Thinking Small  

July 21, 2008

The success of an SME exchange needs much more than what SEBI has proposed, argues Deepak Sanchety, a former SEBI executive

Small and medium enterprises (SMEs) represent innovation and potential for growth into tomorrow’s successful businesses. Venture capitalist funds, angel investors and private equity funds scout for promising SMEs for investment. For investors of such funds, it is an indirect avenue for investing into SMEs, like investing in equity through mutual funds. Investors would examine the merits and track record of the funds rather than that of the SME for such investments.

For several reasons, SMEs find it difficult to access capital markets to raise equity. In several countries, markets have created new segments to cater specifically to such needs. These markets help SMEs raise risk capital and provide investors the opportunity to directly participate in their growth.

The need for an SME exchange has been felt for long in India. As early as in 1992, an attempt was made to
create an equity market catering to small enterprises. This, however, was a total failure. With hindsight, it is easier to explain the failure of Over-The-Counter Exchange Of India (OTCEI). It was far ahead of its time and attempted to do much more than be just an SME exchange. It offered electronic trading at a time when the existing market set-up was resistant to the idea; it envisaged rolling settlement when the physical infrastructure did not exist to support it. It created a set of rules for market-making, which proved to be a disincentive. Perhaps, OTCEI mixed up the purpose of being an SME exchange with too many other revolutionary objectives. Another effort was made in 2005 through BSE IndoNext. This was linked more to the survival of the regional stock exchanges rather than creating an SME exchange and has also not succeeded.

Worldwide, a few markets have got it right and have succeeded in creating an effective platform for SMEs to access potential investors. The Alternative Investment Market (AIM) of London, the KOSDAQ in Korea and the TSX Venture Exchange of Canada have generated the maximum SME listings over the past few years. Collectively, these three markets have listed more than 4,000 companies.

To easily access risk capital, SMEs need low costs for raising equity, low compliance cost and a shorter time frame and, therefore, a lighter regulatory framework. Since this poses a risk to investors, there is need to balance the lighter regulation with measures to protect investor interests.

SEBI recently put out a discussion paper on developing an equity market for SMEs. The paper captures the relevant issues succinctly. It has proposed relaxing the criteria for making a public issue and certain listing requirements, as well as reducing costs and time by proposing an electronic issue process for SMEs. Small investors are to be protected by barring them from participating in this market both at the primary and secondary levels. The paper proposes that a separate exchange to be set up for SMEs and specialised merchant bankers may be licensed for exclusively catering to the SME segment.

When India opened up the IPO market in 1993-94, norms were relaxed enough for SMEs to tap the
markets. The issues which came up then are the baggage we carry till now. The discussion paper has left unaddressed the mechanism to ensure that only genuine players enter the market, the need to provide sufficient liquidity in the SME market and related incentives to SMEs as well as potential investors.

AIM of the London Stock Exchange follows a principle-based approach rather than a rule-based one for enabling small enterprises to tap the market; this demands maturity among the players. AIM registers nominated advisors (nomads) and monitors their performance to ensure good-quality issues. Nomads also perform the function of handholding and mentoring for SMEs, guiding them through the issue and listing process, and post-listing compliances. TSX Venture helps SMEs to go public through a ‘capital pool company’, and provides for a system of ‘sponsors’ for new listings. New markets enable SMEs to tap investors as easily as possible while ensuring good-quality issues by placing greater responsibility on investment
bankers/brokers.

For post-listing compliance, the discussion paper has proposed the relaxing of rules related to reporting of results and sending annual reports to investors. There are several other requirements like those related to corporate governance and ‘Takeover Code’ which are not proposed to be relaxed and which may add to compliance costs for issuers. If the idea is to create a separate market, it may make sense to review all post-listing compliance requirements for SMEs. Taxation is another issue. Trading on the main market attracts a host of taxes – securities transaction tax, capital gains, service tax on brokerage, exchange transaction charges, etc. In addition, companies have to pay dividend distribution tax. To attract investors to the SME market, listed SMEs and their investors can be taxed at lower rates. AIM has done this.

Another issue inadequately addressed in the paper is that of liquidity. To protect retail investors’ interest, it proposes a minimum investment of Rs five lakh in both the primary and secondary markets. Absence of retail participation in the secondary market may lead to the problem of poor liquidity. There is a cap on the post-issue capital of an SME – of Rs25 crore. For maximum capital of Rs25 crore with a minimum investment of Rs five lakh, an SME will have a maximum of 500 investors. If the non-
promoter holding is 50%, it would be distributed among a maximum of 250 investors. Assuming that investors in SMEs will largely be institutional
players, this number may be even lower. Liquidity will, therefore, continue to be a problem.

Also, with the entire capital in the hands of a few persons, the possibility of artificial prices remains high. Assuming that, at some stage, the company seeks to migrate to the main market, the retail investor will then end up receiving overvalued shares in the main market. The logic of protecting the retail investor in the SME segment may thus fail at a later stage. It may be noted that the AIM and TSX Venture allow retail investors to participate in the secondary market. The KOSDAQ market is dominated by retail investors.

The discussion paper mentions that merchant
bankers/underwriters may be compulsorily required to be market-makers for the security issued. However, the existing rules on market-making are not conducive to providing much liquidity. Very tight rules on bid-ask spread may lead us to revisit the experience of OTCEI, where market-making never picked up. The proposal to exclusively license merchant bankers for the SME market may fragment the investment banking market and increase regulatory burden as existing merchant bankers seek separate registration for the SME market. Instead, the involvement of merchant bankers in ensuring
good-quality SME issues could be ensured by asking merchant bankers to accept their fee as shares in the issuer SMEs and by making them hold the shares for minimum one year.

A separate exchange would mean fresh membership, new clearing and trading system, separate settlement guarantee fund, etc. All this is likely to increase the cost for SMEs as well as investors. The possibility of using the nationwide infrastructure of existing exchanges needs to be examined. Barring a few reliefs related to entry norms for issues and continuous listing requirements, the remaining regulatory regime for SMEs is not proposed to be changed. This may not be the best recipe for success of an SME exchange.