A weak resolution environment is negative to promote entrepreneurship
COVID 19 exposes the vulnerability of MSMEs in the face of uncertain events. This shows a need for a robust resolution mechanism to deal with creditors and find a viable path forward.
I met with a group of partners of a restaurant business who had been doing extremely good till the COVID 19 pandemic started. The format was very unique in the industry and has the potential to be replicated elsewhere. In fact, the promoters had drawn an ambitious plan to expand the footprint through the franchisee route to take it is to different parts of the city as well as pan India. Pandemic and consequent sudden lockdown had made the calculations go haywire.
The business just slipped out of control. They could not salvage the business. The creditors and suppliers demand was too much to bear with. The bank loan which was well within the normal level till the lockdown suddenly became too much to digest as there was no income flow. The leased property, wherein they invested more than Rs 1 crore to create a unique theme, had to be demolished as the rent payment becomes burdensome. With the removal of the store from the place which was part of their brand, there was no chance to return to the normal business. The condition deteriorated to the level beyond their imagination in the wildest of dream and all happened in just a matter of a few months.
Now the partners are helplessly watching the unfolding of recovery actions from the multiple lenders who have extended business loan at a high rate of interest with a short maturity.
The absence of policy support to deal with uncertain times is the central issue
The pandemic was unanticipated rather an uncertain event. Equally the lockdown was sudden and there was no time to think of alternative options. None of these was under their control.
Today we are in a situation wherein there is no regulatory or legal framework to enable entrepreneurs troubled by uncertain events to carve out a viable path to return to normalcy. The uncertain events affect all in equal measure. However, what is missing is a legal framework that will distribute the pain without letting anyone in the contract to be benefitted or remain unaffected whereas another the party will remain in an advantageous position at the previous level or better. For instances when the lender is a party to the contract, the borrower undergoing the uncertain event will remain indebted to the fullest extent because there is no statutory binding for the bank to sacrifice a fraction of the loan to make the business viable or allow to service the debt with a haircut and a longer schedule.
This unequal position in fact deteriorates the situation further as it will bring in too much uncertainty in the minds of entrepreneurs who will have to deal with the enlarged ego of the other party. This will divert the focus away from resurrecting the troubled business and end in the destruction of the enterprise. Destruction of an economic enterprise brings agony to not only the entrepreneurs & his family but also but the larger society as it will also suffer loss in many ways.
This unequal position is not a stand-alone event affecting a few. It is visible very widely. The entrepreneur will have to answer the same question from many others such as suppliers, unsecured creditors, tax authorities etc. They in turn will have to face a similar situation with others. In all, it is a challenge for the whole society.
Thus there is a need for a standing mechanism to support those victims of uncertain events. The mechanism should be able to help them to withstand the immediate pressure on cash flow and stabilise the business. Once the business returns to normalcy they should be compelled to make the payment to obligors be it bank, creditors suppliers alike.
In the face of uncertainty, the most important support an entrepreneur require is to stand firmly against the wind flow and thus preventing the run on the business. This will create breathing space and allow the firm to review its business and find a viable path forward.
In the process, it may require the creditors have to make a sacrifice in the immediate future with or without a clawback option to recover the loss in the medium to long term depending upon the circumstances and viability.
Resolution support in India:
There were few attempts to create a window of opportunity for distressed firms to review and rework a path forward. The very comprehensive support mechanism was enshrined in the 2015 circular of the Govt of India (Framework for Revival and Rehabilitation of MSMEs). It indeed addressed the concerns. Unfortunately, it suffered from the lack of enforceability of the guidelines. Rather it remained a wishful policy framework and its adoption is purely voluntary.
However, enactment of the Bankruptcy Code in 2016 had raised hope for many. Though Insolvency and Bankruptcy Code (IBC) has the power and scope for stressed business firms to seek relief as in many advanced countries, it is not fully implemented covering all types of the constitution rather limited to LLC(Limited Liability Companies) and LLPs(Limited Liability Partnerships). For the rest, though the law provides for, Govt has not notified yet.
