Expectations are running high about a possible SME “bailout” package. While there is absolute consensus regarding the need for a government intervention, the form of such intervention is still being debated. The ideas range from providing payroll loans to covering first loss of lenders lending to SMEs. However, almost all suggested plans involve some form of debt infusion. I argue that too much debt with too little equity could distort incentives of entrepreneurs leading to bad investment choices. I suggest an equity infusion plan which is built on public participation and backing by the government.

While there are many ways in which debt can distort incentives, I will focus on two such ways that are relevant in the present context. Let me start with the debt overhang argument. Debt overhang is a situation where the debt-service burden ends up eating up the entire income of a firm. In other words, the entrepreneur is expected to work only for the benefit of lenders. Naturally, such a situation leads to reduction in effort and, more importantly, reduced future investments as there is very little internal surplus to invest and even less debt capacity to borrow further.

Therefore, if SMEs are bailed out using only debt, there could be a situation in the medium term where the government may have to waive SMEs’ loans to make them invest. Otherwise, we will have only credit growth and no real growth — the kind of situation we were in between 2011 and 2014.

The second issue that is relevant here is the problem of risk shifting. The intuition is straight forward. A firm financed mostly by debt has an incentive to invest in speculative projects, which are not expected to succeed on an average. This is because the shareholder liability is limited. A typical speculative project has a low probability of success but leads to huge rewards in case it succeeds. A thinly capitalised firm latches on to such projects as shareholders have very less to lose.

In case the project succeeds, they get to keep most of the upside after paying fixed interest. In the event of failure, they lose only the little equity that is left, leaving the lenders to pick up rest of the losses. Widespread risk shifting could lead to excess investments in speculative projects at the national level and result in large scale project failures and large non-performing assets in bank books.

Venture capital fund

Both the above problems can be substantially ameliorated if the SMEs get access to equity financing. Who will fund SMEs which are out of work is a proverbial million dollar question. The government does not have the fiscal space to infuse equity over and above the probable debt package. The banks clearly cannot invest in SME equity. Institutional investors and the general public are unlikely to invest in SME equity due to high risks involved.

I suggest that the government should consider launching a SME venture capital fund. The units of the fund should be open for investment by professional investors, including foreign investors and the general public. The government should guarantee the principal value invested for a limited number of years. The investment should be locked in for at least a year. The guarantee should be unconditional. In fact, an appeal by the Prime Minister promising capital guarantee should allay fears about investing in such a fund. Foreign investors can be given exchange rate guarantee with appropriate adjustment for the inflation differential.

The fund should be run by prominent industry captains who have a reputation to keep. The fund should have the mandate to infuse equity into SMEs. The units of the fund should be listed, giving investors an exit option. The managing committee of the fund should have the freedom to decide the selection criteria for investment. To encourage participation by good SMEs, the government should tie future SME-related benefits to accepting equity from the fund. Otherwise, the fund may be stuck with bad SMEs — the lemons in economists’ lingo.

This plan can lead to a number of other benefits. The fund may insist that the investee companies maintain standard accounting and management information records in digital form and register under GST in due course. The fund may also organise some common services such as management consulting, human resource management, accounting, technical support, and others.

The fund may also take up large-scale training for SME entrepreneurs to help them transition from informal ways of working to the formal system. Finally, if the fund grows big, it may be able to organise internal product and capital markets, allowing investee companies to trade with and invest in one another.

Risk factor

Of course the plan has flaws and risks. It is possible that despite the capital guarantee, given the risk aversion, not many investors may come forward and invest. Even bigger risk is the possibility of large amount of guarantees being invoked leading to fiscal strains. There are other risks ranging from bad selection to political intervention.

I believe that the risks of stuffing the SME and NBFC balance sheets with too much debt outweighs the above risks. I am not suggesting that the RBI or the government should not ease the flow of credit. They should. However, along with debt, the policymakers should think of ways of increasing the equity cover of SMEs. The plan suggested here is only one of many ways of achieving this goal.

The writer teaches at the Indian School of Business

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