it

can approach another rating agency. However, the firm must disclose in its

prospectus all the Grades that it has obtained . The Grade also has a validity period

and on expiry needs to be revalidated by the rating agency which takes into account

any material developments for or against the firm before this revalidation.

The Grading exercise starts simultaneously with the firm filing its draft prospectus

before the regulators. In terms of the information content, the rating agencies have

more information about the firm than is reflected in the draft prospectus. The rating

agencies hold a series of meetings with the firm. These meetings are held at the level

of the Chief Executive Officer(CEO) and Chief Financial Officer(CFO) besides the

heads of the Strategic Business Units(SBUs). The rating agency also visits the firm’s

plants if required. The rationale of the Grade awarded by the rating agency is to be

communicated to the firm and the firm is supposed to disclose this rationale in its

prospectus. At present there are four credit agencies registered with the market

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regulator Securities and Exchange Board of India( SEBI) who can carry out IPO

Grading. These are Credit Analysis and Research Limited(CARE), ICRA Limited,

CRISIL and FITCH Ratings. CRISIL is owned by Standard and Poor(S&P) while

Moody’s is the largest shareholder in ICRA Limited. It is noteworthy that S&P,

Moody’s and Fitch are recognized as Nationally Renowned Statistical Rating

Organizations (NRSRO) of the Securities and Exchange Commission (SEC) in the

United States.

Table2- Distribution of grades by rating agency

Grade CARE CRISIL ICRA

FITCH Total (S&P) (Moody’s) Obs. % Obs. % Obs. % Obs. % Obs. % 1 3 16.7 1 7.1 1 8.3 0 0 5 10.6 2 4 22.2 3 21.4 3 25 0 0 10 21.3 3 7 38.9 6 42.9 7 58.3 2 66.7 23 48.9 4 4 22.2 4 28.6 1 8.3 1 33.3 9 19.1

Total 18 38.3 14 29.8 12 25.5 3 6.4 47 Average grade 2.67 2.93 2.67 3.33 2.77

Test of difference in Grades (p value) 0.62    0.43    0.63    0.2         

Table 2 presents the distribution of the grades assigned by the rating agency. 23 out

of the 47 graded firms (48.9%) had a grade of 3 which means average fundamentals,

while the least grade of 1 was assigned to only 5 firms (10.6%). The rating agency

CARE handled 18 issues (38.3% of the sample) whereas FITCH handled only 3 issues

(6.4% of the sample) . The p values obtained show that the differences of the grades

obtained across the agencies are not statistically significant.

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4. Research Design

4.1 Testable hypotheses

Given the unique nature of the Indian regulatory set up where many regulations

have been framed for protecting the interests of retail investors, it is not intuitively

clear whether the introduction of Grading benefits the issuers and/or the investors.

We accordingly formulate the following hypotheses-

a) The first hypothesis being examined is that the reputation of the investment

banker would act as a certificate and affect the IPO underpricing. Carter and

Manaster (1990) demonstrated that more reputable investment bankers associate

themselves with low risk offerings. Because the inherent risk is lower, such firms

have lesser initial returns. Carter, Dark and Singh (1998) also found that when

reputed investment bankers handle an IPO, the associated short-term underpricing

is lesser. However recent evidence on the underwriter reputation is exactly the

reverse. Loughran and Ritter (2001) find that during the internet bubble period, the

prestige of the underwriter went hand in hand with leaving more money on the

table. It is understandable that while on the one hand the investment banker has the

firm going public as its client, on the other hand its clients are the informed

institutional investors. If the investment banks value their relationship with these

institutional investors more than they do with the firm, then they would be leaving

more money on the table, to be picked up by the institutional investors. Ritter and

Welch (2002) in their review paper have mentioned about the reversal of the sign of

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the relationship between the reputation of the investment banker and underpricing.

It is extremely interesting to examine this relationship in India because in India, the

investment bankers cannot make discretionary allotments to institutional investors

and such allotments have to be made on a pro-rata basis. Therefore we hypothesize

that more reputed investment bankers would leave more money on the table.

b) Our second hypothesis is related to the certification by Venture Capitalists (VCs).