It is time for Govt makes IBC law accessible to all forms of businesses uniformly. There were apprehensions that bankruptcy tribunals will be overwhelmed with litigations. It is not the correct position. Because having an option in the hand will facilitate dialogue among the creditors with the firms and will help to find a viable solution voluntarily. If you look at the history of litigations in Bankruptcy Tribunals(NCLTs), the voluntary understanding that arrived among the stakeholders forms a significant proportion of resolutions than otherwise.
MSME Prepack- A welcome step
There are discussions in various fora that the Govt will bring in a Prepackaged resolution solution under IBC to simplify the process and expedite the resolution for the benefit of MSMEs. The process under the pre-pack insolvency envisages formulation of a resolution plan before the initiation of a formal court process. It is a welcome step and it should be made available to all forms of the business including proprietorship firms and partnership firms along with LLCs and LLPs.
Resolution support de-risks the operating environment and hence promotes entrepreneurship:
A populous country like India needs to encourage entrepreneurship to create employment opportunity and improve the competitiveness of the economy. However the journey of entrepreneurship is filled with experiments, adventurism, and itself is a learning curve for many. It is unlikely to be smooth and cannot be predicted to proceed as planned.
Having a support mechanism for those who may suffer along the path of the entrepreneurship journey to revisit the journey will create a great enabling environment for many to take entrepreneurship. In the long run, the country will win.
A law like IBC is much needed for businesses at this point in time than ever in the history of organized business because the uncertainty in the operating environment is at an elevated level. The entrepreneurs require a sense of assurance through the legal framework to seek a solution if the business proposition fails to yield the desired result. This way the resolution support can promote entrepreneurship.
Proper classification of entries in the annual accounts- An essential task for SMEs
Accurate classification of entries in the book of account is a basic requirement for proper representation of financial standing before lenders and other stakeholders.
Recently we were approached by one construction company having many projects in its fold for advice on the difficulty in securing the bank loan despite having a good amount of own investment and healthy growth over a few years and he was willing to extend good collateral security to the comfort of the bank.
He said that the bank is not in favour because the financial ratio is not favourable. As per the initial assessment the current ratio, key ratio to decide on the working capital limit was below one. Something the banks consider not acceptable.
We started analysing the financial records of the year 2019-20. We found that the reason for the low current ratio was the wrong classification of the unsecured loan. To our dismay, we found that the unsecured loan was clubbed with sundry creditors. On the hand the firm has acquired fixed assets to that extent.. Of course in the first reading, anybody will get an impression the firm has diverted the short term creditors’ money to acquire long term assets.
Apparently the bank had drawn a conclusion that the party does not have financial discipline and has diverted the short term money for long term use.
Party indeed invested the money into the business in the form of an unsecured loan and he has no plan to get back that loan in the near future. Rather this amount was invested keeping in view the requirement of long term funding needs for the growth of the business.
Here the wrong conclusion on the part of the bank originated in the wrong classification of the loan from the promoters into the short term liability that too clubbed with sundry creditors.
Annual Accounts –an important document to represent our business:
Maintaining books of the account is the process of recording and maintaining financial transactions and information relating to a business, on a day-to-day basis. It ensures that records of the individual transactions are correct, comprehensive and updated with accuracy.
Some of the entrepreneurs treat book keeping as a low priority one and hardly look at it for its veracity and integrity. Further, they treat annual auditing of accounts is just a ritual for compliance and tax assessment. They do not see any significant relevance to their business plan. Still worse many boldly state that the books of accounts do not reflect the true picture of the business.
In fact, some SMEs failed in financial management due to weak or no accounting records. On the contrary, financial management is very crucial to the success of a small business. Many repent this when they hit the distress.
These opinions and perceptions won’t help the entrepreneurs. The books of accounts are important for many reasons. Annual accounts are only documents that address the concerns of stakeholders – bank, suppliers, buyers, potential investors, tax authorities etc.
