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Role of Risk-Capital in Building A Sustainable Growth Business

If it is possible to forecast the pace of slowdown and its recovery, we can model the expected cash flows, identify the probability distribution and thereby the level of variability.

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We know that profit is the compensation for taking risk and being able to deal with uncertainty. It is the availability of adequate risk-capital which determines whether we realise the desired level of profits or not. A growing business needs increasing amount of risk-capital unless, of course, it is a money machine. That is, the operating cash flows are sufficient to finance its growth under all circumstances. Globally, firms like Johnson and Johnson, Coca-Cola, 3M and IBM (more recently Apple, Microsoft and Google) are few such money machines. 

Specifically, a sustainable growth business is the one that can 

  • Invest when it has an opportunity to invest for growth 
  • Meet its day to day obligations in operations 
  • Meet its obligations towards its financial creditors, i.e., lenders 
  • Pays regular dividend to its shareholders, depending on their needs and expectations

A sustainable growth business can meet the above-mentioned needs across economic and business cycles, even when the deep cyclical troughs put the business through a severe test. It also has the ability to deal with situations where we can foresee but not forecast – situations that are uncertain. 

Risk and Uncertainty: Not a Continuum 

A situation where it is possible to assess the magnitude of decline in cash flows and estimate the duration that the trough would last is classified as a risky situation. But the situations where it is neither possible to assess the magnitude of decline nor its timing or the duration are referred to as uncertain situations. 

Economic slowdown that started during the Q4 of fiscal year 2017-18 in India is characterised by steady decline in quarterly growth rates. It is not difficult to see where it is heading or identify the point of recovery (with one or two quarter error in timing). 

If it is possible to forecast the pace of slowdown and its recovery, we can model the expected cash flows, identify the probability distribution and thereby the level of variability.  

On the other hand, Novel Corona Virus (NCV) has put the global and the Indian economy in a situation which is a typical uncertainty. We know that the growth rates will decline, in many cases the decline (e.g., transportation and trade) will be severe but it is not really possible to forecast the extent of severity and the duration that the decline will last. It is not even possible to build a range forecast as it is still an evolving situation. We need to build multiple scenarios to identify different determinants and then determine the possible cash flow paths. We will only be able to second guess the magnitude of cash flows in different scenarios. It is therefore not going to be easy to estimate the amount of risk capital needed at different points in time in future. 

In order to deal with an uncertain situation, the business needs significant amount of capital buffer or the ability to raise capital at short notice. Capital buffers come at a cost, as the equity or long-term debt, which are the safest buffers, are the most expensive sources of risk-capital. 

Financial Market Behaviour: “Flight to Safety” does not allow us to Build Capital Buffers at Short Notice. Hence, we need to build them in advance. 

The situations where the cyclical troughs are likely to be deep and their duration and timing unknowable are invariably the situations where fear gets better of us, resulting in an increase in risk-aversion. Consumers as well as investors start conserving cash. Sales fall faster than anticipated, even after the business drops prices. The investors flee to safety, even when one is willing to pay a higher cost. During the recent years, we have observed such a phenomenon in civil aviation (Jet Airways), non-banking financial services (DHFL and ILFS) and banking (PMC and Yes Bank) in India. We have seen many such situations globally, where some of largest firms in the world have failed in matters of months and quarters. 

We have observed the ‘flight to safety’ behaviour at country (e.g., capital moves to the US and Japan from emerging markets), industry (e.g., movement of capital from discretionary spend business to staple business) and at the business level (small-medium firms to large firms or low-rated to high-rated firms). In addition, the ‘flight to safety’ distorts pricing of financial assets and results in misallocation of capital, where risk-aversion keeps pushing up the cost of capital for low-rated firms and lends to or invests in large firms even when they don’t need capital. During the recent years, we have seen large firms taking mountains of debt to buy back stock or for going on an acquisition binge.   

In short, if I lead a business that has higher risk or faces a relatively higher uncertainty, it is best to bear the cost of capital buffers, as the ‘flight to safety’ may ground my business forever. 

Not having adequate Risk Capital can cause an irreparable damage to a business’ ability to sustain itself: The Case of Airlines Industry 

We have firms and industries that prefer to live on the margin, they have low profitability, but don’t raise or carry enough equity to go past a difficult day. 

Global airlines industry is a classic example of an industry living on the margin for a very long-time – an industry that has made large losses and has needed multiple bailouts. The large carriers in the US have been biggest cash guzzlers, making a net loss of ~USD 61 billion from 2000 to 2012, which was followed by record net profit of ~USD 58 billion between 2013 to 2018. The industry is now seeking a USD 50 billion bailout, in about a year’s time of making record profits. The need for bailout arises from the fact that they have not made any serious effort to conserve and retain risk capital.

