At the heart of the stressed asset mess - the need for patient capital

So often have we heard about Non Performing Assets (NPA) of India lenders being debated across multiple fora that it now evokes indifference at best. The problem however can’t be wished away and is back in the headlines with the Supreme Court lifting the stay on banks classifying stressed accounts as fresh NPAs post-August 31, 2020. The Insolvency and Bankruptcy Code is also back in the reckoning after a year’s hiatus.

Going by RBI’s estimates the gross NPA level of Indian banks could rise to 13.5% by Sep 2021. The government has approved the formation of a bad bank for a one-time cleanup and well-run large banks have been aggressively providing for this scenario over the past few quarters. Prudent measures all. However, it’s equally important to step back and see if we have understood all the key reasons for a repeated build-up of these stressed assets which then require large dollops of public money for recapitalisation of banks to keep them running. 

So why do companies really go bust leading to lenders being saddled with NPAs? A multitude of issues ranging from unscrupulous promoters, inadequate loan underwriting standards at banks, unforeseen calamities like COVID-19, fundamental changes to concessions mid-way during the life of an infrastructure asset, etc. Most of these have been debated ad-nauseam.

A key factor that needs attention relates to the starting blocks - i.e. the nature and proportion of capital that joins hands at the time of a company’s formation. An important perspective to keep in mind before we dive into analysing the components of the capital structure is that India is a developing economy and GDP growth had been more in the mode of a three-toed sloth than a sprightly hare, even before COVID-19 pushed us to into the zone of negative growth. A developing economy saddled with slow growth and characterised by an evolving policy and regulatory framework that consistently throws up curve balls will, without fail, ravage shaky balance sheets. The stability of balance sheets which directly correlates to the capital structure of a company is therefore paramount. As Covid-19 has proven, players with stronger balance sheets have thrived and gained market share while the leveraged ones are on their knees.

The conventional wisdom on capital structure restricted itself to equity and debt in their simplest form. Variations if any, to enhance returns, were brought in once the firm and its balance sheet were like well-settled batsmen seeing the red cherry more like a football. Erring on the side of caution and conservatism in the debt-equity mix was also the preference. Alas, this left very little space for finance professionals to showcase their intellectual prowess. 

Equity - getting more impatient than debt by the day

There is no denying that we are a capital-starved economy. Fierce competition in bidding for contracts and concessions is also a reality. The natural outcome of this is to squeeze the quantum of the costliest source of capital i.e. equity. Fertile ground for the entry of quasi-equity instruments like subordinated and mezzanine debt. To make matters worse, it's also not uncommon that promoters borrow money at the personal level even for the pruned-down equity. The result is a company often funded entirely by debt that has an interest meter ticking across all parts of the capital structure. 

Onerous covenants of mezzanine debt providers that are keen for an early exit, ideally even before the banks get serviced, add to the instability of the overall non-debt portion of the capital structure. A perfect recipe for bringing the house down if the ride gets bumpy. Cruise control mode right from the start is unfortunately not something that a sputtering economy and ever-changing regulatory framework are willing to support. With no protective shield of the erstwhile licence raaj regime, the fate of these companies is not difficult to predict.  

Debt - on tap and in abundance, but preference is clearly for the short term

In the post Development Financial Institution (DFI) era, banks remain the primary source of debt. Given their inherent asset-liability mismatch, the preference is to continuously push for shorter tenors. We have thrown DFIs at this problem in the past with little success and are doing it all over again. However, banks are likely to remain the major source of debt providers for new projects for the foreseeable future. 

While it may suit the banks, shorter tenors bring along the risk of refinancing because there sadly aren’t too many businesses that can service their entire capital over a 3-5 years horizon.  Short-term borrowing to optimize on interest rates and squeeze out those few extra basis points of equity returns is also a drug that promoters crave for. Blame it on the Gods, but periodic disruptions in financial markets have timed exceedingly well with such refinancing stubs and brought down many a viable business.

Impatience for an exit, across the capital structure from the big bang moment of a company’s existence, is no different than playing roulette. Beginners' luck will work for a handful few while the majority would keep adding to the stressed asset pile. 

Inevitably, this is what gets corrected as part of deep haircuts that any stressed asset resolution involves. The unstable equity gets wiped out, debt gets substantially written down and stretched out to give breathing space for the ailing patient to limp back to normalcy. Unfortunately, it's the public that pays for all this misadventure by picking up banks’ recapitalization costs.

A better way would be to revert to conventional wisdom on capital structuring right from the start. The building of a great franchise is the test match equivalent of the corporate world. Little point in burdening the test match openers then with a high asking rate (of return on capital) right from the word go, typical of a T20.

Subdued commodity prices post the global financial crisis of 2008, a low-interest rate regime and banks awash with liquidity fuelled the oft romaticised “animal spirits”. Significant capacity expansion quite often in non-core areas and overseas markets was the outcome. Thus, thermal power saw participation from promoters with core operations as varied as sugar and media. Surprise, surprise the largest and trickiest piece of the unresolved current stock of NPAs is contributed by zombie thermal power projects. 

It’s ominous to note that the world is again awash with liquidity, interest rates remain low, and what many experts opine as the start of a new commodity cycle. Let’s hope better sense prevails across banks and promoters to err on the side of caution and not lay the grounds for another round of stressed asset pile-up.