Why SMEs should maintain proper books of account
To prepare Financial Statement: Balance sheet, profit and loss account, cash flow statement are the key elements for reporting to investors/ financiers/bankers on crucial information about the financial status of the enterprises, and books of account are a precursor for it.
To fulfil tax obligations: Paying tax is an obligation by law; beitincome tax, customs and other taxes and duties. To know the correct amount of obligation and to resolve any disputes, one needs adequate and accurate books of account
Legal requirement: There is a certain stipulation in the IT Act to file the returns and this requires to be backed by the books and account. Further Companies Act 2013 also requires every company to maintain their books of account.
Better financial management: At present, better financial management provides a better picture of the health of a company. To make forecasting of financial requirement, acquiring necessary capital and to analyse investment decisions, you should have adequate records of business transactions. Also, the review of the operating performance in relation to time periods or peer comparison can be effective only with proper accounting practice.
Long term sustainability: A thoroughly studied and prepared annual accounts throw many facts and expose the inefficiencies in managing the finances. Thus it will eliminate scope for the surprise appearance of liabilities and financial stress.
Interacting with Accountant especially Auditor is important task:
Proper preparation of our books of accounts is our primary responsibility and getting it thoroughly audited by a Chartered Accountant is an equally important job.
No accountant is interested to make a wrong representation of entries. However, for want of clarity or lack of evidence in the books about the nature of the transaction or by oversight, they may also err in the grouping of the data.
Further, the Auditor having gone through your books of accounts during the course of the audit may have observed deficiencies. Such observations are vital to improving our internal control and risk mitigation. Thus entrepreneurs should interact closely with their Auditor during the annual audit process. Their wisdom drawn from multiple engagements will help you to improve internal control. Also, it will eliminate the scope for errors.
Accurate classification of the entries in the books of account is in the interest of the entrepreneurs. A growing business requires support from multiple sources including banks. Hence accurate representation of the annual accounts is important for winning the confidence of finance providers such as bankers and investors.
CGSSD Scheme: New lease of life for stressed MSMEs in India
The new scheme is a well-conceived framework to enable stressed potentially viable MSMEs to secure a new lease of life and a much needed bridge to facilitate constructive engagement with the bank.
Recently an entrepreneur sought our assistance to revive his business units, one in South and the other one in North. Both are in the same activity and are incorporated in the year 2016. Both together consumed the investment in excess of Rs 30 crores with little than 50% of the bank loan. The business was new to the family although they are in the higher reach of the value chain of the industry for more than four decades.
Both businesses faced quite the same problem. They failed to gather a robust team. The capacity utilisation was lower than the minimum viable level. . The key risks were not in control. Since the family members were at the helm of affairs, there was lax internal control and governance. No one took the burden of running the business professionally.
Despite the most modern production facility and promoted by the family of successful entrepreneurs, the business failed to reach the expected revenue targets and started incurring huge losses resulting in the account becoming NPA in the books of the bank. Having no option left with, Banks in both the places initiated recovery action under SARFAESI Act.
The family repeatedly sought assistance from the banks to restructure the loan and revive the business by infusing additional capital. However, banks were very adamant insisting for the recovery of the loan.
Latest Development: Revival is underway
Thanks to the Govt’s initiative of helping the stressed MSMEs through a new scheme “Credit Guarantee for subordinated Debt (CGSSD)”, the businesses of both these units are seeing a revival.
Under the new scheme, the loan restructuring is underway at the individual bank level. A new business strategy is put in place. The operation is restarted in both the units. The capacity utilisation is steadily rising.
The new guidelines from the Govt of India made the difference:
Recently Govt brought out a new scheme to facilitate the revival of stressed but potential MSMEs. The purpose is to provide guarantee coverage for the CGSSD and provide Sub-ordinated Debt support in respect of the restructuring of MSMEs. 90% guarantee coverage would come from scheme/ Trust and the remaining 10% from the concerned promoter(s). The objective of the scheme is to provide personal loan through banks to the promoters of stressed MSMEs for infusion as equity / quasi-equity in the business eligible for restructuring.
