In recent years, private equity funds have emerged as a critical provider of early-stage and growth-stage capital to businesses across industries. While this trend can be observed worldwide, dominance of private equity has had a longer history in India. While there are likely multiple factors behind this phenomenon, an important one is the rather tight regulation of public equity markets.
Securities and Exchange Board of India (SEBI) leans heavily in favour of de-risking retail equity investors in public markets by erecting high barriers to the entry of new companies into public-capital market. But the fallout from such an approach is the stifling of growth of public equity via initial public offerings (IPOs).
SEBI has relatively tough eligibility criteria for companies wishing to float an IPO. For example, it requires them to have tangible assets of at least Rs 3 crore. The regulator also requires them to exhibit average operating profits of Rs 15 crore in the preceding three years with no operating losses in any one of those years. A further requirement is net worth of Rs 1 crore in each of the three preceding years.
Contrast these requirements with those by the Securities and Exchange Commission (SEC), SEBI’s counterpart in the United States. Unlike SEBI, SEC accepts the prospectus of a new company upon being provided a detailed business case and a comprehensive statement of financial and corporate information, vetted for completeness and accuracy not by the regulator, but by qualified private entities such as investment banks and legal counsels.
SEC focusses on disclosure and transparency, taking the view that such information would enable investors to make informed judgments about whether to invest in a company’s securities. It effectively assigns the task of ensuring true and accurate representation by the issuer to the investment banks and legal counsels. Rather than prescribe a number of qualifying criteria, the regulator focusses its efforts on enforcement. This open entry is a big reason why young ventures in sunrise industries are able to access public equity markets in the United States.
India needs to revisit the entry conditions in the light of international best practices. Many new age technology companies are able to build successful businesses even though they incur operating losses in the early years due to high operating costs of building a customer base, which brings profits in later years via network economies of scale flowing from an expanded customer base. Private equity investors view such customer acceptance positively and ascribe substantial valuations to the companies despite large losses in early years. Under current eligibility conditions, neither are these ventures able to access public markets in India nor can retail investors invest in them even though the business models are now much better understood.
In a recent consultation paper, SEBI has proposed four other reforms aimed at making public equity markets more attractive to investors and companies wishing to float IPOs. While all four reforms deserve implementation, two are especially important.
First, under the current rules, the company promoter is required to lock in 20% holding for at least three years. Likewise, non-promoter shareholders acquiring securities prior to the public issue are required to hold the shares for one year. The paper proposes to reduce these lock-in periods to one year and six months, respectively. This will allow initial investors early exit and free up their capital for fresh investments.
Second, the concept of “promoter” is a uniquely Indian one. In the past, when promoters usually held majority of the securities, this made sense. But today, companies increasingly raise capital privately from institutional and other sources. As a result, many companies face a situation in which the promoter is able to exercise influence disproportionate to her economic interest in the company, which may potentially undermine the interests of majority shareholders. Furthermore, many startups and non-family businesses today have no identifiable promoters.
Consequently, the paper correctly proposes to shift from the concept of promoter to that of the “person in control”. This is an eminently sensible reform and the government must make necessary amendments to related corporate laws to implement it. Promoters who have controlling rights in the new regime can be redesignated as persons in control, while those lacking such rights may be turned into ordinary shareholders.
The purpose of regulation should be to ensure that equity markets are competitive. This requires low barriers to entry into and exit from equity markets. Regulations that set a high qualifying bar for companies wishing to float IPOs can serve as entry barriers. To be sure, legitimate interests of retail investors must be protected. But this is best done by ensuring transparency and full disclosures on the part of companies seeking listing, investor education and regulation that fosters competition in equity markets.
(Arvind Panagariya is Professor, Columbia University and Rajeev Mantri is Managing Director, Navam Capital.)