Arvind Panagariya and Rajeev Mantri
The equity market sector was among the first beneficiaries of the economic reforms launched in 1991. As a result, India today has a vibrant equity market. Recently, the market capitalization of companies listed on the Bombay Stock Exchange crossed the $ 3 trillion mark, making it the eighth largest stock market in the world in terms of market capitalization.
In recent years, private equity funds have become a critical provider of start-up and growth capital to companies across all industries. While this trend can be seen around the world, the dominance of private equity has a long history in India. While there are probably several factors behind this phenomenon, an important one is the rather strict regulation of the public stock markets.
The Securities and Exchange Board of India (SEBI) leans strongly in favor of reducing the risks of retail equity investors in public markets by erecting high barriers to entry of new companies into the public capital market. But the fallout from such an approach is stifling the growth of public stocks through initial public offerings (IPOs).
SEBI has relatively strict eligibility criteria for companies wishing to launch an IPO. For example, this requires them to have tangible assets of at least Rs 3 crore. The regulator also requires them to post average operating profits of Rs 15 crore over the previous three years with no operating losses in any of those years. Another requirement is the net worth of Rs 1 crore in each of the previous three years.
Compare these requirements with those of the Securities and Exchange Commission (SEC), SEBI’s counterpart in the United States. Unlike SEBI, the SEC accepts a new company’s prospectus after receiving a detailed business case and full statement of financial and corporate information, verified for completeness and accuracy not by the regulator, but by qualified private entities such as investment banks and legal advisers.
The SEC focuses on disclosure and transparency, believing that such information would allow investors to make informed judgments about whether to invest in a company’s securities. It effectively entrusts the mission of ensuring a faithful and faithful representation of the issuer to investment banks and legal advisers. Rather than prescribing a number of eligibility criteria, the regulator focuses its efforts on enforcement. This open entry is one of the main reasons that young companies in emerging industries can access public stock markets in the United States.
India needs to review entry requirements in light of international best practices. Many new age tech companies are able to build successful businesses even if they experience operating losses in the early years due to the high operating costs of building a customer base, which generates profit. the following years thanks to the economies of scale of the network coming from an extended clientele. Private equity investors view this customer acceptance positively and attribute substantial valuations to companies despite the large losses in the early years. Under the current eligibility conditions, these companies are also not able to access public markets in India and retail investors cannot invest there either, although the business models are now much better understood.
In a recent consultation paper, SEBI proposed four other reforms aimed at making public stock markets more attractive to investors and companies wishing to launch IPOs. While the four reforms are worth implementing, two are particularly important.
First, under the current rules, the business developer is required to lock in a 20% stake for at least three years. Likewise, non-promoter shareholders who acquire securities prior to the public issue are required to keep the shares for one year. The document proposes to reduce these blocking periods to one year and six months, respectively. This will allow initial investors to exit earlier and free up their capital for new investments.
Second, the concept of “promoter” is uniquely Indian. In the past, when promoters typically owned the majority of securities, this made sense. But today, companies are increasingly mobilizing private capital from institutional and other sources. As a result, many companies are faced with a situation where the promoter is able to exert an influence disproportionate to his economic interest in the company, which can potentially harm the interests of the majority shareholders. In addition, many startups and non-family businesses today have no identifiable promoter.
Therefore, the article rightly proposes to move from the concept of promoter to that of “person in charge”. This is a very sensible reform and the government must make the necessary changes to related company laws to implement it. Promoters who have controlling rights in the new regime can be re-designated as controlling persons, while those who do not have these rights can be transformed into common shareholders.
The aim of regulation should be to ensure the competitiveness of stock markets. This requires low barriers to entry and exit from the equity markets. Regulations that set a high qualification bar for companies wishing to initiate IPOs can serve as barriers to entry. Of course, the legitimate interests of retail investors must be protected. But this is best done by ensuring transparency and full disclosure from companies seeking to be listed, investor education, and regulation that promotes competition in the stock markets.
Arvind Panagariya is Professor, Columbia University and Rajeev Mantri is Managing Director, Navam Capital
The opinions expressed above are those of the author.
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