India's SME IPOs: A Bubble Ready To Burst?

Recently, renowned investor Vijay Kedia sounded cautious about India's booming small and medium enterprises (SME) sector, labelling it frothy and vows to sidestep initial public offering (IPO) and pre-IPO investments amidst soaring valuations and market exuberance.

In a televised interview, he said, “In this kind of market, I will not invest. I am just sticking to my old investments and I am comfortable. When there is a typhoon, the best thing would be to stay calm.” Kedia added that a market correction is expected soon, however, the flow of money has not been allowing any meaningful pullback.

The current volatility in the Indian capital markets, particularly in the small-cap, is largely driven by sentiment. Recent news about manipulations in the SME segment has heightened investor panic. Over the past year, SMEs have experienced significant interest from various investor groups, leading to a surge in demand and substantial listing gains. Some listings have seen gains far exceeding their fair valuations, raising concerns about long-term viability. 

Inflated Price And Manipulation
SME IPOs are an essential platform for small and medium enterprises to raise funds, reducing their dependence on traditional bank financing. For years, the government has emphasised enabling capital market access for SMEs to foster financial inclusion and economic growth.

High demand for certain stocks, especially when paired with limited allotment, often leads to price inflation as investors compete to acquire shares. For example, Bajaj Housing Finance, a mainboard company's IPO, was oversubscribed 67 times. A 6,500 crore IPO received applications worth 4.39 lakh crore.

Investors often buy stocks based on future growth projections, which can lead to prices appearing overvalued in the short term. Prices are frequently adjusted according to the strength of the order book, reflecting the balance between demand and supply. While these initial valuations may seem inflated, they are driven by optimism about the company's potential, experts noted.

The rising momentum of SME IPOs and the lure of higher listing gains attract traders to focus more on price trends than company fundamentals, further contributing to price inflation.

“With smaller share floats, SME IPOs are vulnerable to price manipulation and volatility. Retail investors, drawn by the potential for quick listing gains, often overlook fundamentals, leading to inflated valuations. The speculative nature of retail investors further pushes prices up, turning these investments into short-term bets rather than long-term growth plays," said  Narinder Wadhwa, Managing Director and Chief Executive Officer (CEO), SKI Capital.

SME IPOs have recently garnered significant attention due to strong subscription numbers and impressive listing gains. However, there is a growing unease that this market is riding a wave of inflated prices and questionable fundamentals, which may lead to a painful crash for those who are not careful.

Shedding light on the factors contributing to inflated prices in SME IPOs, Sunil Shah, CEO, Khambatta Securities said, "Fundamentals may be questionable for a few companies but all issuers’ financials and business models are disclosed in the offer document so that the investor can make an informed decision based on their analysis and risk appetite. Concerning offer prices, I believe a majority of SME IPOs are being offered at reasonable valuations which is one of the factors driving investors’ interest in them."

Interestingly, the IPO of Boss Packaging Solutions became a focal point of controversy when the company was heavily oversubscribed 135 times despite facing criticism for its inadequate infrastructure. Investors flocked to the offering, lured by the prospect of high returns, even though the company’s shabby office and a small workforce of 64 employees raised questions about the due diligence process. Despite these concerns, Boss Packaging’s shares debuted at a 25 per cent premium on the National Stock Exchange (NSE) SME platform, highlighting the speculative nature of such investments.

Recently, BSE made a last-minute decision to postpone the listing of Trafiksol ITS Technologies’ SME IPO, which was set for 10 am on 17 September. The debut was expected to deliver strong returns, with a grey market premium indicating potential gains of 135 per cent. However, growing caution around the SME sector led BSE to halt the use of funds, directing that the amount raised from the issue be held in escrow until complaints are satisfactorily addressed. The IPO attracts significant investors, being subscribed 345.65 times overall, with the retail portion at 317.66 times and non-institutional investors nearly 700 times. Trafiksol raised Rs 12.75 crore from anchor investors, but the listing has been delayed until queries are resolved.

Unfazed Retail Investors
Amid this euphoria in the SME IPO segment, one thing that stands out is retail investors appear unfazed by the Securities and Exchange Board of India's (Sebi's) warning on manipulation being seen in some SME IPOs, diving headfirst into yet another high-risk bet. Well, for starters, investors with a high hurdle rate seek to invest in businesses with exponential growth potential. Larger companies offer stable returns whilst smaller businesses present a much higher probability of becoming a multibagger.

In several cases, the significant listing gains attract investors despite the risks. For example, companies like Owais Metal And Mineral Processing Limited and Australian Premium Solar (India) Limited have delivered extraordinary returns, gaining over 1500 per cent and 700 per cent, respectively, on their issue prices.

However, this speculative activity comes with risks. In contrast to the high flyers, companies such as M.V.K. Agro Food Product and Italian Edibles Limited have seen substantial losses, with their stocks plummeting by 57.63 per cent and 33.01 per cent, respectively, since their listing. Notably, the risk of investing in the capital market whether the primary or secondary market remains uniform across all investor categories, whether they are domestic institutional investors (DII), foreign institutional investors (FII), or retail investors. However, despite the inherent risks, DIIs, FIIs, and financial institutions such as banks continue to participate actively in IPOs.

