SMEs (Small and Medium Size Enterprises) are a major driver of economic activity, in developed and emerging markets alike. In India, SMEs not only provide key inputs to industry but also contribute a substantial portion of GDP as well as rank amongst the largest employers in the country.

A key challenge SMEs face is raising capital. While both bank credit and capital markets play a pivotal role as capital sources for SMEs in developed markets, companies in the emerging markets are relatively dependent on the banking sector. Even within that, lenders are seen to prefer larger-sized clients due to risk perceptions related to smaller companies. Even bond issuances have generally seen to be more successful if done by large companies. In terms of equity, most SMEs generally find it difficult to garner financing on the main exchanges.

Given the two observations raised above – i.e. funding constraints and SMEs’importance for the economy, an SME stock exchange is believed to be a choice that can give a boost to their finance raising needs. Such a platform would attract early stage, growth investment firms, and investors may get a niche platform to analyse and invest in the ‘Next- Generation of Bluechips’.

While the initiatives of the main equity bourses to launch SME exchange platforms is a positive move, including that in India in 2012, the long-term success of these ventures will largely depend on its format and execution. This faces certain challenges. Firstly, this platform will need to bring together the SME universe, which is very diverse in terms of sectors and segments. Investors need research on these companies and the smaller companies are often the ones which have less research available.

The ability of sell-side intermediaries and buy-side managers to ensure regular delivery of research insights on such a diverse sectoral universe is a challenge. Secondly, corporate governance and disclosure practices need to be followed in a standardized manner across the SME universe. Next, the success of the main equity exchanges has traditionally been in high liquid scrips, which are constantly in the radar of investors. Not all listed stocks are actually traded actively, and in fact, most scrips with lower trading volumes are actually the smaller companies. During periods of broad-based market rally, there is still some interest that flows down to the mid-caps/small-caps following the initial large-cap rally.

However during market downturn, these smaller companies struggle to generate investor interest. Periods of market downturn also render primary market activity as sluggish, which impacts the success of the exchange platform. Globally, SME exchange platforms have targeted either niche segments or offered attractive terms and requirements. Examples are UK’s AIM which kept flexible requirements like no minimum listing size and trading in any freely available currency, Japan’s Jasdaq which targeted small technology stocks, USA’s Nasdaq First North targeting small, young and growth companies, Tokyo Exchange’s Mothers, a market for high-growth, emerging stocks, PLUS Markets which aims to create a pool of small & mid-cap liquidity in Europe, Toronto’s TSX Venture Exchange which provides access to public venture capital for new ventures, Johannesburg’s Alternative Exchange, a parallel market for quality high growth SMEs, Hong Kong’s Growth Enterprise Market, which offers investing in high growth-high risk businesses.

Using the global observations to address the challenges an SME exchange can face, new SME exchanges may target niche segments like high growth sectors or companies and ensure those scrips get listed. Expanding research coverage will enable transparency, information access, and understanding on a larger universe of stocks and help showcase companies with strong business performance and corporate governance. This could, in turn, help retail investors identify value-picks from amongst the mid and small cap universe and help them participate in these companies with much greater conviction.

On the distribution side, sell-side intermediaries may need to identify specific niche pockets of liquidity for this segment. Improving corporate governance and governance principles would prevent frauds, and it is critical to identify those who score highest on corporate governance practices including audited accounts disclosure, annual management statements and enterprise policy statements. A culture of professionalism as some SMEs bring in experienced management and independent board members can help take those companies to a higher growth trajectory, and deliver superior performance vs. peers. The transaction costs involved should be kept at reasonable levels to act as an incentive.

Lastly, the launch timing is dependent on the existing market conditions, so time it right. Access to capital at the right time for a growth company may help reap rewards, however, addressing the concerns is a priority in order to build the long-term reputation, trust and participation.

By Sourajit Aiyer

Image Courtesy: Sourajit Aiyer, Frankfurt

Originally published here – SME & Entrepreneurship Magazine, Malaysia – Stock Exchanges for SMEs