India has in the latter half of 1990s experienced a good growth rate in its economy

attracting the attention of VCs. As mentioned before, theoretically the evidence of

the presence of venture capitalists on IPO underpricing is mixed. Lee and Wahal

(2004) have demonstrated that the presence of VCs increases underpricing refuting

the earlier evidence of Barry et al (1990) and Megginson and Weiss (1991). In India,

our data suggests that VCs rarely exit fully at the time of the IPO, although

regulations permit them to do so if they have held the shares of a firm for more than

a year prior to its going public. Given this context, presence of VCs should reduce

underpricing as increased underpricing is going to result in the dilution of the VC

holdings. On the other hand, presence of VCs is likely to act as a signal to the

uninformed investors about the likely growth prospects of a firm. As mentioned by

Derrien(2005), the presence of uninformed investors or noise traders results in

higher first day returns. Hence we hypothesize that presence of VCs in the Indian

IPOs is going to result in higher first day returns.

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c) One of the primary objectives of the Grading exercise is to reduce information

asymmetry between the issuers and investors. A high Grade should signify quality

of the firm for the investors. The Grading exercise compresses the overall effect of

the business prospects, financial prospects, management quality and Corporate

Governance of the firm into a single letter Grade for the investors. Thus the Grade is

an assessment by an independent agency of the true value of the firm when

compared to listed peers. Therefore the Grade should reduce the ex-ante uncertainty

about the firm going public and consequently should reduce underpricing of the

Graded issues with respect to the non graded issues. The third hypothesis that we

examine is that the higher the Grade awarded to a firm, lower should be its

underpricing.

d) Even though the rating agencies in India have started the Grading of the IPOs

only recently, yet they have been present in the debt markets in India for a long time.

Therefore the rating agencies have a reputational capital to protect in the case of IPO

Grading which is another product in their basket. Since CRISIL,ICRA and FITCH

have an ownership of the International players (these owners are Nationally

Recognized Statistical Rating Organizations-NRSRO in the United States) and since

the International players would have more reputation to protect hence our fourth

hypothesis is that issues graded by CRISIL,ICRA and FITCH would have lower

underpricing than issues graded by CARE.

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e) If the Grading is indeed resulting in an analysis of fundamentals then the Grades

should be conveying the same information to the uninformed investors, what the

costly research would be conveying to the Institutional investors. The rating agencies

are supposed to give the Grades based on Business Prospects, Financial prospects,

Management quality, Corporate Governance practices and the assessment of the

quality of projects for which the firm is seeking the IPO funds. Most of these are the

parameters on which the QIBs also do costly research. Taking an analogy from the

debt markets, better credit ratings do result in higher investments by institutional

investors2. Hence our fifth hypothesis is that IPOs with higher grades should exhibit

greater demand from the Institutional (QIB) investors in these IPOs.

4.2 Data and Sample

The data for this study have been collected from several sources. Our first source of

information was the web-sites of the two main stock exchanges in India-Bombay

Stock Exchange (BSE) and National Stock Exchange (NSE). These web-sites gave us

information on the number of firms that went public before and after the Grading

scheme was introduced in the Indian IPO market. The IPO Grading in India first

started in 2006 on a voluntary basis and was made compulsory from May 2007. Till

2 For example in the United States, Money Market mutual funds cannot invest in short term debt

which has not been rated under the highest or second highest category.(Security and Exchange

Commission,2003.)

