Are we ready for a high growth exchange?

By Rasika Nanayakkara

The London Stock Exchange Group’s (LSEG) Alternative Investment Market (AIM) is one of its success stories. Established over 20 years ago, the AIM is a separate market that was intended to act as a “feeder” to the main market. Today, it has become a market in its own right, raising over GBP 100 b to date with over 3,500 companies joining the AIM. 

The AIM was established to enable high growth, Small and Medium Enterprises (SME) to float shares on an exchange with a more flexible, principles based regulatory system. In addition, in the AIM, the companies are regulated by the exchange (AIM) rather than the regulator, the Financial Conduct Authority (FCA). 

Another key highlight of the AIM is the use of a nominated advisor or “Nomad” as it’s more popularly known. The Nomad essentially, is an advisor retained by the AIM company to assist in listing the shares on the AIM, similar to an investment bank listing a company. The Nomad will initially decide on the company’s suitability for a listing on the AIM and upon approval will undertake due diligence and guide the firm through the listing process. 

The salient feature here is that unlike with investment banks, the Nomad’s relationship with the AIM company continues for the entire duration the firm is listed on the AIM. This ensures that the Nomad’s and the AIM company’s interests are aligned. 

The AIM offers investors an opportunity to invest in high growth, early stage companies with potential to make rapid gains. However, investors will have to face higher risk and low liquidity. Therefore, the AIM is usually aimed at professional investors. On the other hand, the AIM offers nascent companies easier access to capital, visibility of a listed company as well as an exit strategy for early stage investors.

Most exchanges around the world have a secondary board for the listing of smaller companies. The Colombo Stock Exchange (CSE) has the Diri Savi Board (formerly known as the Second Board) for companies with at least Rs.100 million in stated capital. The idea behind the Diri Savi Board is to encourage new listings on the CSE and it is a successful initiative with 73 companies currently listed contributing to a market cap of approximately $ 1.7 b. 

However, if we are to gauge the success of the Diri Savi Board, we need to look beyond absolute measures such as the number of companies listed. Rather, we should look at the number of companies that had moved from the Diri Savi Board to the Main Board. Unfortunately, looking at the recent past, only two companies, namely Softlogic Holdings PLC (SHL) and Citizens Development Business Finance PLC (CDB), had moved on to the Main Board. 

In addition, a strict 25% and 10% free float rule was enforced for the Main Board and the Diri Savi Board respectively, by the Securities and Exchange Commission (SEC) in an attempt to boost liquidity in the CSE. This, however, has led to several firms delisting from the CSE in a bid to avert dilution of ownership or seek a transfer from the Main Board to the Diri Savi Board which has a lower free float criteria. 

In a developing market such as ours with a very low market capitalisation to GDP ratio of 23% (vs. 69% for India, 216% for Singapore, 33% for Vietnam and world average of 81%), it is vital that we retain all listed firms. Stopgap measures such as simply ensuring a higher free float would not address liquidity issues and garner investor interest overnight. 

This is the issue with rules led regulation, especially in an under-developed market like Sri Lanka with low financial literacy. When rules are applied, even with the fairest of intentions, it is very hard to find a “one size fits all” solution. There will be winners and losers. 

The objective of regulation is not to create winners or losers but rather create a level playing field for all participants. Instead, a solution would be to adopt a principles-based regulation approach to the secondary or growth Boards much like in the AIM. The principles of conduct could be defined by the regulator and the regulated parties can decide on the how best to do the implementation.

We could take elements of what made the AIM a success and introduce it to the CSE on an existing board or a new board altogether. This board should be considered as a “breeding ground” for new high growth companies, instead of just being a namesake listing board for small companies, with the focus being on growth. A much more competitive secondary board is vital as it is what drives new companies to grow and contribute to the economy. 

Sri Lanka is still relying on companies which have been in existence for several decades, with some even dating back to the colonial era. Looking at the current constituents of the S&P SL20, there are only two new companies on the list, Access Engineering PLC (AEL) and TeeJay Lanka PLC (TJL). Both companies have been breakout stars with AEL and TJL listing after only five and ten years of operations respectively. The remaining 18 companies in the S&P SL20 have been in existence for decades. 

Most importantly the concept of a Nomad is interesting, especially for a market where financial literacy is limited. According to the SEC, Sri Lanka has only 38,781 active investors (accounts that have traded at least once in 2016) out of a total of 801,685 registered accounts with the CDS.  Therefore, the role of a Nomad can do more than simply advise companies on the listing process. They can continue to guide the company into its next stage of growth, akin to a permanent consultant. 

Nomads can be held legally responsible for the company’s compliance with listing rules and regulations. This is an essential check and balance which ensures the interests of the Nomad and the company are in line as it is the case in the AIM. Further, listing a high growth company can help the company obtain funding from capital markets and provide early stage investors an exit strategy. 

Further the recent announcement of the CSE’s US Dollar denominated exchange can prove beneficial in attracting high growth companies in regional markets, given the government’s vison to develop Colombo as an international financial hub. 

If Sri Lanka can implement a high growth exchange modeled after the AIM, that could put the CSE at a significant first mover advantage in the region as there are no regional competitors apart from Hong Kong Stock Exchange’s Growth Enterprise Market (GEM) and Tokyo Stock Exchange’s Tokyo PRO. Such a market could attract high growth companies from countries such as India, which is home to a thriving tech and start up sector, which could funnel high growth companies into this market. 

In this rapidly-changing financial environment, relying on traditional sources of growth is cause for concern. This is the age of disruptive technologies and firms. A non-traditional exchange modeled after the LSEG’s AIM could create a niche in regional markets and could help cement Sri Lanka’s place as a regional financial hub.

(The writer is a capital markets professional with over six years of experience in the industry. He is currently attached to a leading financial services firm. He can be contacted at [email protected].)