SunEdison has recently joined the long list of companies which have got drowned and gone bankrupt due to overwhelming debt. Most infrastructure firms (as well as capital-intensive and long gestation businesses) in India are unable to be profitable due to high debt on their books. The entire Indian banking system, especially the public sector segment of it, has almost gone into a tailspin due to delinquent loans. The ratio of equity and debt, together with return of total capital, has always been one of the most important indicators of current and financial prudence of a corporation. Ratio analysis is also a fundamental lesson that is taught in financial management. Yet, debt has emerged as the most dangerous threat to both corporate economy as well as global economy (as brought out by the 2008 global crisis).
Debt is an essential elixir for economic growth. Without debt, the level of economic activity that happens the world over would just be impossible; more so, in emerging markets such as India where equity capital is not easily available and stake dilution by promoters is frowned upon. Debt, has many components. The most basic one is the money taken from family members and friends as one embarks on a career or sets up a business. Not known to many, such debt has supported and even transformed lives or helped entrepreneurs find their roots. The more involved one is the organized credit offered by banks and financial institutions to individuals and companies or credit accessed by governments, banks, financial institutions and companies from public and other investors, nationally and internationally. As economies grew, the categories of institutions as well as categories of debt products have seen a phenomenal growth.
Debt, interestingly, is a welcome friend in all ideologies, even in the contrarian ones of capitalism and socialism. In the case of former, debt is seen as the abettor for capitalists to accumulate assets and means of production ahead of demand. Debt-dependency has been extended to workers and employees as well, largely through credit card and personal loan products, enabling them to accumulate both essential and non-essential assets ahead of their savings. Carl Marx held decades ago that banking and credit had become the most potent means of driving capitalist production beyond its own limits – and become one of the most effective vehicles of crises and swindle. While one may not agree with all the ideologies of Marx, the global credit crisis of 2008 and the bailout of various banks and mortgage institutions by the developed nations at great cost points to the wisdom that was embedded in Marx’s ideological observations.
Socialism, the opposite so to speak of capitalism, has also been quick to embrace debt. Socialist governments have, for long, used public debt and loans extended by government owned institutions as means to kick-start industrialization, support the weaker sections of society, and facilitate social equity. In fact, former Prime Minister Indira Gandhi, who nationalized 14 private banks (accounting for 85 percent of deposits) in one fell sweep in India in July 1969 claimed the need to control commanding heights of the economy, and ensure social equity, as a primary consideration for bank nationalization. The rather lacklustre financial performance of public sector banks, and their fearful non-performing asset problem are reflective of the risks of using debt as a lever for socialistic pattern of growth. Socialistic Greece accumulated as much as USD 350 billion of international debt as it sought to support public welfare at the cost pf private efficiency.
The great Bard, William Shakespeare (whose 400 years of incomparable contributions to, and legacy for, English literature we are celebrating now), proclaimed through Polonius in Hamlet that ‘neither a borrower nor lender be’, for ‘loan often loses itself and the friend, and borrowing dulls the edge of husbandry’. Wisdom in his words apart, the Globe has indeed been shaken so much by the problem of debt that there is some serious discussion as to how to retain the essential advantages of debt and eliminate the deleterious consequences. In a sense, there is no difference between equity capital and debt capital, in the sense that both involve their own risks. Relatively speaking, however, equity capital is scarcer than debt capital. There is possibility to convert a debt into equity but not the other way. Both are, however, potentially liable for erosion and write-off respectively.
In theory, debt financing is more secure than equity financing. Firstly, debt is usually extended only after equity is mobilized by the promoters/companies. That way, promoters’ stake is considered tied to the fortunes of the company before debt is extended. Debt carries prescribed interest which the company must pay along with a portion of principal as per a pre-agreed schedule before equity investors can be serviced through dividends. Equity investors have few forums to review a company’s performance other than the annual shareholder meetings and analyst reports whereas lenders have the systems of regular reviews with the company management based on regular reporting and institutional interface on prescribed lines, besides having their nominee directors on company boards. Despite all this, the debt sphere is marred by defaults while the equity sphere is buoyed by valuations.
Debt as a bet
Like equity capital, debt is also a bet into the future of a company. However, given the fact that debt is resorted to by companies only when equity capital is no longer available (which means acceptable risk level is reached) and given also that debt is used by companies to expand and diversify more than the means in command of the company would have allowed them to (often to beat the competition), debt tends to be a huge bet for the company which borrows and to the banks and financial institutions which lend. Also, unlike equity which comes in only at measured doses, albeit at a premium, debt tends to be a continuous infusion, either by way of working capital ( based on scale of operations) or by term loans (based on scope of projects). If proper due diligence and ownership is not exhibited by the company and the bank, collectively it becomes a national economic calamity. That said, there are many good reasons why debt is a desirable bet, particularly for emerging markets such as India.
