Published on April 17, 2024 at 3:24:19 AM
SME IPOs: Higher Risk, But Rewards may be higher too
India's stock markets are going through a bullish phase, prompting dozens of companies to float initial public offerings. Last year, for instance, there were 59 IPOs on the main board and 127 on SME exchanges, or the junior bourses of the BSE and NSE meant for small and medium enterprises. That’s nearly one IPO every other day.
Companies that wanted to raise money or whose founders and other shareholders were looking to monetise their investments did not want to miss out on the IPO frenzy. Just like the venture capital investors were affected by the fear of missing out or FOMO syndrome to bet on startups during the go-go year of 2021, a large section of stock investors was hooked onto the reports about listing gains.
The frontpage headlines on IPOs were mostly about the main board. But if you were to sift through the inside page there was another opportunity waiting to be tapped, powered by smaller companies that tapped investors on the two SME exchanges of BSE and NSE.
SME IPOs
The two junior exchanges, BSE SME and NSE Emerge, have a history of just over a decade. But they have been kicking dust. They have brought a new set of companies to the public market that may not have otherwise made the cut due to strict criteria for listing on main exchanges.
SME IPOs are now seen as an alternative mode to raise capital as investor lap up such issues with as much gusto as those on the main board And, there is also the possibility of migrating to the main board in the future.
Risk-Reward Tradeoff
The modern portfolio theory syncs with the principle of risk-return tradeoff where an investor can be pushed to take a higher risk if there is a possibility of a higher reward. If we apply the same principle to what is happening in the two sets of primary markets- main boards and SME exchanges- we get to see how it is playing out in the country. There are some caveats, however, that we shall come to later.
Data on IPOs in 2023 gives an insight into how the probability of one making positive returns from investing in the public issues on the SME exchange is relatively lower with around a quarter of the companies turning a flop show while the ratio was just one in twelve on the main board.
In simple terms it means that the empirical evidence from 2023 shows that if one invested in all SME issues, one in four of the bets would have turned bad.
But what piques one’s interest is this: The rest would have spun big profit. Mostly bigger than mainboard IPOs.
A reasonable outcome one would say.
The median returns after listing, on the listing day, as of January 1 (before the new year rally took the benchmark indices to new highs) on the junior exchanges of NSE and BSE has been a little over 47%. This means that gains after listing on half the SME IPOs was less than 47% and of the other half was more than 47%.
This implies that on an average if one made a punt on companies going public on the SME exchanges, he or she grew the value of investment by nearly 50% within months. Even if one chose to monetize the investments, after 30% short term gain, capital gains tax on the gains made would have been around 33%.
This is much higher than what one would have made on the larger companies that went public on the main boards. The median returns for the IPOs on BSE and NSE was 32% and post-tax returns would work out to be around 22.4%.
To be sure, the average listing-day gain on the SME exchanges was lower on average compared to the main board.
This means, the probability of making money on first-day first-show was higher for the IPOs on the main exchanges but the percentage gain on SME IPOs was higher on average. One reason for this might be lower valuations of SME companies in their IPOs.
Endnote
As in all things in life, in the world of finance too, higher returns come from taking higher risks. The same analogy is at play in the primary markets in India. SME exchanges, seen as a hotbed of small unproven companies with lower corporate governance benchmarks and market making by punters is no pushover when it comes to generating wealth and returns for an investor.
Hard data shows that new companies making their debut on the SME exchanges churned out more returns than bigger peers listing on the main boards.
That said, one should play the game with a high dose of caution as the smaller companies do face a tougher challenge from larger competitors, lack of low-cost credit and in attracting talent to make it big. Corporate governance risk may also be higher in the case of smaller companies. This makes them a riskier value proposition for any investor.
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