POSSIBLE SOLUTION TO THE PROBLEM OF STRESSED ASSETS

The gross
Non-Performing Assets (NPAs) of all Scheduled Commercial Banks shot up from Rs.
69,300 crores in 2009 to Rs. 9,33,609 crores in 2019. The stress in the industrial
sectors such as power, roads, steel, textiles, ship-building, etc. are mainly
responsible for this huge increase. RBI has time and again come up with various
guidelines to resolve the financial stress in NPAs and reclassify them to
standard assets. The Government of India also brought the Insolvency and
Bankruptcy Code (IBC) into force in 2016 to bring about quick resolution of
NPAs. However, the results have not been very encouraging.

BBBB MODEL OF INFRASTRUCTURE /
PROJECT DEVELOPMENT

Infrastructure
development and financing of green field / brown field projects is generally
plagued with several issues. And it is this area that has significantly
increased the NPAs in the banking sector. Since the opening up of the economy
the nexus between the 4B’s has been at the centre of the problem. One can
term it as the ‘BBBB model’ of infrastructure development wherein the
Bureaucracy, Businessmen, Bankers and the Bench (Judiciary) have played a key
role in creating stress in the project / company and consequently leading to
non-viability of the projects and the rise in NPAs. The role played by
these 4Bs which has led to cost escalation of the projects or delays in their
implementation can be summarised as under:

Bureaucracy: The number of regulatory approvals creating hurdles in doing business,
delays in getting several regulatory approvals, land acquisition delays,
greasing of the palms of bureaucrats and politicians for expediting approvals,
compliance / clearances and licenses, etc.

Businessmen: Aggressive / unrealistic projections, siphoning off of funds and fund
diversion, gold plating the cost of projects, etc.

Bankers: Financing based on aggressive / unrealistic projections, lack of
project monitoring, delays in sanctioning / disbursements, phone banking /
corruption, technical and physical incapability / inefficiency for project
appraisal / analysis, etc.

Bench: The slow process of the judiciary / arbitration / claim settlement and
justice delivery system in India.

The above are some of
the primary reasons for delays in implementation of projects, consequently
leading to cost escalations, increase in the overall cost of the projects and
their non-viability.

Understanding financial stress in the
company / project

We normally hear
about ‘signs of financial stress’ like (1) the company is making losses, (2)
the net worth of the company is negative, (3) the company is not able to meet
its present payment obligations, (4) the company’s rating is downgraded, (5) it
has a high debt-to-equity ratio, (6) there is consistent over-drawl in the cash
credit account, and (7) it has a low current asset ratio.

These are only
‘signs’ of the financial stress in the company. Some of these signs would be
common across sectors, industries or among various companies in distress.
However, the causes of the financial stress among them would vary and could
relate to regulatory approvals, labour, reduction in demand for products /
services, land acquisition, debtors unable to pay, litigations, reduction in
revenues or prices of products or services, increase in input costs,
non-availability of inputs / raw materials, etc.

In order to resolve
the financial stress in companies and for resolving the NPA issue, we can
broadly categorise the solutions adopted by the regulator / government into two
kinds:

(1)
  Sweep the dust under the carpet:
Under this, the regulator allowed lenders to defer their interest and principal
payments, allowed lenders to provide additional funding and required promoters
to infuse more capital and provide personal and / or corporate guarantees. The
regulator even allowed regulatory forbearance (i.e., special dispensation to
lenders for not categorising these borrowers / assets as NPAs once the
restructuring plan was implemented) so that the company and existing capital
providers are given enough time to resolve the real cause of the financial
stress and the company can be revived.

The
problem with this approach was that the cause of the financial stress never got
resolved but the payment to lenders got postponed and the build-up of NPAs in
the system did not get reversed. Further, the lenders failed to monitor things
once the restructuring scheme got implemented whether or not the cause of
financial stress was resolved. Lenders with their short-sighted view were only
bothered that they did not have to classify the asset as an NPA or make
additional provisions immediately, and for the time being they could sweep the
dust under the carpet. This led to lenders approving restructuring schemes that
were based on aggressive business assumptions and sometimes even unrealistic
assumptions.

