Initial public offerings: Why retail investors should be wary of SMEs

Sebi launched new investor protection measures covering small and medium enterprises on Monday. (Mint)
Sebi launched new investor protection measures covering small and medium enterprises on Monday. (Mint)


The SME segment has attracted the interest of retail investors but experts say there is reason to be cautious.

On Monday, market regulator Securities and Exchange Board of India (Sebi) launched new investor protection measures covering small and medium enterprises (SMEs). It extended the applicability of Additional Surveillance Measure (ASM) and Trade for Trade (T2T) regulations to the SME segment, following consultations with stock exchanges. These measures were previously limited to mainboard stocks—those listed on the primary market.

To be sure, ASM involves implementation of enhanced pre-emptive surveillance methods from time to time to control price volatility. T2T is a regulatory framework that is used to monitor and control the trading of stocks considered to be highly speculative or illiquid. The new measures, which are effective Tuesday, shines the spotlight on SME initial public offerings (IPOs).

The SME segment has seen an impressive 135 listings so far this year, compared to just 33 in the primary markets. The capital raised through SME IPOs has been the biggest this year since their introduction in 2012.

Graphic: Mint
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Graphic: Mint

Industry experts say several SME stocks are seeing remarkable growth, but pinpointing the driving factor can be challenging—be it authentic market optimism or potential market manipulation. SMEs often thrive in specialized markets, showcasing innovative business models or offering distinctive products and services, which can create opportunities for substantial returns on investments.

Incorporating SME IPOs into a portfolio can introduce diversification, spreading risk across various sectors and industries. Notably, the standout performers of 2023 have been Krishca Strapping Solutions and Exhicon Events Media Solutions, both enjoying an impressive surge of nearly 350%, more than quadrupling their initial issue prices. Sungarner Energies’ IPO witnessed a remarkable triple-digit increase on its listing day.

Mainboard vs SME IPOs

The mainboard typically demands a minimum of 1,000 subscribers or allottees for an IPO, with application amounts ranging from 13,000 to 15,000. These offerings undergo rigorous scrutiny as their Draft Red Herring Prospectuses (DRHP) are thoroughly vetted by Sebi. Moreover, companies aiming for the mainboard listing must have a post-issue paid-up capital exceeding 10 crore. While it offers a prestigious platform, the mainboard pathway is slower and often more expensive, with companies obligated to report their financials on a quarterly basis.

On the other hand, the SME segment caters to smaller enterprises, requiring a minimum of 50 subscribers or allottees, with an IPO application amount greater than 1 lakh. Notably, DRHP filings for SMEs are vetted by stock exchanges rather than Sebi. These enterprises are required to have post-issue paid-up capital ranging from over 1 crore to under 25 crore. The SME IPO route is known for its swifter and more cost-effective processes, with companies having to report their financials on a half-yearly basis. This differentiation in requirements and regulations provides a tailored approach to businesses of varying sizes and capital needs in the Indian IPO landscape.

Frenzy for SMEs

Over the past decade, the BSE SME IPO Index has demonstrated remarkable growth, surging a staggering 100 times. The index has delivered impressive annualized returns, with gains of 132% over the last year, 195% over the past three years, 82% over the past five years, and a solid 60% since its inception. These statistics highlight the robust performance of SME IPOs in India, making them an attractive investment avenue.

As per current data available from BSE, 454 companies have been listed on the SME segment, while 179 have migrated from SME to the main board. Presently, 275 companies are actively listed in the SME segment, while 24 have been suspended.

In the past few months, several companies have garnered significant attention and investor interest. Basilic Fly Studio Ltd, with a IPO size of 66.35 crore, received subscriptions totalling 359 times its initial offering, garnering an impressive 23,793 crore in subscriptions. Similarly, Madhusudan Masala Ltd, operating in a different niche with a size of 23.8 crore, witnessed substantial enthusiasm from investors, resulting in subscriptions 444 times its offering, translating to 10,574 crore. Oriana Power Ltd, with a size of 59.66 crore, attracted 177 times its offering, amounting to 10,535 crore. These impressive subscription figures underscore the enthusiasm and confidence that investors have shown in these companies, reflecting the vibrancy and buoyancy in the segment.

