1. The norms though
well-accepted in banking have not been adopted for NBFCs and other business
entities.
2. The quality of assets, existence of sub-prime assets, risks associated with off balance sheet exposure, especially derivative instruments is not effectively captured in the capital adequacy norms.
3. The entire approach because of the formula-based working gets reduced to a mechanical exercise and coupled with VAR (Value at Risk) approach gives a feeling of preciseness to an analysis that is at best judgmental. It is essential to keep in our mind that decision-making starts where formulae end, and it is never more true than for issues like capital adequacy.
Business/Industry practices?:
Capital adequacy and capital structure also depends upon industry/business norms and practices. Thus those businesses that are high risk, e.g., construction industry, film and entertainment industry often reveal a paradoxical situation where minimal funding is out of own or structured capital and maximum funding is from private external sources.
One explanation for this phenomenon could be that the owners themselves as well as the formal sources of finance find these ventures too risky. Hence, as a fallout these businesses have to raise external funds at a very high cost even up to 3% per month (36% per annum) to meet and balance the risk return trade-off.
The less risky, more stable and efficient the venture, the lower would be the need for expected return and higher the borrowing capacity.
Case study of the month?:
Tata Motors one of the flagship Indian Corporate multinational companies of the Tata Group was adequately funded, had a good capital adequacy and was generally successful in all its ventures. The business of Tata Motors continues to thrive even today with the success of the Nano and the Manza.
However, a very significant event happened in June 2008 when Tata Motors acquired Jaguar and Land Rover from the US-based Ford Motors for approx. USD $ 2.3 billion. Tata Motors planned to raise Rs. 72 billion through rights issues which did not meet much success as the share market fell on weak global cues and they were available in the market at prices much lower than the offer price. On tak-ing the bridge loan the debt-equity ratio increased to 1.21 from the previous debt-equity ratio of 0.53 in March 2006 and 0.8 in March 2008. The dilemma which an entrepreneur always faces is balancing ‘risk’ and ‘progress’.
During the economic recession the price of its equity share from the high of Rs.750 to Rs.800 per share in January 2008 came down to a level of around Rs.150 in December 2008 and Rs.130 in February 2009. The right issue was priced at Rs.340 per share which naturally found few takers.
Other option to fund the acquisition like divesting stake in group companies or an international GDR/ADR issue were also abandoned due to adverse markets.
The third and final effort of the company was to raise funds by way of private deposits to refund the bridge loan due by June 2009. Even this effort met with limit-ed success and despite repayment of USD 1 billion till 2008, the bridge loan had to be rolled over in part.
As a risk manager, identify the issues and outline additional strategies that could have been attempted in the given scenario.
Solution to the case study?:
The issues are primarily those that deal with the basis of capital budgeting, fund management and planning the capital structure?:
1. The acquisition of JLR was an effort by Tata Motors to stay ahead of the competitors using inorganic growth.
2. The global meltdown and recession in the world economy adversely affected the market putting the company into a tight spot.
3. The availability of funds in the Indian markets shrank due to the meltdown, credit squeeze, withdrawal of FIIs and adverse market sentiment.
The causative factor primarily was the fact that in the heat of the moment and rush of the deal the short-term sources of funds were used for a long-term use of funds — namely, capital acquisition.
As Warren Buffet the legendary investor says, “It is always easier to think clearer and comment in hindsight.”
The way out and that is what Tata Motors tried is to?:
i) Diversify into different segments including small cars
ii) Improve profitability
iii) Raise resources including by way of deposits for company products from customers.
And ultimately wait and watch for the right time to raise long-term funds to replace the short-term sources tapped for the long-term uses and bring back stability to the financial structure of the company.
Ultimately, if the company had maintained capital adequacy throughout the deal and not jumped in using bridge finance, probably the outcome would have been different.
Postscript?: Now, because of the steps taken the price is back to Rs.842 in January 2010 and around Rs.750 in March 2010. Crisil upgraded Tata Motors’ short-term debt to A+ as reported in March 2010. Hence capital adequacy impacts risk ratings and borrowing capacity in the market.
(The case study and solution are not intended to be in the nature of comments on the functioning or management of the companies but represent one of the possible approaches selected by the author for demonstrating the concept and issues of risk management.)