"Their motivation stems largely from the potential for higher listing gains and the prospect of relatively easy returns, especially in a favourable market environment. Retail investors, in turn, are often influenced by the actions of these larger players, market news, and prevailing sentiment. If prominent institutional names are entering the market, retail investors are unlikely to hold back, following the belief that they too can benefit from these opportunities," Kresha Gupta, Founder and Director, StepTrade Share Services.

Gupta, however, added that it is not entirely accurate to say that retail investors have been unfazed by warnings. Notably, the SME exchange did experience a setback in March 2024 when news of manipulation in SME IPOs came to light. However, many of the companies listed on the SME exchange have since demonstrated good performance.

Despite repeated warnings, retail investors persist in risky investments, driven by the allure of quick profits. Lack of due diligence and limited financial literacy exacerbate this trend. Loopholes in regulatory frameworks and inadequate scrutiny enable unscrupulous operators to thrive. Experts noted that this mix jeopardizes hard-earned savings, underscoring the need for enhanced investor education and stricter oversight.

SKI Capital's Wadhwa stated, "The lure of substantial listing gains makes retail investors ignore warnings, despite the risks involved. At the same time, many of the SME issues also offer very good long-term investment opportunities for wealth creation. Many retail investors are driven by sentiment rather than analysis, resulting in an uninformed rush into SME IPOs. Many issues are getting good reviews by market experts at the time of IPO, which IPO investors follow."

Loopholes In The Regulatory Framework
At least five SME IPOs this year have seen major subscriptions of around 1,000 times, fuelled mainly by retail investors. In fact, over half a dozen have seen retail subscriptions soar beyond 1,000 times. Shah stated, "Subscription in a public issue cannot be controlled by either the stock exchange or the lead manager. Subscription is a direct function of demand and the current liquidity in the market is also contributing to it. The best way to protect investors is by conducting thorough due diligence and developing a robust offer document, and all stakeholders in the IPO market must strive towards making that framework robust."

Talking about loopholes in the system, SME IPOs face less rigorous regulatory scrutiny than mainboard IPOs, creating opportunities for manipulation. Experts noted that Sebi's warning needs to be backed by stronger regulations, including stricter eligibility and enhanced monitoring of post-listing price movements. Observers noted that implementing more stringent regulations and improved transparency can reduce the risks of price manipulation.

Gupta also talked about how this issue can be addressed. Gupta added, "Measures such as extending lock-in periods for significant shareholders and ensuring dedicated allocations for Anchor and QIBs can be placed. Sebi can put stricter monitoring in place for activities leading up to an IPO, including tracking large and unusual investments by specific entities. Raising the net worth requirements for companies seeking to list."

Bubble Ready To Burst?
Is India's SME IPO market exhibiting warning signs, fueling fears of an imminent bubble burst? Well, with 230 per cent growth in SME listings since 2020, valuations have surged, often disconnected from fundamentals. Rising cases of price manipulation, lax regulatory oversight, and investor frenzy have prompted Sebi warnings. Experts caution that unsustainable growth may lead to a sharp correction.

Shah stated, "As long as good companies with robust business models and growth potential keep coming to the market, the informed investor will keep looking out for such companies." He added that the recovery after a general market correction if that happens, is a market phenomenon. Good companies will always bounce back based on their strong fundamentals.

While the SME IPO market offers significant opportunities for growth, the challenges are equally substantial. With 207 SME IPOs already listed in 2024 and more expected, Sebi’s proactive measures will play a crucial role in ensuring the market remains credible and investor-friendly. As companies like TAC Infosec and Alpex Solar deliver impressive gains of over 500 per cent, the demand for SME IPOs shows no signs of slowing. However, with increased regulatory scrutiny, investors will need to conduct thorough research and remain cautious of the risks involved.

"Despite concerns, the SME IPO market will likely continue attracting investors, particularly those looking for short-term gains. However, a market correction could lead to significant losses, especially for retail investors who are underprepared. This could undermine the credibility of the SME platform, impacting its role as a vital funding source for legitimate and promising companies," Wadhwa stated.

Experts told BW Businessworld that while concerns surrounding inflated valuations and manipulation risks in SME IPOs warrant attention, it's essential to distinguish between legitimate opportunities and malicious activities. Dismissing the entire platform overlooks the promise of innovative, well-managed emerging companies with solid growth strategies, which can drive economic expansion and create value for investors.

"While the SME market may face a correction if concrete evidence of manipulation emerges or if SEBI takes regulatory action, the overall market sentiment remains bullish. With the broader capital market performing well, the SME IPO market is likely to continue attracting investors, driven by optimism and institutional backing. Additional point – While the SME exchange is still in its growth phase, it is important to address and resolve the challenges it faces," Gupta noted.

Amid the concerns over inflated valuations and manipulation, few experts warn of a potential correction, others see legitimate growth opportunities. Stricter regulations and investor education are crucial to sustain the platform's viability and distinguish between promise and speculation.