Opinion

Equity infusion into SMEs is a great idea, but proper execution is key

Prasanna Tantri | Updated on May 18, 2020

Feasible measures in place for raising capital, setting valuation and managing the investments and the fund itself must be put in place for successful implementation

A previous article had argued that it is important to infuse equity capital into SMEs because too much debt distorts investment incentives and creates debt trap. Debt alone will not lead to increased investments.

It is heartening to see that the FM has made a beginning in this direction by announcing the setting up of a ₹50,000-crore fund of funds, whose objective is to infuse equity capital into SMEs. While the intention is laudable, there are a number of implementation-related issues that need to be worked out.

Raising funds

The FM indicated that the government will fund ₹ 10,000 crore into a mother fund and the daughter funds will borrow the remaining ₹40,000 crore from the market. While in normal times infusing equity through borrowed funds is common, it may not be a great idea in this context. The leverage so created is likely to make the fund of funds conservative and look for, on paper, high-quality SMEs or impose undue restrictions on the investee companies. This may defeat the whole purpose of the rescue plan.

It is important that the fund of funds should be free to take calculated risks. At this time, banks or other investors may not have the stomach to lend to such a fund of funds, which is aimed at infusing equity into SMEs, and hence by definition, is risky. As indicated previously, the government will do well to raise risk capital from the investors, including general public and foreign investors, based on an explicit capital guarantee for a period of, say, three years. A significant sum of money can be raised this way without bothering the bond market yields. In the absence of such a guarantee, the expected return of the investors may make the whole idea infeasible.

Fund management

The issue of managing the fund is even more important. If the government gives a guarantee, then it is in its interest to ensure that the funds are invested well. Managing this kind of fund of funds requires diverse expertise and high reputation. The previous AIF on real estate was handed over entirely to one subsidiary of a PSU. Such an approach is not optimal in this case.

The government should try to tap into the public spirit that the pandemic has awakened, and get on board a diverse set of reputed people with experience in corporate management, venture capital funding and other type of early stage investing, and other related technical fields. The role of the government should be limited to that of a facilitator and a guarantor. There will be enough such people willing to work pro bono for a national cause. In fact, they can be compensated after the initial turbulent phase is over.

SME value

It is also important to worry about the liquidity of the investments made by the fund and the investors, especially given that investees are also SMEs whose securities are extremely illiquid. Again, the FM did mention moving towards listing of the SMEs ultimately, which is welcome. However, listing of thousands of SMEs will take time. As we know from the experience of the SME exchanges, even if some SMEs get listed, there is unlikely to be significant investor appetite.

Instead, as a starting point, the government should consider listing the units of the fund of funds itself. Of course, the capital guarantee should not apply to premature secondary sales. The listing of the fund is likely to bring the required discipline in management of the fund and also give an advance estimate of the likely cost of the guarantee to the government. Such an advance warning can result is early corrective actions at the fund-of-funds levels.

Another important issue pertains to the valuation of SMEs. Unfortunately, the balance sheet numbers of the SMEs are not very reliable in most cases. Starting with a multiple of the revenue as declared in the GST returns as the sole valuation criterion, is suggested. More sophisticated methods can be used as more data becomes available with time. Delaying equity infusion or delaying the launch of the fund itself until some expert committee comes out with the “right” methodology may defeat the whole purpose of the fund itself. Linking the valuations directly and explicitly to GST revenues also incentivises firms to disclose their true revenue to tax authorities.

Best practices

Finally, it is important that the managers of the fund do not interfere in the day-to-day management of the SME. The entrepreneur should not feel like an employee in his own firm. The stake of the fund should be limited to 49 per cent and the entrepreneur should have the option of buying back the stake following SEBI norms. The fund should incentivise best practices such as adoption of modern management practices in all areas ranging from inventory to human resource management, investment in technology, and most importantly, transparency in maintaining books and in communication. The fund should also try to create common internal markets for capital and other resources within the investee firms.

The best practices should be highlighted throughout the investee companies. The fund should thrive to ensure that at least some of the investee companies grow to become global giants and create large-scale employment opportunities.

The writer teaches at Indian School of Business

Published on May 18, 2020

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