How can family businesses keep themselves from splitting? By separating ownership and management

This article was first published in the Economic Times on March 10, 2021, Co: Author: S.Subramanian;

https://economictimes.indiatimes.com/news/company/corporate-trends/how-can-family-businesses-keep-themselves-from-splitting-by-separating-ownership-and-management/articleshow/81427776.cms 

Affiliation to a business group has many advantages in emerging economies. Access to internal capital, labour and product markets often provide the affiliated firms with competitive advantages in highly competitive markets. Being a part of the same group provides the firms with a common identity, mutual trust in ensuring coordination between the legally independent firms and framing joint-venture norms as in the case of the Tata group. The Tata Group is planning to enter the retail business in a big way, with a super-app, by combining the strengths of various Tata firms like TCS, Cliq, Croma and Trent.

Similarly, the cost of capital is also cheaper for the business group affiliated firms, compared to the standalone firms. One of the mains reasons for the success of Reliance Jio in the telecom business is the access to low-cost capital being a part of Reliance Industries. The access to low-cost capital provides a head-start while entering new ventures or in providing resources to a troubled group firm.

Further, the group firms can always seek proven talent from affiliated firms, immersed in the group’s work culture, to pursue new ventures or resolve problems. When the Murugappa group acquired the troubled CG Power recently, it appointed group veteran Natarajan Srinivasan, a proven talent, as CEO. The appointment was quick, saving valuable time, which otherwise would be spent on a lengthy selection process. Further, he could also quickly tap other proven talent across the group to resolve specific problems at CG Power.

Despite these obvious and proven advantages, why is it that the family business groups split?

Traditionally, in Indian family-controlled business groups, the family members were employed in the group firms at leadership position, by virtue of family membership. This worked well during the license raj era. The competition was limited, and success of the firm depended on the ability to deal with the bureaucracy to a large extent. Being a family member, the executive was able to use the family connections to manoeuvre the bureaucratic maze. The need for family connections to conduct the business to a greater extent worked as the glue that kept the family and the business together, generation after generation. But as the governmental controls came down, the role of connections within the government and bureaucracy started to come down. With increased competition, talent and innovation started to make a difference in the performance of the firm. Thus, it became imperative many family businesses to look outside for fresh ideas and talents to manage the businesses while they remained owners.

Many family businesses continue to appoint their progeny as the successor for the management of the company. All things being equal, it would be the right decision as a family member would bring greater continuity and would be steeped in the values of the family. However, when the next-gen is not the best person to lead the company, either due to lack of capability or willingness, it becomes a disadvantage for the firm and the group at large.

Especially in a business group, the individual capabilities of the family members playing executive role in affiliated group firms and the performance of those firms differ. Differing performances of group firms imply unequal contributions to the business group by the family members. This typically leads to an uncomfortable relationship among family members. This might also become a vicious cycle as the differences between family members may feed on to the poor performance of group firms. Even if all the firms in the group do well, there are often differences between the family members about executive decisions. The differences feed the need for a formal split in the business group.

Many Indian family-owned business groups have undergone split in the last two decades — Thapars, Munjals, Jindals, to name a few. Many of them had family members at the executive positions. Some groups managed the separation seamlessly like the TVS group and RPG group, while many other splits — like Ambanis and Kirloskars — happened after bitter fight among the family members.

We posit that if the advantages of a business group are to be more or less retained, a conscious separation of ownership and management must be made. The family members must restrict themselves to monitoring role (non-executive board positions), leaving the firm management to qualified professional managers. This is not to say that family members should not join the business at all. They should if they are the best talent available to manage the company. There should be a clearly laid out criteria for them to join the business that should be at par with that applicable for a non-family talent pool. Thus, even if the family member occupies executive leadership position, it should be based on merit and experience and not by virtue of being a member of the family. This is easier said than done. However, some business groups, like Aditya Birla group, Burmans and Mahindras have done it successfully, showing the path for other groups.

In the long run, the realization for the need to keep the group together, and subsequent action to keep the ownership separate from the management, will be critical to keep the business group together and reap the benefits of being a business group.

