Financial Daily from THE HINDU group of publications
Friday, Jul 19, 2002
Does India need an equity cult?
"Equity is soft, debt hard. Equity is forgiving, debt insisting. Equity is a pillow, debt a sword."
Bennett Stewart and David Glassman, quoted by Michael Jensen in his seminal paper, `Eclipse of the Public Corporation'. (Harvard Business Review, September-October, 1989)
INDIA'S economy and its capital needs are too big to be managed on principles that belong to cults. Cults are systems of beliefs that are founded on fads and unsound theories. Since cults are fads, their influence is limited to small groups of people and to limited periods of time. Cults are not expansive and inclusive; they are not enduring too. If we are determined to undermine the national corporate economy, we could attempt to promote the equity cult and ignore the principal characteristics and the components of the savings-assets loop.
The rights of lenders and shareholders are the principal components of the savings-assets loop. If we are determined to strengthen the loop and, thereby, the national economy, we should promote and protect the rights of lenders and shareholders. The promotion of their rights is not a fad.
Empirical evidence shows that the benefits that arise from the protection of their rights are based on sound financial economics. If the economy has to be grown at over 8 per cent, we should expeditiously reinforce the legal infrastructure and orient it towards the rights of suppliers of capital to corporate organisations. Both lenders and shareholders are suppliers of capital. Lenders supply debt. Shareholders supply equity. But both debt and equity arise from savings, and savings arise from households.
The protection of the rights of lenders and shareholders offers protection to households that have a stake in the economy, financial markets, banks and corporate organisations. Corporate organisations, banks, financial services, firms and households often have to reconcile objectives that compete with one another, especially in times of economic stress. Hence, the promotion and protection of the rights of shareholders and lenders should be absolutely free of biases and prejudices.
The absence of legal biases and regulatory prejudices allows households to allocate `properly' their savings to corporate debt and equity in a manner that is consistent with their future needs pertinent to liquidity and returns and compatible with their appetite for risk. Households may allocate their savings directly to corporate debt and equity through channels that facilitate disintermediation. Households may also allocate their savings indirectly to corporate debt and equity through banks, investment trusts, mutual funds and pension funds. Though capitalism is not derived from or driven by capital flows from the capital market, the proper allocation of household savings to corporate debt and corporate equity is among the principal prerequisites for the long-term viability of corporate capitalism that is powered by public savings and the capital market. India has a stake in the long-term viability of corporate capitalism. But it would be unwise to secure that stake by inciting an equity cult.
Cult or cul-de-sac?
Corporate organisations are not managed directly by savers but by teams of managers chosen by investors. The extensive analysis of the behaviour of corporate organisations and their managers under such circumstances shows that the characteristics of a company's ownership structure and debt and equity claims affect its performance. Managers are more likely to do their best if a large part of a company's equity is owned by them and when a large part of the company's assets are financed by debt from banks, financial institutions and the financial markets.
An equity cult is associated with the dominance of equity financing over debt and by the simultaneous dominance of `outside' equity over `inside' equity. An equity cult is the perfect recipe for enervating the corporate economy since it allows easy money from the public to flow into companies and into the control of managers. The direct financial stake of managers is very small in a corporate economy that is enthralled by the equity cult. What follows an equity cult is the squandering away of resources by managers. An equity cult does not demand good corporate governance.
Hence, it would be unwise to mandate an equity cult in India or promote it subtly through taxation and other policies. India should promote the virtues of inside equity and debt. If such promotion appears to be incompatible with an open economy and objectivity, it should at least ensure that debt and inside equity are not punished or discouraged. India should not place a ceiling on corporate debt and leverage; there should be no ceiling on inside equity too. Above all, the rights of lenders and shareholders should be vigorously protected without compromise.
Companies would then choose to do what is best for them. Lenders and shareholders would choose to do what is best for them. Good corporate governance would be the most important result when companies, lenders and shareholders choose what is best for them. Good corporate governance and an unbiased legal and regulatory system that acts expeditiously would allow households to derive the best from their savings. This would trigger an expansive and inclusive investment environment that is both enduring and reliable.
One loop, one goal
Debt and equity have heterogeneous risk, returns and liquidity characteristics, but both debt and equity arise from savings, and savings arise from households. The heterogeneous risk, returns and liquidity characteristics of debt and equity serve the needs of different households at a point in time and of the same household at different points in time. Corporate debt is a finite maturity claim and its redemption at maturity is specified. It usually requires the payment of periodic interest ahead of any equity dividends. Debt is, therefore, a riskless or low risk investment. If a company fails to honour its debt, lenders could take charge of the company's assets.
Equity has infinite maturity because it does not stipulate a redemption date. It does not enjoy a first and fixed claim. Shareholders receive dividends if the issuing company's cash flows are in excess of interest on debt, taxes and cost of operations. Dividends are residual and variable.
Equity is a risky investment, but shareholders have the right to vote in and vote out the management of a company. Debt and equity have dissimilar risk characteristics but the recourses available to lenders and shareholders when expected cash flows do not materialise are not very dissimilar. When lenders take possession of corporate assets, they exercise their right to displace incumbent management. When shareholders are disappointed with corporate performance, they have the right to replace one management team with another. The displacement of incumbent management is common to both sets of rights. This would explain why the rights of lenders and shareholders are the principal components of the savings-assets loop.
Reinforcing the loop
Any biases in the structure of the rights of lenders and shareholders would adversely affect the allocation of household savings to debt and equity. Any biases in the structure of their rights would also have an unfavourable impact on their willingness to assume risks when risks are no longer compatible with their appetite for risk. This would have an adverse impact on their allocation to debt and equity investments and, therefore, on capital formation and asset financing. Households, in such circumstances, would move from one fad to another until they lose their savings and, worse, their appetite for risk. Indian households have lurched from one fad to another and, quite certainly, from incipient security to desperate insecurity. The equity boom that followed the first phase of reforms in 1991 tapered off within five years. Investments in large financial institutions turned sour thereafter. A large number of households may have lost both their savings and their appetite for risk since then.
The economy is now at a stage where the restoration of the willingness to save and the restoration of a healthy appetite for risk are prerequisites for rebooting the national economy. The restoration of the willingness to save and the restoration of the appetite for risk would be easy if the impact of managers on performance is regarded as the most important underlying factor in corporate organisations.
Sound economic theory suggests that assets could be financed with equity alone or with a mix of equity and debt. It also suggests that corporate assets do not know how they are financed. But empirical evidence shows that asset utilisation and the resultant cash flows are dependent on how corporate assets are financed. The mode of financing works on asset productivity because it works on the mode and intensity of utilisation of assets by corporate managers. Assets cannot work themselves; managers are the sole determinants of asset productivity and corporate performance.
Corporate performance is maximised when the penalties for indifferent asset utilisation are clearly specified. The penalties for poor productivity are an intrinsic part of the rights of lenders and shareholders. Reliance Industries understands this. It has recorded the highest annual growth in productivity among 35 Indian companies since the Asian crisis in 1997 (Business Line, October 31, 2001). Its productivity has grown by over 20 per cent annually.
The successful pursuit of higher productivity and asset performance by Reliance reinforces the results of the empirical studies that have examined corporate ownership and financial structures. Reliance is characterised by significant inside equity and debt. Reliance may have triggered off the nation's interest in equities, but it aptly regards debt as one of its five principal value-drivers. It lives on debt.
(G. Ramachandran is a financial analyst and a director of Sentient Advisors.
Mohan Khanna is managing director of Sentient Advisors. Feedback may be sent
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