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

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.

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 2

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 3

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 4

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 5

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)

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 Indias 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. 7

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 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008(April to August)

1 10

3 1

5 11

9.8 10.09 16.67 33.33 38.89 65.22 70.51 86.25 86.05

1 1 2 6 25 36 33 8 1 4 5 27 23 27 3 1 4 3 10 14 1

1 2 7 15 55 69 74 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 8

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. 9

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) investors preferences. The Grading of the IPOs addresses only the 10

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 firms 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 11

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 Moodys is the largest shareholder in ICRA Limited. It is noteworthy that S&P, Moodys 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

CRISIL Grade 1 2 3 4 Total Average grade Test of difference in Grades (p value) 3 4 7 4 18 2.67 CARE Obs. % 16.7 22.2 38.9 22.2 38.3 1 3 6 4 14 2.93 (S&P) Obs. % 7.1 21.4 42.9 28.6 29.8 Obs. 1 3 7 1 12 2.67

ICRA (Moodys) % 8.3 25 58.3 8.3 25.5 0 0 2 1 3 3.33 FITCH Obs. % 0 0 66.7 33.3 6.4 5 10 23 9 47 2.77 Total Obs. % 10.6 21.3 48.9 19.1

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. 12

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 hypothesesa) 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 13

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.

15

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

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.)

16

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 17

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 Pyles (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.

18

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 underpricingUP MAAR Where Return on the stock=(CP-OP)/OP where CP is the closing price on Ri Rm first day and OP is the offer price 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. Underpricing adjusted for the market=100*(Ri-Rm) Market adjusted abnormal returns={(1+Ri)/ (1+Rm)-1}

19

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 doesnt 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 20

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 21

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

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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 23

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 24

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 25

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 winners 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.

26

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.

27

References Akerlof, G. (1970) The Market for Lemons: Quality Uncertainty and the Market Mechanism, Quarterly Journal of Economics, Vol.84, pp.488-500. 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. Carter, R.B. and Manaster S.(1990) Initial Public Offerings and Underwriter Reputation, Journal of Finance, Vol.45(4),pp.1045-1067. 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 28

Table3-Relation between the grades, underpricing and subscription patterns Underpricing Grade 1 2 3 4 Diff across groups(p value) CARE CRISIL (S&P) ICRA (Moodys) FITCH Overall * significant at 10% level Obs. 5 10 23 9 Mean -0.51 28.72 19.61 33.67 Std Dev 13.61 59.19 46.63 45.25 Retail Mean 2.58 6.84 11.28 15.34 0.55 18 14 12 3 47 25.87 11.83 29.98 6.48 22.1 53.85 25.49 57.77 20.77 46.82 8 6.61 20.49 0.66 10.19 14.11 6.41 27.17 0.41 17.47 Std Dev 2.92 9.27 21.54 17.18 NII Mean 7.8 13.28 25.88 61.73 0.12 15.84 31.21 61.75 1.07 28.14 29.08 55.36 72.7 0.55 49.93 Std Dev 12.76 17.7 5.98 66.08 QIB Mean 2.07 4.87 33.79 59.18 0.08* 16.18 25.4 64.16 6.17 29.13 33.15 43.43 75.81 4.53 52 Std Dev 2.07 6.85 61.12 54.32

29

Table 4

Pearsons Correlations of the variables used for the study

Variables are as defined in Table11 Issue size 0.29(*) 0.22 -0.07 0.36(**) 0.29(**) 0.04 0.42(***) 0.21 1

Grade Grade OP Underpricing Eqt_RET IBREP RET_sub NII_sub QIB_sub Issue size VC_Presence AGE 1

OP 0.45(***) 1

Underpricing 0.14 0.12 1

Eqt_RET 0.17 0.16 0.01 1

IBREP 0.55(***) 0.74(***) 0.22 0.15 1

RET_sub 0.22 0.35(**) 0.64(***) 0.2 0.45(***) 1

NII_sub 0.32(**) 0.51(***) 0.52(***) 0.22 0.57(***) 0.8(***) 1

QIB_sub 0.37(**) 0.67(***) 0.48(***) 0.21 0.67(***) 0.82(***) 0.89(***) 1

VC_Presence 0.33(**) 0.41(***) 0.26(*) -0.12 0.56(***) 0.17 0.18 0.32(**) -0.04 1

