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.
All-weather friend
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.
Shaken-sphere
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.
Indebted responsibility
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
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