Perspectives on the Banking Dilemma in India: A Q&A with Vivek Kaul

This interview was first published in Risk Intelligence on March 5, 2021; https://www.garp.org/#!/risk-intelligence/credit/counterparty/a1Z1W000005krEZUAY

Recent projections by the Reserve Bank of India confirm that non-performing loans remain a significant hazard for banks. What are the origins of this risk, what’s the connection to COVID-19, and what are the prospects for India’s economic recovery?

Bad loans and deteriorating asset quality continue to plague banks in India. Last September, the gross non-performing assets ratio (GNPA) at Indian banks stood at 7.5%, but that number potentially could double in just a year’s time.

In its recent financial stability report, the Reserve Bank of India estimated that Indian banks’ GNPA ratio could increase to 13.5% under a baseline stress scenario and 14.8% under a severe stress scenario by September 2021. What’s more, for public-sector banks (PSBs), GNPA may rise to nearly 18%.

Vivek Kaul, the author of Bad Money: Inside the NPA Mess and Hot It Threatens the Indian Banking System, is a well-known commentator and podcaster who has written several books on India’s economy. He talked with Risk Intelligence about the NPA dilemma, the impact of COVID-19, default risk, regulatory flaws, and India’s path to economic recovery.

Risk Intelligence (RI): Can you pinpoint the primary reason for the bad debts and non-performing assets (NPAs) in India? Where does the fault actually lie?

Vivek Kaul (VK): If you look at the current phase of bad loans, which have accumulated over the last five years, I think the main reason for that lies in the period pre-2008. Between 2004 and 2006, the Indian economy grew by greater than 9% annually, resulting in a great deal of optimism among the politicians, bankers, businessmen, entrepreneurs and the public, in general. Suddenly, there was this story going around that India will be the next China, which basically meant that since China was growing in double digit rates, India would follow a similar path.

Entrepreneurs and businesses saw an opportunity. They believed that the growth would fuel demand for goods and services. They started to invest in the infrastructure that would drive this growth and fulfill the demand. The data between 2004 and 2008 shows that the loans to industry given by banks in India went through the roof, and that is where it all started:  the belief that India would continue growing at 9%.

RI: In India, the government uses PSBs to increase the money supply in the market. The latest financial stability report of the RBI, released in January 2021, says that the GNPA ratio of PSBs may increase to 17.6%. That number is frightening.

VK: It needs to be mentioned that if you calculate the numbers properly, they are even worse. What has happened is that the categorization of IDBI Bank - which was by far the worst-performing PSB, with a very high NPA of almost 32% - has been changed to that of a private bank. IDBI has NPLs of close to ₹500 billion, but these are now categorized by the RBI as the bad loans of a private bank, rather than a PSB.

Another well-kept secret of banking in India is that once a bad loan has been on the balance sheet of a bank for four years, it can be written off. After that period of time has elapsed, the loans drop from the balance sheet of the bank, reducing the bad-loan numbers for PSBs.

Moreover, Indian banks have a very low recovery rate of bad loans. Once you take these factors into account, it gives an entirely different dimension to the story.

Here’s what will happen: the bad loans that were recognized, let's say, in 2016, 2017, and 2018, will keep getting dropped off from the balance sheet of banks in the next couple of years. This will lead to the bad loans number coming down in the 2020-2021 financials of the banks. But there will also be fresh bad loans, which we will start to see on account of COVID-19.

RI: You mentioned about the mid-2000s and the optimism that followed. But then the global crisis happened in 2008, which led to the optimism not being there. What do you think the spirit of the times now is with the COVID-19 slump and recession? How will it impact the mess further, and what will recovery look like?

VK: This time around, the issue is a little different. Common sense tells us that this time there will be retail defaults, as well corporate defaults, because salaries have been slashed and people have lost jobs. The entire informal sector has seen huge destruction.

The data for listed Indian corporates for the quarter July to September 2020 actually shows that their profits went up, mainly because they have cut down their costs. But when a corporate cuts costs, someone else's income is being impacted.

For example, if you're a corporate who's making profits, and you've managed to cut down on your raw material costs, some supplier somewhere is seeing reduced business.  As a consequence, that supplier is likely doing the same thing with some of its third-party vendors. The impact is felt across the hierarchy, and that’s problematic.