AGE 0.27(*) -0.2 -0.09 0.07 0.04 0.05 0.1 0.11 -0.22 0.05 1

***Correlation is significant at 1% level ** Correlation is significant at 5% level *Correlation is significant at 10% level

30

Table 5-Relationship of Investment Banker reputation with Underpricing Panel A Dependant Variable Independent Variables (Constant) Underpricing Coefficient 67.35(1.58) MAAR Coefficient 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 Adj. R square

251 4.50%

251 4.50%

** indicates significance at 5% level

31

Table6 -Relationship of VC presence with Underpricing Dependant Variable Independent Variables (Constant) Underpricing Coefficient 39.31(0.95) MAAR Coefficient 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 Adj. R square

251 4.90%

251 4.90%

* indicates significance at 10% level

32

Table7: Effect of Grading on Underpricing Dependant Variable Independent Variables (Constant) Underpricing Coefficient 56.87(1.35) MAAR Coefficient 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 Adj. R square

251 3.4%

251 3.4%

33

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 Independent Variables Grade Coefficient

IBREP VC_Presence Log_AGE Log_issuesize

-2.61(0.02**) -0.64(0.46) 1.88(0.01***) 0.58(0.11)

N Pseudo R square ** indicates coefficient is significant at 5% level ** *indicates coefficient is significant at 1% level Panel B CARE IPOs Graded Average Grade Diff in Means p value Underpricing Diff in Means p value 19 2.68

47 49.30%

NRSRO agencies 28 2.82

Total 47 -0.14 0.62

25.87

19.54 -6.33 0.67

34

Table 9- Effect of Grading on subscription patterns of investors Dependent Variable Independent Variables (Constant) QIB_sub Coefficient -56.29(2.89) NII_sub Coefficient 33.1(1.11) RET_sub Coefficient 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 Adj. R square

249 17.40%

246 1.6%

249 1.7%

35

RET_Sub=0+1(QIB_penultimate)+2(NII_penultimate)+3(Log_AGE)+4(Log_issuesize)+ 5(IBREP)+6(Grade) + Table 10 signals Relative effectiveness of IPO Grading and book transparency Coefficient

Independent Variables

(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 Adj. R square

47 68.20%

*** indicates coefficient is significant at 1% level ** indicates coefficient is significant at 5% level * indicates coefficient is significant at 10% level

36

Table

Variation of Underpricing in the sample

Year 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Total

N 5 11 1 2 7 15 55 69 74 12 251

Mean 55.34 16.04 -8.68 15.03 69.74 45.11 33.91 18.00 34.00 13.24 29.57

Median 18.31 17.94 -8.68 15.03 45.97 27.83 29.55 1.06 20.11 1.54 17.94

Minimum -30.62 -30.54 -8.68 -1.88 3.82 0.17 -18.94 -30.95 -23.27 -38.15 -38.15

Maximum 155.28 72.59 -8.68 31.94 181.94 207.08 336.89 235.53 241.91 174.89 336.89

Descriptive statistics of the variables used

Variable Shares offered (in 00,000) Issue size(in billion INR) Age(in years) Eqt_RET(in %) RET_sub(no. of times) NII_sub(no. of times) QIB_sub(no. of times)

N 251 251 251 251 249 246 248

Minimum 13.71 0.02 <1 20.42 0.11 0.05 0.00

Maximum 8658.30 102.60 100.00 90.00 133.52 316.46 185.09

Mean 291.98 3.86 14.52 59.27 12.52 34.31 25.96

Std. Deviation 857.77 10.97 12.25 15.76 17.38 50.44 35.93

37

Table 11 Variable OP CP

Description of the variables used in the study Description Offer Price (INR*) Closing Price(INR) 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 Number of years since incorporation of the firm to the year of the IPO Percentage of equity retained by the owners of the firm

IBREP

AGE Eqt_RET

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. 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. 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. 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. 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.

QIB_penultimate

NII_sub

NII_penultimate

RET_sub

Grade VC_Presence

The actual grade (1 to 5) awarded to the firm by the rating agency A dummy variable which takes a value 1 if the Venture Capitalists have invested in an IPO and 0 otherwise This is the measure of market adjusted underpricing used in the literature [(CPOP)*100/OP]Market return

Underpricing

38