The Securities and Exchange Commission of Sri Lanka (SEC) has sought views from the public to set up a rating agency to grade Initial Public Offerings (IPOs) and fund independent research on listed companies, as practiced in developed capital markets.
The SEC stated that the purpose of rating/grading equity is to provide the potential, retail or institutional investor with an independent view on the fundamentals and prospects of the company seeking to be listed on the stock exchange.
“The investor has only the IPO prospectus to go by and sometimes even the information contained in the prospectus may not be grasped by some investors. There is also a risk where a company that raises capital from the public successfully, ends up in financial difficulties, shortly after the IPO,” the SEC noted.
The regulator proposes to bridge this information gap with an IPO grading, establishing a rating agency which will be registered with the SEC.
This rating agency will provide an independent and objective analysis which would in turn help enhance an investor’s ability to make an informed investment decision.
“Equally important is that prospective issuers with strong fundamentals and good prospects can be in a position to justify a higher share price, as a result of obtaining a higher IPO grade,” it said.
Defining as to what exactly an IPO grade is, the SEC stated that it is the grade assigned by the rating agency registered with the SEC to the initial public offering of shares by a corporate seeking to list.
“The IPO grade represents a relative assessment of the fundamentals of that issue in relation to the other listed equity securities. It is generally assigned on a five-point point scale with a higher score indicating stronger fundamentals and vice versa,” the SEC added.
Accordingly, an IPO grade one would mean poor fundamentals, two would mean below average fundamentals, three would mean average fundamentals, four would mean above average fundamentals and five would mean strong fundamentals.
The IPO grade tells the investor about the prospects of the company seeking to list. It is issued based on a thorough study of f undamentals of the prospective issuer Company, the industry in which it operates and the competitive strengths of the Company amongst other factors.
“From the investor’s point of view, it provides an indicator to make a judgment that can also be used to assess the fairness of the IPO price,” the SEC noted.
Several areas of a company will be taken in to consideration by the rating agency when awarding the rating. Among them are business prospects and competitive and financial positions, management quality, corporate governance practices, compliance and litigation history and new projects.
The rating agency will conduct site visits, interviews, prepare questionnaires, and meet with external related parties such as banks, auditors etc to obtain the necessary information about the Company seeking a listing.
The SEC further stressed that IPO grading does not consider the IPO issue price. “The IPO grade is an independent and credible input to aid the investor in the investment process, and the investor needs to make his/her own independent decision regarding investing in the IPO,” it explained.
In order to implement this mechanism, the pricing for IPO grading will be relatively minimal and would be based on the size of the issue.
This system could be a deterrent for overrated IPOs, such as some recent IPOs which were highly overrated by research companies but have yet failed to deliver on their promises and have misled investors in to believing they were indeed companies with good fundamentals.