Firstly, emerging markets need growth far more than the developed nations; debt is the only way to bridge the capital gap. Secondly, emerging markets do not have a strong and healthy equity culture that attracts and channels public and retail savings into productive activity. Thirdly, even when equity flows exist, they are into domains which (are expected to) pay off in the short and medium term, rather than in the long term and perpetuity. Fourthly, banks and financial institutions are an important limb of the economy which need to advance monies to be able to accept deposits; the size of national banks reflects the strength of national economy. Fifthly, debt fulfils a major macroeconomic imperative by smoothening the vicissitudes of equity markets. Overall, therefore, the issue is not whether debt is desirable; the more pertinent issue is how to ensure that debt does not cloud the thinking of companies and lenders, and how debt should not overwhelm and drown companies and lenders.
With debt comes a great responsibility as debt is nothing but public money. When companies and individuals falter on debt repayments, the strength of the lenders is eroded, compromising their ability to support further economic growth. There are, however, a few ways in which debt can be a truly responsible, responsive and motivational lever for economic growth, as discussed below.
Firstly, realistic optimism must prevail. Both the borrowers and lenders must be futuristic in their growth aspirations, and be realistically optimistic. For example, it could take the shape of funding companies that cater to rural demand, Make in India initiatives or start-up dreams, on the basis that these are the directions of progress for India. Past should not be seen as a constraint for the future but should be seen as a provider of corrective lessons.
Secondly, thematic lending must increase. Certain sectors of the economy, notably infrastructure, capital-intensive sectors, and other long gestation businesses such as transportation, steel, healthcare and pharmaceuticals, need thematic financing. Lenders’ capital requirements for such activities must come from special sources such as capital contributions from governments and multilateral agencies, overseas bonds, perpetual bonds, etc., and the repayment from borrowers must synch with the special needs of infrastructure and such other sectors.
Thirdly, lenders must be client-savvy. Lenders cannot assume that their job is fulfilled by review of client project report and extension of a loan. Rather, the lenders should be able to challenge the clients with alternate models. This requires that the lenders have sector-specific technical appraisers (or, at least outsource the activity to expert third parties). Lenders should also have senior corporate leaders who can participate in company boards, and contribute on a peer director basis.
Fourthly, loan products must be tradeable. In the ultimate analysis, and in the long run, in a capitalist economy there can be no better forum to reward performers and punish defaulters than the stock markets. A portion of loans from the banks must, therefore, be issued as convertible and non-convertible debentures to the lenders, in a manner that they are rated by expert agencies and traded on the stock markets. Their performance would sober runaway managements.
Fifthly, and most importantly, debt is a responsibility that companies and lenders have towards the nation. Extension and receipt of loans is not just a commercial transaction merely between the lenders and borrowers. It is a responsibility that they both together owe to the nation. All loans must be productive, repayable and value-accretive.
From the above, it is clear that debt is not a bilateral transaction but is a socio-economic activity with major impact on the behaviour of the economy. This requires a heightened responsibility on the part of the companies on one hand and the banks on the other, with some helpful policy framework from the Ministry of Corporate Affairs, Reserve Bank of India (RBI), and Securities and Exchanges Board of India (SEBI). The Board of Directors of each company could have a vital role in this process.
Boards as trustees
The Board of Directors of a company is a highly responsible and extremely important body to ensure good corporate governance, to ensure that the operations are run profitably as well as ethically. Over time, the Boards have got more concerned about the operations of the company, returns to the equity investors, and market capitalisation of their firms than about the debt portfolio and the position of lenders. Even under the guidance of corporate governance (Clause 49) or under the prescriptions of the Ministry of Corporate Affairs specific stress is not laid on the management of debt folio as is laid on energy conservation, technology assimilation and R&D. Boards are the trustees of all the monies that flow into a company, and their utilization. It behoves the Boards to lay equal emphasis on management of equity as well as debt. As many times systemic prescriptions are required to ensure such needed changes, the following rules and regulations are suggested.
Firstly, annual reports of companies should be mandated to include a detailed discussion of debt portfolio and strategies to correct debt profile, where required. Secondly, quarterly advertisements in newspapers on the results should incorporate a meaningful notation on the management of debt profile. Thirdly, lenders should nominate senior leaders from their institutions to participate on their behalf as directors on board. Fifthly, there should be a specific board committee dedicated to review the debt profile and debt management of the company and report to the Board in detail. Fifthly, analysts should focus on management of debt as a specific topic in their reviews of companies. Sixthly, there must be a transformation in the mind-set of all involved players that money from banks and financial institutions has enormous cost or value to the economy depending on whether it is improperly or properly deployed and managed. Productive deployment of capital is indeed the primary corporate social responsibility.
Posted by Dr CB Rao on April 25, 2016