A key factor when investing in quality stocks is the sustainability of a company’s competitive advantage. In their article, Entry and Exit Barriers, the authors Baijnath Ramraika and Prashant Trivedi suggest that while most investors look at entry barriers as a proxy for the ability of a business to persist with its supernormal returns, the presence or absence of exit barriers is a key factor as well and may at times serve to nullify the impact of entry barriers.
While entry barriers dictate the ability of potential entrants to enter the business, exit barriers dictate their ability to wrap up the business and leave. Exit barriers determine the competitive structure that persists among the incumbents within the industry, because when exit barriers are high, even businesses with poor economics are forced to stay. In such industries, the profitability of everyone is dictated by the most inefficient competitor; if a financially inefficient competitor exits, the other players in the market gain – higher prices or more business or both.
An additional concern is the protection afforded to creditors when the ability to hasten exit is hampered. Often termed as a market that embraced “capitalism without exit”, India’s business environment has been plagued with slow insolvency resolutions, slower debt recovery mechanisms and near to nil monetary relief to creditors.
Exit Barriers In India
According to the World Bank it can take a sick company more than four years to wind up its business in India. This is double of what it takes for an ailing business to exit in China. Nearly 60,000 bankruptcy cases are believed to be pending in India’s courts. The burden of the ineffectiveness of insolvency procedures in India have been borne by banks, whose NPA issues seem to have increased manifold (as seen in chart below).
Nearly 12% of all loans disbursed by India’s public sector banks are troubled, which is severe considering that PSBs account for 70% of all loan stock within the country.
Rise in NPA Levels
Insolvency Tardiness In India
Kingfisher Airlines is a great example of the failure of the insolvency mechanism within India. Once India’s second-biggest airline, its finances ran dry with operations being shut down in 2012. The company reported a debt of over $1.5 billion and the creditor banks took three years to get even a tiny share of the loans back.
Other pertaining issue that may have to be resolved is the labor’s grievance. One of the major stakeholders, labour often end up being the hurdles in any exit process whether in or out of court. It is important to look into Labour Laws and reform it adequately to build a conclusive insolvency procedure.
Moreover, developed countries have a simplified legal process to enable acquisition during bankruptcy. On the other hand, India has a bifurcated legal framework with laws like Companies Act, SARFAESI etc, which makes acquisition of a sick company tedious. Also, in some cases auctions have been designed to suit the influential Equity owner.
It has also been seen that banks prefer to carry the loans at historical cost on the balance sheet rather than swap with equity or auction out assets and book one-time loss transparently. On the other hand, Promoter’s attitude has been to control ownership without any new fund infusion. Overall, inability of factors of production or resources to redeploy further causes system wide decline in efficiency/productivity.
Many European countries and other developed countries were forced to go through these reformed through decades of recessions and thus lowered the inefficiency costs. However, even after many bankruptcy cases, India has been a slow-learner finding its own pace to set things right.
Recently, the Bankruptcy Law Reforms Commission (BLRC) set up in August 2014 submitted its report and a draft bill. The current draft of the BLRC has consolidated existing laws related to insolvency. Prescribing a timeline of 180 days to deal with applications of insolvency resolution, the BLRC has stressed on the need for an insolvency regulator. Since the new bill proposes to ensure speedy recovery, we believe that it will aid loss making companies to sign out without causing much damage to stakeholders and investors.
As discussed by Baijnath and Prashant in the article, a market with high entry barriers and low exit barriers, gives rise to natural moats. While high entry barriers provide protection against new competition, low exit barriers allow excess supply to be weaned out.
A realistic exit procedure will not only ensure speedy recovery of investor’s capital but it will also ensure that a business can bid goodbye and leave. An easy insolvency procedure will also improve the profitability and competitive positioning of the remaining players by allowing excess/inefficient capacity to exit, and reduce systemic risks for potential lenders.
We hope to see an easy insolvency procedure which will enable the sustainability of the most competent players in the market. However, as the bill is in its preliminary stage, any future amendments or modifications will decide the path in which this recourse offered by the government is headed.