Moneycontrol Pro Panorama | Can IBC explain the private capex animal’s weak spirits? 

The fact is that the government cannot keep funding capex by itself for longer than is desirable.

Dear Reader,

It’s been some time since the government, investors and economists have keenly awaited signs that the private capex animal will revive and its spirits soar. There have been various explanations given for its recalcitrance, right from COVID’s lockdown aftereffects, to a slowing economy, to inflation and higher interest rates and so on.

Some signs of a revival have indeed emerged, partly helped by the government’s thrust on using PLI to drive investments in the private sector. But there’s no private capex wave that one has seen even as India’s status as one of the fastest growing large economies should ordinarily have led to a spurt in investments to capitalise on this growth. There is no dearth of capital. Banks are willing to lend. Equity investors also are likely to be enthusiastic. Our Chart of the Day today talks about how strong corporate balance sheets should pave the way for a capex recovery. Fingers crossed.

Now one explanation for the low interest in capex is that there is not enough growth in domestic demand to support it. The K-shaped nature of the economic recovery has been evident for some time now.

But there could be another reason too, one that finds its roots in the epochal change that took place in India’s economic history, the passing of the Insolvency and Bankruptcy Code of 2016. While the Code itself was path-breaking, the passing of Sec 29 A of the code, which automatically removed the defaulting company’s promoter’s ability to participate in the resolution process was a life-changing moment for India’s business community.

Another likely momentous step could be the recent SC decision on personal guarantors under the Code that could see personal guarantors feel the heat. There have been cases of corporate insolvency where banks have taken personal guarantees from promoters. Recovery from personal guarantors is 5.2 percent at present and is expected to improve after the SC ruling, said a CareEdge report.

India is one among a few unique countries where the concept of a promoter-shareholder and the owner also being the manager of a company exists. While the laws have progressively tried to separate the two, in reality promoters own and run the company as if it were their own. This is something investors are also agreeable to, as they believe that a promoter with skin-in-the-game works to their benefit.

But these very promoters now find that they no longer have a very long rope, one they were accustomed to, when things go wrong as in earlier decades.

Of course, there is risk in doing business. Those with an equity holding have little recourse if a company falls on bad days, unless there was fraud or other illegal activities. There is the concept of limited liability too of a company. But lenders will seek to recover their loans in some form or the other, a process that begins with provisioning and restructuring of loans. Insolvency is the last recourse, where banks seek the protection of the bankruptcy courts and its ability to provide a comprehensive solution, including a new owner for the asset.

But the automatic removal of the promoter as an eligible resolution applicant hits them hard. If they have given personal guarantees, then their risks are even higher. The intention behind the provision was to prevent promoters from having their cake – let the company default—and eating it too – by getting it back cheap with a sharp haircut on debt and made whole on all aspects. A political backlash from promoters gaming the process was probably the main reason for removing promoters altogether from the insolvency process.

But the point is that the process treats promoters whose companies may have fallen on tough days due to reasons relating to an industry downturn, wrong capital allocation decisions or simply incompetence in the same bucket as those who may have committed fraud or siphoned money from the project. While there is a case for the latter to be removed from the process, there is perhaps a case for a different view for the former.

Now, you might and rightly so, say that in India trying to separate the two is an impossible task. So it’s easier to penalise them equally. And later, if fraud is proved through a forensic audit or by some other investigating agency such as the ED, these offending promoters can be prosecuted separately. In other words, punish both but punish one more.

But view this from the prism of a promoter. An established, or even a new promoter, risks losing everything if an expansion or a new project suffers and the company gets dragged to the NCLT for having defaulted. If an existing business is generating good cash flows and is growing along with the economy, promoters will make investments to support that growth, for sure. But they may not take a huge leap of faith on economic growth continuing and make commensurately huge investments in projects, which could pay back after several years.

In a volatile environment such as this, where for example crude oil prices change direction every quarter or so, who can say what may happen five or ten years down the line? But what is certain is that if the company defaults, the promoter loses control and if they have given a personal guarantee too, then they may be on the hook for that amount as well.

Therefore, while investments will happen they will happen where promoters have a reasonable confidence that they will yield expected returns and also where promoters have reasonable resources to last out difficult periods. The other outcome is that projects may be funded mainly through equity with debt forming a small sliver. But that’s not an ideal situation as financial theory says that equity is more expensive compared to debt. Second, in a project with a huge equity component, the promoter’s share is likely to be a diminished one. That will then affect the skin-in-the-game theory. But if equity funding goes up, that may be a good outcome for capital markets.

The insolvency process has progressed much in these years, the initial flood of egregious cases of bad corporate loans have been admitted and have either been resolved or in the process of doing so. Now, it’s nobody’s case that fraudulent promoters should be allowed to get away with daylight robbery. But clubbing even those who stumbled but did not defraud in the same bucket is a concept that may need to be relooked at. An alternative could be to keep promoters on board during the resolution process but under strict conditions.

Lastly, lending has some risk inherent in it which is priced in the cost of the loan and therefore, defaults can be seen as an acceptable price of doing business. If all loans must be repaid, then where’s the risk? If banks improve their credit appraisal and fund-use monitoring practices, then the big frauds that have been unearthed should get minimised. With the accumulation of defaulting loans tackled and if new defaults are minimised through better processes, then a dilution may not hurt much.

All of this may seem fanciful or even seem like pandering to business interests. But the fact is that the government cannot keep funding capex by itself for longer than is desirable. The alternative is that we may have to live with the private capex cycle recovering at a more leisurely pace.

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