IPO Grading in India: What the Old Optional Rating Was and Why It Faded

If you bought into Indian IPOs around 2008 to 2013, you probably remember a small line in every ad and prospectus: “IPO Grade 4/5” or something like it. That was IPO grading, a score from a credit rating agency that tried to sum up a company’s fundamentals in a single number. Today you almost never see it. This piece explains what the grade actually measured, what it never measured, why SEBI stopped insisting on it, and what we use in its place when we read an offer document.

What IPO grading was, in SEBI’s own words

SEBI’s investor FAQ on IPO grading describes it as a grade assigned by a SEBI-registered credit rating agency to the initial public offering of equity shares, or of securities that can later convert into equity. The grade is meant to be a relative assessment of the issue’s fundamentals compared with other listed equity in India.

The scale had five steps, and a higher number meant stronger fundamentals:

• Grade 1: poor fundamentals
• Grade 2: below-average fundamentals
• Grade 3: average fundamentals
• Grade 4: above-average fundamentals
• Grade 5: strong fundamentals

Simple enough. The idea was to give a retail investor, who may never read a 400-page prospectus, an independent professional’s view in one digit.

From compulsory to optional: the short history

SEBI’s annual report for 2007-08 lists grading of all IPOs as one of the year’s major primary-market reforms. Under those rules, grading by at least one SEBI-registered rating agency was made mandatory, the grade had to appear in the prospectus, the abridged prospectus and every IPO advertisement, and the issuer had to pay for it. BusinessLine dates the compulsory regime to May 2007.

That lasted about seven years. On 4 February 2014, SEBI notified an amendment to the ICDR Regulations, the rulebook for public issues, that rewrote the grading clause. The old regulation 26(7) said no issuer could make an IPO without a grade from at least one registered agency. The new text, quoted by IndiaCorpLaw, says an issuer “may obtain grading” from one or more registered agencies. One word, “may”, and the grade became voluntary. SEBI’s FAQ confirms that grading has been optional for issuers with effect from 4 February 2014.

BusinessLine reported the reasoning at the time: the move was part of SEBI’s effort to revive a dormant primary market and to reduce reliance on rating agencies, whose role in the wider financial system was being questioned globally. The SEBI board had approved the proposal in December 2013.

An IPO grade never looked at the price. A grade 5 company sold at a silly valuation was still a grade 5, and that single gap explains most of what went wrong with how people used it.

What the rating agencies looked at

The SEBI FAQ lists the areas agencies generally examined, while noting the list was indicative and could vary case to case:

• Business prospects and competitive position, covering both the industry and the company
• Financial position
• Management quality
• Corporate governance practices
• Compliance and litigation history
• Risks and prospects of new projects

Read that list again and it looks a lot like the checklist any decent analyst runs on a company. That was the point. The grade was a compressed version of fundamental analysis, done by someone with access to management and a professional methodology.

The big blind spot: price

Here’s the part many investors missed. SEBI’s FAQ is blunt that IPO grading was done without considering the issue price. Because the grade ignored price, the investor still had to judge for themselves whether the shares were worth what the company was asking.

The FAQ also says plainly that a grade is not a recommendation to subscribe or skip. It had to be read with the prospectus disclosures, the risk factors and, again, the offer price.

This matters more than it sounds. A business can be solid and still be a bad buy at the IPO price. Think about it the way you would a flat. A well-built building in a good locality is a good asset, but if the builder prices it at double what nearby flats sell for, the quality of the construction doesn’t rescue your return.

A worked example: two hypothetical issues

To make this concrete, let’s take two made-up companies. These are illustrative numbers only, not real issuers or real data.

Company A is a mid-sized packaging maker with a long record, steady profits and a clean litigation history. Suppose it gets an IPO grade of 4. It prices its issue at 45 times its last year’s earnings per share, while listed peers in our example trade at around 20 times.

Company B is a smaller engineering firm with patchier margins and one pending tax dispute. Suppose it gets a grade of 3. It prices at 14 times earnings, against the same peer group at around 20 times.