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the end of August 2008, there were 51 firms which had utilized the Grading

mechanism to go public. Out of these 47 firms used the book building method and 4

firms used the fixed price method. Since our focus is on the effect of Grading on the

bookbuilding process, we use these 47 firms for our tests related to Grading. The

information on the entire population of Indian IPOs was taken from PRIME

Database. This gave us a total of 251 firms which had used the bookbuilding route

from 1999 to August 2008. The web-sites of the stock exchanges also gave us

information on the price of the issue, size of the issue, the day of the closure of the

issue and the day of listing of the firm. We also obtained the value of S&P CNX 500

Index from the NSE web-site. The next source of data were the prospectuses filed by

the firms with the Securities and Exchange Board of India (SEBI). Each prospectus

gives us details on the number of shares issued, age of the firm, the main Investment

Banker for the firm (called Book Running Lead Manager in India for Book built

issues), the Grade awarded to the firm, the name of the Grading agency and the

percentage of equity retained by the promoters in the IPO. We also obtained the

presence of Venture Capitalists in a firm by assiduously going through all the

prospectuses in India as this information is not available with the databases. We

obtained the reputational proxy of the Investment Bankers from their market shares

published by PRIME database. Investment Bankers which were in the first ten of

PRIME rankings were considered to be having a reputational advantage over the

other Investment bankers. We obtained the data on investor subscription patterns

from the Basis of Allotment documents published by the Registrars of the IPOs. This

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gave us the demands of the three categories of investors-Retail, Non Institutional

Investors (NIIs) and Qualified Institutional Buyers (QIBs). We also hand collect the

day by day bookbuilding patterns of the investors for the 47 Graded IPOs in our

sample.

4.2 Estimation model and variables

The first of our control variables to test the above hypotheses is the amount of equity

retained by a firm's promoters. The higher the percentage of equity retained by a

firm, higher would be the degree of underpricing and vice versa. Leland and Pyle’s

(1977) model predicts that the retention of a large amount of equity in the IPO by the

firm sends out a signal that the firm is sure of its future cash flows whereas

offloading a large amount of equity in the IPO gives the signal of expected bad news.

More recently Brau and Fawcett (2006) surveyed Chief Financial officers (CFOs) and

confirmed this hypothesis.

The second control variable is the age of the firm. The older a firm is higher are the

chances that the market has some information about the operations of the firm which

helps the market reduce the ex-ante uncertainty about the firm. Beatty (1989) shows

that the reduction in ex-ante uncertainty reduces the underpricing for the firm.

Bubna and Prabhala (2008) find a negative, although insignificant correlation

between firm age and underpricing in the Indian context.

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The third control variable is the issue size. Higher issue sizes are expected to be

underpriced lesser as per the standard results in IPO literature. Besides these we use

control for hot periods and industry by using year and industry dummy variables.

Since our main concern in this paper is on the effect of Grading of IPOs on

Underpricing we shall use the following two methods to measure underpricing-

UP Underpricing adjusted for the market=100*(Ri-Rm)

MAAR Market adjusted abnormal returns={(1+Ri)/ (1+Rm)-1}

Where

Ri

Return on the stock=(CP-OP)/OP where CP is the closing price on

first day and OP is the offer price

Rm Return on the index=(Closing value of S&P CNX 500 on the day

of listing-Closing value of S&P CNX 500 on the day of book closure)/

(Closing value of S&P CNX 500 on the day of book closure)

It is important to note that in India there is an average time of three weeks between

the closure of bookbuilding to the listing of the stock. Therefore we correct our

measure of underpricing for the market movements during this period.

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5. Results

5.1 Univariate Results

Table 3 presents the relationship between the grades assigned and the first day

underpricing observed. The mean underpricing associated with grade 3 was 19.61%

which was lower than the mean underpricing associated with either grade 2 or grade

4. Hence there doesn’t seem to be any monotonic relationship between the grade

assigned by the rating agency and the observed first day underpricing.

