Recent news items in business dailies of India have carried two important messages. The first is that India inc’s greatest ‘fire sale’ is underway to reduce the colossal levels of debt accumulated by the Indian companies. The second is that the India will soon have as a law, The Insolvency and Bankruptcy Bill 2015, which was passed by the Lok Sabha as well as the Rajya Sabha (the “Law”). The first is validated by speedy developments such as Tata Steel placing its assets on the block, JSP striking a deal with JSW to sell off the former’s power plant and GMR selling off certain stake to Malaysian entity. At the same time, a news item on JSW trying to bid for Tata Steel’s UK assets makes one wonder whether the lessons of leveraged expansion and growth have been fully appreciated.
The development on the Insolvency and Bankruptcy Bill is welcome, in that it provides a more contemporary definition of bankruptcy and insolvency, substitutes several archaic laws by the new single Law, provides a safety net for workers, and creates a board for regulating bankruptcy and insolvency. The government believes that it would restore the balance between the companies and creditors and also strengthen the debt recovery mechanisms. As per expectations, it will reduce the time to resolve bankruptcy and insolvency issues to as low as one year. It also proposes to set up the Insolvency and Bankruptcy Board of India. It provides for setting up information utilities to collect information on debtors and serial defaulters, under the aegis of the Board. It is also hoped that the Law will move India up in the global rankings in speed of doing business.
Cart before the horse?
The whole debate on current undeclared bankruptcies and future relief through the Law begs certain basic questions. It is true that free market economy is all about free entry and free exits of companies but it presupposes that all stakeholders including the companies themselves will make their best efforts to establish, manage and grow their businesses. It also presupposes that investors and lenders conduct their due diligence prior to investing in or lending to companies. In other words, a company, even in a free market economy, has no business to fail except for reasons beyond the control of companies, governments and nations. Poor management or ignorance of competitive dynamics could also lead to failure but companies and stakeholders must be agile enough to spot the creeping inefficiencies and take remedial action.
The current excitement on fire sale of the stressed assets well as the Law on bankruptcy and insolvency does not seem to address the root cause of the current malaise; rather it focusses on the unsavoury endpoints. Given the way Indian companies and lenders operate, quite possibly, there could be a flood of applications for declaring bankruptcy and insolvency. The current excitement does not also address why the earlier measures such as corporate debt restructuring (CDR), strategic debt restructuring (SDR), national company law tribunals, debt recovery tribunals, SARFAESI act or asset reconstruction agencies have failed to deliver. Without addressing the root cause for the scale-down of performance concentrating on winding up of companies may rank the country up in the ease of doing business in the eyes of multinational corporations and multilateral funding agencies but may not lead to overall business health.
The Governor of Reserve Bank of India has stated that the root causes of bad loans or non-performing assets are many, and all of them cannot be attributed to malfeasance by promoters or mismanagement by executives. He opined that huge delays in land acquisitions and revocation of rights and licenses by governments and courts are two principal causes beyond the control of promoters and managements. The issue probably is not one of assumptions going awry; rather the issue is why the plans are not updated to reflect changes. More fundamentally, the plans as drawn up originally tend to be highly optimistic, in terms of investments, lead times, costs and prices with a view to satisfy banks and obtain funding. When the environmental changes superimpose further unanticipated delays and changes, the compounded impact would be extremely high.
Imperfect business plans, failure to course-correct the plans, lack of flexible repayment options in line with realistic business growth, and lenders’ anxiety to have early paybacks, together, constitute the root cause for bad loans to creep in at the first instance. What comes up in late stages as a CDR or SDR plan would actually be the right one that should have been operating in the first place. Also, the multiplicity of lenders with every lender trying to get some share of the loan portfolio without really going into the fundamentals is another cause. What normally is done at the endpoint, like establishing a joint lenders forum, electing a lead banker, having strong bank nominee on boards and having third party review of plans, should be done at the very beginning of a firm’s journey on debt path. Rather than set up an insolvency board, the need is for setting up solvency boards which objectively analyse the business plans at the beginning.
