Small and medium enterprises (SMEs) are viewed as an engine of economic growth and source of job creation. In an attempt to ease their financial constraints, India and some other countries, have experimented with enabling SMEs to access public markets by listing their shares on exchanges with less stringent criteria. This column analyses the impact of listing on the fortunes of SMEs in India.
There is wide consensus that small and medium enterprises (SMEs) are an engine of economic growth and source of job creation, and policies should be developed to support and facilitate their growth. Based on the recognition that SMEs face financial constraints in their growth, India and some other countries, have experimented with enabling SMEs to access public markets by listing their shares. Since these firms are small and unlikely to satisfy the listing criteria of main board exchanges, this requires a policy to encourage setting up of new exchanges with less stringent listing criteria.
This has advantages and disadvantages. One advantage is that it allows the general public, beyond private equity management firms, to participate in the return and risk profiles of SMEs. A second advantage is that these firms are exposed to greater visibility and transparency of the public markets. This will lead to greater comfort on the part of the formal financial sector to lend to listed firms, which in turn will reduce their financial constraints and lead to better performance. On the flip side, the process demands greater diligence on the part of the investor: since the listing criteria have been relaxed, it implies that there is lesser transparency about firms that list on these exchanges compared to firms that list on the main board exchanges, which can raise two types of concerns. One concern is that a larger fraction of the firms that list on exchanges with less stringent listing criteria are more likely to be lemons compared to those where the listing criteria is stronger. The second and related concern is that these lower criteria exchanges become a platform for existing investors to exit at higher valuations than the firm is actually worth. This may mean that new investors are likely to earn lower returns on these firms relative to those that list at the main board exchanges.
In a recent International Growth Centre (IGC) working paper, we study the Indian initiative, when the securities market regulator, Securities and Exchange Board of India (SEBI), proposed dedicated national trading platform for SMEs to raise equity capital (Aggarwal and Thomas 2017). In response, the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) launched SME exchanges in 2012. By August 2017, there were 191 firms that had listed on the BSE SME platform, and 75 firms on the NSE SME exchange. Of these, 33 firms on the BSE SME exchange also migrated to the main board. We study the firms that listed on these SME exchanges and ask two questions: What has been the impact of the listing on the financial constraints of these firms (as measured by their access to debt financing in the post-listing phase)? What has been their performance post their listing? We use firm-level data of listed SMEs between March 2012 and March 2015 and compare these with the firms that were similar to the listed firms in terms of size, age, and industry, but chose not to list, to understand the causal impact of the listing on the fortunes of SMEs in India.
We start by identifying patterns in characteristics of SMEs that list at the Indian exchanges.
Characteristics of SMEs that list at stock exchanges in India
Industry type and firm size
We find that 35% of firms that list on the SME platform are engaged in non-financial services such as hotel and tourism, wholesale and retail trading, transport and communication services. Real estate represents the second largest set of firms (13%) that list on the platform. These patterns are similar to listings on the main board, which has the traditional, more stringent listing criteria. However, the sizes of the firms that choose to list on the SME exchanges are significantly smaller than those that list on the main board. For example, the median value of total assets of firms that list on the SME exchange is Rs. 200 million pre-listing, while the median value of total assets for firms that list on the main board are more than double of that (Rs. 500 million pre-listing). Thus, there is a clear size differential between firms that list on the SME exchange and on the main board.
Financing sources, prior to listing
We examine the financing sources of SMEs prior and post listing with a view to testing the hypothesis that prior to listing, these firms will be more dependent on internal sources of finance. These include promoters' loans, trade credit, and retained earnings. If listing has an impact on a firms' ability to raise external finance (borrowings from banks and financial institutions, debt markets), we expect that the reliance on internal sources will reduce.
We find that prior listing, besides owners' capital (15%), SMEs typically use trade credit (28%) as a major source of financing. The reliance on trade credit is not surprising for financially constrained firms as suppliers generally have better knowledge of firms' operations than banks and other formal institutions. However, close to 43% of the capital raised by listed SMEs is from banks and financial institutions.
SME listing, access to finance, and firm performance
We set up a difference-in-differences1 framework to analyse the causal impact of listing on the firms that list on the SME exchanges. We estimate the difference in access to finance and operating performance of the listed firms with that of matched, unlisted firms (also called controls), in the pre-listing and post-listing periods. If there is a significant difference between the listed firms relative to their matched counterparts in terms of these outcomes, we can make the claim that the listing had an impact.
We find that exchange listing results in a significant improvement in the equity capital of listed firms. However, we do not find any evidence of significant improvement in access to finance, measured by higher debt finance post listing, for these firms relative to control firms. We also do not find evidence of any improvement in the operating performance of these firms relative to their controls.
A review of the literature on this question finds that this feature is not unique to India. Studies including Pagano et al. (1998) find that transition from private to public ownership is followed by a decline in operating performance. While these findings are based on large firms in developed economies such as Italy and Sweden, our study suggests that it holds for smaller firms in an emerging economy as well. Possible explanations offered in the literature are that firms decide to go public to rebalance their balance sheets following periods of large capital expenditure, or firms decide to go public to liquidate promoter wealth (Rydqist and Hogholm 1995). Besides it is also argued that managers window-dress their profits before going public, which results in overstated pre-listing performance and understated post-listing performance.
While the above are plausible explanations, another possible reason for our findings is that this is a recent aspect of financial access, and there is as yet too little data available to establish causality with confidence. A majority of our sample firms listed in 2014 and 2015. This provides only one or two years of post-listing data. Further, there could be a delay between the availability of data based on improved information disclosure and the ability of the formal financial system to incorporate these into credit decisions.
The policy push to develop market channels to provide access to finance through public markets has led firms that have been traditionally too small or have non-traditional business models to access equity financing from dispersed investors in public markets. In an emerging economy like India where risk capital is relatively scarce, this appears to be a success, with several firms having listed on the SME exchanges of BSE and NSE. Our analysis suggests that it is too early to conclude that this new mechanism is an established channel to ease financing constraints for SMEs.
- In the simplest set-up, difference-in-differences compares the outcomes of two groups for two time periods. One of the groups is exposed to a treatment (for example, a policy change) in the second period but not the first. The second group is not exposed to the treatment in either period. To provide a clean measure of the impact of the treatment, the difference-in-differences technique subtracts the average gain of the second (control) group over the two periods from that of the first (treatment) group. This removes biases arising from permanent differences between the two groups as well as biases arising due to general (trend) changes in the treatment group over time.
- Aggarwal, N and S Thomas (2017), ‘Response of firms to listing: evidence from SME exchanges’, International Growth Centre Working Paper. Available here.
- Pagano, Marco, Fabio Paneta and Luigi Zingales (1998), “Why do companies go public? An empirical analysis”, The Journal of Finance, 53(1):27-64. Available here.
- Rydqvist, Kristian and Kenneth Högholm (1995), “Going public in the 1980s: Evidence from Sweden”, European Financial Management, 1(3):287-315.