Table 3 also presents the relationship between the grade assigned and the investor

subscription patterns. As can be seen, the retail subscriptions do seem to be

increasing with the grades assigned with the mean subscription rising from 2.58

times oversubscription for grade 1 issues to 15.34 times oversubscription for grade 4

issues. However the standard deviation also seems to be increasing and a one way

ANOVA test does not reveal any significant differences across groups with a p value

of 0.55 which indicates that the null of all groups having the same mean retail

oversubscription cannot be rejected. As with retail investors, the mean NII

oversubscriptions also seem to be increasing across grades but as before a one way

ANOVA test results in a F value of 2.08 with a p value of 0.12 which means that the

null of no differences across groups cannot be rejected. The mean QIB

oversubscription level in graded issues increases from 2.07 times in Grade 1 issues to

59.18 times in Grade 4 issues. The QIB investors did not subscribe at all in the IPO of

Niraj Cement and subscribed by more than 185 times in the IPO of Religare

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Industries. The oversubscription levels of the QIBs seem to be increasing

monotonically with higher grades. Interestingly, a one way ANOVA test across the

groups results in a F value of 2.45 with a associated p value of 0.08 which shows that

the null of same mean across the groups has to be rejected at 10% level. The implication

of this result is that the QIBs do seem to be increasing their subscriptions in IPOs with

higher grades. So grading does seem to have resulted in some value for QIB investors

although the intent of the grading scheme was to create value for retail investors.

Table 4 presents the correlations table. The correlation of grade with QIB

oversubscription (Table 4) is 0.37 which is significant at the 5% level. One possibility

could be that QIBs might hesitate to invest heavily in low grade issues although

investment decisions should be determined by their own research teams. Table 4

also shows that higher grades are also significantly correlated with higher offer

prices, more reputed investment bankers, higher NII subscription levels, presence of

Venture Capitalists and older firms. There is a small correlation of 0.29 with issue

size also which shows that bigger IPOs are also likely to get higher grades. The

grade has the highest correlation of 0.55 with the reputation of the Investment

Banker. Since the decision of having the Investment Banker precedes the grade, it

can be inferred that more reputed Investment Bankers who are also associated with

costly research about a firm going public, are able to correctly pick the IPOs with

better fundamentals and therefore with higher grades. Surprisingly there is no

significant correlation of grades with underpricing or first day returns as well as

with retail oversubscriptions. One of the primary objectives of the grading exercise

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was to reduce the ex-ante uncertainty. The correlations of table 4 which show that

neither the first day returns nor retail subscriptions are significantly correlated to

grades are a pointer that the grading exercise might not have been able to reduce the

ex-ante uncertainty surrounding the IPOs. It is also interesting to note from Table 4

that although the offer prices are not significantly correlated with offer size yet they

have significant positive correlation with the reputation of the investment banker as

well as with the subscription levels of the three categories of investors. We check the

intuition arrived at from the correlations table with Multivariate regressions in the

following section.

5.2 Multivariate Results

Table 5 presents our first set of regression results. In this, table, we try to determine

the certification role of the Investment Bankers in Indian IPOs. We use year and

industry dummies as control variables besides the variables reported.

The results from Table 5 indicate that investment bankers with higher reputation do

not matter as a determinant of underpricing while controlling for other variables.

The coefficient of IBREP has a positive sign but it is insignificant. The results also

indicate that issues of higher size are underpriced lesser. The robustness of these

results is checked by having Market Adjusted Abnormal Returns (MAAR) as a

dependent variable with the same set of independent variables. The results

demonstrate once again that higher reputation investment bankers are not associated

23

with significantly higher MAAR while controlling for other variables. These results

do not support our first hypothesis.

Table 6 demonstrates the certification role of Venture Capitalists (VCs) in Indian

IPOs. We find that the presence of the Venture Capitalists results in a significant

increase in underpricing. The data suggest that VC presence seems to increase

underpricing by more than 12%. This result is in contrast to the result of Megginson

and Weiss (1991) and in consonance with a recent work by Lee and Wahal (2004)

which demonstrates that VC backed IPOs have higher underpricing. 87 firms in our

sample of 251 firms (34.66%) were VC backed which is quite similar to 37% VC

backed IPOs in the sample of Lee and Wahal (2004). Effectively these results support

our second hypothesis.

