Adherence to the Regulations by Lenders – Enforcement is needed
The pandemic is still raging and many entrepreneurs are living under the shadow of uncertainty with regard to restructuring.
We have been assisting the couple to deal with financial distress emanated from COVID 19 pandemic and consequent lockdown in the early last year. The flourishing restaurant business nosedived to a complete standstill. Thanks to their spirited reworking of the strategy and increasing online orders, the business remains afloat. Though the profitability is still a far cry, there is a glimmer of hope and optimism that the days ahead will be better. They have few loans from NBFCs and banks as well. We all know that when the going is good, the enterprises tend to borrow a business loan that comes without any collateral security and it is quick in delivery of the loans. Unfortunately, the Covid 19 made things go very bad. NBFC which had been recovering the regular instalments till the pandemic did not show any remorse at the situation rather insisted on payment though there is not enough cash flow. The borrower made repeated requests for restructuring the loan and a softer repayment schedule for the balance outstanding which they ignore.
What is astonishing is- the approach of the NBFC to ignore RBI’s guidelines on One Time Restructuring (OTR). The subject party is eligible to seek OTR as per RBI norms. Despite repeated requests to consider under the RBI Scheme of OTR, they ignored the request.
The question is- what is the sanctity of the regulations which is not adhered to by the NBFC
In the midst of the COVID 19 pandemic and post lockdown, the Reserve Bank of India came out with series of regulatory guidelines to banks and Non-Banking Finance Companies(NBFCs) to extend relief to customers to overcome the financial distress and smoothen the process of recovery of loans in an orderly fashion. Also, Govt of India came out with many guidelines to help the MSMEs to overcome the stress.
RBI issued two comprehensive guidelines on August 6 2020. They are: Resolution Framework for COVID-19-related Stress (for personal loans and corporate exposures) and Micro, Small and Medium Enterprises (MSME) sector – Restructuring of Advances.
The circulars were very clear and unambiguous in their intent. It has given enough flexibility to enable banks and NBFCs to restructure loans with liberal terms and addressed the key concern by waiving the condition to downgrade the loan to non-performing status.
In the first reading, it sounded as if it is a panacea for avoiding conflicts between banks and borrowers. There was a great sigh of relief among MSMEs that there will not any harassment for recovery rather the process to recover from the COVID 10 pandemic will be smoothened.
Many MSMEs have given a request for restructuring in view of the delay in the onset of business recovery.
This particular couple also made a request way back in September 2020 to restructure the loan to NBFC. However, it was very agonizing to see that the lender neither took serious note of the request nor shown any inclination to implement RBI guidelines. They were absolutely cold to the proposal. In fact, there was no one to discuss the proposal.
It is not an isolated case rather than a system-wide practice. Despite the standard conditions set by RBI for identifying the eligible entities to undertake a restructuring, the banks and NBFCs are not enthusiastically taking up and do not see any obligation to act under the regulations. Their action is very patchy.
The obvious question is- what is the sanctity of the regulations issued by the RBI. Who will have to oversee the implementation?
The regulations are announced as a response to demand from industry bodies and citizens. If it is ignored by the lenders and if they focus on recovery, it will not serve any purpose.
Bank/NBFC is a party for the transaction. It is prudent to leave it to their wisdom to decide on the restructuring proposal? Is there any department or a statutory body which is having the supervisory responsibility to enforce the regulation promulgated by RBI? Indeed it is needed.
Regulations and policies are meant to remove personal prejudices, individual discretions and notably, it will facilitate the contract between two parties conflict-free. Having regulations on OTR is indeed positive for the MSMEs to overcome the covid induced stress. However, its significance is lost when there is no appetite among the lenders to implement.
An agency from Govt/Regulators will have to look at the efficacy of implementation of schemes. This is needed to eliminate the uncertainty and enable effective implementation. It requires setting up a mechanism to help the borrowers to notify their desire to seek restructuring in an independent platform and such request should be referred to Bank /NBFC headquarters for further action.
Setting up such a mechanism with the online channel is quite easy and requires minimal investment. The benefit will be multifold. Having provided the platform, the process will become more transparent and the banks & NBFCs will be compelled to take an objective view of the proposal. It will take away the uncertainty. Brining more stressed business assets into productive use will result in a more economic capacity to grow.
Restructuring is beneficial to all the stakeholders:
Restructuring of loan is one important step in the broader agenda of the revival of stressed business. Unfortunately, there is an element of restlessness among the bankers and NBFCs to undertake this. Rather many are willing to call the customers for One time Settlement of the loan; a sort of inducement. It is not correct. A business of an individual member of the society constitutes an economic asset of the whole country.
Secondly, it is in the interest of banks and NBFCs to hold a dialogue with stressed customers and create a viable path for turnaround. After all pestering, the borrower in the hour of the crisis engulfing the whole society will only lead to self-inflicted injury to these institutions than bringing meaningful recovery.
The fact is in the long run the restructuring is indeed beneficial to the banks and NBFCs though they have to endure short term mismatches in the asset-liability management.
COVID19 Pandemic is causing havoc in the economy. Small business owners are bearing with brunt. The OTR scheme is very much important for stabilising their business and finance. RBI and Govt should make its implementation very effective and facilitate fixing the stressed relationship with lenders so that they will move to revive their business. That will facilitate faster economic recovery.
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.
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.