Diversification: A significant transition risk for MSMEs
Many entrepreneurs opt for diversification to mitigate the risks from existing business. However, success depends upon how well it is handled from the beginning.
Recently I had interacted with an entrepreneur who is setting up a new business in an altogether new vertical. His existing business is doing very well. There is enough buoyancy in the order flow and he could almost overcome the challenge from COIVD 19 lockdown. However, having seen the volatility in the business he started exploring the ways and means to mitigate the risk to himself by diversifying into another area which is not sharing the same type and level of risks the present business is witnessing.
During the interaction, I could found his approach was very detrimental to his own interest and there are very chances of harming himself if he takes that route. I would like to summarise in the following points:
- He asked his senior executive to hire a person to prepare DPR (Detailed Project Report). He, in turn, hired a consultant having long years of experience and got the DPR done.
- The entrepreneur did not involve himself during the course of the preparation of the report and the author was asked to submit the final report
- The assumptions were outdated and not reflect the present situation in the industry.
- Strangely the DPR is not exactly aligned to the objectives set by the promoters
- DPR is prepared with an aim to secure the bank loan; not a document to help the entrepreneurs to understand the nuances of new business.
- It does not explicitly say whether it is worth pursing; how is the reward structure for investors.
- No risk analysis from the perspective of the entrepreneur and mitigations they suppose to look at.
- Packed with download from search engines, the DPR does not discuss the technical feasibility to the point of relevance.
Transition Risk for MSMEs
The change is an integral part of the entrepreneur‘s journey. In the normal course within the existing business, these changes are brought in the incremental way to align with new trends, introducing new products as per the customer requirements or compliance the new regulations etc.. It rarely requires external help except for some highly specialised interventions. In any case, the context and expected outcome are well within the comprehension of the entrepreneur. Thus there is little chance of failure due to the changes going to be implemented.
However, it is not the case with entering into a new venture where we have no knowledge or have any expertise. Transition risk is a significant risk for MSMEs. We have studied many MSMEs which have failed during their transitional phase of diversification. We observed the common traits as below:
Hands-on involvement, a hallmark of their success in the first venture is notably missing in the subsequent ventures. It is a fact that the visibility of the leader and the day-to-day involvement of the entrepreneur in the operations is a potential advantage in the implementation of a new venture. We did not see that level of involvement in the proposed ventures among them. It can be attributed to their unwillingness to come out of their comfort zone( of running core venture).
Not enough deliberations, just pursuing ideas; sometimes just fancy ideas- Many a time the strategy of diversification is driven by the irrational perception of the potential of the opportunity presented than validated by the facts and figures. No attempts were made to understand key success factors of the opportunity and how we are placed to capitalise that. The depth of deliberations is very shallow. Low level of preparedness including identifying key risks is quite evident.
No proper financial planning. In some of the projects, surprisingly they have initiated the construction without financial closure leading to midway stoppage of the work. No milestone, or no visibility of date to launch the commercial operations. In almost all cases the financial distress in the new venture just seeped to exiting one resulting in the loss of momentum in the well-run company.
Lack of HR strategy: It is a fact that when a company sets on the ambition of high growth or diversification, what is important is clear and unambiguous HR strategy that creates a sense of assurance and promote willingness among the employees to work passionately for the betterment of the organisation.
Absence of Internal audit: Having vested the responsibilities in the hands of the professionals is not enough. In an employee-driven business environment, there is a need for rigid checks and balances to oversee the performance and mitigate the risks.
Diversification is needed…
Many sectors show some sort of cyclicality of varying degrees. Any business faces a higher risk of a downturn and diminishing revenues when it caters to one product or market. During economic uncertainties, small and medium enterprises are more vulnerable than their larger counterparts to this risk.
Diversification is beneficial for an entrepreneur to secure long-term financial stability. It is prudent to diversify into different products, industries, and markets. This not only helps one to boost revenue but minimize risks associated with business uncertainties.
However, what is important is the degree to which the promoter involves himself in shaping the new entity matter the most to see its success.
We believe that the following measures help to reap the benefit of diversification:
- 360 degrees view of our preparedness and meticulous analysis of the opportunity.
- Entrepreneurs need to study the business plan thoroughly before consenting to it
- Seek independent advisors to help to shape the venture however make a background check to validate their credentials. Give attention to conflict of interest, if any.
- The attention span required will remain as much as in the startup stage of the first venture.
- People make difference: It doesn’t matter how great your products or services if you don’t have great people, and if they are not being led by great leaders then you’re not going to be realising your company or organisation’s full potential. It is possible to groom people for excellence provided if we have a clear HR strategy.
- If you choose to operate through management team it is also necessary to have independent audit (internal & management) of the business on an ongoing basis to get a third party view about the state of affairs in the new entity. The ongoing audit will bring the checks and balances that there will not be surprises and shocks.
The diversification strategy is good to beat the downturn in the existing core business and secure financial stability. However, its success depends upon entrepreneurs approach and policies.
Leverage & Uncertainty- Double Whammy for MSMEs
The MSMEs which are leveraged will find going will be very challenging in the present circumstances. This should enhance the appreciation for prudent financial management.
Recently I had a call from one entrepreneur who has been into a movie screening business. The unit is leased to an operator for a monthly fixed rental payment. The same is discounted with a bank to get into another business. Unfortunately, that new business suffered a huge loss as they were new into it and they did not make a proper financial strategy before entering.
Despite the loss in the new venture, the debt servicing remains intact due to regular rental income from the tenant. However, the global pandemic of COVID 19 has changed all the calculations. The movie screening is stopped and so is the cash inflow.
The industry is not sure how long the situation will persist. The entrepreneur and his family are very tensely watching the evolving scenario.