Table 7 demonstrates the effect of Grading on the IPO underpricing in India. Instead

of using a Grade_Dummy since Grading is compulsory for all firms going public,

and is not a choice that the firm is making, we use the actual Grades assigned to

firms as dummies. Thus we assign a dummy variable 1 to a firm which has been

graded say a 3 and zero otherwise. The results of Table 7 indicate that there seems to

be no impact of Grading on the underpricing of IPOs as the coefficients of the

Grades turn out to be insignificant. These results do not support our third

hypothesis.

Table 8 presents the determinants of Grades. Here we look at the 47 IPOs which

were graded and try to find out from an ordered logistic regression as to what

24

determines higher grades. As can be seen from Panel A, the significant factors in

the determination of the Grade are the age of the firm and the reputation of the

investment banker. However the presence of VC is insignificant. Older firms get

higher grades and firms who have investment bankers of lower reputation get lower

grades. Interestingly, despite the popular perception of higher issue size being

associated with better grades, data does not suggest the same. Panel B shows that

there is no significant difference in the underpricing between IPOs which were

graded by CARE (whose ownership is not with the NRSRO of the US) and those

graded by other rating agencies (CRISIL, ICRA and FITCH –the owners are all

NRSRO in the US). The Underpricing associated with IPOs graded by CARE is

25.87%whereas with IPOs not graded by CARE it is 19.54%. However this difference

is not statistically significant. This result does not support our fourth hypothesis.

Table 9 presents the effect of grading on the subscription patterns of the investors.

As can be seen from the table the explanatory power of the models is very low in

explaining the subscription levels of the NII and the retail investors. We will explain

in a later section the reason for this. Interestingly the coefficient of IBREP-the

reputation of the investment banker is significant in all cases. This implies that the

subscription levels of all three categories of investors increase with higher reputation

of the investment bankers.

The explanatory power of the model is significant in explaining the QIB interest in

the IPOs. The QIBs subscribe higher in

25

a) Issues which are handled by highly reputable investment bankers.

b) In large sized issues and

c) Issues which were Graded 3 or 4 by the grading agencies.

These results support our fifth hypothesis. It can be inferred that higher Grading

does seem to be pointing towards the right direction. The costly research that is

available to the QIBs would make them discerning investors. The results of Table 9

lead us to infer that the costly research of the QIBs and the research of the Grading

agency are pointing towards the same set of investment decision for higher grade

IPOs. For Grade 1 and Grade 2 IPOs the QIB demand although negative in sign is

insignificant. As mentioned earlier the NII and retail investors do not seem to be

utilizing the information content of Grading in making their investment decisions.

Theoretically it seems that the retail investors should have subscribed more in IPOs

with better grades. India has a unique institutional feature that the demand patterns

of all categories of investors are displayed online and the retail investors can view

the demand patterns of the QIB investors. We have also demonstrated that higher

Grades are having a positive effect on the QIB subscription patterns (Table9 ). We

therefore now investigate whether the transparency of the book is a much stronger signal

to the retail investors rather than the grading of the IPOs. For this purpose we look

at the day by day bookbuilt demand in all the 47 graded issues. We try to evaluate

whether the retail investors in the graded issues make their investment decisions by

observing the demand patterns of the QIBs one day before the closure of the book or

26

they make use of the grades assigned to a firm. Table 10 presents the results. As can

be seen from Table 10, the retail subscription levels in graded IPOs are largely being

determined by the QIB subscription levels on the penultimate day of bookbuilding.

The coefficient of NII demand on the penultimate day is negative and significant at

10% level. The coefficient of grade is insignificant. Effectively the grading exercise is

not providing any additional information to the investors than what is provided by

the transparency of the bookbuilding process in India.

Our results have important policy implications. The regulations in Indian IPO

market have been designed to protect the interests of retail investors. The IPO

Grading exercise was therefore one of the means of providing the retail investors

with an unbiased opinion from an external rating agency, for making their

investment decisions. Our data show that retail investors’ subscriptions are not

driven by the Grade awarded to the firm but by the demand patterns of the

informed investors in such IPOs. Therefore the retail investors can protect

themselves from the “winner’s curse” in Indian IPOs even without the grading

exercise. Nevertheless, it seems to us that the Grading exercise is pointing towards

the right direction because the subscription patterns of informed investors are

positively correlated with higher grade IPOs. At present this might be a second

order effect for retail investors but in the longer run the retail investors would

perhaps also get benefitted from the Grading exercise because of their mimicking of

the demand patterns of informed investors.

