The Hindu Business Line : Solutions for SMEs from inside the ‘Budget’ prism

Budget 2008 has evoked mixed feelings — a solid grey instead of pure black or white. Investment bankers, taxation pundits, industrialists, capital market stalwarts, politicians and the common public have discussed in-dept the impact of the Budget on many industries and demographic segments, but not so much has been said about small and medium enterprises (SMEs).

India has 8000 companies listed in the stock exchange, a significant number of which is family-owned. The rate of growth in the conversion of SMEs to large enterprises has been increasing by the year. Despite the importance enjoyed by SMEs, they continue to face many impediments in their day-to-day operations.

Capital starvation

In the interest of inclusive growth, policy-makers should avoid introducing distortionary measures that would create long-term structural problems. The Finance Minister, Mr P. Chidambaram, did just that with the Rs 60,000-crore loan waiver creating a two fold impact:

Encouraging the continuance of the moral hazard problem when banks can still not distinguish between good and bad loans with the waiver; and

The elated farmer still remains ill-equipped to repay future loans, what of training in improving farm productivity and cash flow sustenance?

The priority sector lending reforms have already sucked a significant share of banks’ loan base. The reimbursement of the farmers’ bad loans from the exchequer will certainly have to be reciprocated by continued lending to the same loan recipients — probably the same share of bad loans will recur.

As a profitable independent company, answerable to its shareholders, banks will try and make the best of the balance disbursable base.Banks continue to lend to SMEs mostly on collateral. In the past, most SMEs had a strong asset base by holding real estate, but not so currently, given the soaring land prices. Hence, what is there for them to collateralise — inventory? Furthermore, the working capital lending is largely dependant on the historical financial performance of these companies than its future potential.

In all, banks are forced to take the risk of loss by lending to farmers, having high moral hazard problems, but are unwilling to take the same risk of lending to SMEs, where the problems of moral hazard and adverse selection are less pronounced.

In such a situation, the presence of institutions that assess credit worthiness of SMEs would set a strong edifice for a long-term benefit of these companies.

Having examined the debt side, let’s analyse the equity side — the ability of SMEs to attract capital from private equity/venture capital funds.

According to the Emerging Markets Private Equity Association estimates, the number of private equity funds in India, over 160, is higher than in any other emerging economy — China has 115 and Brazil, 89.

According to a recent private equity (PE) report, PE investments in India in 2006 were $7.46 billion, of which, $3.7 billion was in late stage deals, $1.3 billion in PIPEs (Private Investments in Public Enterprises), $2.24 billion in growth stage/buyouts and other deals with early stage investments being a mere $236 million.

The volatility and bearish trends in capital markets will have many PE players rethink their potential investments in public listed enterprises. Hence, this situation presents a good case for PE firms to scout for value investments in early stage companies, having a good potential to scale up in next 5-7 years. It’s certainly good for the SMEs but not without problems.

Despite being cognisant of the benefits of investing early in good SMEs, PE/VC funds remain hesitant for two reasons:

High transactions costs given the typical early stage deal is sub $5 million; and

In some cases, weak balance-sheet and margins, often impacted by high interest rates. Again, the establishment of good institutions to rate SMEs would alleviate to a large extent the reticence of funds in exploring investment opportunities in this area. Also, with a legitimate third part institution undertaking the rating job, the fund would save a significant amount of transaction costs.

A separate exchange for SMEs

In context to the current Budget, the increase in STCG (short term capital gains) tax is a positive as it will force investors to hold stocks for a longer term, thereby reducing momentum driven price rises. However, how many retail investors think of it that way? The measure has only dampened sentiments further.

From the small enterprises angle, SIDBI is taking parallel steps in the direction of London’s AIM in trying to set up a separate exchange for SMEs. It is a positive direction no doubt, but one should try and mitigate any perverse effects of one good action. In the case of an SME exchange, the Finance Ministry should give fiscal incentives to potential investors to encourage greater participation. However, this alone will not be enough. Investor education should be supreme and the presence of debt and equity rating institutions is a must to ensure transparency on fundamentals.

Inventory management

By reducing the direct taxes, the Finance Minister has left more money in the hands of the middle class, thereby fuelling consumption. This is definitely a positive for SMEs, especially those involved in the consumer good sector.

While the Budget has laid the foundation for incremental growth in urban and rural infrastructure investments, weak delivery systems are a big hurdle in the way translating the measures into benefits. SMEs sourcing materials across geographies are impacted by (a) high transportation lead time and (b) prices of consumables.

Given that their business volumes are comparatively lower, the inventory management of SMEs is not optimal as promoters try to stock goods way in advance to counter price rises and address risks of delay in transportation. This results in significant amount of working capital being blocked. Improving the width and depth of commodity exchanges alongside addressing transportation bottlenecks are long-term solutions.

Rising rupee

The Budget has not satisfactorily addressed the export-oriented sectors, which are particularly affected by the rupee rise. The large IT players and other export-oriented industries are trying to cushion themselves by focusing on domestic services and exploring acquisition opportunities that would improve margins. What of the SMEs? Indeed, the need for incentives to export-oriented SMEs cannot be overemphasised. Poor cash flows and inadequacy of capital will not allow many SMEs to take advantage of the rise in home consumption. With banks not showing interest and PE funds’ sentiments towards export-driven businesses remaining bleak, these SMEs have a hard battle on hand.

By empowering the education sector, the Finance Minister has laid a strong foundation for improving the skill shortage currently faced by the industry. However, only good infrastructure and accessibility will encourage youths to seek employment across geographies, and not limited merely to the IT realm. SMEs will benefit from this, as they are located across geographies in India. There are many more issues plaguing the SMEs.

(The author is Assistant Vice-President, Investment Banking, Brics Securities Ltd, Chennai.)