Wednesday, May 28, 2008

Enabling SMEs Access the Capital Markets

Although the small and medium enterprises (SMEs) constitute a significant portion of India’s economy, they face several hurdles in accessing capital in a cost-effective manner. As far the capital markets are concerned, the SEBI (Disclosure and Investor Protection) Guidelines, 2000 provide several eligibility criteria for companies to qualify for being able to initiate public offerings. These include a past track record, minimum net worth requirements and the like that maintain the bar at a high level for SMEs to clear, and hence they are effectively kept out of the capital markets.

In order to overcome this present disposition, SEBI has recently issued a discussion paper that not only relaxes some of these eligibility criteria for public offerings of securities by SMEs, but even provides for a separate stock exchange on which SMEs can list their securities. The consultation paper details the need for a separate securities listing and trading route for SMEs. It also lists out parallels from other countries such as the Alternative Investment Market (AIM) in London, the Growth Enterprises Market (GEM) in Hong Kong and MOTHERS in Japan. All these provide separate avenues for listing of SMEs shares in the respective economies.

Since the eligibility criteria for listing have been relaxed, investor protection measures are sought to be introduced through different means. And that is by limiting investment opportunities in the SME listed segment only to large investors (investing and trading a minimum of Rs. 500,000). This is similar to the US concept of accredited investors, with the logic being that large investors (both institutional and individual) are either sophisticated enough to appreciate risks involved in investments or are able to obtain suitable investment advice; in any case, large investors are better able to absorb the risks involved in any such investments.

The minimum Rs. 500,000 investment requirement will continue in the secondary market as well. This will be ensured by way of imposing minimum trading lots of that amount, so that large investors do not purchase SME securities in public offerings and then down-sell them in smaller lots in the secondary markets. The continuous listing as well as financial reporting requirements for SMEs would be less stringent compared to their larger counterparts.

Overall, this is a welcome move as it could potentially create financing avenues for SMEs and also a separate market for investors keen to target that segment of the economy. This is also in tune with the international trend as we have seen earlier. However, it also calls for some caution and pessimism, particularly in view of past attempts which have failed. The prime attempt relates to the establishment of the OTC Exchange of India (OTCEI), which has not garnered the attention of the SME segment as it was expected to. Recent reports and commentaries have pointed to the need to ensure that this is not repeated with the current attempt (see, LiveMint and Mostly Economics blog).

From a legal and regulatory standpoint, it is likely to be more difficult to control the activities of SMEs as they may not have adequate infrastructure to meet with the required audit, reporting and compliance procedures as compared to the larger more established corporates. The reputation incentives of SMEs to comply with listing requirements and corporate governance may not be as high as their larger counterparts. One way to overcome this problem would be to have the SMEs piggyback on the reputation of a third party intermediary (also commonly referred to as “gatekeepers”). For instance, several jurisdictions still follow the requirement of having an intermediary such as an investment bank act as a sponsor in respect of an SME entity.
The role of the sponsor is to ensure compliance of norms by the SMEs failing which the regulator would hold the sponsor responsible. The mechanism is designed to provide enough reputation incentives to the sponsor to ensure that the SMEs do not fail, and therefore indirectly protect the interest of the investors. This “sponsor-supervised” model is being followed in the recently established Catalist, which is Singapore’s market segment for growth companies. The Catalist website describes its regulatory structure as follows:

“In a Sponsor-supervised market, SGX [Singapore’s stock exchange] continues to regulate companies through its admission and continuing obligation rules. It also retains the power to discipline them when there is a rule breach. However, approved "Sponsors" undertake the direct supervision of the companies.

Sponsors are qualified professional companies experienced in corporate finance and compliance advisory work. They are authorized and regulated by SGX through strict admission and continuing obligation rules.


The Sponsor's main role at IPO is to assess the company's suitability to list and to prepare it for listing. After IPO, Sponsors are to advise and supervise listed companies on responsibilities in a public market. Sponsors are expected to whistleblow to SGX when there is an affirmed or suspected rules breach.”
There are indeed benefits in this sponsor-supervised model, and it may help for SEBI to explore this option in the Indian context as well.

Comments are due on SEBI’s discussion paper by June 6, 2008 (which does not leave much time though).

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