Don't treat failed promoters with kid gloves: They know exactly why their business tanked
Posted by: Uma Shashikant on Dec 05, 2017, 01.06 PM IST
The debate about promoters whose businesses have failed is not new. Some argue that failed promoters should be penalised. Others feel in the interest of fostering the spirit of entrepreneurship, promoters should get a chance to run a business that may have gone bad due to factors beyond their control. The principle of equity between the various providers of capital to a business demands they should be kept out.
Research shows that over 50% of businesses can fail in the first five years of being set up. Among the top three reasons of failure are: inadequacy of cash flows, inability to capture the market and incompetence of the management team.
If there are no specific models for defining who will succeed, there are none that can define failure either. It would, therefore, be fair to assume that promoters who set up businesses, managers who work for the firm, and capital providers such as banks and investors, can go genuinely wrong in their assessment of a business’ ability to succeed. It can be argued that capitalism thrives on the ability to raise risk capital to fund new ideas. There is an important distinction between inside and outside investors.
Promoters know everything about how a business is doing. If a business is in trouble, they know it first. Outside investors, who hold equity shares but do not participate in managing the business, and lenders who provide debt, seek information but run the risk of knowing about possible failures much later.
This information asymmetry is the problem that capital markets seek to address when seeking outside capital for setting up, expanding and growing businesses. Both lenders and outsiders seek information to help them assess how a business is doing.
Regulators insist that books are audited and relevant information is made available to investors; lenders seek detailed information and place restrictions on the business through indentures to protect their money.
There are two important conditions that have to be fulfilled if money has to flow into ideas that may or may not succeed. One: investors should have a fair and independent assessment of the value of the assets they are funding. Two: investors should be able to exit the business if they think the risk is not worth taking anymore. The stock markets serve this important function for the benefit of outside investors. Equity investors in risky stocks of several untested businesses, are able to see how the share price moves, and are able to get out if the risk is too much to bear. Falling share prices are also known to signal business failure very efficiently.
The case of lenders is however, more complex. They are able to derive a fixed interest from the business, but their capital is at risk if the business fails. They may have a charge on the assets of the business, but the assets lose value when the business is failing. They may or may not be able to recover their money in full, and they may find the business of disposing of assets cumbersome. This is the status of banks staring at NPAs and hoping to recover something out of the new bankruptcy code that enables them to auction the assets.
Investors are able to use falling equity price as a proxy of things going wrong with the business. They are able to quit when a business is expected to fail. Lenders have to rely on information provided by the borrowing business, and do not act until the interest payments fail to come in time. They act after the time lapse (90 days for banks) following the default. The recovery is long drawn and a failing business loses value through this time. Lenders can act only when the risk of failure has manifested, unlike the equity investor who can act on the expectation of failure.
This is why treating the promoter of a failed business with kid gloves is wrong. Promoters may have had the best intention; they may have created a sound business plan; they may have acted to the best of their ability to keep a business running; and they may have the best credentials to turn a business around. However, they also have the advantage of knowing first when their businesses begin to fail. The erosion in the value of their equity in the business is a loss they bear for being the first inside investors. The equity market limits their liability to outside equity investors, who lose capital with no redressal. But the lenders are left with depreciating assets and loss of capital, thus promoters cannot claim preferential status over lenders.
To allow promoters to bid for their own failed business is wrong in principle, as it shifts the loss in value of assets of failing business into the balance sheets of lenders. A promoter who claims to be able to turn a business around by buying it at a discount from a banker who is putting up the distressed assets for sale, is trying to strike a bargain out of a situation that has already hurt lenders. If he had been capable, the promoter had enough time, having spotted the first signs of failure, to act on it. Any loss from revaluing a business or its assets, should primarily fall on equity investors, and not lenders.
The principle of recovery by the creditor also hinges on the benefit of limited liability that equity investors, including the promoter, enjoys. The promoters essentially bring some of their own money and using a substantial portion of outside money from investors and lenders, build the business. On its failure, they are not expected to pay any compensation to investors. The assets of the business whose equity has been eroded belongs to the lenders, to dispose of and recover what they can. The promoters cannot seek a role in this process, as their reward for the risk they took has already come in the form of limited liability on equity capital raised.
The government's decision to keep promoters out of the process of recovery and resale of distressed assets is right in principle and fair to the banks. We fail to see the story behind these failures when we try to explain them away as having been caused by external factors. If we went back to the heydays of these businesses that are today's NPAs we will find the following common themes-rapid and unrealistically high growth rates in revenue and profit; expansion into new and unrelated businesses with large capital outlays; and growing leverage to create assets without securing revenue or profits. They wanted to become too big, too soon.
Investors who think that failing businesses are "value" propositions in the stock market, have to be very careful in their assessment. These are businesses with too much debt and holding assets that do not generate revenue; their revenue is so inadequate that it does not generate margins to cover interest costs; and the margin is not stable enough to sustain the assets, whose value is deteriorating. Breaking this vicious cycle needs capital, time and expertise. These were the very things that the promoters had to begin with, and squandered away before finding themselves in the current situation. Keeping them out is the right thing to do.
The author is Chairperson, Centre for Investment Education and Learning.
Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com. This article appeared in Economic Times dated Dec 05, 2017, 01.06 PM IST