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Should You Invest In SME IPOs?

By Sanjay Kumar Singh, Karthik Jerome
Last updated on: October 04, 2024 10:05 IST
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'Many do not have robust business models, and their prospects of survival and long-term growth are poor.'

Illustration: Dominic Xavier/Rediff.com
 

The BSE recently halted the listing of shares of Trafiksol ITS Technologies, whose initial public offering (IPO) received bids worth Rs 10,000 crore (Rs 100 billion) and was subscribed 300 times, following investor complaints to the market regulator.

At a Confederation of Indian Industry summit held recently, Ashwani Bhatia, a whole-time member of the Securities and Exchange Board of India, voiced concerns about manipulation and fraud in small and medium enterprise (SME) IPOs.

He highlighted issues such as promoters inflating their balance sheets and insufficient due diligence by auditors and the market ecosystem.

These developments raise the question: Should retail investors invest in SME IPOs at all?

What's driving the SME IPO boom?

Many SME IPOs have been heavily oversubscribed over the past year. Investors who have not joined this gold rush experience FOMO (fear of missing out).

"When they hear of colleagues or neighbours making money from SME IPOs, they feel compelled to jump on the bandwagon, throwing caution to the wind," says Deepak Jasani, head of retail research, HDFC Securities.

In an environment where most SME IPOs list at a premium, investors believe there is potential for significant upside if they get an allotment, while 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 also leads to oversubscription.

"Investors' money gets locked in for two days only. And even then it remains in their bank account, which makes them willing to take a bet," says Jasani.

He predicts this trend will only reverse when some SME IPOs list below their issue price.

A high-risk bet

The issue size in SME IPOs is smaller, usually Rs 15 crore to Rs 50 crore. The size of these companies is also smaller.

"Companies that list on the SME exchange have smaller revenues and profits, which makes them riskier," says Ankur Kapur, head of investment, Plutus Capital.

Their weaker financials mean they are less resilient against economic downturns.

"Many do not have robust business models, and their prospects of survival and long-term growth are poor," says Kapur.

Most retail investors lack the skills to assess these companies.

"They have experience of equity investing on the mainboard, making it difficult for them to understand the risks in SME IPOs," says Yatin Singh, head of investment banking, Emkay Global Financial Services.

SME IPOs are also exempted from making several disclosures. Their red herring prospectus (RHP) is cleared by the exchanges, not Sebi.

"The rigour involved in preparing a draft red herring prospectus (DRHP) for a mainboard listing and the scrutiny Sebi applies to them is absent in the case of SME IPOs," says Singh.

He explains that there is a considerable gap between the level of scrutiny applied by Sebi and the assessment carried out by an exchange's compliance team.

"Even lower-quality companies and promoters come to the market through this route and secure undeserved valuations," says Jasani.

The investment bankers and auditors involved in these issues are usually not among the top-tier ones. "It is hard to verify the accuracy of the numbers that are presented," says Kapur.

In a mainboard IPO, the anchor book typically comprises 30 to 45 per cent of the issue. "Sophisticated institutional investors commit to a certain price even before the issue opens.

"Participation by institutional investors, who have the 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?

Experts suggest most retail investors should steer clear of SME IPOs.

"SMEs are smaller, provide minimal information, and do not undergo rigorous due diligence, so retail investors should avoid them altogether," says Singh.

Venture capital firms take a portfolio approach when investing in early-stage companies, spreading their risk across multiple firms.

"Retail investors lack the capacity to take such diversified bets," adds 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 mainboard IPOs.

"Here, they are further hamstrung by the lack of adequate information," he says.

Kapur suggests that retail investors should only consider SME IPOs if they have direct knowledge of the company.

"If you understand the business, have used its products, believe the promoter is ethical, and the firm has considerable growth runway, then it might be worth considering," he says.

How to conduct due diligence?

Given the limited information available, the scope for due diligence is limited.

"Ensure the company's top line and bottom line are substantial and it has a history of consistent 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," adds Jasani.

Kapur recommends scrutinising the red herring prospectus and obtaining additional information from the ministry of corporate affairs Web site.

"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.


Disclaimer: This article is meant for information purposes only. This article and information do not constitute a distribution, an endorsement, an investment advice, an offer to buy or sell or the solicitation of an offer to buy or sell any securities/schemes or any other financial products/investment products mentioned in this article to influence the opinion or behaviour of the investors/recipients.

Any use of the information/any investment and investment related decisions of the investors/recipients are at their sole discretion and risk. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Opinions expressed herein are subject to change without notice.

Feature Presentation: Ashish Narsale/Rediff.com

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Sanjay Kumar Singh, Karthik Jerome
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