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.

Conclusion

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.

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.

Unlikely …….

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.                   

Conclusion:

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.