COVID 19- Not a risk rather an uncertain event
Many are cribbing that they are not prepared for intense liquidity stress due to the economic impact of COVID 19 and resultant difficulty in debt servicing. The fact is that COVID 19 is not a risk to anticipate. The risk is one which can appear and reappear on the horizon and a positive probability can be assigned to it. Such that we may take some preventive measures, avoid its happening and /or at least we can mitigate its impact. In case of uncertainty based events, nothing can be predicted- neither its arrival nor its impact.
Today the whole world is experiencing an uncertain event and its longevity is unpredictable. So is its impact on the individual business.
Leverage is a prudent strategy in the period of high economic growth. But timing high growth is a challenge:
The leveraged business model is good so long as the economy keeps an upward trend in growth because the cost of debt is lower than equity. The challenge is to predict how long it will last. It is difficult to predict. Growth prediction is becoming a challenge due to the globalised trade regime and newer disruptions from evolving regulations, technological advancement and changing business process driven by the internet.
If the economy hits a downward spiral or industry in which you are operating is slowing down, the debt will be a serious challenge. Once trapped into a vicious debt trap, many entrepreneurs borrow more to meet the repayment obligations. As they borrow more and more, the cost of borrowing will go up and eventually the credit record will suffer. More borrowing coupled with slowing business is sure toxic combination for any business to survive.
In India, we have been witnessing a steady decline in the growth in the last two to three years. That has affected the business of many well-run entities. We have witnessed the collapse of many large companies and being sold under bankruptcy code in the last two years. The common denominator was a high debt load.
COVID 19 has aggravated this. Many long-standing businesses are facing a serious crisis of survival in the wake of pandemic and coupled with borrowing. The borrowing now appears excessive due to lowering sales and they are facing a double whammy situation.
Policy Response to COVID 19: Govt/RBI initiatives and their impact
Many debt-laden firms are staring at the imminent collapse. Govt & RBI came to their support by offering fresh loan under ECLGS, Moratorium and MSME Debt restructuring Scheme.
Fresh loan under ECLGS has helped many to postpone their immediate repayable to four-years spread. Moratorium gave temporary respite from cashflow burden for stalled businesses. Whereas the restructuring extended a window of opportunity to take a fresh look at the business scenario and revise the debt servicing.
The measures are lead to rearranging the payables with reference to timing; whereas interest burden pertaining to moratorium remains and business sentiment remains weak. Otherwise, a normal level of leverage in the orderly economic scenario is now crystallizing to distress due to lower than expected cash flow. Burden from the period of the moratorium will have a compounding effect. A realistic solution could be allowing reduction or sacrifice of the interest burden. In the absence of such a step, the viability of many businesses will remain doubtful.
MSMEs are more vulnerable and affect the personal life of an entrepreneur
The long term prediction of the prospects with excessive reliance on debt is becoming a risky proposition for businesses –big or small. The impact will be more severe for small businesses because they normally mortgage their assets like living home to secure credit for the business. Any impact on the business will directly affect their family life. This is not the case with large corporates.
Many of the entrepreneurs do not think about derisking their business model while seeking more growth. They continue to pursue the growth through loans from banks and NBFCs and thus retaining 100% risk for themselves. All their assets and cash flow(business as well as personal) are intensely leveraged to meet the financing needs.
COVID should be an eye-opener. It is the high time for MSMEs to explore ways and means of de-risking the business model and take it as a precursor for pursing the growth ambition. At least explore ways of minimising the risks to the family through smart structuring.
A leveraged business model is a good option in a high growth period. However, it can be toxic if there is a decline in the business that may arise due to internal and external factors. Creating excessive leverage on the cash flow anticipating the same economic scenario into the future for years is quite a dangerous phenomenon. No business can be stable in the long term in the new trade regime.
The learning from the present crisis is- Restrain from unbridled borrowing to fund the business plans. Rather derisking oneself while pursuing the growth should be the preferred option.
Credit Guarantee- A reality check
In the post- COVID scenario, MSME financing is almost identified with Credit Guarantee schemes. We look at its effectiveness and appetite among the consumers (MLIs).
Credit guarantee was born with a promise to ensure the availability of bank credit without the hassles of collaterals / third party guarantees to the entrepreneurs and others, Initially, it was established for Micro and small enterprises since the year 2000 as CGTSME (Credit Guarantee Scheme for Micro & Small Enterprises). In 2014-15, the credit guarantee got a huge boost with establishing National Credit Guarantee Trust Company(NCGTC) and the scope of credit guarantee expanded to include educational loan, MUDRA loan, Skill Development Loans, and Standup India Loans. The scheme operates with a pre-condition that these loans are not covered with any collateral security/personal guarantee by the MLI(Member Lending Institutions)
The main objective is that the lender should give importance to project viability and secure the credit facility purely on the primary security of the assets financed. The other objective is that the lender availing guarantee facility should endeavour to give composite credit to the borrowers so that the borrowers obtain both term loan and working capital facilities from a single agency.
The Credit Guarantee Scheme (CGS) seeks to reassure the lender that, in the event of a borrower, which availed collateral-free credit facilities fail to discharge its liabilities to the lender, the Guarantee Trust would make good the loss incurred by the lender up to 50/75/80/85 per cent of the credit facility.
The recent schemes:
The need to analyse these have cropped up because recently Govt made two new schemes to support MSMEs who are facing a huge challenge for survival in the wake of a global pandemic caused by COVID 19 and sharp lockdown imposed overnight without giving time to reduce the activities in an orderly manner.
ECLGS (Emergency Credit Limit Guarantee Scheme): It is a top-up loan for existing borrowers within a cap of Rs 3 lakh crores. The scheme envisages 100% guarantee support from NCGTC.
CGSSD (Credit Guarantee Scheme for Subordinate Debt): This is another scheme to support distressed entities to secure a subordinated debt to the extent of 15% of their contribution and seek a restructuring of the bank loan to revive the business. This scheme is piloted by CGTMSE and the maximum cap is at Rs 20000 crores.