27

7. Conclusion:

This paper examined the certification role of various signals in the bookbuilt Indian

IPOs. First of all, we find 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 underpricing in consonance with the results of Lee and Wahal (2004). Given this

positive certification by the Venture Capitalists we 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. Our 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. We further 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. Our 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.

A puzzle for us was as to why the uninformed retail investors in India, for whom the

Grading process was intended to be, are not making use of the Grades. We find that

the retail investors find the unique regulatory feature of the transparency of the book

to be a much stronger signal than the information provided by the Grades.

28

References

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Barry,C., Muscarella, C., Peavy, J.,Vetsuypens, M.,(1990) The role of venture capital in the creation of public companies: evidence from the going public process, Journal of Financial Economics, Vol.27, pp.447-472.

Beatty, R.P., (1989). Auditor reputation and the pricing of initial public offerings. The Accounting Review 64(4), 693-709.

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

Brau, J.C., Fawcett, S.E., (2006). Initial public offerings: an analysis of theory and practice. Journal of Finance 61(1), 399-436.

Bubna, A., Prabhala, N.R., (2008). When bookbuilding meets IPOs. Unpublished working paper. University of Maryland.

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

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Derrien, F., (2005) IPO pricing in the hot market conditions: who leaves money on the table? Journal of Finance 60(1), 487-521.

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

Leland, H.E., Pyle, D.H.,(1977) Informational asymmetries, financial structure and financial intermediation. Journal of Finance 32(2), 371-387.

Loughran, T., Ritter, J.R., (2001) Why has IPO underpricing increased over time? Unpublished working paper. University of Florida.

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

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

Securities and Exchange Commission(2003) Report on the role and function of credit rating agencies in the operation of the securities markets

29

Table3-Relation between the grades, underpricing and subscription patterns Underpricing Retail NII QIB

Grade Obs. Mean Std Dev Mean

Std Dev Mean Std Dev Mean

Std Dev

1 5 -0.51 13.61 2.58 2.92 7.8 12.76 2.07 2.07 2 10 28.72 59.19 6.84 9.27 13.28 17.7 4.87 6.85 3 23 19.61 46.63 11.28 21.54 25.88 5.98 33.79 61.12 4 9 33.67 45.25 15.34 17.18 61.73 66.08 59.18 54.32

Diff across groups(p value) 0.55 0.12 0.08* CARE 18 25.87 53.85 8 14.11 15.84 29.08 16.18 33.15

CRISIL (S&P) 14 11.83 25.49 6.61 6.41 31.21 55.36 25.4 43.43 ICRA (Moody’s) 12 29.98 57.77 20.49 27.17 61.75 72.7 64.16 75.81

FITCH 3 6.48 20.77 0.66 0.41 1.07 0.55 6.17 4.53 Overall 47 22.1 46.82 10.19 17.47 28.14 49.93 29.13 52

* significant at 10% level

30

Table 4 Pearson’s Correlations of the variables used for the study

Variables are as defined in Table11

Grade OP Underpricing Eqt_RET IBREP RET_sub NII_sub QIB_sub Issue size VC_Presence AGE

Grade 1 0.45(***) 0.14 0.17 0.55(***) 0.22 0.32(**) 0.37(**) 0.29(*) 0.33(**) 0.27(*)

OP 1 0.12 0.16

0.74(***) 0.35(**)

0.51(***)

0.67(***) 0.22 0.41(***) -0.2 Underpricing 1 0.01 0.22 0.64(***) 0.52(***) 0.48(***) -0.07 0.26(*) -0.09

