In today’s Finshots, we talk about NSE’s new strategy to crackdown on those sneaky, manipulative SME IPOs.

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The Story

If you’ve seen The Wolf of Wall Street, you’ll probably remember that iconic scene where Leonardo DiCaprio’s character, Jordan Belfort, spins a slick pitch over the phone, selling a questionable penny stock. But if you haven’t watched the movie, here’s what the scene looks like. The investor, sceptical at first, gets completely swept away by Belfort’s smooth talk and ends up investing more than they initially planned. It’s a masterclass in persuasion, and a cautionary tale for anyone thinking of jumping into the stock market.

Now, if you think that this kind of pitch belongs only in the ’90s; believe it or not, something similar is playing out in the Indian markets today. But instead of Belfort’s phone calls, we’ve got small Indian companies asking for massive sums from the public. And investors aren’t shying away from showing up in droves.

You could look at Resourceful Automobiles Ltd., for example. It’s a bike dealership with just 2 showrooms and 8 employees. In FY23, the company recorded close to ₹20 crores in sales and made a profit of about ₹40 lakhs. Yet, it wanted ₹12 crores from its IPO. Sure, that might seem reasonable when you look at the sales-to-valuation figure. But here’s the kicker. The company was clearly running on negative operating cash flows. And nearly 40% of the IPO funds were intended to repay loans, not fuel business growth. Despite this, investors flooded the bike dealership with offers totalling a staggering ₹4,769 crores. And although the stock remained flat at ₹122 per share on its first day of trading, it never dipped below its issue price of ₹117.

Or consider Broach Lifecare Hospital, a tiny 25-bed facility. It set out to raise ₹4 crores but ended up with offers exceeding ₹640 crores from eager investors.

These are just a couple of handpicked examples, but they’re far from isolated cases. So far in 2024, over 140 SMEs (small and medium enterprises) have launched IPOs, raising a jaw-dropping ₹4,800 crores.

Sounds like a win-win for the company and the investors, right? Well, not quite.

Unless you’ve been living under a rock, you’ve probably heard SEBI Chairperson Madhabi Puri Buch raise concerns about this trend, pointing out that the market regulator has spotted signs of manipulation in the SME segment.

And when we talk about SME IPOs, we’re referring to small Indian companies with ₹25 crores or less in paid-up capital that are looking to raise money through IPOs, just like the big players. But they’ve got a different path. Instead of listing on the regular exchanges, they go public on platforms like BSE SME or NSE Emerge where investors can bid for shares. The idea is simple. SMEs need funds to grow before they can become big, listed companies.

Well, on paper, it’s a brilliant move. It offers growth opportunities for these companies, new investment avenues for investors and boosts the economy too. Plus, it’s often a cheaper way for these businesses to raise money compared to taking on high-interest bank loans.

But there’s a catch. When companies with shaky foundations start asking for, and also get huge sums of money, it stops being something to smile about. The National Stock Exchange (NSE) certainly isn’t amused. And that’s why it’s stepping in with stricter rules for listing SME IPOs on its NSE Emerge platform.

One of these new regulations, in fact, have already kicked in for companies filing their IPO documents from yesterday (September 1st).

But how do these new rules work, you ask?

First up, the NSE is saying, “Show me the money”. Simply put, it wants companies to have positive Free Cash Flow to Equity (FCFE) for at least two of the last three years. This means that after paying off all its debts, the company should still have some cash left — money that could be returned to shareholders. This ensures that only companies with real financial stability can make it to the market.

Sounds solid, we know. But, like most rules, this one has its downsides too.

For instance, a company could show positive cash flow while still being weighed down by high debt or declining revenues. Imagine a startup that reports positive FCFE after a temporary sales spike. If those sales aren’t sustainable or consistent, the company could find itself in trouble soon after, despite passing this rule.

Moreover, this requirement might sideline promising SMEs that are in a growth phase. Let’s say a manufacturing firm invests in new machinery to boost production. That investment could lead to significant future profits, but it might also result in negative cash flow in the short term, disqualifying them from an IPO under the current rules.

And let’s not forget the investors. Some of them might want to back high-risk, high-reward opportunities or innovative, fast-growing businesses. This rule could limit their options too.

Then there’s the rule about a 90% cap on the opening share price compared to the issue price. And if that sounds confusing, here’s what it means.

See, SME IPOs often face lower demand and supply, which can lead to a lot of stock price swings. That’s where this new rule comes in. It's designed to keep those crazy fluctuations in check. For example, if a company issues shares at ₹100, they can’t trade at more than 90% above that issue price. In this case, it means no higher than ₹190 on the first day. The goal here is to create a fairer pricing environment and protect investors from extreme volatility.

But even this rule has its challenges. Once trading begins, stock prices can still swing wildly based on market sentiment and news, no matter the initial 90% cap. Plus, some high-potential SMEs might hesitate to go public if they feel that their true market value won’t be reflected.

And that’s not the only problem. This price cap could also open the door to more manipulation. Investors with large share holdings might inflate demand during the pre-open market session by placing big orders at inflated prices. This could end up pushing the share price closer to the 90% cap. For the uninitiated, the pre-open market session runs from 9:00 a.m. to 10:00 a.m. and helps set the IPO listing price. Once trading begins, these investors could then sell off their shares at a profit, leaving smaller investors stuck with the losses.

Now, we aren’t saying that these new rules won’t change the game at all. They might. The SME market is wrestling with manipulation. And it’s great that regulators are gearing up to clean things up. They could bring more transparency to the SME market and also help investors make better choices.

But let’s be honest. They’re not a magic fix.

In the meantime, if you’re thinking about diving into SME IPOs, now might be the time to channel your inner Sherlock Holmes. Don’t get swept up by the charm of slick company pitches. After all, in a market filled with potential Jordan Belforts, it pays to be cautious, no?

Until next time…

Note: In an earlier version of this story, we mistakenly mentioned that the pre-open market session runs from 9:00 a.m. to 9:15 a.m. We’ve since corrected it, and we apologise for the oversight.

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