That is, an industry makes record profits, generates a lot of cash, but uses it to return to its shareholders rather than hold it for dealing with an uncertain situation – situation that it has had to deal with in the past more than once. 

In the Indian context, we have the airlines industry being financed through a mountain of debt, when it should have been raising equity to invest for growth. For example, Air India invested ~INR 26,000 crore in capital expenditure, with an average net worth of ~INR 500 crore, between 2008 and 2010. Similarly, the Jet Airways invested ~INR 14,000 crore, with an average net worth of ~INR 3,000 crore, between 2007 and 2009. Post the global financial crisis, both the airlines incurred large losses, once again funded largely by debt. In both these cases, the major owners did not provide equity even when it was just too obvious that the business needs it. A case of self-inflicted financing choice – a choice that involved having no capital buffer even when it is known that the business requires large capital buffers. 

India has limited availability of Risk-Capital

It is known that India has limited availability of risk-capital, as it is only about 5% of the household financial savings get invested in shares and debentures (major forms of risk-capital). In the best years, the number is about 10%, which has been just twice during the last 25 years. At the same time, we have observed a decline in the level of household savings (from 25.2% of GDP in 2010 to 17.2% in 2017), though the corporate savings have been growing (from 8.4% to 11.6% during the same period).

Risk Capital: When debt hopes to become Equity but does not!

In a capital starved economy, the only way to grow is to leverage the available capital as much as possible, as we have seen for Air India and Jet Airways, but with disastrous consequences. 

The Indian entrepreneurs have, like many of their Asian peers, have leveraged their capital in another manner. The entrepreneur raises debt, in personal capacity, against his or her equity holding (let us say a parent business) and invests the newly raised debt as equity in the parent or a new business. In this situation, the entrepreneur expects the business (parent as well as the new one) to generate enough cash flows to pay dividend to its shareholders or grow valuation so that he or she can service or repay the debt in due course. 

It is a perfectly efficient approach for financing growth without diluting promoter ownership, but as long the parent business is doing well and its valuations get better over time and/or the new business starts generating cash to pay dividend to service the entrepreneur’s personal debt. 

Valuation Double Whammy: Stake Sale by Entrepreneur and Rerating of Market 

We have had cases where an entrepreneur has pledged his or her shares in low risk, growing business and invested the proceeds in an infrastructure business, which is notorious for time and cost overruns.

If the infrastructure business does not generate adequate operating cash flow to pay dividend and/or it requires greater equity investment to finance project delays, the entrepreneur is stranded, as he or she does not have adequate personal risk capital to invest in the new business. If the concerned person chooses to sell his stake in the parent business, it is expected that the valuation (Price-Earnings Ratio) of the parent business will fall, calling for additional margin to be brought in by the entrepreneur. 

If the valuation drop happens to come from the rerating of the markets, as it often happens in case of emerging markets dominated by FIIs/FPIs trading, the entrepreneur faces a double whammy – requiring the entrepreneur to post even greater margins for loans against share of the parent firm. If the borrowing is through the shadow banks and more than one entrepreneur is hit by valuation double whammy, we end up adding to systemic risk in the economy.[1] 

Currently, we are not only facing rerating of the Indian market by financial investor, economic uncertainty caused by NCV is creating an even more challenging environment for promoters who have borrowed money to invest as equity in businesses that are riskier than their parent businesses. In other words, debt can hope to become equity only under limited circumstances. A business needs equity to grow and sustain and therefore an entrepreneur must have the required equity or find investors who are willing to share risk as equity investors and not expect debt to become equity. Debt can only pretend to be equity, that too under limited circumstances. Diluting one’s stake may be a better choice. 

In summary, while profit is compensation for taking risk and dealing with uncertainty, it is the adequacy of risk-capital that determines if the business will deliver adequate cash flow for sustaining itself across cycles. It is worth having undeployed risk-capital and bear the cost rather than having to give up a business or see it wither away. One may also need to make a choice between growing and growing sustainably if one does not have adequate risk-capital. Growing sustainably is better than growing without a provision of adequate capital.

Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house. Unless otherwise noted, the author is writing in his/her personal capacity. They are not intended and should not be thought to represent official ideas, attitudes, or policies of any agency or institution.


Tags assigned to this article:
risk capital Sustainable Growth Business

Anil K Sood

The author is Professor and Co – Founder, IASCC (The Institute for Advanced Studies in Complex Choices)

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