As small caps soar, HNIs ape VC funds with ‘spray-and-pray’ bets via warrants route

It works like this: if an HNI subscribes to equity warrants of a stock at say Rs 100, he has to pay just Rs 25 upfront. At the time of conversion, if the stock is quoting at say Rs 125, he can pay the balance Rs 75, convert the warrants into shares, immediately sell the shares and pocket Rs 25 as profit. On the other hand, if the stock is quoting below Rs 100, the HNI may choose not to convert, and forgo the Rs 25 he had paid upfront.

The numbers

Given the strong demand for preferential issues, HNIs have become the go-to source of funds for many small companies.

Numbers sourced from Prime Database show that 252 out of the 257 companies that have come out with preferential issues in FY24 so far, have a market cap of less than Rs 25,000 crore.  These companies have cumulatively raised around Rs 17,700 crore or a little over $2 billion.

Of these, 131 preferential issues have been in the form of equity warrants.

Some issues as large as Rs 2,000 crore have been successful without a single domestic mutual fund participating. Filatex Fashions preferential issue saw interest from 197 investors, including HNIs and Portfolio Management Service (PMS) funds. Gensol Engineering’s issue attracted 161 investors, Salasar Techno Engineering’s issue 139 investors, and Man Infracontruction’s issue drew 135 investors.

Brokers say unlike in the past when a preferential issue would at the most have a dozen-odd investors, 50-80 investors for a single preferential issue has now become a routine affair.

Bonanza for promoters

The craze among HNIs for a piece of the action in the small cap space is understandable- the NSE Small Cap 100 and NSE Small Cap 250 have risen 71 percent and 64 percent, respectively, over the last one year.

But some market players are worried that many HNIs are not aware of what they are buying into.

“Because they have made a lot of money from the market, they are taking a ‘spray-and-pray’ approach followed by VC (venture capital) and PE (private equity) funds,” the above-mentioned dealer told Moneycontrol.

In other words, HNIs are investing in a large number of small and micro cap companies in the belief that even if a handful of them go on to become multi-baggers, it will more than compensate for the ones that flop.

“In the case of warrants, the upfront amount—often less than Rs 5 crore--is loose change for these HNIs, considering the huge upside potential if the bet is successful. It is almost like they are playing the F&O (futures and options) game in small caps,” said the dealer.

Red flags

Brokers say HNIs should pay heed to the amount of capital being raised by the companies in the context of their annual sales.

“Because there is ample liquidity in the system, many companies are able to raise far more money than they actually need,” said a veteran investor and market observer. “Investors are lapping up any story that promoters tell them, convinced that it will come true over the next couple of years,” he said, adding that many companies were raising multiples of their annual revenue through preferential issues.

“True, the SME story is looking good right now, and many companies have seen a massive growth in their earnings over the last couple of years. But there are also cases where the revenue growth is being supported by huge fund raises.

If equity capital dries up and these companies are forced to borrow from banks, the margins may not look as great and market will be quick to punish the stock,” he said.

Lessons from history

Investors subscribing to equity warrants are confident that the stock prices will be significantly higher than the acquisition price in 18 months when the warrants come up for conversion. That is because they are extrapolating the upbeat mood in the market and the strong business environment.

Such assumptions could turn out to be dangerous, as history shows. In 2006 and 2007 many companies raised money through foreign currency convertible bonds (FCCBs). Bondholders had the option to convert their bonds into equity at maturity at a pre-decided price. The companies were betting that the bond holders would convert, since the market price was likely to be much higher than the conversion price. But when the market crashed in 2008-09, stock prices fell way below the conversion price. Bondholders then asked for their bonds to be redeemed. Many companies were hit by a double whammy because the rupee had depreciated and because the borrowing was in dollars, the cost of repayment rose even higher. Many companies, including today’s market darling Suzlon, defaulted on the bonds.

Reverse swing

Similarly, many promoters who tried to increase their holdings on the cheap during the bull market of 2007 by using warrants, as well as other investors too came to grief. Back then, the upfront payment for subscribing to warrants was 10 percent. When the market crashed, promoters and investors collectively forfeited the Rs 1,000 crore they had paid upfront. Companies whose convertible warrants lapsed include Hindalco, Tata Power, GE Shipping, Pantaloon Retail and Indiabulls Real Estate.

Many minority shareholders had already complained to SEBI that equity warrants unfairly allowed a select set of investors a shot at a huge upside with limited downside. In February 2009, SEBI hiked the upfront margins to be paid by allottees of warrants to 25 percent from 10 percent earlier.