We haven't yet begun to see the impact of this, because there is a case going on in the Supreme Court about whether the interest on loans during the COVID-19 months should be waived. Until that decision arrives, banks are not allowed to recognize defaults as bad loans. So, will we come to know how bad the defaults situation is at PSBs only after the Supreme Court hands down its decision.

It is also important to remember that more than 50% of all retail loans are home loans, and people will try their best to not default on home loans. So, that is a very good thing going for banks. But the other kinds of loans – e.g., credit card debt, personal loans, consumer durable loans and auto loans - will see an uptick in the defaults.

RI: In this case, culture could also play a big role, right?  In the U.S., the subprime crisis was essentially driven by home-loan defaults, but in India, people probably try to hold on to their homes more dearly, correct?

VK: Yes, the stigma of losing your home is huge in India. People will try selling everything, defaulting on everything else before they default on their home loan.

The other good thing is that even if people default, banks may not lose much. The first reason lies in the loan-to-value ratio (LTV). The LTV of entire home-loan business in India is between 65% and 70%, giving some margin to the banks.

What’s more, over and above the registered price of a house, in many parts of the country, there is a so-called “black portion” in mortgages, which gives a bank the right to recover most of the home loan, if defaulted, by selling the house.

RI: You mentioned in your book that there was an era of easy money in the Indian financial system in the aftermath of the financial crisis of 2009. Do you predict the same will happen after COVID-19?

VK: That is already happening. The amount of money floating around right now is just humongous.

Banks don't know what to do with it. That is clearly visible in the fact that, one, they’re depositing billions of rupees with the RBI to the reverse-repo window, because they don't have any use for that money.

There is indeed a huge amount of liquidity in the system. Some of this has been driven by the RBI printing money, some of it has been driven by the fact that the psychology of a recession is totally in place.

Even though interest rates are falling, people want to save money with banks as deposits because, as of now, they are more worried about return of capital than return on capital.

People are scared. They have lost jobs, and salaries have been cut. Even for those who have not been economically impacted, the psychology of fear is at play, given that everyone wants to be prepared for a situation where, say, jobs are lost, and they are unable to find new positions.

Businesses are not borrowing, too, because with private consumption coming down, there is no need for businesses to borrow and expand. All these factors have come together, and there is consequently a huge amount of liquidity in the financial system.

RI: What can you say about India's path to economic recovery and the current so-called technical recession that we are in? How does it compare to other countries?

VK: The Indian economy contracted by around 15.7% during the half-year from April to September of 2020. In between April and June, we were right at the bottom. Between July and September, we were in the bottom quartile, though not right at the bottom. There were countries, like Chile and UK, which performed worse than India.

Now, to answer your question about when the economy will recover and when growth will go back into positive territory, there are varying opinions. But what most people are not talking about is the fact that India will not return to its 2019-20 GDP level until either late 2021 or early 2022, at the earliest. By the time we see this return, moreover, we will have lost two years of economic growth.

Another point to keep in mind is that a lot of this economic contraction is not simply because of COVID-19. The economy had been slowing down much before the pandemic struck. Indeed, if you look closely at the data between October and December 2019, India grew by just 4%. So, issues which were plaguing the Indian economy, even pre-pandemic, will now only get worse.

For example, the investment-to-GDP ratio has been falling in India since 2012, and that is not going to improve anytime soon. A lot of growth that is happening, or will happen, is basically jobless growth.

The rate of unemployment has been coming down, but how that rate is coming down is very interesting. It is because the labor force participation rate - proportion of the population that is looking for jobs - is also declining.

What that means is that many people who have been unable to find jobs have stopped looking for a job, and, hence, have dropped out of the labor force. This is a very worrying trend, because India anyway has a low labor force participation rate (especially among women), and I think this will only get worse post-pandemic.

The growth will eventually come back. For an economy of India’s size, people will eventually consume and spend money, and we can debate about t when this will happen. But long-term growth prospects of India have now, I think, been hurt, and all the talk of 8%-9% growth is overly optimistic. At this stage, even a 6% growth rate will be brilliant for India.