(2)   Lift the mat, show the dust to everyone and
let someone else clean it up: Under the second type of solution, the regulator
took away the regulatory forbearance (i.e., special dispensation for not
categorising the account by lenders as NPA on restructuring). The regulator
allowed the lenders to defer their interest and principal payments and required
promoters to infuse more capital and provide personal and / or corporate
guarantees. The lenders were required to reach an agreement for a restructuring
scheme within specified timelines. If the restructuring scheme was not approved
within the specified timelines, lenders either had to change the owner or
resolve the matter under the Corporate Insolvency Resolution Process (CIRP).

The timelines
specified by the regulator again resulted in lenders approving some of the
restructuring schemes that were based on aggressive business assumptions and
sometimes unrealistic assumptions.

Another issue was
that each and every decision of the lenders was viewed and reviewed with
suspicion and the sword of inquiry by various investigative agencies of the
government and its authorities was hanging on the lender’s decision. This led
to lenders not reaching any decision at all in some cases. In such situations,
lenders preferred to let the NCLT, NCLAT or the Supreme Court decide under the
IBC even at the cost of possible value destruction of the asset on referring to
these forums.

These solutions did
not lead to a reversal of the build-up of NPAs or resolving the real cause of
the financial stress in the company. Further, shareholders and depositors of
lenders continued to lose money under both the above methods due to various
reasons.

As
you may have noticed under the above two approaches, the government or the
regulator is only providing a solution for postponing payment of interest and
principal but has failed to provide a solution for resolving the cause of the
financial stress. Resolving the cause of financial stress has been left to the
existing lenders or promoters, and in some cases to new lenders and promoters
where the asset is sold to a new investor. In order to resolve the stress of
NPAs in the economy, the government and various regulators need to step in and
resolve the true cause behind the financial stress. At the same time, it is
virtually impossible for governments and regulators to have a customised
solution for each company for resolving its financial stress. Hence there is a
need to generalise the causes of financial stress in a company and then
government and regulators need to find a solution for resolving these issues
rather than merely postponing interest and principal payments.

The factors leading
to financial stress in a company can be broadly categorised as under:

Table 1

Financial stress in a
company can be reduced if the role of any of the above can be reduced or
eliminated. The factors stated in A, B and C above can be difficult to reduce
or eliminate. However, the factors stated in D and E can be reduced or
eliminated to make the operations of the company viable and resolve the
financial stress in the company.

‘Utility
Instruments’: A possible solution for resolving stress / NPAs

One of the solutions
for resolution of stressed assets and reducing the NPAs in the books of lenders
can be the issuing of ‘Utility Instruments’. A typical project which is an NPA,
especially in the infrastructure space, is funded by a mix of debt (from banks)
and equity infused by the promoters / investors in the company. What if an
instrument is introduced which replaces all the debt and equity in the company?

Two questions arise:

(1) Who will
subscribe to these ‘Utility Instruments’?

(2)
What will be the return on these ‘Utility Instruments’ – especially when the
project is not even able to service the interest, forget servicing of principal
and return on equity?

The answers to the
above questions will be explained in detail with the help of an example of a
stressed power-generating company that is an NPA asset in the books of the
bankers.

How it will work

A typical Power
Generation Company POGECO Ltd. has set up a coal-fired thermal power plant of
1,000 MW at Rs. 5 crores per MW with a debt-to-equity ratio of 70:30.  When the project is implemented and
operational, the balance sheet of such a company would broadly look as under:

Table 2

A typical Profit and
Loss account of POGECO Ltd would look as per Table 3, had it been
operating under normal circumstances based on certain assumptions.

These
assumptions are further detailed in Table 4 (for those interested in
understanding the details of calculations).

Table 3

Cost components of
POGECO Ltd. and assumptions

Table 4

Let us critically
analyse the above cost components.

As you can see (refer
Table 3), 28% of the cost is fixed cost (in the first year). Normally, this
cost would gradually go down over the years as the debt gets paid and the
interest cost on long-term loan would gradually decrease. However, costs of
other components that are fixed will not decrease over the years and will
remain constant throughout the plant life.

Any investor putting
in his time, money and effort would want a normal return on his investment.
Hence, PBT of Rs. 226 crores is nothing but 15% return on Rs. 1,500 crores
equity investment. Accordingly, PBT would represent about 7% of the tariff
which will be charged to the consumers of POGECO Ltd.

From a consumer’s
perspective he will be paying ~ 35% (28%+7%) of the power tariff on account of
O&M, depreciation, interest and return of equity. As a consumer, he would
be interested in reducing these components to the maximum extent.

