Outcome of 35% minimum public shareholding

Such an enforced dilution will offer chances to buy into certain closely-held shares

The implications of the Finance Minister’s “thought experiment” – every listed entity should have a minimum 35 per cent public shareholding – are worth considering in detail. Most Public Sector Units (PSUs) don’t meet that criteria and a counting-on-fingers assessment suggests that one out of every three or four listed companies doesn’t meet that criterion.

Assuming Securities and Exchange Board of India (Sebi) goes along – and don’t forget that Sebi is, technically, an independent regulator – there would be an enormous sequence of follow-on-public offers (FPOs). Say, conservatively, somewhere between 5-10 per cent of listed shares would have to be offered for sale by the current promoters. That could amount to shares worth several trillion rupees in value being offered.

Although the major market indices are near all-time highs, the rest of the market is not that bullish. The bulk of midcaps and smallcaps have seen sustained deep corrections. It is unlikely that this amount of supply could be easily absorbed, unless of course, the foreign portfolio limits (FPI) were eased considerably. 

If Sebi does mandate the dilution, it would have to give ample time. Going by what happened when the 25 per cent public shareholding was mandated in 2010, there would be a huge bunch of FPOs towards the end of that period, however long it was.  

Companies with larger public shareholdings tend to have more liquid trading characteristics. That means price-discovery for shares can be better and it can be easier for investors to buy and to book profits. But more liquidity can also mean a drop in share price at the point of time immediately after the FPO. This is especially true if there’s a huge supply in a relatively short timeframe.

What reasons could there be for the government to want larger public shareholdings? It stands to gain somewhat on the tax front, both when FPOs happen and afterwards, if the trading volumes also improve. This is also one way to coerce household savings and institutional funds into making equity investments.

If corporates receive large infusions of risk capital, they will have to do something with it. They may pay down long-term debt, or invest in capacity expansions, or even buy the shares of other companies.

In one scenario, many Indian companies will end up being essentially holding companies and the stock market will become characterised by vast crossholdings, controlled by relatively few, large promoter groups.  That has interesting and negative implications in terms of conflict of interest, and of corporate governance. Markets like this do exist in Japan, for example, and this can work as an economic model, even though it has some obvious downsides. This sort of enforced dilution could have positive impacts on corporate governance. That would of course, depend on the level of activism among public shareholders. In a third scenario, cash-rich companies may opt to delist instead of diluting. They might even borrow to fund a leveraged buyout.

The impact on PSU disinvestment could be interesting if such a dilution is mandated. Few PSUs are monopolies anymore, and if there is a comparable private entity operating in the same space, it usually tends to have better financials and tighter management.  If the investor has a choice between buying into a PSU – say an Air India, versus an Interglobe Aviation — she might well opt for the private concern and ignore the PSU.

Is this “thought experiment” likely to be acceptable to Sebi? If the government wants it badly enough, it can make it happen, even if the regulator has misgivings about the implications. It may not happen in this fiscal – the last dilution to 25 per cent took over three years (and some PSUs have still not complied). But once it has been mentioned, the possibility is permanently on the table.

The market will discount this possibility perhaps by valuing all such companies at lower multiples. If it does happen, it could well have positive outcomes in that it could lead to improved debt:equity ratios and it could lead to capacity expansions.

For the individual investor, such an enforced dilution would offer chances to buy into certain closely held shares. If those become available at lower prices, so much the better!  On the flip side, it could lead to strange outcomes for the overall market and ultimately, for the economy.