The schemes generated a lot of hope as well as the hype.
Hope because many entrepreneurs who are already reeling under distress due to slowing economy over the last few quarters and sudden lockdown have got a window to stabilise the finances as the loan under the scheme is a cash loan with an extended repayment plan.
It is hype because policymakers have positioned it as the panacea for the entire MSME segment thought the relevance is not inclusive and just top-up for those who are having loans. Further its utility is unlikely to benefit to the fullest extent unless there is a revival of demand for their trade.
The concerns around credit guarantee schemes and its affinity to primary consumers:
There is a proverb. It says every journey should start with the end in mind. This is relevant here for lenders. Because the lenders are the primary consumers of the credit guarantee schemes. After all, they are responsible for the recovery of the money that is lent and they ought to return to the depositors with the promised return.
Hence it is obvious for them (lenders) being concerned about the efficacy of the Credit guarantee with reference to claim settlement to ensure that they get back their money rather depositors money safely.
Claim settlement: The guidelines for settlement of the claims are very much published on their website. What is relevant for how effective it is…….
There are two important issues. One is Guarantor’s insistence for proceedings of staff lapse if any in handling the loan account. The second one is the mandatory filing of the case before the court/DRT before making a claim under guarantee. Another important related issue is lack of access to Bankruptcy Avenue instead of court proceedings.
Many of the ex-bankers whom I have interacted are of the same opinion that CGTMSE seeks confirmation of non-existence of staff lapse within the bank. It is an obnoxious demand because the staff lapse may arise for many reasons not necessarily relating to the loan transaction. Secondly depending upon the banks’ internal proceedings reflects badly on the underwriting standards within the Credit Guarantor’s set up.
Reliance on Banks’ internal process to deal with lapses is the source of uncertainty for the banks to seek a claim from the Credit Guarantor. Thus their appetite for credit guarantee in lieu of collateral security is low. Probably that is the reason bankers are not very enthusiastic about the schemes floated by the Govt.
It is unfortunate that despite being in existence for 20 years CGTSME and NCGTC have not evolved their underwriting standards and rather relying on certain internal processes of lenders having different purposes and outcomes. This is probably hindering the growth of credit guarantee market thus depriving the opportunity for many entrepreneurs to go for orderly capital formation path.
Filing a case for recovery before preferring claims: It reflects the unwillingness of credit guarantor to accept the risk though the guarantee meant to do so. It suggests that the failure of a business is unacceptable. It is a fact that the reasons for failure are not necessarily with the borrower. The industry and economy-related factors will also decide on the performance of a loan account. Another significant issue is there is no enabling provision to deal with the issue under bankruptcy code. Probably that would help to give new lease of life and or quicker resolution than seeking court intervention.
Credit guarantor should have provided a broad range of solutions to deal with events of defaults and the option of fling case should be invoked very discretely.
The Credit guarantee option is very good for entrepreneurs who lack the collateral security to start the venture. However, the Credit Guarantors should do more to convince MLIs who are their primary consumers of the products through modifying their operating guidelines. Being set up exclusively to promote the entrepreneurship among the economically weaker section of the society, they must evolve a broad range of solutions to deal with failures that are endemic to entrepreneurship journey.
MSME Funding Package of Govt of India – A Critical Analysis
MSMEs are offered a financing package to overcome pains from COVID19 lockdown. The package is not universal and likely to have limited impact on the segment.
Govt of India recently announced a scheme for supporting MSMEs who are affected due to sudden lockdown and resultant total disruption of their money flow on account of COVID 19 pandemic.
The package comprises the following:
- ECLGS Scheme -Three lakh crores collateral-free automatic Loans, with a tenure of 4 years, which will have a one-year moratorium on repayment.
- Rs 20,000 crore subordinated debt will be provided for stressed MSMEs under the ambit of CGTMSE.
- To set up a Fund of Fund with an outlay of Rs 10000 that will create a total of Rs 50000 crores of equity for MSMEs
The package apparently sounds very good. It is felt that these measures require critical analysis.
ECLGS Scheme- Three lakh crore loan scheme:
The highlights of the scheme: It is available for those who have SMA 0/1 gradation and obviously SMA2 is not eligible. It is guaranteed by NCGTC, a central govt entity meant to undertake credit insurance activities. The term of the loan is 4 years with one year repayment holiday. It is a cash loan without any requirement of drawing power. The package restricts its relevance for those who are already having a loan as a top-up.
It does not cover those who do not have a loan but require some support to transition through the painful situation and the next two quarters are crucial for them.
It is not a collateral-free loan. Rather it is said that fresh collateral will not be asked. It implies that the collateral security already given will be extended to a new loan and added to that there will be an additional cover of guarantee.
The product is extremely risk-averse: In the event of default, the guarantee cover will be relevant only after executing the recovery action against the securities extended. Against this backdrop, one can easily assume that the relevance of guarantee cover is very minimal. It may be useful to those who already availed under CGTMSE scheme (Maximum of Rs 2 crores).
To set up a Fund of Fund(FoF) with an outlay of Rs 10000 crores that will create a total of Rs 50000 crores of equity for MSMEs
Along with the above, Govt. made an ambitious announcement of setting up funds to provide equity investment to MSMEs. It has proposed to set up an FoF of Rs 10000 crores.
There are two issues here- Mechanism of FoF and past performance of Govt’s FoF
Mechanism of FoF: Whenever I interact with MSMEs they have an impression that Govt will be providing equity capital support of Rs 50,000 crores. Hence I found it is better to clarify the exact position in the matter.
