Smaller size, fewer disclosures, light scrutiny make SME IPOs risky bets

The market regulator recently halted the listing of shares of Trafiksol ITS Technologies, whose initial public offering (IPO) received bids worth Rs 10,000 crores and was subscribed 300 times, following investor complaints. At a business summit, Ashwani Bhatia, a whole-time member of the Securities and Exchange Board of India (Sebi), highlighted concerns about manipulation and fraudulent practices in small and medium enterprise (SME) IPOs. He spoke about promoters inflating their balance sheets and the lack of due diligence from auditors and the market ecosystem. All these developments raise the question: Should retail investors invest at all in SME IPOs?

Behind the SME IPO craze

Many SME IPOs have been heavily oversubscribed over the past year (see table). Investors who have not joined the SME IPO gold rush experience FOMO (fear of missing out). “When they hear of colleagues or neighbours who have made good money in an SME IPO, they feel impelled to jump on the bandwagon, throwing caution to the wind,” says Deepak Jasani, head of retail research, HDFC Securities. In the current bullish environment, with most SME IPOs getting oversubscribed and listing at a premium, investors believe that while there is potential for significant upside if they get an allotment, the downside is limited. Investors also take cues from the grey market, where premiums suggest these IPOs are likely to perform well. The two-day process is another reason for oversubscription. “Investors’ money gets locked in for two days only. And even on those days, it remains in their bank account, which makes investors willing to take a bet,” says Jasani. He adds that as long as SME IPOs continue to list at a premium, retail investors will continue to apply for them. The tide will only turn once a few IPOs get listed below the issue price.

A high-risk bet

Typically, the issue size in SME IPOs is smaller, ranging between Rs 15 and Rs 50 crores. The size of these companies is also much smaller than those that go for main board listings. “The companies that list on the SME exchange have smaller revenues and profits, which makes them riskier,” says Ankur Kapur, head of investment, Plutus Capital. Small companies usually have weaker financials and less resilience to withstand economic downturns. “Many of them do not have a robust business model. Their chances of survival and long-term growth are not very bright,” says Kapur. On their part, most retail investors lack the skill to evaluate these companies. “Their experience of equity investing is on the main board. Hence, they lack the ability to understand the risks in these companies and make informed decisions,” says Yatin Singh, head of investment banking, Emkay Global Financial Services. These companies get a number of exemptions and relaxations in terms of disclosures. Sebi does not clear the red herring prospectus of these companies – the exchanges do. “The rigour involved in preparing a draft red herring prospectus (DRHP) for a main board listing and the scrutiny Sebi applies to them is absent in the case of SME IPOs,” says Singh. He explains that there is a substantial gap in the level of scrutiny applied by Sebi and the assessment carried out by an exchange’s compliance team.

“Even lower-quality companies and promoters are able to come to the market through this route and secure valuations they do not deserve,” says Jasani. The investment bankers involved in these issues are usually not among the top-tier ones. Auditing of these firms is also conducted by less-established auditors. “It is harder to know whether the numbers they are presenting are accurate,” says Kapur. In a main board IPO, the anchor book typically comprises 30-45% of the issue. “Sophisticated institutional investors commit to a certain price even before the issue opens. Participation by institutional investors, who have the technical expertise to conduct thorough analyses, provides a strong signal to retail investors. The concept of an anchor book is absent in SME IPOs,” says Singh.

Should retail investors participate?

Market experts believe most retail investors would be better off avoiding SME IPOs. “Given that SMEs are smaller, the information they provide in the RHP is minimal, and they don’t undergo rigorous due diligence, retail investors should stay away from these IPOs completely,” says Singh. According to him, venture capital funds, when investing in early-stage companies, take a portfolio approach by investing in 35–40 companies. Of these, usually 50% make losses while another 25–30% barely return the invested capital or offer a nominal return. Only a small percentage provide high returns that offset the losses on the rest. “Retail investors do not have the capacity to take these kinds of portfolio bets on early-stage companies,” says Singh. Jasani echoes similar sentiments. “Most investors do not have the time or the skills to conduct sufficient due diligence even in the case of main board IPOs. Here, they are further hamstrung by the lack of adequate information,” he says. According to Kapur, the only situation in which retail investors should participate in SME IPOs is if they have dealt with the firm in some capacity. “If you understand its operations, have used its products or services or received positive feedback, know that the competition is not too fierce, and believe the promoter is ethical, only then should you proceed. Ensure the company has a significant growth runway,” he says.

What due diligence should you do? 

Given the limited information available, the scope for due diligence is also limited. “Ensure the company’s top line and bottom line are of a decent size and have a consistent history of growth. Also avoid very small-sized issues,” says Jasani. Review the track record of the investment banker handling the issue. “Check the SME IPOs they have handled in the past and their performance,” he says. Kapur recommends going through the red herring prospectus and also downloading information about the company from the Ministry of Corporate Affairs website. “On the financial side, you may need to conduct forensic accounting to determine whether the numbers make sense,” he says. He concedes this is a task that professionals, rather than retail investors, are equipped to do.

Oversubscriptions fuel SME IPO rush

Top 5 SME IPOs in past year in terms of oversubscription