In India we have also
seen the issue relating to gold plating of projects or cost escalations /
overruns due to delays. In such a scenario, per MW cost of setting up the power
plant is much higher than Rs. 4 crores to Rs. 5 crores per MW (as assumed in
our example). In such an event the consumers would be paying more than 35% of
the tariff in fixed costs component.

To put it in a different
perspective, the stress in POGECO Ltd. will be due to the following conflicting
factors among various parties:

(1)
Consumers and regulator will want to
minimise the tariff / revenue, i.e. component A from tariff (refer
Table 3);

(2) Bankers or debt
providers will want to ensure their
interest and principal gets paid hence they will not be interested in reducing
component Cii, Ciii and Civ (i.e. depreciation and
interest) from the tariff and the Profit & Loss statement (refer Table 3).
The reason for including depreciation here is that although in the P&L it
is a non-cash item, but commensurate cash flows will be utilised to service the
principal portion of the debt.

(3) Investors /
promoters will want to maximise
their return, hence they will try to increase component Cii and D
(i.e. depreciation and PBT) (refer Table 3).

The
conflict among the above factors makes POGECO Ltd. unviable (the example
tariffs are too low or the cost of project is high which has increased the
fixed costs). What could be the solution for making POGECO Ltd. viable which
ensures principal payment to banks, return of investment / equity of promoter /
investor and tariff reduction for consumers?

The key is to
eliminate some of the components of the fixed costs which will benefit the
consumer while ensuring that the investments of the banks and investors are
returned.

How do we reduce the
fixed cost components?

Step 1 – Issue ‘Utility Instruments’ to
the end-consumers of the power

To make it easier to
understand, let us assume a town with 30 lakh consumers / families /
connections is consuming electricity from POGECO Ltd. Further, it is assumed
that distribution lines are already set up and cost related to distribution /
distribution losses is not involved. These consumers are directly purchasing
power from POGECO Ltd. These 30 lakh consumers on an average would consume
about 180-190 units per month which is about 6,776 million units of electricity
requirement.

The net generation of
the 1,000 MW power plant (assuming it operates at 85% PLF and 9% of auxiliary
consumption) would be roughly ~ 6,776 million units.

Hence, POGECO Ltd.
would issue ‘Utility Instruments’ to these 30 lakh consumers. Each instrument
issued by POGECO Ltd. would give the right to the consumer to purchase 10 units
of electricity from POGECO Ltd. at a discounted price per unit.

POGECO
Ltd. will issue 67.76 crore ‘Utility Instruments’ at Rs. 73.79 each to its
consumers. This will enable POGECO Ltd. to generate Rs. 5,000 crores from the
issuance. The calculation can be better explained in the table below:

Table 5

Step 2 – Utilise the proceeds received
from these ‘Utility Instruments’ to pay the bankers and the investors

A Board of Trustees
can be appointed to oversee the entire process of getting the proceeds from
consumers and paying the bankers and investors (once the plant is made
operational). An O&M contractor should be appointed who will be managing
the plant and will be operating under the supervision / oversight of the Board
of Trustee and the regulator. With the proceeds from the ‘Utility Instruments’,
POGECO Ltd. will pay back the debt of Rs. 3,500 crores and the equity
investment of Rs. 1,500 crores.

RETURN ON INVESTMENT

The investor will
demand some return on investment up to the date he receives his money from the
‘Utility Instruments’. Further, there will also be a working capital
requirement to fund coal / fuel inventory and receivables. These additional
requirements can always be factored into the amount to be raised from the
consumers through the ‘Utility Instruments’.

Step
3 – Supply electricity to consumers at variable cost

The ‘Utility
Instruments’ will not carry any interest, nor will the amount paid by consumers
for purchase of the same (@ Rs. 73.79 per ‘Instrument’) be repaid to the consumers.
However, with the ‘Instruments’ the consumer has the right to purchase
electricity from POGECO Ltd. at a variable cost. Accordingly, each unit
consumed by the consumer will cost him only Rs. 3.07 per unit vs. Rs. 4.39 per
unit (that he would have otherwise paid to purchase power in our example –
refer Profit & Loss statement in Table 3 above). This is a saving of
about 30% in electricity cost for the consumer!

Let us do the math on
how he is getting the return on his investment of Rs. 73.79 per ‘Utility
Instrument’.

