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.
Root cause
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.
Sector prudence
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.
Strategic
perspectives
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 variations
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.
Startup
perspectives
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.
Turnaround
options
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
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