In this scheme, Govt will provide 10000 crores to a notified organisation most likely SIDBI. In turn, SIDBI will invest this money in daughter funds. Here the daughter funds are private equity/venture capital funds set up by private entities. These entities will have to secure 80% of the fund on their own and then only they will be eligible to secure balance 20% from this fund.
In the ideal situation, this should lead to the creation of an equity fund base of Rs 50000 crores.
To check the reality, it is better to review the similar scheme of the Govt in the recent past.
Recent History of Fund of Funds Set up by the Govt of India:
Upon assuming power NDA Govt announced an FoF of Rs 10,000 crores to support startups. Even after six years of existence, the performance of this fund is abysmal.
Under that fund as on 18th February 2020, SIDBI has committed Rs 3,123.20 crore to 47 SEBI registered alternative investment funds (AIFs). These funds have raised a corpus fund of Rs 25,728 crore. This information is shared by none other than Mr Piyush Goyal Miniter of Industry & Commerce.
The Minister’s statement is the pointer to what will be the fate of new FoF that they are proposing.
It is unlikely to garner the interest of PE/VC funds to participate in the FoF because they may not be comfortable with the conditions which are normally associated with Govt money and it is just 20%. Secondly, the impact will be felt in the very long run and not in the immediate future to help MSMEs to beat the challenges from COVID 19.
Rs 20,000 crore subordinated debt will be provided for stressed MSMEs under the ambit of CGTMSE.
Govt proposed a new fund to help MSMEs in distress to revive their business. As per the press statement, each entity will get 15% of their equity capital as subordinated debt to the maximum of Rs 75 lakhs.
It implies that an entity having a capital of Rs 5 crores will be eligible for Rs 75 lakhs. Secondly, it will be restricted to limited companies or may require conversion of the firm into a limited company to become eligible to issue subordinated debt papers to investors (In this case banks).
It is a welcome step for one reason. For the first time, the Govt made an attempt to identify potentially viable firms through policy and fiscal support. Instead of whitewashing the stressed businesses as bad people and emphasising to recover through various means leading to the destruction of the economic value of the enterprises.
However, given the magnitude of the stressed assets in India and the size of the scheme (Rs 20000 crores) is disproportionately low. The govt’s commitment (not necessarily an investment) will be Rs 4000 crores in this scheme.
Govt should lead by committing more own resources:
One thing that is apparent in these measures is that Govt is not providing leadership in the crisis time. Govt has turned risk-averse. Instead, Govt is satisfying itself by creating a scheme that is aiming to transfer the risk on one hand and deflate the interest rate to public depositors whose money banks are supposed to protect. If Govt can’t, the banks which are already having strained balance sheet may not be able to serve with full vigour and assist MSMEs to overcome the challenge from lockdown.
Another point is Govt is abundantly cautious and maybe fearing that the facility may be misused. Against the backdrop of their own fierce campaign against misuse of banking facility during the previous regime, they are treading cautiously, it appears. Secondly, Govt is not parting with money in any of these measures and sounds extremely vary of rating downgrade by the international rating agencies. Hence they are trying to do without expressly committing any monetary support.
The measures announced so far not enough to support the MSMEs segment. It is not universal and not reflective to address the needs in sufficient quantity. If Govt chooses tread carefully, who else will bear with the risk that too when the COVID spread is getting severe.
COVID 19: The key risk for MSMEs- Liquidity or Solvency?
Post lockdown there is confusion about MSMEs’ real challenge- Is it temporary liquidity mismatch or long term sustainability.
Recently RBI announced a relief of moratorium (to pay EMIs) to businesses for three months. There was indeed a sigh of relief for many MSMEs as the cash flow is completely dried up and the obligations are firmly staring due to sudden disruption under COVID 19 lockdown. In addition, RBI also extended the relief from NPA classification for three months for the accounts in arrears.
They are welcome steps but will they suffice? Whether MSMEs will revert to normalcy even if the lockdown is removed now and economy return to normalcy immediately.
Because each industrial segment has its own timeline to return to normalcy assuming every other factor is constant, and COVID19 will be at a manageable level.
Recently, Mr Deepak Parekh, an outstanding public personality and thinker said that the recovery may not happen at least for the next nine months. He also urged RBI to extend debt recast to enable the businesses to cope with the challenge.
I believe that it may take three quarters or more before we can see the normalcy returning to pre-March 24 level(the date of announcing the lockdown) in view of the steep demand destruction and uncertainties in the general economy that may lead to restricted consumption and investment.
If the general the situation should persist for such a long time, then obviously the question is whether the challenge for MSMEs is of Liquidity(cash crunch) or its solvency (survival).
It is indeed solvency. The measures announced by RBI will not be sufficient to save the MSMEs from distress.
The present measures ( Moratorium and Suspending NPA classification) will last till May 2020. It requires one to think of the possible solutions in a longer-term horizon. We are of the view that the policymakers need to extend more measures and options to deal with the crisis and to take away the pressure points in the relationship between creditors and borrowers.
What are the other options?
a) Debt Restructuring
b) Resolution support
Debt Restructuring: Debt restructuring is beneficial in the long-run to save from the distress and create breathing space to mitigate the impact of sudden disruption. MSMEs must look at this option without any hesitation. However, they have to have a properly drafted debt recast plan to realise its value.
Present debt restructuring scheme is available to those whose accounts are classified as standard and not availed the scheme earlier. This will last up to December 2020. Govt may prevail upon RBI to allow those who had already taken before this CoVID-19 event to help them as well.
In any case, it is desirable to wait (to apply) until the clarity in the situation emerges, maybe till June /July or before the account turns NPA.
Resolution Support: There are many firms which have been sustaining their business on informal sources and even the suppliers also extend credit to them. Some of the MSMEs are used to funding the business through multiple business loans from different banks and NBFCs. In the present circumstances, people with diverse borrowing practice will suffer the most. Their numbers are not few. Bank loan restructuring scheme won’t solve their problem.