Systemic solutions for solvency
Businesses are fundamentally set up to grow and be profitable. At the very least they must aim to be solvent. Attempting to be solvent is not a conservative and defeatist approach; rather it attempts to correct distortions that could arise in the mad scramble for scale, scope and market share gains. The following principles of solvency are useful to consider in structuring and evaluating debt proposals.
Debt to equity ratio is still the critical ratio that determines the net operational profitability, along with operational performance. It is understood that certain sectors, such as power, ports, construction and other infrastructure areas which are not attractive to retail investors and certain categories of equity investors, require long term debt. Higher debt allocation to such sectors from the banking system is an economic imperative. That said, the economy cannot sustain a situation wherein debt equity ratios of 7 to 1 and above are freely allowed. It is time that independent institutions like National Institute of Bank Management conduct research and come up with prudential debt-equity norms for all industrial and business sectors, and provide guidance to banks as well as clients. These norms may be revised each year based on performance of portfolio companies.
It is not sufficient for banks and companies to be guided just by prudential norms. There could be an opportunity cost to the firm (and the economy) of not putting up a project because of funding gap. It could be a global generic market entry for a pharmaceutical firm or an import substitution project for high speed rail coaches. It is important that the strategic perspective is understood and funding support provided. Such incremental funding over and above prudential norms should be provided through term loans and working capital loans bearing a special nomenclature of strategic term loans and strategic working capital, and structured with appropriate moratorium and back-ending of interest rates. These should have a narrower tenor of 3 to 5 years, and reviewed half yearly. These instruments would be, in a way, anticipatory strategic debt instruments.
Locational perspectives are especially important in certain categories of projects. There should be a ranking of ease of doing business for different industries in different states, and credit risk accordingly assessed. While this may ruffle some feathers, in the long run there would be a virtuous impact on the business climate. The need for such rating is clear given the differential levels of incentives as well as hurdles faced by different companies in different regions, especially in the fields of metals and mining as well as road and port development. Many times locational hurdles are related to certain genuine concerns related to environmental impact of projects; bank financing may, therefore, be made conditional on independent environmental analysis prior to full scale credit release.
Banks are now being encouraged to fund startups. While a special financial institution, MUDRA, has been established, the case of startup financing is not one of a uniform financial prescription. Some startups which are technology oriented require funds for experimentation, laboratory analysis or licensing while some which are application oriented require funds for beta testing of products etc., In some cases, it could be better to fund the incubators and research parks, and let them undertake the task of allocating financial support to their constituent ventures. Extending the philosophy further, bank finance may be made available to special vehicles such as alternative investment funds etc., which can have a cascading and ripple effect on more startups.
If in spite of the best possible diligence and management, ventures turn bad, they should be addressed through the endgame mechanisms. The endpoint, of course is the insolvency and bankruptcy which hopefully will be addressed efficiently and effectively by the new Law. Prior to that, the options of CDR and SDR must still exist and be effectively deployed. However, unlike leaving all the reins in the very same promoters and managements, CDR and SDR must be mandatorily accompanied by high quality turnaround plans developed by truly independent agencies, infusion of fresh professional talent and restructuring of boards. All of these measures, including technology and business development as per turnaround plans, would cost significant additional money but are worthy of inclusion in the CDRs and SDRs. Banks must appreciate that not all turnarounds can be achieved just by cost compression!
As this blog post brings out, maintaining solvency is far more important to the economy than solving insolvency. At the core of India Inc’s deemed insolvency riddle are two fundamental reasons: a propensity to bank oneself (through overwhelming debt) to bankruptcy, and secondly, a reluctance to take objective and competent professional help (before it is too late) to turn things around. Hopefully, there will be a better appreciation of these two factors, by the banks as well as companies, going forward.
Posted by Dr CB Rao on May 12, 2016