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Can Small Be Beautiful?

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On March 13, 2012, the Bombay Stock Exchange's (BSE) small and medium enterprise (SME) stock exchange platform was formally launched and listed its first stock, that of BCB Finance. The company offered 3.46 million shares at Rs 25 a share (2.5 million shares through an IPO) for subscription by the public on 23 February this year, and the issue was subscribed one and a half times. BCB Finance is a securities broking firm, whose other business is to give loans against shares.

The new SME exchange — the Small Industries Development Bank of India (SIDBI) has regulatory approval to start another in partnership with the National Stock Exchange (NSE) — is the promise of hope to many entrepreneurs, for whom the launch of these exchanges may become a capital lifeline. SMEs face several obstacles to raising growth capital, and rely heavily rely on banks for loans.

But history has a few warning lessons. Three decades ago, a similar exchange, Over the Counter Exchange of India (OTCEI), was launched with much fanfare. During its heyday, the exchange had 115 listed companies; that number is down to just 62, according to an exchange official, who requested anonymity. A number of companies went bust, while a few graduated to the larger exchanges. "There has virtually been no trade on the OTCEI for around 6-7 years," adds the official. Says a Mumbai-based medical instruments manufacturer who came out with an IPO on the OTCEI in 1997 to fund his start-up: "There was zero liquidity in the exchange," he says. "Our stock was traded just four times in three years. We still get calls from shareholders asking what to do with shares, but we do not have an answer."

The IPO for the issue of 600,000 shares cost his company about Rs 8 lakh . He had hoped to be able to graduate to the BSE in about 3-5 years. But the company shut down operations in 2000 and the promoter never delisted, as he found it an expensive and cumbersome affair. Will the new SME exchanges succeed where OTCEI failed?

Making A Case
Advocates and believers in SME exchanges trot out a host of figures to justify their faith. SMEs account for 45 per cent of annual industrial output, 40 per cent of exports, employ 60 million people, create 1.3 million jobs each year, produce over 8,000 products and contribute 17 per cent of India's GDP, according to the Small and Medium Business Development Chamber of India. There are nearly 30 million SMEs in operation. "Given all this, SMEs are not looking for charity," says Uma Reddy, managing director of Hitech Magnetics, a Bangalore-based technology firm. So far, banks have been providing the finance that SMEs need, but the demand exceeds supply by a wide margin. Financing terms are fairly stiff too. "A typical promoter to banker contribution to working capital ratio is 1:2," says Amit Rambhia, group chairman of  Vardhaman Technology, a computer parts manufacturer. "Where is the growth capital going to come from?" Others point to the presence of successful SME exchanges in other countries, like the Growth Enterprise Market (GEM) in Hong Kong, the TSX Venture Exchange in Canada, the Market of the High-Growth Emerging Stocks, or Mothers, in Japan, even the London Stock Exchange's (LSE) Alternative Investment Market (AIM).

The key difference between these exchanges and our own experiment with OTCEI is that they were part of larger and successful stock exchanges, rather than standalone like the OTCEI has been. Many believe that creating the new exchanges — the SIDBI-NSE exchange is likely to be launched in a few months — as part of the countries' two premier stock exchanges can prove to be a successful model. While there is a strong argument in favour of lowering entry barriers for SMEs, Lakshman Gugulothu, managing director and CEO of the BSE's SME exchange, says: "Right now, companies with a paid-up capital of less than Rs 10 crore can list on the BSE's SME platform."  "Once paid-up capital reaches Rs 25 crore, they can graduate to the main exchange." Some of the rules for listing on the exchange could be made less stringent. "One mandatory requirement relates to quarterly reports. Bringing out reports entails high costs that affect their (companies') profitability," says DR Dogra, managing director and CEO of CARE ratings.

The Liquidity Challenge
The success of any exchange hinges on just three factors: liquidity, more liquidity and retail participation, as the OTCEI's failure has clearly demonstrated. A challenge given the small equity base of most SMEs, which is unlikely to tempt investors. "Small companies will not generate the volumes and interest that large companies do," says Bimal Thakkar, managing director of ADF Foods, a food processing SME. "That presents big operational and management challenges for the exchange."

"Small companies will not generate the volumes and interest that large companies do," says Bimal Thakkar MD, ADF Foods (Courtesy: ADF Foods)

The critics of SME exchanges argue that private equity (PE) and venture capital (VC) firms are more reliable sources of capital; by their very nature, PE and VC firms also get involved in management and bring an array of business skills to the table that entrepreneurs could avail of. "SMEs normally rely on bank loans and/or personal savings for initial capital, followed by additional funding  from VC firms," says  Shyam Srinivasan, managing director at Federal Bank. But a spate of exits by PE firms from SME companies in the recent past has proved to be a dampener for the sector.

One critical factor to ensure ample liquidity will be successful market-making; in BCB Finance's IPO (it received about 750 applications) market-makers were allotted 640,000 shares to offer buy and sell quotes. Market-making for new listings is mandatory for a period of three years, which could offer investors some degree of comfort.

Gugulothu thinks it will take about a decade to create a successful parallel exchange. And as CARE Ratings' Dogra points out, lessons from other markets — including the OTCEI — such as those for forex, commodity and interest rate futures — will have to be carefully studied. Learning from the mistakes of others is a far cheaper option than paying the huge price of failing on one's own.


(This story was published in Businessworld Issue Dated 02-04-2012)