Supporting these organisations is important because they are huge in number and secondly they play an important role to facilitate return to normalcy in the economy.
The revival of these debt-laden yet potential firms require a different approach. The normal debt restructuring is not effective to help them sail through. There is a need to create a new roadmap within the existing institutional and policy measures.
Govt may help them by leveraging two instruments: Reactivating MSME revival framework and using the service of Insolvency Professionals to create a resolution framework.
Govt of India in the year 2015 came out with a framework to assist stressed MSMEs to undertake a Corrective Action Plan(CAP) to give the second lease of life. It is titled as “Framework for Revival and Rehabilitation of Micro, Small and Medium Enterprises (MSMEs)” In consonance with this framework, RBI came out with new regulatory guidelines in 2016 ( ref: RBI/2015-16/338 FIDD.MSME & NFS.BC.No.21/06.02.31/2015-16 dated March 17, 2016 )
This framework is quite comprehensive. A little bit of clarity and more inclusivity of interested persons /stakeholder will definitely help to find a viable solution to through resolution.
Some of the rules can be simplified For example it asks for forming a committee at the bank level to consider the cases and classification of the loan restructured as NPA. We suggest that in place of the committee, Certified Insolvency Professionals who are specially trained and certified to handle the cases of distress may be roped in. Insolvency and Bankruptcy Board of India (IBBI) has empanelled a large number of professionals countrywide.
This special pool of competent people may independently assess the viability and bring on board all the interested persons to create a solution that will work at the grass-root level.
Another point is keeping the asset classification standard will obviously incentivize Banks and NBFCs to opt for this route.
Lastly, any resolution requires all the stakeholders to accept the longer timeline to recover their dues. Also, this mechanism may require that Banks and others commit to a lower rate of interest for the past as well as future. Still, it is a better option than One-time settlement that calls for a deeper haircut and causes permanent damage to the credit history of the borrowers. Whereas reviving potential business asset leads to the huge economic multiplier effect.
The situation is alarmingly different. Explicit policy support is the need of the hour. Without active policy support, many of the MSMEs may not sustain in the long run. Govt needs to bring a comprehensive broad range of options to support the distressed entities to overcome the challenge posed by COVID 19 crisis without any element of uncertainty. It is because what MSMEs are facing is not just immediate liquidity risk alone but also long term solvency.
Covid 19- Banks need to be more flexible to support the businesses
Evolving scenario due to Covid-19 endemic is creating a huge liquidity crunch for many businesses especially MSMEs. Banks should support by extending loan with very flexible terms.
Post lockdown announced by the Hon’ble Prime Minister, the economy suddenly came to grinding halt. There are hue and cry in the business community for a rescue package to help them to overcome the challenge they face in managing the cash flow. In response, RBI Governor on March 27, 2020, announced to extend the moratorium on loans.
Alongside few Banks have announced schemes to support the business to tide over the acute cash crunch.
Against this backdrop, we reviewed the CoVid-19 loan of few banks on how they support the struggling businesses.
COVID-19- is an uncertainty based risk:
The present global crisis triggered by the Coronavirus outbreak is one of its kind never seen since the organized lending (under the regulatory oversight of central banks) is started in the global economy. The pandemic is not a routine risk confronting the businesses. No positive probability can be assigned to estimate the likelihood of recurrence. It is an uncertain risk and can be classified as an act of god. In other words, it can be described as a force majeure event.
Since it is a special event and an extraordinary situation is developed and still evolving. Its longevity, spread and impact are still unclear. The world economy is entering into uncharted water and does not have the capability to estimate the impact.
Hence the situation demands special attention to those who need help to stabilise the economy by supporting the economic enterprises to prevent their collapse and or value destruction due to their inability to adjust to the new challenge. It is more pertinent to the MSME segment who are shouldering the social burden of engaging unorganized & semi-skilled labours and largely financially weak to navigate the challenge from Covid 19.
Banks have an important role to bail out the business in the scenario
The circumstances we are discussing is extraordinary and the global community never experienced this in the past. It needs special attention. The consequences on the business as well as finance providers are needed to be handled with the utmost sensitivity to the people who are affected.
RBI and Banks are responding well. Many banks have shown an inclination to assist the businesses in many ways. We have been seeing the press publications of special loan products launched by the banks in India to help businesses to tide over the cash crunch. Their enthusiasm is amazing.
I had a chance to review the special COVID 19 loan products launched by three banks recently. Though the narrative signifies the commitment and concern for the businesses affected, the finer reading of the products is highly disappointing.
Out of three banks, two are major nationally important banks and. The glaring aspect is- products seeks to limit the eligibility to those customers whose account/s is graded SMA0 only. (SMA0 grade indicates the account which is a standard asset in the books of the bank and not having any adverse features in the operation. Other two categories are SMA1 and SMA2. These two categories are also standard assets but suffer from some deficiency in meeting their commitment on a timely basis).
There are two important points which negate the relevance of the Covid-19 loan products of these banks:
a) Narrow scope: Limiting the eligibility to SMA0 means exclusion of a very large section of the borrowers to get accommodation, especially MSMEs. They lack the financial flexibility to remain SMA0. It is quite likely that banks mightn’t have made an assessment of what proportion of their customers will be eligible. As a result, this product is just a narrative than a source of comfort in the trying circumstances for many.
b) The product does not recognize the evolving scenario: In the global crisis like the one we are witnessing, the risk across the asset class converge as we had seen in the Global Financial Crisis in 2008. In other words, the riskiness of SMA0 and SMA2 will be the same in this scenario. The distance between these two asset classes is not significant enough to predict the better default probability. Because they are going to confront the challenge in almost equal level. If the business scenario deteriorates and the default chances will be almost the same.