The salient features are:
- The borrower should be the promoter of MSME unit
- The Account should be SMA 2 or NPA as on 30.4.2020
- The accounts classified as NPA after 1.4.2018 are eligible
- The loan amount will be 15% of Promoters stake in the business to the maximum of Rs 75 lakhs
- The loan will be extended to promoters.
- The loan will have guarantee cover from CGTMSE
The scheme is a game-changer:
The scheme is a source of great relief in the above instance. The promoters were sincerely looking for a way out from the messy banking relationship to revive the business. The scheme extended a framework to work with the bank and find a viable path to return to profit. Today the units are in a position to extend jobs to many unskilled and semi-skilled employees in the region. Precious public money will come back to the bank in a phased manner without going through stressful, expensive and value destructive recovery actions.
A mechanism for handholding during the stressful scenario is needed for MSMEs.
Entrepreneurship requires to be encouraged for India to become a global powerhouse and assisting entrepreneurs in the stressed scenario should be part of the policy support they need. We explain here below some of the reasons:
- Dealing with an uncertain environment is endemic to entrepreneurship: Despite the best planning, many firms may challenge to survival due to factors not in their control. Many time changes in the policy or local regulation do impact the business of the small businesses very badly.
- Internal factors and learning curve: There are chances that many a time entrepreneurs fail to get the grip on certain vital functions that may be the key success factor for the business. Every venture has its own learning curve and they need to be supported if there is any delayed onset of the business for want of understanding if its nitty-gritty.
- Bad financial planning: Many a time the decision to launch new busies is more an emotional decision than followed up with a clear financial strategy. We have seen many entities struggling to put the financial maths in place despite the best of technology, manpower, and having huge opportunities to become successful.
- Absence of professional advisors and mentors: Many first-generation entrepreneurs go through a long-struggling learning curve in the absence of access to independent and credible advisors and mentors. As a result, the process of finding the right formula for success gets longer.
Entrepreneurs do make mistakes especially in the early stage of new business. There should be an avenue for course correction. Such businesses deserve a chance to correct the course and redraw their path to success.
In the above cases the CGSSD scheme played a major role to bring in difference. In the similar instances elsewhere entrepreneurs need to be given chance for course correction. An opportunity to review and strategize their business will be of great to protect the value of enterprise they have passionately built.
Also the CGSSD scheme can create a good platform to make the engagement between the bank and entrepreneurs more constructive even when there is distress and facilitate them to find a viable path jointly to turn around the stressed business. In any case It will not take away the discretion of the bank to enforce the recovery if the attempt does not help to revive.
Further improvement required:
CGSSD scheme is a welcome step to help the stressed MSMEs. The support mechanism for stressed MSMEs may be further improved to broaden its horizon. Some of them are:
a) Make it available all across the banks and NBFCs: The borrowing of any MSME is wider than one source. This should be mandatory of all of them join in the process. Unfortunately, lenders other than Govt owned banks are not supporting the MSMEs in this regard. It should be available on a non-discriminatory basis. Govt may bring in required legal and/or regulatory actions in this regard.
b) Remove the age of NPA clause: As per the norms of the guidelines, accounts classified as NPA from April 1, 2018, onwards are eligible. This may be relaxed to cover any potentially viable unit irrespective of the date of becoming NPA.
CGSSD scheme is a welcome step to help the stressed MSMEs to find new lease of life. Also, it is a much better option for the banks instead of seeking recovery action immediately after becoming NPA.
Sustainable competitive advantages and Financial discipline in SMEs
COVOD19 pandemic triggered disruptions have shown how important it is to build good financial discipline alongside building sustainable competitive advantages.
Recently we met an entrepreneur who has been into a service industry. He came with a request to advise him to tide over the crisis which is threatening his survival in the business. He has been into this industry for a long time and steadily built his business over the last 10 years. The business started from scratch reached a level of a couple of crores per month. Even before the COVID 19 pandemic business had been quite weak for some time due to poor financial management mainly diversion of funds outside the business. That had indeed damaged the banking relationship.