Eqt_RET 1 0.15 0.2 0.22 0.21 0.36(**) -0.12 0.07 IBREP 1 0.45(***) 0.57(***) 0.67(***) 0.29(**) 0.56(***) 0.04

RET_sub 1 0.8(***) 0.82(***) 0.04 0.17 0.05 NII_sub 1 0.89(***) 0.42(***) 0.18 0.1 QIB_sub 1 0.21 0.32(**) 0.11 Issue size 1 -0.04 -0.22

VC_Presence 1 0.05 AGE 1

***Correlation is significant at 1% level

** Correlation is significant at 5% level

*Correlation is significant at 10% level

31

Table 5-Relationship of Investment Banker reputation with Underpricing

Panel A

Dependant Variable Underpricing MAAR

Independent Variables Coefficient Coefficient

(Constant) 67.35(1.58) 70.40(1.66)

IBREP 11.37(1.38) 11.89(1.45)

Log_AGE 3.41(0.70) 3.45(0.71)

Log_issuesize -6.91(-1.99**) -7.26(-2.10**)

Eqt_RET -0.23(-1.02) -0.22(-1.00)

N 251 251

Adj. R square 4.50% 4.50%

** indicates significance at 5% level

32

Table6 -Relationship of VC presence with Underpricing

Dependant Variable Underpricing MAAR

Independent Variables Coefficient Coefficient

(Constant) 39.31(0.95) 41.28(1.00)

VC_Presence 12.31(1.71*) 12.68(1.77*)

Log_AGE 4.67(0.95) 4.74(0.96)

Log_issuesize -5.23(-1.76*) -5.49(-1.85*)

Eqt_RET -0.15(-0.65) -0.14(-0.62)

N 251 251

Adj. R square 4.90% 4.90%

* indicates significance at 10% level

33

Table7: Effect of Grading on Underpricing

Dependant Variable Underpricing MAAR

Independent Variables Coefficient Coefficient

(Constant) 56.87(1.35) 58.65(1.4)

Grade 1 - 38.80(-1.29) -41.04(-1.37)

Grade 2 -11.44(-0.57) -7.05(-0.35)

Grade 3 -16.75(-1.16) -16.4(-1.14)

Grade 4 1.82(0.10) 2.17(0.12)

Log_AGE 2.63(0.53) 2.60(0.53)

Log_issuesize -4.74(-1.56) -4.89(-1.61)

Eqt_RET -0.25(-1.1) -0.25(-1.09)

N 251 251

Adj. R square 3.4% 3.4%

34

Table 8-Determinants of Grades

The results presented below in Panel A are from an Ordered Logistic Regression. The dependent variable is the Grade assigned by the Grading agency. p values are reported in parentheses. Panel B reports the difference in Grading between CARE whose owners are not Nationally Renowned Statistical Rating Organizations (NRSRO) with FITCH,CRISIL and ICRA the owners of whom are NRSRO in the United States.

Panel A

Dependant Variable Grade Independent Variables Coefficient

IBREP -2.61(0.02**)

VC_Presence -0.64(0.46)

Log_AGE 1.88(0.01***)

Log_issuesize 0.58(0.11)

N 47 Pseudo R square 49.30%

** indicates coefficient is significant at 5% level

** *indicates coefficient is significant at 1% level

Panel B

CARE NRSRO agencies Total

IPOs Graded 19 28 47 Average Grade 2.68 2.82 Diff in Means -0.14

p value 0.62 Underpricing 25.87 19.54 Diff in Means -6.33

p value 0.67

35

Table 9- Effect of Grading on subscription patterns of investors

Dependent Variable QIB_sub NII_sub RET_sub

Independent Variables Coefficient Coefficient Coefficient

(Constant) -56.29(2.89) 33.1(1.11) 38.96(3.8)

IBREP 14.36(2.94***) 16.41(2.19**) 4.59(1.78*)

Grade 1 -9.11(-0.54) -17.89(-0.7) -9.29(-1.05)

Grade 2 -4.95(-0.41) -12.4(-0.67) -5.42(-0.85)

Grade 3 13.91(1.81*) -3.94(-0.33) 0.6(0.15)

