The Hindu Business Line : Who funds Indian industry, why it matters

In an analysis of the ownership structure of Indian firms, the author finds that promoters have been making hay with India's substantial corporate assets while their own financial contributions amount to less than 2 per cent, on average, of a company's finances. This divorce of ownership from control is disturbing, says Sumit K. Majumdar, suggesting ways by which the stakeholders can monitor the performance of entrepreneurs and promoters and ensure they generate value.

THERE has been quite a bit of squabbling in major corporate houses over the control of the group itself or of their constituent companies.

But in this noise that of the ordinary investor has been lost, while that of the promoter is heard the loudest. Is this right? Does the promoter deserve so prominent a place?

Using data on listed Indian firms from the mid-1980s to the 1990s, I had investigated several issues relating to Indian industry. One aspect that consistently struck me then was the extremely limited extent to which promoters and entrepreneurs actually owned shares in the various companies they had control of.

Nevertheless, in spite of the relative lack of ownership, the majority of listed entities,, mostly private sector companies, were managed by these founders, their successive family members and other promoters as if they were fiefdoms.

The popular press, too, in its search for the glorification of individuals and, no doubt, with an eye on sales, consistently played up, as it still does, the doings of these individuals as if they were popular entertainers. In fact, I kept wondering whether the feudal mindset had not really ever left India's shores. Did a feudal mentality always characterise the way economic wealth was organised and controlled in the country? As an economy, we were hardly mature and democratic in the way industry was organised and governed.

Had we merely replaced the Mughal Raj with the British Raj, and that, in turn, with the Licence Raj? When the last, too, fell under the overwhelming weight of its own internal contradictions, did we just replace it with another rent-seeking organism that was the Promoter Raj?

No doubt, the marvellous measure termed `liberalisation' unleashed an army of talented entrepreneurs who would take the Indian corporate sector to the next trajectory of global economic success.

But these were — and most, though not all of them, still are today — mere striplings compared to the large number of firms in India that had reached their middle years and were ruling the listing roost on the major stock exchanges.

Yet, what was the real story of the structure of ownership? Was it vastly different? Who owned Indian industry? Who really funded it?

In an effort to answer these questions I went back to the data-set of the thousand or so firms I had been assessing over the past several years, making up most of the listed companies in India in market valuation terms, to disentangle their ownership structure.

The facts

By and large, Indian companies were essentially financed by debt. This was unlike in the West. If the total debt plus nominal equity capital in the average Indian company was 100, then 67 per cent of that amount came in the form of debt capital while equity capital contributed only 33 per cent.

This finding itself was hardly surprising. Indian firms have always borrowed heavily, and many of them have taken the money and not been able to deliver on promises, a factor behind the recent dismal balance-sheets of many commercial banks and long-term financial institutions such as IDBI, IFCI and IRBI. But what was interesting was gaining an understanding about which category of lenders contributed to the companies' debt and which category of equity suppliers contributed to the companies' equity capital.

For the cross-section of companies that represented Indian industry, as a whole, the public sector financial institutions, which are basically what commercial banks and financial institutions were, funded about 47 per cent (26.69 + 19.89) of a company's finances.

If the share of government ownership in corporate equity and the share of financial institutions' equity was added, then over 60 per cent (26.69 + 19.89 + 5.49 + 8.44) of firms' finances were funded by the state in one form or another. Again, this is not at all surprising.

The break-up of the equity capital provided the surprises. The Herfindahl index value turned out to be 1,499. This is not an overly large number and suggests that, by and large, there is no substantial ownership concentration in Indian companies with any one class of supplier of money in industry.

Foreign shareholders, in spite of a lot a clamour about their role in India's corporate economy, hardly owned more than 4 per cent (3.54) of the shares in India's listed companies. While the public at large provided about 11 per cent of the finances of an average Indian listed company, the share of the Top 50 shareholders was less than 2 (1.85) per cent.

It is within this particular shareholding category that promoters, entrepreneurs and the other large shareholders' equity stakes fall under for the purposes of classification.

In other words, the private sector company promoters who have emerged as a part of the political economy of Corporate India, have been making hay with India's substantial private sector corporate assets while their own financial contributions amount to less than 2 per cent, on average, of a company's finances.

