Investing in SME companies while managing risk and lack of liquidity

In the world of investments, often the small things make the biggest impact. Small businesses—despite their modest size and limited resources—have a remarkable history of reshaping industries and outperforming their larger counterparts. 

The age-old wisdom, "small is beautiful", remains relevant for a significant purpose, and when it comes to the stock market, small stocks can yield significant rewards. 

Over the past year, small caps have outperformed their large and medium cap counterparts. This trend has spurred adventurous investors to increase their allocation to SME IPOs, where over 100 listings have collectively raised over Rs 2,600 crore. 

These companies typically exhibit higher profitability, liquidity, and asset utilisation ratios compared to their unlisted counterparts. Notably, SME exchanges can have lower liquidity metrics compared to the smallest 25% of firms listed on the main boards, as reflected in lower quick ratios, current ratios, and cash-to-current liabilities ratios.

Investing in SMEs

Small and medium-sized enterprises are not just the backbone of local economies but also pivotal contributors to global employment and innovation. 

The World Bank reports that SMEs account for nearly 90% of all businesses globally, generating over half of the total employment opportunities. Further, formal SMEs contribute up to 40% of the national GDP in emerging economies. 

For investors, SMEs offer an avenue for diversification across sectors, including technology, healthcare, manufacturing, and services. However, this path also comes with unique challenges in the form of risk and liquidity constraints.

Risk mitigation strategies

When considering SME investments, conducting thorough due diligence is paramount. Analyse the company's financials, business model, competitive positioning, and the expertise of its management team. This vigilance can help identify potential red flags like excessive debt, deteriorating revenues, or frequent leadership turnover.

Further, diversify your SME investments across various industries and developmental stages to manage risk effectively. A diversified portfolio can mitigate the impact of underperformance by a single company.

Moreover, while early-stage startups may offer substantial returns, they inherently carry higher risks. Investors should look at investing in growth-stage SMEs, which have a proven track record, a solid customer base, and a well-defined path to profitability.

Addressing liquidity concerns

Recognise that SME investments may require a longer investment horizon. Be prepared to hold your investments for several years, allowing the company ample time to grow and potentially secure a substantial return.

Delve into secondary markets or consider private equity funds specialising in SME investments, which can provide partial liquidity solutions, allowing you to divest your holdings to other investors.

Contemplate co-investing alongside other investors or venture capital firms. This collaborative approach can help distribute risk and potentially facilitate liquidity events should the company attract follow-on investments or go public.

Conclusion

Investing in SMEs holds immense promise, but it requires a calculated approach to mitigate risks and address liquidity constraints. Comprehensive due diligence, strategic diversification, and a patient investment horizon are fundamental strategies for risk management. Simultaneously, exploring secondary markets and co-investment avenues can offer solutions to liquidity challenges.

It is also crucial to stay well-informed and adapt a strategy in response to market dynamics and the unique circumstances of the SMEs in your portfolio. 

You can unlock the vast potential of SME investments, bolster economic growth, and reap the rewards of your astute investments by diligently managing risk and proactively addressing liquidity issues.

Taking guidance from experts, such as financial advisors, can offer valuable insights. Their specialised knowledge and experience can help investors navigate the complexities of investing in SMEs. 

With risk management techniques, such as setting investment limits, and often reviewing the portfolio, help ease potential losses and create opportunities to generate alpha.

Kush Gupta is the Director of SKG Assets and Holdings Pvt Ltd.