SEBI's Tightened Grip on SME IPOs: A Necessary Reform?

SEBI Cracks Down on SME IPOs Amid Governance Concerns

The Securities and Exchange Board of India (SEBI) recently cancelled the initial public offering (IPO) of Trafiksol ITS Technologies, a small and medium enterprise (SME), highlighting rising concerns about corporate governance and transparency in the SME IPO segment. Trafiksol, a Noida-based company specializing in intelligent transportation systems, was directed to refund investors' money after SEBI's investigation revealed dubious dealings with a shell entity. This is one among several recent SME IPO controversies that have put this fast-growing market segment under regulatory scrutiny.

Trafiksol ITS Technologies Case

Trafiksol ITS filed its Draft Red Herring Prospectus (DRHP) on May 31, 2024, aiming to raise funds via an IPO on the Bombay Stock Exchange's (BSE) SME platform. The issue, priced between ₹66 and ₹70 per share, was oversubscribed by a staggering 345.65 times during its September 10-12 window. However, SEBI discovered that ₹17.7 crore from the IPO proceeds was earmarked for purchasing software from a vendor identified as a shell entity. Acting swiftly on complaints, SEBI annulled the IPO and instructed the company to refund investors, signalling its intent to curb malpractices.

Other Recent Controversies

The Trafiksol case is not isolated.

1. C2C Advanced Systems: C2C Advanced Systems' IPO on the National Stock Exchange's (NSE) Emerge platform faced complaints about financial discrepancies. While initially oversubscribed by 125 times, the listing was delayed as SEBI mandated an independent audit. Post-audit, SEBI allowed the IPO to proceed, but not before 370,000 applications were withdrawn. The regulator also instructed NSE to monitor fund utilization.
2. Rosmerta Digital Services: Rosmerta Digital Services withdrew its ₹206 crore IPO after complaints of DRHP inconsistencies and alleged market manipulation. While the company cited "adverse market conditions" as the reason, reports suggest SEBI's intervention prompted the withdrawal.

Red Flags in SME IPOs

The SME IPO market, while highly lucrative, has seen rising instances of governance lapses:

• Circular Transactions: Inflated revenues through related-party transactions mislead investors.
• Related Party Transactions (RPTs): SEBI noted that 50% of listed SMEs have RPTs exceeding 10% of their turnover, and 20% have RPTs exceeding 50%.
• Diversion of IPO Proceeds: Funds are often misused via connected entities or shell companies.
• Illiquidity: Many SME stocks face trading suspensions or become illiquid post-listing, making profit booking difficult.

As of October 15, 2024, 12 listings were suspended on NSE Emerge, and no trades occurred in another 15 companies over the past month. Similarly, BSE's SME platform had 28 suspensions, with 35 companies showing no trades in the same period.

SEBI's Proposed Reforms

To address these issues, SEBI has proposed several regulatory changes:

• Doubling the minimum application value for SME IPOs to ₹2 lakh.
• Increasing the minimum number of allottees to 200 (from 50).
• Restricting Offer For Sale (OFS) to 20% of the issue size.
• Mandating monitoring agencies to oversee IPO fund utilization.
• Extending the lock-in period for minimum promoter contribution to five years.

These measures aim to enhance transparency, curb malpractices, and protect retail investors.

The Growing Popularity of SME IPOs

Despite these challenges, SME IPOs remain an attractive investment avenue:

• Strong Growth: SME IPOs raised ₹1,980 crore in 2022, ₹4,967 crore in 2023, and ₹8,859 crore in 2024 (till December 11).
• Oversubscription Frenzy: Since September 2024, 61 SME IPOs have launched, with 29 receiving over 100 times subscriptions. Many have witnessed 200 times oversubscription.
• High Returns: Several recent SME IPOs, like Rajesh Power (109%), Neelam Linens (160%), and Danish Power (168%), have delivered significant post-listing gains.

Why SME IPOs Attract Investors

1. Low Initial Costs: Raising equity via SME IPOs is cheaper than debt financing, without the obligation to pay interest or dividends.
2. Massive Returns: Oversubscription ensures listing at premium prices, often doubling or tripling investor capital.
3. ASBA Interface: Application Supported by Blocked Amount (ASBA) keeps investor funds in their accounts until allotment, reducing opportunity costs.

Challenges and Risks

While SME IPOs offer lucrative returns, they come with inherent risks:

• Governance Issues: High promoter concentration increases the risk of fund diversion and mismanagement.
• Illiquidity: Lack of trading activity post-listing hampers exit opportunities for investors.
• Market Volatility: A bearish stock market could dampen interest and liquidity in SME stocks.

Conclusion

The SME IPO market has transformed into a high-reward investment space, enabling small enterprises to raise capital and grow. However, recent controversies and governance issues underscore the need for stricter regulations. SEBI's proposed reforms aim to restore investor confidence and ensure sustainable growth in this segment.

While the market remains hot, investors must exercise caution, thoroughly research offerings, and be mindful of associated risks. The future of SME IPOs will depend on maintaining the delicate balance between investor enthusiasm and regulatory rigor.