In recent controversies, assets worth thousands of crores of rupees, acquired with public money, have been treated as building blocks that small children squabble over at playtime, while the inheritance of the children themselves amounts to a mere snip. This pattern of behaviour is not unique to any one controversy, but to many that have emerged in the past and will, no doubt, keep occurring in India's Promoter Raj. Only when the Promoter Raj moves to a Professional Raj will we see a change.

The concerns

The numbers revealed a disturbing problem of the divorce of ownership from control in India's industry. The Government, in its various manifestations, provides more than two-thirds of the finances of a private sector listed company.

The public at large provides five times as much money for the company as the entrepreneurs. Yet, a group of individuals, whose financial contributions towards a company are exceedingly small in magnitude, effectively control the company. This phenomenon has enormous implications for corporate governance in India.

The classic agency problem, identified by Adam Smith, and examined in detail for India in the 1930s by P. S. Lokanathan, has surfaced in contemporary corporate India in a substantial way. To the extent that agency problems do exist, there will be incentives for the decision-makers of the firm to not act in the other owners' best interests as far as performance-enhancing strategic choices are concerned.

Control and governance structures are put in place so that property rights of the various owners and lenders of a company are not compromised, and these assets are deployed effectively to create value.

To the extent that there is substantial separation of ownership from control, as seems to be the case in India, some or all of these resources may be diverted away by those controlling the effectively company for personal consumption; or, following the classic x-inefficiency argument, as a result of incompetence there can be a failure to exploit the asset attributes that generate value for the firm.

The public, which in contemporary India's share-owning culture does contribute substantially to companies' finances, faces singularly difficult agency problems.

As a collection of many principals, they have neither the incentives, nor do they find it easy to control those in charge of industrial enterprises. The very diffuseness of public ownership implies that citizens acting individually have small probabilities in influencing outcomes or expressing voice. As a result, listed companies become proprietary organisations completely owned de facto by the entrepreneurs who know that they are free of sanctions from the ultimate principals.

The biggest provider of money to the corporate sector is, of course, the government in its various avatars. Nevertheless, where the government is concerned there is a further agent-without-principals problem.

Government departments themselves are agencies for citizens who are the de jure owners of government enterprises.

This means that the control of enterprises with government ownership, currently being undertaken by civil servants, is vested in persons who are themselves agents monitoring other agents and have no incentives for carrying out their tasks and enhancing property rights for the citizens of the country as a whole.

In such a situation, the boundaries of the Promoter Raj, with all its negative connotations are surely going to be expanded.

The solution

The complexities of who provides the funds for India's industry and who ultimately controls it, has created a huge governance problem for which there are obvious but no short-term solutions.

India's regulatory organisations lack teeth. In the US, the SEC can and has put entrepreneurs in jail. Can SEBI do the same? Not so long ago, the EU collected a $500-million fine from Microsoft. Can TRAI do the same?

The timidity of the IDBIs, the ICICIs, the IFCIs, and the LICs — all financial institutions that had lent well and truly for the Dabhol project during the Enron affair — is well recognised. Short of a constitutional amendment, there is, for the moment, no other way for regulatory agencies to acquire canines and molars. Wisdom teeth will only follow only if the basic dental work exists.

For a start, effective shareholder voice can only emerge when there is a collective organisation of such shareholders which can effectively take on the few promoters that do behave egregiously. This will happen as more and more individuals, instead of investing in the companies themselves, invest in mutual funds, which then invest in companies.

The expectation, thereafter, is that mutual fund managers, in an effort to boost their funds' value, will effectively monitor the promoters and make sure that company value is enhanced and leakages from the company do not take place. Already, the presence of Western style private equity and venture capital firms has begun to be noticed in the Indian corporate firmament. These firms would, in the ordinary course, demand a seat on the boards of the companies they invest in and, thereby, monitor the performance of the entrepreneurs and promoters.

The presence of mutual funds, private equity houses and venture capital firms presages a change in the structure of financing of Indian companies, and the model that is emerging is more akin with that commonly noticed in the West. While it is early days yet, it is expected that these entities will begin to apply institutional pressure on promoters and entrepreneurs that government-owned financial institutions have so far singularly failed to do.

(The author is Professor of Technology Strategy, University of Texas at Dallas. Feedback may be sent to majumdar@utdallas.edu)

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