The 1980s witnessed a major mushrooming of finance companies of different shades that constituted a significant part of the hype in the capital markets when funds were raised at elevated valuations and brought up, for the first time, the question of how a business, that was most capital-intensive, could command astronomical valuations that companies which possessed key manufacturing capabilities could not!
One of the major reasons was that the finance companies could take advantage of a highly favourable tax regime that allowed significant incentives like investment allowance and front-ended depreciation. The companies could defer taxation payouts and the assumption that this could be perpetuated helped create the myth of high earnings per share, propelling the market valuations. There was little in the form of standard rules in accounting to provide for deferred tax liabilities or to discourage aggressive booking of income, upfront.
The music didn’t last long and the typical greed of the entrepreneurs, which included incestuous and questionable lending practices, left a huge pile of shattered investors’ and depositors’ dreams.
In all this, the Reserve Bank of India (RBI) was yet not the nodal regulator which it later became. Essentially, the rise and fall of shadow banks in the pre-millennium was largely attributable to the tax and accounting arbitrage!
Come 2020s, is there a possible repeat of this with a different logic and rationale as there is seldom history repeating in the same way, but, somehow, it does!
After the financial crisis, central banks in all major economies let loose a flood of liquidity that brought down the cost of capital to almost zero. The fulcrum of valuation, being discounting the earnings by the cost of capital, collapsed. Money availability was taken for granted in perpetuity and could be funded in any project whether it had predictable cash-flows or not. So many examples are on the fingertips of investors who recently burnt them!
Global private equity has been chasing the chimera of a great business opportunity servicing the burgeoning bottom of the pyramid; a large mass in poor countries that, typically, had unfulfilled wants which conventional capital was not servicing.
Thus, micro finance, lending for students education, small and tiny business, affordable housing, pay day lending, etc, became hot destinations for the loose capital floating around. The fact that the regulations had tightened, meanwhile, provided the comfort to trust new ventures as the risk of malpractices was expected to come down.
This phenomenon of well-capitalised finance companies, with huge dose of private equity (PE) funds that embraced astronomical valuation, became the bulwark to create a breed of low-leveraged finance businesses, that could generate high income with little cost on the income statement as the equity servicing cost is not debited to earnings calculation!
Thus, earnings per share of eye-popping numbers started becoming a norm and challenged the conventional wisdom of the finance industry which, typically, borrowed and re-lent with an arbitrage; eking out a marginal return on its capital.
Companies started listing at price-to-earnings ratio (P/E), which was a multiple of two or even three, to established players in the business who had stood for decades and more and seen many business cycles. Century-old banks, which are considered well-run, are quoting at a P/E of say 10 or 12 when new businesses, that came about in recent days on the back of PE money, are quoting thrice that! In fact, new listings are happening at such valuations even when there are worries of global slowdown and recession, on the back of unabating inflation.
The major difference between the phenomenon of 1980s and the present is that the accounts are a lot cleaner, the regulations are tighter and the investors more aware.
Nevertheless, if taxation was the arbitrage in those times, cost equity is the one now. Though PE funds pour money as if there is no tomorrow, they plan their exit by banking on the strong performance in the net earnings and making a case that this phenomenon would go on!
The question is: Will it? The current set of PE investors may partially or fully exit and make their money. The new investors can secure a return only if the current business model can perpetuate. In order to sustain the growth, which these businesses promise, capital would be required on an on-going basis.
In the past, for reasons stated, it was freely available. With the global tightening on liquidity and the cost of money, this may not be feasible. Thus, the high EPS (earnings per share) syndrome may not sustain as fresh capital has to be borrowed. This may also become more expensive as interest rates are climbing.
The other side too, the attraction is that most of these businesses occupy the gaps and crevices where the main banks have not stepped in. According to some statistics, public sector banks (PSBs) could lend only Rs235bn (billion) of loans of less than Rs25 lakh category while the shadow banks did almost four times in FY20-21.
There is a large under-serviced market supporting the rationale for these new entrants. The deprivation of finance naturally allows these shadow financiers to charge—what could be to outsiders’ usurious rates—but within the regulatory guidelines. Many of these are well-collateralised as well. Thus, the enthusiasm of the investors to pile in cannot be faulted.
Will this sustain? Will those entering at the current stratospheric valuation get an exit, say two or three years later? Will these businesses continue to find growth capital at the old attractive rates? Will borrowers continue to patronise, at somewhat unreasonable rates, in comparison to the banks? Will the banks stay away from penetrating these markets as they have learnt hard lessons in lending to the so-called mega projects?
If you wish to know the answers, do subscribe to an issue of a like nature opening this week and get the first-hand opportunity to find the answer!
(Ranganathan V is a CA and CS. He has over 43 years of experience in the corporate sector and in consultancy. For 17 years he worked as Director and Partner in Ernst & Young LLP and three years as senior advisor post-retirement handling the task of building the Chennai and Hyderabad practice of E&Y in tax and regulatory space. Currently, he serves as an independent director on the board of four companies.)