It is a myth to assume that valuations are precise, one can only be less wrong
By B Sambamurthy
The blame game around non-performing assets (NPAs) is so much in abundance that even after apportioning blame to various actors (lenders, errant borrowers, auditors, rating agencies, supervisors, government, analysts, award givers, etc), there is plenty left on the table unclaimed. This attitude only delays objective diagnosis and remedial measures. A similar blame game appears to have engulfed the Insolvency and Bankruptcy Code (IBC).
Mercifully, the IBC, the landmark legislation (2016), gave a booster shot to resolve some of the zombie businesses, particularly large corporates. Till the other day, paeans of praise were showered by the high and mighty on the performance of the IBC and deservedly so. But this year, almost in a U-turn, the same IBC has become a butt of criticism. The recent comments by the Parliamentary Committee only make the chorus louder.
What has gone wrong in this short span of one year? One of the villains of the piece is massive haircuts in some large corporate accounts. The IBC appears to be caught in the crosshairs of quick resolution and maximising value. Is quick resolution and maximising value a Holy Grail or an oxymoron? The Insolvency and Bankruptcy Board of India (IBBI) is on record that it cannot deliver on multiple objectives and they lean on a Nobel laureate to buttress this claim.
Performance evaluation of the IBC is quite divergent – excellent, good but can do better to failure. In the narrative of Daniel Kahneman, another Nobel laureate, this is a typical case of Noise — unwanted divergence of judgement. This begs the question: How does one evaluate performance with a fair degree of objectivity? One of the models goes like this:
1. Output: What the organisation is expected to see or deliver? This defines the quality and scale of activities.
2. Outcome: What the organisation wants to see? What other stakeholders do with the Output?
3. Impact: What policymakers hope to see? What may be the long-term development?
Output: The IBBI has resolved/closed over 2,600 cases during 2017-21. The average time taken is brought down to 1.6 years against the earlier dilatory regimes run rate of 4.3 years. Its average recovery rate of 45% beats by miles the dilatory incumbent recovery regimes like Sarfaesi (26%), DRT (4%), Lok Adalat (6%) and ARCs (17%). It is difficult to dismiss the output. These averages tell a broad story. But one may not be faulted in asking for more, ie, reduce time and maximise realisations.
Outcome: The resolution is faster than ever though it spills over the initial time limit set by the IBC. In many cases, these productive assets are redeployed unless they are consigned to liquidation dock. Some of these cases are claimed to be dead on arrival cases. But the lenders incurred huge haircuts, and in some cases as high as 95%. While this is the butt of criticism, the IBBI belabours that it gives precedence to quick resolution and cannot deliver on multiple objectives. Lenders demand Holy Grail.
Impact: One cannot deny the fact that initially it sent shivers down the errant borrowers by divesting them of the divine right to continue to own and manage the companies they pushed to bankruptcy. A discernible observer cannot miss the positive incentive to try hard to keep the credit performing and disincentive to moral hazard. One begins to see signs of improvement of credit culture.
Lenders and lately the Parliamentary Standing Committee frown upon huge haircuts. Valuation issues, legal delays and lack of marketing are the main contributory factors. There is a delay between the time the account sours (even before classified as NPA) and its actual resolution. Time delay is natural.
There is a lot of controversy and confusion around valuation of the enterprise. Prof Aswath Damodar of NYS University, considered as the Guru of Valuation, lays out three fundamental approaches to valuation.
1. Intrinsic valuation: The key drivers are cash flows, growth rate/potential and riskiness of cash flows. Anything else is pricing and not valuation.
2. Relative valuation: The key driver is comparable businesses in the sector.
3. Contingent valuation: The valuation is contingent on fulfillment of certain conditions like licences, government approvals, IPR, etc.
Firstly, he enlightens that valuation is neither science nor art but a craft. Thus, it requires several years if not decades of experience of actually doing. Secondly, valuation is a bridge between business story and number crunching and the construction shall begin with building story. Valuation is interplay of story and numbers. The story shall not be a fairy tale but shall be possible, plausible and probable. Thirdly, he likens valuation challenge to Bermuda triangle of Bias, Uncertainty and Complexity and offers solutions. Cash flows, value creating growth rate and risk are the principal sources of value. But these sources are besotted by Bermuda triangle.
Business stress or financial stress, cyclical downturn or secular decline, going concern or gone concern are some of the contexts that need to be aligned to a particular valuation approach. There is no one size fits all. But lenders/creditors need to recognise whatever be the reason, a lot of value is destroyed and this precisely drove them to the arms of the IBC. It is futile to chase intrinsic value, and haircuts are inevitable.
Valuations vary and depend on the context and one may not expect to realise intrinsic value many a time. Nonetheless, the huge differences by an order of magnitude in valuations by the IBBI valuers and debtor’s auditor need to be reconciled to ensure objectivity, transparency, high degree of skill and care, and of course, integrity.
The IBBI, National Company Law Tribunal (NCLT), Committee of Creditors (CoC), Resolution Professionals (RP), valuers, Information Utilities, comprise the critical ecosystem components. Most of the players are new to the game. The trust level among these actors leaves much to be desired and needs to improve. The NCLT suffers from a huge staff and talent shortage to deliver time-bound quality judgments narrowing the scope for further litigation. These need to be fixed early.
The IBBI and CoC need to come out with a robust framework for valuation. There is a need to develop top-notch professionals to run the companies under the IBC process. This will help mitigate erosion in value and even improve it.
The size of our stressed asset market is over $150 billion with many individual cases of over $1 billion. This is a global scale and as such, it may be useful to source global expertise. The CoC should lead from the front, including marketing these accounts globally. Junk bond market needs to be developed. These measures would enhance output, outcome and impact of IBC.
Large corporate lending market’s doors were wide open in the earlier decades but the exit door wasn’t. Virtually these borrowers had a lock on the exit doors. The IBC has started taking baby steps and got the keys. It is important that the government nurtures the baby and does not throw it away.
“It is a myth to assume that valuations are precise. One can only be less wrong”.
(The author is a former banker and Director, IDRBT)