In the nutshell, the products of two banks have narrow relevance and have ignored an important aspect- how default probability will behave in the face of evolving uncertain scenario. Unless it is made more inclusive and having flexible terms, there are high chances that many of the standard loan accounts may not be able to navigate the challenges, especially in MSME space.
Businesses are confronting a very unique challenge and scenario is going affect them in almost equal measure for a large section of the business community. Banks need to structure the Covid-19 loan products to make it relevant to bail themselves out.
Loan Restructuring support for MSMEs –Extension is positive
The extended restructuring window to assist the MSMEs in distress is a welcome step. However, its utility depends on how we draw the restructuring proposal.
Finance Minister Mrs Nirmala Seetharaman in her budget speech announced that the scheme of one-time restructuring of existing MSME loans that have defaulted but are not non-performing as on January 1, 2020, will be extended for one more year. Consequently, RBI also took steps to issue the notification in this regard.
The key points as below:
1. The aggregate exposure, including non-fund based facilities, of banks and NBFCs to the borrower does not exceed ₹25 crores as on January 1, 2020.
2. The borrower’s account was in default but was a ‘standard asset’ as on January 1, 2020, and continues to be classified as a ‘standard asset’ till the date of implementation of the restructuring.
3. The restructuring of the borrower account is implemented on or before December 31, 2020.
4. The borrowing entity is GST-registered on the date of implementation of the restructuring. However, this condition will not apply to MSMEs that are exempt from GST-registration. This shall be determined on the basis of exemption limit obtaining as on January 1, 2020.
5. It is clarified that accounts which have already been restructured in terms of the RBI’s previous circular dated January 1, 2019 shall be ineligible for restructuring under this circular.
Extending the support by another nine months is a good step to assist the MSMEs to restructure their business and work out a turnaround path for themselves.
In the ongoing economic slowdown and growing incidences of Covid-19 outbreak, many MSMEs may suffer liquidity stress and require some breathing space to realign the financial model. If any entity experiences symptoms of distress, it is better to approach the bank to restructure the loans than seeking short term high-cost borrowing to keep the account regular.
However, we observed that due attention is not given to draw the proposal to avail its benefit.
The key factor of failure of restructuring – Not synchronizing with cash flow:
Recently I met an entrepreneur who has availed this facility in the month of September 2019. Despite restructuring, he is still grappling with the same level of distress as it was prevailing before. Upon reviewing the revised repayment schedule, I found that it was drawn arbitrarily and there was no linkage to the business characteristics and cash flow from the operations. I found that the restructuring is undertaken without drawing financial projections and solely with the focus of avoiding to classify it as NPA.
It is not the right approach. The scheme is a one-time opportunity for both borrower and banker to undertake a course correction so that precious public money will be returned in an orderly manner. It is an appropriate context to review the business holistically and draw a realistic financial projection for the few years and draw the repayment schedule based on that.
Arbitrariness in fixing the revised schedule will not serve any purpose and likely to render the project unviable leading to perennial distress. A situation can be easily avoided provided we give little attention to make a detailed and realistic financial plan.
We suggest a simple process to make restructuring successful:
1. Review the business holistically and understand the challenges and opportunities in a very unbiased manner
2. Draw a realistic financial projection based on step 1
3. Identify the needs – Rescheduling the existing loan/s, carving the deficit, seeking additional funding, stretching the repayment holiday etc
4. Make a comprehensive formal proposal and don’t accept the changes if it does not support the planned turnaround.
5. Highly desirable to seek expert support while drawing a revival and restructuring plan
A sustainable and enduring turnaround from financial distress requires a very meticulous approach. Restructuring of bank loan is an important step in this regard. The exercise needs to be approached with the utmost care and due concern to cash flow. As emphasized by the RBI circular, it is a one-time benefit for stressed MSMEs to undertake course correction. Don’t ignore the basics.
SMEs in Distress- Beware of ‘Soldiers of Fortune’
When in distress, many SMEs chase new money and normally end in traps of mischievous elements who make tall promises and swindle money.
I recently met one entrepreneur after a gap of two years. Once he had a flourishing business in excess of Rs 50 crores. He had built the business by himself brick by brick. Having come from a middle-class family, despite the success, he stuck himself to the higher values-Extremely affable, god-fearing, and committed to meet promises.
The back to back the introduction of policy measures – Demonetisation and GST-pushed him to the slippery position. Before he could make the required changes in the business process and financial management, the situation went out of control. The liquidity stress started appearing and he started defaulting on the payments resulting in personal insinuations from the providers of loan and suppliers which he never experienced in his life. On the other hand, the trade cycle got disrupted and order flow dried up as his principals started realigning their business to adjust to the new reality.
While he was battling in multiple fronts he started getting offers for a comprehensive bailout. Obviously these offers attract him as he was already exhausted to deal with demand from various people.
They offered to arrange a very large sum and consolidate the borrowings into a single source along with a very attractive rate of interest much below the RoI applicable to well-rated borrowers despite being highly stressed.
The waiting is still on…
Unfortunately, he is still hoping for the new money ever after two years. In the meantime bank and NBFCs have initiated recovery action against his properties and have been establishing their rights. The business is closed and the family is living with agonising pain and praying for better days.
It is commonly observed among the entrepreneurs in distress:
Most of the entrepreneurs in financial difficulty look for quick solution fearing that continued distress may affect the business and their reputation. Having pledged every asset to lenders they fear the impact of distress much more than what it really is. That in turn, prompts them to seek an instant solution. They tend to react to any proposal with much more intensity and avoid confronting those mercenaries to understand their credentials.
Fortune soldiers- Mercenaries who boast about exclusive access to money:
These agents claim that they have an exclusive arrangement to secure money at very soft terms. They show a lot of empathy and promise to work for clients with all the sincerity. If we analyse the experience of interaction with these fortune soldiers there are commonalities in their approach. Some of them are :
- They present as if they enjoy a high degree of confidence of the financiers.