Grade4 21.14(1.85*) 23.98(1.37) 5.74(0.96)

Log_AGE 1.75(0.55) -0.59(-0.12) 0.65(0.38)

Log_Issuesize 7.23(3.57***) -0.6(-0.19) -3.2(-3.0***)

N 249 246 249

Adj. R square 17.40% 1.6% 1.7%

36

RET_Sub=β0+β1(QIB_penultimate)+β2(NII_penultimate)+β3(Log_AGE)+β4(Log_issuesize)+ β5(IBREP)+β6(Grade) +ε

Table 10 Relative effectiveness of IPO Grading and book transparency signals

Independent Variables Coefficient

(Constant) 48.53 (2.79)

QIB_penultimate 1.81 (7.53)***

NII_penultimate -0.79 (-1.74)*

Log_AGE 0.55(0.17)

Log_issuesize -5.51(-2.62)**

IBREP 5.01(0.88)

Grade 1.45(0.62)

N 47

Adj. R square 68.20%

*** indicates coefficient is significant at 1% level

** indicates coefficient is significant at 5% level

* indicates coefficient is significant at 10% level

37

Table Variation of Underpricing in the sample

Year N Mean Median Minimum Maximum 1999 5 55.34 18.31 -30.62 155.28 2000 11 16.04 17.94 -30.54 72.59 2001 1 -8.68 -8.68 -8.68 -8.68 2002 2 15.03 15.03 -1.88 31.94 2003 7 69.74 45.97 3.82 181.94 2004 15 45.11 27.83 0.17 207.08 2005 55 33.91 29.55 -18.94 336.89 2006 69 18.00 1.06 -30.95 235.53 2007 74 34.00 20.11 -23.27 241.91 2008 12 13.24 1.54 -38.15 174.89 Total 251 29.57 17.94 -38.15 336.89

Descriptive statistics of the variables used

Variable N Minimum Maximum Mean Std.

Deviation Shares offered (in 00,000) 251 13.71 8658.30 291.98 857.77 Issue size(in billion INR) 251 0.02 102.60 3.86 10.97

Age(in years) 251 <1 100.00 14.52 12.25 Eqt_RET(in %) 251 20.42 90.00 59.27 15.76

RET_sub(no. of times) 249 0.11 133.52 12.52 17.38 NII_sub(no. of times) 246 0.05 316.46 34.31 50.44 QIB_sub(no. of times) 248 0.00 185.09 25.96 35.93

38

Table 11 Description of the variables used in the study

Variable Description OP Offer Price (INR*) CP Closing Price(INR)

IBREP

This variable is a proxy for the reputation of the book running investment banker. IBREP is set equal to 1 if the book-running investment banker is in the top 10 ranks of Prime Database, else it is set equal to 0. The Prime Database uses the market share of the investment bankers to determine these rankings

AGE Number of years since incorporation of the firm to the year of the IPO

Eqt_RET Percentage of equity retained by the owners of the firm

QIB_sub The total shares subscribed by Qualified Institutional Buyers (QIBs) as a proportion of the total number of shares available to them for allocation. This is measured after the book has been built.

QIB_penultimate The total shares subscribed by Qualified Institutional Buyers (QIBs) as a proportion of the total number of shares available to them for allocation till the penultimate day of bookbuilding.

NII_sub The total shares subscribed by Non-Institutional Investors (NIIs) as a proportion of the total number of shares available to them for allocation. This is measured after the book has been built.

NII_penultimate The total shares subscribed by NIIs as a proportion of the total number of shares available to them for allocation till the penultimate day of bookbuilding.

RET_sub The total shares subscribed by Retail Investors as a proportion of the total number of shares available to them for allocation. This is measured after the book has been built.

Grade The actual grade (1 to 5) awarded to the firm by the rating agency

VC_Presence A dummy variable which takes a value 1 if the Venture Capitalists have invested in an IPO and 0 otherwise

  

Underpricing This is the measure of market adjusted underpricing used in the literature [(CP-OP)*100/OP]−Market return