Embracing Private Equity – A need for SMEs in India
The business environment is getting complex. SMEs in India need to reorient the funding mix of business by expanding into equity investment than relying on the debt alone for sustainable growth.
State Bank Chairman Arundhati Bhattacharya today urged small and medium enterprises (SMEs) to focus on raising funds through equity instead of debt to drive their businesses in a healthier manner.
She said SMEs’ relying more on debt for their growth capital in the initial stage of their business put pressure on their balance sheets.
“One of the major problems facing SMEs in our country is lack of equity. Equity capital is a much-neglected area in the SME sector,” Bhattacharya told an SME summit and asked them to learn from technology players which have sourced a large amount of equity to ramp up their business and market share.
Quoting the examples of e-commerce companions like the Flipkart and Amazon, she said these firms have done wonders with the help of equity.
SMEs are fixated about debt funding:
It is very common to find that largest of SMEs in India always consider debt funding of their business -be it expansion or a new project- a fait accompli. They take it for granted to raise debt funds ignoring the risks to their present business or the family if the strategy goes wrong.
In addition, their success in the present business makes them feel confident about of repeat of success going forward.
Further many SMEs feel it is binding their banker to consider financing their project irrespective of whether the new project or the indented expansion is viable.
They are not very enthusiastic to discuss other funding sources and their advantages. Many are apprehensive of dilution of the grip on the company which they have assiduously built over the years.
Advice is timely:
Honourable Chairperson of SBI has aptly made this remark in a very contextually relevant time. The global economy is experiencing tardy growth. The domestic industrial segment is witnessing slowdown due to the cumulative impact of many regulatory actions such as demonetisation, implementation of GST, etc. Banking industry more specifically public sector banks are reeling under tremendous pressure from NPAs.
In this circumstances, looking at the bank for a fresh loan to finance expansion or new projects not only beset with challenges at the transaction level but also undesirable given the inability of debt to absorb the risk and indifference of its repayment schedule to uncertainty if creeps into future cash flow from the business.
Debt versus Private equity:
The main difference between private equity and loan finance is that a loan is usually secured on either business assets or on the personal assets of the entrepreneurs. If the business defaults on its repayments, the lender can put the company into recovery mode and, in extreme cases, even bankruptcy under newly enacted Insolvency and Bankruptcy Code 2016.
If not recovered full, the enders may enforce recovery action against him if he has given the personal guarantee. This type of secured debt is known as ‘senior debt’ because it takes precedence for repayment over unsecured creditors. In return for this security, senior debt is a relatively inexpensive form of finance.
Private equity ranks behind the senior debt in the order of recovery if the firm is liquidated. As long as there is significant senior debt outstanding, equity investor is, in reality, unsecured and as vulnerable to the risk of failure as the other shareholders. As an equity business partner, the private equity firm both gains from success and loses from failure. As a result of this exposure to risk, private equity is considerably more expensive than senior debt.
Private equity has many positives for SMEs such as strengthening the balance sheet, better capacity to endure the volatile business environment, flexibility in structuring return of investment, access to high-level intellectual capital, beefing up bench strength etc. Further private equity raising is not as difficult as raising money from public issue and require minimum regulatory compliance.
Loosening control means broadening the management and not conceding the space to Investors:
One apprehension for many entrepreneurs is that they will lose the control of their company and they have to onboard the views and advises from representatives of private equity investors.
It is not true. Let us assume that a company is accumulating good profit and growing by double-digit CAGR year after year. In order to supplement the growth, the company invariably will have to hire more management staff in the leadership position. Hiring more in leadership position effectively mean conceding the space to them to take decision otherwise delegating the responsibilities.
Thus loosening the control or broadening the management bandwidth is not due to private equity investment rather it is a requirement for augmenting the developmental needs.
Secondly having another responsible person on the board will help to improve the thought processes preceding decision taking. It will help to run the business in a more organised way that in turn will attract good professionals to join the company.
The equity is a better choice to navigate the risks and strengthening the balance sheet. SMEs should desist from raising debt alone for future growth rather explore and evaluate the option of raising private equity keeping in view the circumstances and targeted goals.