- They seek very small fraction as advisory fee and a still smaller fraction as advance
- Terms are so compelling to justify taking risk of giving advance
- The advance will be packaged as a commitment fee or insurance premium to bring the money from abroad etc
- They do not reveal much about the financier.
- They prop up the names of people in higher offices
- They set the meeting in very premium places
Eventually, their target is to extract advance as much as possible, keep giving excuses to frustrate and eventually make one go away.
Entrepreneurs are more vulnerable in India for financial distress than in any other country:
The options for turnaround are limited in India. The general perception of the stressed enterprise is highly prejudiced. Many see them with suspicion of laundering money from the firm. Being in stressed and struggling lonely, entrepreneurs are obviously vulnerable.
Many take risk of giving the advance in the hope of getting a large sum. Unfortunately, many entrepreneurs have lost a huge sum of money in their hunt for fortune.
The greater damage will be when an entrepreneur diverts his attention to chase this route and keep away from immediate tasks. Lack of credible proposal may prompt recovery action leading to the collapse of the business and destruction of enterprise value.
How to deal with this situation?
If anyone offers a deal which is cheaper than a bank loan, it is to be examined thoroughly before committing. We have not still come across a charity extending helping hand to distressed businesses.
Entrepreneurs should desist from the temptation to seek quick money and allow them to be drifted away from reality. It is nothing but a distraction to find a viable solution within their reach and exacerbating the distress.
Keep your attention to immediate tasks such as talking to creditors and suppliers.
Many a time we falsely blame the absence of money for our distress. However, the fact is that most of the reasons for distress lie elsewhere and pumping more money won’t solve the problem.
Review the business strategy with the support of professional advisors. With professional assistance, you can build a new roadmap and lower the risk to sustainability. When an outsider is roped in, fresh scrutiny will open the mind to explore alternatives.
Distressed entities require better policy support:
MSMEs need better implementation of the law to assist entrepreneurs to undertake course correction. Unfortunately, half-hearted implementation of regulations to support distressed entities in India is preventing entrepreneurs from taking an orderly path to turnaround. This will naturally make them fall prey to unscrupulous elements.
The Insolvency and Bankruptcy code needs to be made universal. The option of restructuring of loans should be enforced upon all the banks(public/private) and NBFCs.
In the present era of globalization, the vulnerability for risks is unlikely to recede rather likely to go up. Thus a stable policy environment is needed to support the turnaround of distressed entities. Also tagging prejudice of criminality with distress situation must end.
Entrepreneurs in distress should appreciate that there are no short cuts to come out of it. Recovery from distress is an orderly process and time consuming requiring one to review in entirety and draw a new strategy.
Anil Kumar Shetty, Founder, SME Advisors
Bank merger: Re-entry to the pre-1969 era for small businesses?
There is an apprehension that merger among the PSBs may lead to deprivation of opportunities for small businesses and startups to obtain a bank loan.
Govt has been pursuing the policy of consolidation of public sector banks(PSBS) into 4 to 5. Already SBI subsidiaries are merged. Last year another round of merger was implemented under the Bank of Baroda. Now again we are witnessing one more round of mergers.
We are looking at how this plays out in supporting small businesses that were one of the reasons behind bank nationalization undertaken in 1969.
Contribution of PSBs in Lending to MSMEs
It is a fact that PSBs are shouldering the responsibility of delivering credit support to the needy section of the society- be it agriculture, MSME, etc. PSBs are always very magnanimous in supporting the MSME ventures, patronized innovations and have extended the long & short term loans. They have been wholeheartedly participating in Govt Schemes like PMEGP. The support for financially distressed entities is commendable and they are meticulously implementing guidelines from Govt and RBI.
How the scenario may change:
With the consolidation, it is likely that the business at the branch level will also be consolidated like it is done with other mergers in the past. This will lead to lesser attention span for the extra customer load the branch will have to deal with. The attention span is important for the reason that social sector banking activities require handholding of the customers that is the hallmark of public sector banking service since 1969.
With reduced branch presence of PSBs, the access points will dwindle and invariably small businesses will have to have banking business with private peers however what they likely to miss is credit support the way they get in PSBs.
Thirdly even for PSBs, more orientation will be towards profitability since capital efficiency was the reason for consolidation. That may drive them to reorient towards large value exposures.
Private Banks show no or less keen to lend in priority sector lending:
It is a fact that private sector banks show little or no interest in priority sector lending. They prefer other via media to engage with such clients resulting in higher cost of credit for end users. Also, they are happy to compensate for the gap through alternate options extended by RBI.
They are very particular about securing their loans by taking collateral of fixed assets. Even though Govt has implemented CGTMSE scheme to extend credit guarantee for small business loans and it has been here since nearly 20 years, private banks have not shown much inclination to extend loan under this window.
They are obsessed with securing their loan more than supporting the entrepreneurship. As a result, many budding entrepreneurs will not have access to bank credit and will be forced to seek support from predatory lenders.
If one looks at the profile of the product of many private banks, they are more keen to finance immediate needs than supporting capital investment. Support in distress is a far cry.
Role of RBI needs special mention:
Presently priority sector lending is handled by RBI. Most of the compliance with its directions are coming from only PSBs. With the reduction of their share and the increasing presence of private banks, we may see social sector lending will be reduced to islands everywhere.
Further, the RBI itself has created avenues for private banks to avoid direct participation in the priority sector lending that will further add to the declining credit flow.
Sadly RBI does not measure the flow of credit at the grassroots level rather relies on secondary data from Banks.
One can conclude that RBI action on this front is more of administrative and not accountable for the flow of credit to these needy segments.
How a merger may impact different sectors?
