The start up scene in India is no longer at a nascent stage with a high frequency of booming companies and smooth exits, it has become more competitive, therefore, increasing possibilities of more investments to end up as sunk costs, pushing start-ups to work beyond their capacities and often acting against their interest while having to protect investor interests. What our economy needs now with government initiatives like Start Up India, Stand Up India in place is the availability of a distressed funds market. The name of the asset class is self-explanatory, it’s the practice of investing in distressed debt or start-ups which are debt-ridden or in a state of distress due to things like inability to payback loans, unfulfillment of compliance requirements or corrupt actions by one or more of the promoters.
At first sight, it seems like a horrible idea to be paying to invest your funds in an organization that has already indicated incompetence. Here’s how we can create a demand for investing in such a product, of which, the supply is increasing gradually:
Investment
|
Current price (INR)
|
Value (INR) if turnaround succeeds
|
Value (INR) if turnaround fails
|
Expected value (INR)
|
Debt
|
100
|
200 (100% gain)
|
80 (20% loss)
|
140 (40% gain)
|
Equity
|
400
|
1000 (150% gain)
|
0 (100% loss)
|
500 (25% gain)
|
Assuming there is a 50% chance of success post investment into the distressed asset, the expected rate of return gives us a greater return in the case of investment into distressed debt for the company. The reason investors opt for this is because if a company is to fail, debt is recovered prior to the recovery of equity as lenders are prioritized conventionally. This opportunity is instinctively, then, more attractive to debt investors.
Distressed Funds market across the world doesn’t function just on investing in these companies but investors also often contribute in the decision making processes of these entities, sometimes, investors even get involved in lend-to-own situations wherein they can buy the company’s debt (for a reduced value, if the company is overleveraged) and acquire enough of it such that the investors end up having to make space for you to own the company instead of paying you amounts for debt repayment.
Distressed Funds are attractive for additional reasons like:
- Regular cash flow is paid to investors in the form of interest payments which is compulsory unlike the payment of dividends, specially in the case of start-ups
- Corporate Restructuring power can be concentrated with the lender, structure can be such that debt repayment is prioritized over long term sustenance.
With legal hurdles out of the way with policies like the bankruptcy code in place, start-up failures can be cushioned by the existence of distressed asset purchase possibility. Perhaps, means such as crowdfunding can be used to cushion distressed firms, it can be done in the form of a private equity fund which can be transformed into a publicly tradable asset.
A mechanism as follows can be set-up:
- Allow ARCs like Edelweiss’ Asset Management Department or DSP Blackrock’s Distressed Debt Funds to open to the public for attracting more funds, while necessarily categorizing these investments to be of greater risk for public interest.
Pooling of funds from the crowd will have a two-fold benefit:
A.Incentivize fund managers to advertise strongly (as they can have a new product to reap benefits from as well as have access to more capital) to potential retail investors, thereby increasing awareness.
B.Reduce the risk on the large investment firm who cannot afford to reduce its liquidity by placing funds in a distressed asset.
- Create mechanism within these ARCs to function like Private Equity Players wherein they can charge a management fee for entering investments into these entities and taking charge of the management of these organizations. Active participation in management of distressed entities will increase the chances of gain via investment in Debt situations creating more situations like that of 100% gain as illustrated above, while still being a safe bet for these organizations. In worst case scenarios for the investors, they lose the ability to recover their debt (which too, they acquired for a fraction of its value) but gain the control of the entity, they can then infuse further capital into these corporations for CapEx/OpEx purposes and aim at maximizing returns thereby.
Markets come at a cost of likely inefficiencies and loopholes in the laws that regulate them, with a set-up such as this, boosting interests of venture capitalists and creating a greater demand for direct investments in innovative problem solving start-ups makes it all the more likely for large investors to be interested in lend-to-own situations in order for them to be able to take advantage of access to the entrepreneur’s product while eliminating the entrepreneur with the possibility of placing themselves in “lend-to-own” situations. Therefore, requiring strong regulatory policies in place before a market like this is to be established as this could hamper the growth stage that the start-up space in India is, also worsen the process this measure primarily wants to cushion by aggravating the problems that the Small and Medium Enterprise owners may face.
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