“There is always a frenzied reaction for IPOs during bull markets. A lot of investors still go by the concept of bygone era where the investors would invest in the IPO and sell it immediately after listing. On average, the investor used to make a 10-20 % gain in 3 to 4 months. The IPOs of the current era are priced through the book building process and include premium on face value. This premium is also influenced by current market valuations. There is a time lag between subscribing to an IPO and listing of the offering. A lot of times, these valuations correct heavily during this time lag due to market corrections or other reasons. This results in heavy losses to retail customers. Remember Paytm? The current valuations of small caps is a fertile ground for SME IPOs. Retail investors are best advised to stay away from the primary market or take limited exposure to prevent any heartburn later. Retail investors are better off buying from secondary market after price discovery," said Renu Maheshwari, co-founder of Finscholarz Wealth Managers.

The warning

Industry experts have a word of caution for retail investors. They warn that a combination of financial strategies, market manipulation, and information dissemination can impact stock valuations.

In the first scenario, let’s imagine a promoter aiming for a valuation of 100 crore but decides to launch the issue at a lower value of 50 crore. The promoter then strikes deals with offline brokers to orchestrate an artificial surge in demand. This manoeuvre inflates the share price in the grey market, and the promoter compensates the brokers for their role in stimulating and controlling the market until the issue is open for subscription. As the grey market premium (GMP) rises, unsuspecting retail investors join the fray. The brokers continue purchasing applications from the grey market, ultimately leading to the stock listing at the valuation desired by the promoter. Once this happens, the promoter and brokers liquidate their positions, capitalizing on the inflated valuation.

A second approach involves a cartel of brokers and businessmen who diligently research and identify a promising company. They then recruit social media accounts with substantial followings to generate hype around the impending stock issue. These social media accounts synchronize their posts, creating a buzz that attracts retail interest. When the stock finally goes public, it typically commands a modest premium. At this point, retail investors often begin selling their holdings. Simultaneously, the cartel seizes the opportunity to accumulate shares, leveraging their informational advantage and benefiting from the price differential.

Fraud & market manipulation

In March 2022, PMC Fincorp Ltd issued 70 million warrants, 50 million of which were allotted to non-promoters at 9.90 each. Non-promoter investors paid 25% upfront (around 2.50 per warrant) but later declined to convert them into equity as the share price dropped to under 2. The company retained the warrant application funds, collecting over 2.5 crore from non-promoter investors. Intriguingly, even the promoter participated in the warrant issue but chose not to convert.

The lesson here highlights the potential for fraud by promoters, underscoring the need for enhanced investor protection and regulatory vigilance.

“The simple method is to show paper profit, create receivables (such receivables & inventory frauds are age-old methods) while taking huge salary hikes, consultancy fees, royalties given to group companies or even commissions. SME promoters will typically be hungry for capital and take utmost care, given how difficult it is for them to raise funds.", said Mohammad Nasirul Amin Choudhury, who runs a famous twitter page on SME IPOs.

STL (formerly known as 8k Miles Software Services Ltd) found itself embroiled in a controversy last year. Initially, the company’s promoter alleged that certain sharebrokers and financial service provider firms had duped him by selling shares that he had pledged to secure loans.

However, as the investigation unfolded, it became apparent that the promoter himself played a significant role in the fraud. He was implicated in a more extensive conspiracy involving the manipulation of STL’s financial books and the diversion of funds into unrelated business ventures of the company’s senior executives. The promoter had also sold shares worth 110 crore in the open market and obtained a substantial 40 crore loan from share brokers.

This case serves as a stark reminder of the potential risks and consequences associated with corporate malfeasance, underscoring the importance of investor protection and transparency in financial markets.

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