Mergers and consolidation of PSBs may create a huge vacuum of space of social sector lending. We believe that Micro and small enterprise will suffer more than agriculture because agriculture may get support from Coop Banks and Societies. Also, political activism may help agriculture, that privilege is not available to MSMEs.
The way forward: “Bring in a new law for creating sustainable financial architecture”:
Since consolidation exercise is underway, it seems there will not be any rethinking. However, Govt has to act to alleviate the apprehensions of a lack of access to credit from this process to small businesses.
In these circumstances, it is necessary to bring in legislation to create a sustainable financial architecture that binds regulator (RBI) and the banks to undertake lending to priority sector irrespective of ownership. They may be incentivized, extended liberal guarantees scheme coupled with provision for punitive action for not adhering to stipulations.
The notable benefits are :
a) It will make lending norms a legal mandate and ownership neutral.
b) It will universalise the access to credit in any region or activity
Bank merger without implementing an alternative model to support social sector lending will leave a huge vacuum and may affect the economically weaker section resulting in further widening of inequality. This may end up at creating a pre-1969 era of lack of access to credit for small businesses and others. Legislative action is necessary to preempt this scenario.
By: Anil Kumar Shetty, Founder SME Advisors (email: email@example.com)
A financial safety net for MSME workers: simplified
Govt has implemented few products that benefit the workers of MSMEs if implemented comprehensively.
Recently I had an opportunity to survey the financial safety net implementation by the rural population surrounding an Industrial area, near Bangalore. Many of the members of these households are working or associated with industrial units in that cluster or elsewhere.
In our study, we found that a large section of the households have not subscribed or not even aware of the products despite being widely published by the Govt.
The financial safety net for families- a need felt across more than ever
Every family aspires to secure themselves from the shocks and difficulties of through fair distribution of their earning between savings, risk cover and retirement corpus. The flexibility to do so is very limited if the earning barely covers the living expenses. This situation puts the families into a very vulnerable state and that may act as a deterrent to getting them into activities where the perceived risk to themselves is quite high or they remain alert to risk so much that will lead to lesser productivity from them.
Since their income barely covers the living expenses, Govt has taken many initiatives to supplement these needs by introducing an array of products.
These products are very pertinent for workers in MSMEs. The income level of workers, regular or otherwise, is not very high. These products are made very affordable, meeting their needs.
Financial safetynet –composition:
The financial safety net, we are talking about comprises a few assorted products mainly from Govt sources. In recent times, Govt has made access to avail the products and also to secure the benefits under the products much easier than ever.
These comprise savings, life insurance, health cover, accident cover, pension and skill development. Details as below:
Savings products: Having a bank account is commonplace for employees and it is a good sign. However many of them are just limiting their banking transactions to the savings account and it is no surprise to find some accumulating their hard earning savings in SB account when there are opportunities to maximize their earning even from a scarce amount of savings by opting for products like recurring deposit(RD) and fixed deposits. The spinoff from having an RD account is that it prompts them to adopt a planned approach to save and at the same time maximise the earning.
Term Insurance(PMJJY): Govt has been promoting term insurance of Rs 2 lakhs for an annual payment of Rs 330. It is made available for the people of age group 18-70 years. It is very simple and does not require one to go through any procedure to assess the eligibility.
Accident Insurance(PMSBY): An accident insurance amount of 2 lakhs is available for people for annual premium payment of Rs 12 only. This will help the poor labours to secure the family against accident-related deaths.
Health Cover: To empower poor families against health-related issues. Recently Govt enacted Ayushman Bharat scheme. The coverage is as much as Rs 5 lakhs. This scheme requires one to register and take health card from the nearest Govt hospital at no cost.
Pension products: It has been since a long time that all the citizens are given an opportunity for having their pension account under the National Pension Scheme( Eligible up to 54 years). Thereafter Govt has enacted four new products for the benefit of people in the age group of 18 to 40 years for unorganized and skilled labours. It is called PMSYM( Prime Minister Shram-Yogi Mandhan Yojna) Under this scheme the labours who are not eligible from PF and ESIC can have a pension account with a monthly payment of Rs 55 to 200 depending on their age and will be eligible for a pension of Rs 3000 after 60 years. Under this scheme, the Govt will also contribute an equal amount every month.
Also, those employees who have PF benefit may opt for a pension under Atal Pension Yojna non-subsidised.
Skill Development: Skill makes an individual more valuable for society. It helps one to earn more and to enhance his/her self esteem. It motivates the people to become more productive and he/she can become a source of strength to any organisation. Seeing the skill gap and the industry’s clamouring for support, Govt(state/central) have implemented many schemes to support skill development programmes.
Supporting Employees to become Financially secured- The best CSR initiative for MSMEs:
Corporate Social Responsibility (CSR) has emerged as a new yardstick to evaluate the contribution of an enterprise for the welfare of society. Govt has implemented a law compelling large companies to mandatorily spend on their own to the welfare of the society a portion of the income. However, this is not applicable for MSMEs as they do not have enough financial flexibility to engage in such activities.
It is well said that the best CSR activity for MSMEs is to support their employees. If these MSMEs take initiative to educate and encourage the workers working within their company to take the above social security products, it will improve the goodwill and make employees feel secure. Educating and encouraging these workers to secure themselves under these products does not require any investment. It is the word of encouragement, guidance and follows up will take them to avail these benefits. Some may incentivise in different forms to make them avail these products.
There are benefits for the MSMEs. A financially and socially secured employee makes the working environment secured. Standing as a socially responsible organisation will be further reinforced.
There are many new financial products from the Govt to help the weaker section of the society to become empowered. These products are also very important for employees of MSMEs. Many of the eligible beneficiaries are not aware of these products. MSMEs may encourage workers to cover themselves under these products and make their life more secured. This will augur well for the organisation and counted as a socially responsible organisation.