Assuming a family is
consuming 100 units of electricity every month, it consumes 1,200 units every
year. The consumer will need to buy 120 ‘Utility Instruments’. This will
require him to pay or invest Rs. 8,855. Against this investment he will be
saving Rs. 1.32 per unit of his consumption, or Rs. 1,584 in the first year of
investment on consumption of 1,200 units of electricity (i.e. Rs. 1.32 fixed
cost x 1,200 units). This works out to about 17.88% of the amount invested.

These savings would
gradually reduce (i.e. as discussed above due to the impact of the long-term
debt as it gets paid and the interest cost on long-term loan as part of fixed
cost would gradually decrease). The yearly saving gradually reduces to Rs. 861
in the 25th year of the power plant’s life. However, the Internal Rate of
Return for the consumer would still work out to be about ~ 15.5% over the
period of 25 years of the life of the plant.

With the above
analysis, the questions related to (1) Who will subscribe to these ‘Utility
Instruments’, and (2) What will be the return on these ‘Instruments’ are
answered.

Enumerable factors
such as costs related to distribution licensee, distribution and transmission
costs and losses, etc. will also play a role which would pose practical
challenges for implementing this concept. How to deal with these challenges and
issues can be a separate analysis or part of a study.

Applicability to
other sectors

A detailed analysis
of the concept has been presented here using the example of a power company.
However, this principal / concept can be applied to any company / sector that
is capital intensive or any public utility company, or any company having a
substantial component of operating and financial leverage and is catering to a
large number of consumers.

Examples:

(a) ‘Utility
Instruments’ can be issued to truck owners / transport companies / courier
companies wherein they will be paying toll limited to variable and O&M
costs for a road project.

(b) ‘Utility Instruments’
can be issued by Metro projects in urban areas such as Mumbai Metro or Delhi
Metro to its daily travellers / office-goers.

(c) Companies laying
the network of pipelines for the distribution of natural gas in urban areas can
issue ‘Utility Instruments’ to their consumers who would be using piped natural
gas.

(d) Financing for
setting up of infrastructure for charging stations in the city and providing
batteries for electric cars can be done through issuing ‘Utility Instruments’
to consumers using electric cars.

Implementation of the concept

We can always think
of variations to the above principle for implementation of this concept in the
current scenario with limited changes / amendments to the regulations. Let us
assume that Tata Power (i.e. a generation company) issues ‘Utility Instruments’
to the consumers in Mumbai. The proceeds will be utilised to reduce the debt
and / or equity component in their balance sheet.

As a consumer the
holder of a ‘Utility Instrument’ will be paying the normal electricity bill
every month as per the existing mechanism along with other consumers. At the
end of the year, Tata Power can reimburse various cost components (other than
O&M cost and variable cost) to the holders of these instruments. A
Chartered Accountant can play a role here for identifying companies wherein
this structure / concept can be implemented and give necessary advice to the
senior management to this effect.

Under
the current scenario there would be various regulatory challenges for issuance
of ‘Utility Instruments’. This will even require SEBI and RBI to come together
for necessary issuance and / or amendment of guidelines for enabling their
issuance. Several existing guidelines such as ICDR guidelines, the Companies
Act, 2013, etc. will also have to be amended in order to recognise these
‘Instruments’. A Chartered Accountant can play an important role here, too,
initially making necessary representations to various regulatory and industrial
bodies.

These
‘Utility Instruments’ can also be marketable / tradeable, i.e. if in a
given year the consumer shifts location, there is flexibility for him to sell
the same to another consumer. A Chartered Accountant / Merchant Banker can play
a critical role in the valuation of such ‘Instruments’. The
Board of Trustees will also play a key role in ensuring successful
implementation of the concept. The government will have to issue necessary
regulations for the purpose of setting up, functioning and overseeing of the
Board of Trustees in the interest of the consumers and holders of ‘Utility
Instruments’. Here, too, a Chartered Accountant can play an eminent role as a
watchdog and audit the entire process on a continuous basis.

In these unprecedented times, going forward there is going to be significant
stress in the manufacturing, industrial and infrastructure sectors. Companies
which were probably viable prior to Covid-19 may turn unviable due to lack of
demand or various other factors. We need to think of out-of-the-box solutions
in order to cope with the possible crisis. Through implementation of this
concept in sectors wherein wide numbers of consumers are being catered to, we
can attempt to eliminate the fixed costs related to investments.