An investor who reads only the grade picks A. But walk through the arithmetic. If A’s earnings grow at, say, 15% a year, and its multiple drifts down from 45 to the peer level of 20 over a few years, the price can go nowhere for a long stretch even as the business grows. Earnings would have to roughly double and a bit more (45 divided by 20 is 2.25) just for the share price to stand still at a peer multiple. At 15% annual growth that takes around six years.

B, on the other hand, starts below the peer multiple. If its earnings merely hold steady and the market re-rates it to peer level, the gap from 14 to 20 times is about a 43% gain on the multiple alone. The weaker grade came with a much bigger margin of safety on price.

Nothing guarantees either path, of course. Multiples can stay high for years and cheap stocks can stay cheap. The lesson is narrower: the grade answered “how good is this business?” and left “is this a good price?” entirely to you.

Other rules worth knowing

A few details from the SEBI FAQ explain how the system worked in practice:

• No hiding a bad grade. An issuer could not reject a grade. If it disliked one agency’s score, it could approach another, but every grade obtained had to be disclosed in the offer document and ads.
• Timing. Grading could happen before or after filing the draft offer document with SEBI, as long as the prospectus or red herring prospectus carried it.
• SEBI stayed out of it. The regulator played no role in the assessment, and its observations on the offer document were independent of the grade.
• The paper trail. The rating agency’s grading letter, with its detailed rationale, was listed among the material documents available for inspection at the company’s registered office.

Why the grade faded from view

Once grading became optional, the incentive flipped. A company expecting a strong score might still pay for one as a marketing point. A company expecting a 1 or 2 had every reason to skip it, since there was no longer any requirement to get one. IndiaCorpLaw raised exactly this worry in 2014, arguing that weaker companies would tend to avoid the process.

The context also helps. IndiaCorpLaw’s note pointed to the slump in the primary market after 2010, citing a fall of over 37% in the BSE IPO index between 4 January 2010 and 31 December 2011, and 82 of the 112 companies that listed in 2010 and 2011 trading below their issue price at the time. Mandatory grading had not kept investors out of those losses, which weakened the case for keeping it compulsory.

Selective disclosure is the quiet problem with any voluntary score. If only the good students choose to publish their marks, a published mark tells you less than you think, and a missing one tells you very little at all.

A voluntary rating mostly shows up when the news is good. So when we see one today, we treat it as one input, never as the answer.

What to use instead when you read an IPO today

Without a grade to lean on, the work comes back to the investor. Here’s the order we follow when an issue opens:

1. Start with the red herring prospectus. Our guide to the red herring prospectus covers where the useful sections sit: objects of the issue, risk factors, financial statements and the basis for the issue price.
2. Do your own valuation check. Compare the price-to-earnings and price-to-book at the upper band with the listed peers the company itself names in the “basis for issue price” section. This is the step the old grade skipped.
3. Read the risk factors properly. Litigation, customer concentration and related-party dealings are the same areas the agencies used to dig into.
4. Look at where the money goes. A fresh issue that funds capacity is different from an offer for sale where existing holders cash out.
5. Bid sensibly. If you decide to apply, understand how the cut-off price option works so you are not caught out at allotment.

For the full process from application to listing, our IPO investing guide for India walks through each stage.

The takeaway

IPO grading was a decent idea with one structural weakness. It compressed fundamentals into a number between 1 and 5, but it deliberately ignored price, and price is where most IPO returns are won or lost. Once SEBI made it optional in February 2014, the score became something companies chose to show rather than had to show, and it slowly disappeared from most issue ads. If you do spot a grade in an offer document today, read the agency’s rationale, then do the valuation work yourself. The grade can tell you the business is sound. Only you can decide whether the price makes sense.

Disclaimer: This article is for education only and is not investment advice. The companies and figures in the worked example are hypothetical. Please read the offer document and consult a SEBI-registered adviser before investing in any IPO.