Having been in the business over 10 years he has built a strong sustainable competitive advantage and that is giving him enough room to stay in the business in spite of the lack of financial discipline.
The COVID 19 crisis followed by overnight lockdown orders changed the scenario. When the lockdown was announced he was already on the edge; like many other small business owners who are often financially fragile, with little cash on hand or resources to buffer even a minor financial shock. Many MSMEs have ongoing expenses and little or no revenue and face the prospect that they may not sustain for long or never reopened.
Though Govt had announced many schemes to help MSMEs to overcome the challenge, he could not avail any of them due to his low credit profile. On the other hand, the creditors’ demand just became unbearable.
The sustainable competitive advantages built assiduously over the years under the threat of vanishing as he is not in a position to revive the business to the previous level even though the normalcy is slowly returning to the industry.
Building SCA is no mean task. It is hard work, require sheer dedication & passion. It happens over a period of time.
Sustainable Competitive Advantage(SCA):
Sustainable Competitive advantage stems from the many discrete activities a firm performs in designing, producing, marketing, delivering and supporting its product. Each of these activities can contribute to a firm’s relative cost position and create a basis for differentiation.’
Sustainable competitive advantage is the key to business success. It is the force that enables a business to have greater focus, more sales, better profit margins, and higher customer and staff retention than competitors.
At its most basic level, there are three key types of sustainable competitive advantage.
- Cost advantage: the business competes on price.
- Value advantage: the business provides a differentiated offering that is perceived to be of superior value.
- Focus advantage: the business focuses on a specific market niche, with a tailored offering designed specifically for that segment of the market.
Most MSMEs don’t have the market share and buying power to effectively compete on price and are not big enough to be all things to all customers in a market.
Therefore, to successfully compete, small businesses need to develop a sustainable competitive advantage that is based on providing superior value to a specific niche.
Is SCA enough? Will it guarantee enduring success?
The question can be answered through our own experience or looking at some entities which are passing through financial distress. It is quite obvious among the financially stressed organisation to see the depletion of ‘organisational capabilities’ encompassing both physical resources (raw materials, plant and equipment) and human resources (financial, managerial, technical knowledge and skills) which are critical to the ability of firms to nurture Sustainable Competitive Advantage.
We can infer that Sustainable competitive Advantage alone will not bring success in the business. Having all the ingredients, if there is no financial discipline, the firm will likely to fall into distress sooner or later.
The major areas of financial management that require perennial attention to enduring the success of any organizations are :
Cash flow management– Mainly ensuring that long term asset acquisitions/diversifications are funded by surplus (more than required for existing business’s requirement) or funded by long term sources.
Asset management: Efficient management of current assets (cash, receivables, inventory) and current liabilities (payables, accruals) turnovers and the enhanced management of its working capital and cash conversion cycle.
Financing Decisions and Capital Structure- The firm needs to have a well-defined capital structure. The optimum capital structure is expected to enhance ROCE and ROE, without enhancing the financial risk.
Profitability Ratios: Profitability ratios also indicate inefficient areas that require corrective actions by management; they measure profit relationships with sales, total assets, and net worth.
Tax Optimization: Manage the level of tax expenses undertaken in conducting business and to reduce expected taxes.
In the instant case described above, having robust SCA but poor financial discipline exposed him to face a severe level of risk of failure of the business. It was evident that when things were going good, adhering to financial discipline was the last priority.
The recent incident of Covid lockdown exposed many entrepreneurs to the risk of failure. However, those who have built sustainable competitive advantage coupled with better financial discipline are able to navigate the challenge better.
Possession of Sustainable Competitive Advantage is a necessary condition for success for an MSME. This condition is, however, not alone sufficient. Firms require financial management capability to realize the potential present in that strategic asset. This will help the firms to navigate any challenges, mitigate risks and overcome the impact of uncertainties like COVID 19.
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.
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.
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