31 May 2011

SME exchanges a bad, bad idea

As BSE and NSE got a license today to start an SME (small and medium enterprise) exchange. I have a piece today in the Economic Times where I argue that an SME exchange is a bad idea for exchanges, investors, regulators and SMEs alike. Thankfully, the remission in regulatory burden on such an exchange is so minimal that the SME exchange (segment) at either BSE or NSE is unlikely to take off. Here is an excerpt:
That the absence of the existence of a listing platform catering specially to them deprives the entrepreneurs of India of much-needed capital and growth. While these are valid points, they escape the less obvious fact that 95% of SME businesses will fail within a short period of time. Where investments are made by venture capital and private equity investors in small to medium growing companies, the investments are made with an assumption that 9 out of 10 companies would fail. Utterly and completely self-destruct .

Of course, the gamble is that the 10th investment will not only make up for the other nine failures but also provide sufficient returns on the capital investment of all 10 exchanges. In reality, this 10th company may not exist or of course it could be the next Google . This ratio of failure exists despite the fact that the investor expends significant efforts towards due diligence initially and subsequently they try to improve the performance of the company by hand holding, sitting on their boards and sometimes even provide leads to new suppliers and customer. Investors will lose massive amounts of money out of genuine failure as is common in much of small business.

This will then erroneously be called fraud and people running these companies persecuted. At the same time, investors will be disillusioned because this new beast of an exchange will have 95 failures for every five successes. Imagine if 20% of all companies in your portfolio of listed SME stocks just vanish each year, year after year. Clearly, a typical Indian investor or even a so-called high networth investor will be disillusioned with such a market and will believe the SME space is full of crooks. In fact, they may even wrongly extrapolate that all public markets have fraudulent companies.
Thankfully, in good probability the SME exchange will likely never take off because the remission of regulatory obligations is so little and the cost differential in terms of compliance is nearly as much as a regular listed company, that companies would rather wait for a few years and list on the main exchange rather than list prematurely and make enemies of investors who could be friendly investors in the future. 


Mandar said...

I think this post moves from the assumption that issuers will only issue vanilla equity to raise capital on the SME Exchange. Equity securities have symmetricity and expose investors to both the upside and the downside equally and perhaps manifest the eventualities that you are concerned about.

Yet, With small and medium companies, it may be questioned why they would issue vanilla equity. They are more likely to issue hybrids like convertible debentures or convertible preferreds unlike equity securities that will most likely issue a huge discount to the fundamental value of the venture, because the entrepreneur is unable to "signal" the fundamental value of his venture to the investors owing to adverse selection. The option feature of a convertible is a way of avoiding the adverse selection. And so, a hybrid is most likely preferable both from the issuer and the investors perspective-- the latter having the benefit of unlimited upside because of the option feature (an option that may trigger on achievement of certain management metrics like ROA or some such performance metric) and a hedged downside because of the fixed return upfront. (Additionally, to the extent that the issuer issues convertible debenture, the option feature will lower the upfront coupon on the instrument). In addition to issuing convertibles, the entrepreneur may also signal by having major portion of her personal wealth invested in the venture.

In a nutshell therefore, the speculativeness and the risk of the venture failing, alone without more, may not be a reason to pan the development of this intermediary.

Sandeep said...

Great comment. But a convertible isn't an answer to the issue. The fallacy of convertibles being a 'win-win' has been amply exposed in FCCB bonds which have become a lose-lose instead.

I believe that if we are agreed that 9 out of 10 companies fail, there would also be agreement that in those companies equity, hybrids and debt would sink as well. Besides, am not sure, if any SME market is dominated by hybrids - anywhere else in the world.