India's SME IPO boom has spawned a shadowy practice of unscrupulous investment bankers offering to help small businesses raise money at inflated valuations in exchange for as much as 50 percent of excess funds raised, people aware of the matter said.
Once confined to Gujarat and Maharashtra, this dubious "business model" has spread to other states, fuelled by the exuberance in the market, the people said, requesting anonymity.
The Securities and Exchange Board of India (SEBI) has warned investors to be careful about such dubious practices. In an August 28, 2024, press release, the market regulator quoted numbers to show the sudden surge in interest in this segment. The statement said that Rs 14,000 crore has been raised through the SME platform of stock exchanges over the past decade and nearly 43 percent of it (Rs 6,000 crore) was raised in FY24 alone. SEBI urged investors to exercise caution when investing in these securities.
Explaining the arrangement that bankers work out with promoters, a source said, "For example, say the price that is quoted is 5x the profit earned by an enterprise, which is generally what is quoted in the private market. Now bankers will tell the businesses that they will help them raise money at say 10x or 20x and then ask for a share of what is in excess of the fair value."
That is, if Rs 500 crore is the fair value for an enterprise earning a profit of Rs 100 crore, the banker will offer to raise Rs 1,000 crore or Rs 2,000 crore and then take a half of the excess Rs 500 to Rs 1,500 crore raised.
Also read: SEBI probes find six i-banks charged SMEs fee equal to 15% of IPO size: Report
How it starts
According to the sources, the bankers first approach chartered accountants in small towns asking them if they know of owners of small businesses looking for funds.
"The bankers will then pitch the public issue to the promoters citing easy money or the possibility of a better reputation. If the client looks open to the idea from the initial meetings, the bankers will talk about the additional benefits (of exaggerated valuations)," said one of the sources.
The bankers get the help of some unscrupulous chartered accountants who are willing to cook the books, get false receipts and even file taxes to back these inflated revenue figures.
The banker's regular fee—which is usually 1 percent to 3 percent and now has risen even to seven percent for SME IPOs—is paid through regular banking channels. The rest is made available through cash.
According to a source, this cash can then be used by the banker to manipulate the grey market prices for later issues.
Currently, the current regulations do no set a cap on the fee investment bankers can take but the bankers are expected to follow ethical behaviour, according to a legal expert.
Mukesh Chand, Senior Counsel, Economic Laws Practice, told Moneycontrol, "Based on my assessment, the SEBI (Merchant Bankers) Regulations, while robust in many areas, do not prescribe specific benchmarks for fees charged by merchant bankers. Instead, these matters are addressed through the Code of Conduct, which emphasizes ethical behavior but lacks detailed guidance on fee structures."
But the regulator has to take into account various realities when setting the guardrails in this segment, according to Chand.
He said, "For SMEs, particularly, the challenge is dual. First, most SMEs lack the market visibility or investor reach of larger firms, making extensive marketing efforts essential. This necessity often drives up costs, with a major portion of these higher fees directed toward investor outreach and marketing. Therefore, any discussion of excessive fees must take into account these dynamics and the reality that, for SMEs, effective marketing is not just an added cost but a crucial one for the success of the IPO."
Chand added that Sebi could guidance from regulatory bodies in other areas, such as the Insolvency and Bankruptcy Code (IBC), where the Insolvency and Bankruptcy Board of India (IBBI) initially left fees for resolution professionals to market forces but later prescribed specific benchmarks for determining fees. Similar benchmarks or yardsticks could be established for merchant bankers to ensure that fees remain reasonable while considering the necessary marketing expenses involved in SME IPOs.
The market watchdog has been setting tighter norms to determine the financial health of companies in this segment. On August 22, the National Stock Exchange of India released additional eligibility criteria for entities looking to list on NSE Emerge, its SME platform. The exchange said that the entity should now also have positive free cash flow to equity for at least two out of three years preceding the application.
Also read: F&O frenzy beyond metros: Smaller towns dabbled in trading more than mutual funds, shows Sebi survey
At the recently held Global Fintech conference, SEBI's whole-time member Ashwani Bhatia said that bankers and chartered accountants should exercise more caution when facilitating SME IPOs. He said that he has been a banker and that bankers should learn to say no (when promoters come asking to be listed).
He asked the bankers to act as good doctors, to not make steroids (public market issuances) available to those who can survive on paracetamol (such as venture capitals and peer-to-peer lending).
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