Rising NPAs: Could There Be Behavioural Causes?

By

Suhayl Abidi and Prof. Manoj Joshi

Contact first author:

+919324053831

knoworks@gmail.com

(short bio at end)

---------------------------------------------------------------------------------------------------------

Non-performing loans (NPA) have been in the headlines in the media for sometime now. The reason is that NPSs have assumed epidemic proportions and threatens to derail the banking system.

A recently released survey report by Ernst & Young Unmasking India’s NPA issues – can the banking sector overcome this phase? 72% of the respondents, a majority of whom were bankers, said the crisis is said to worsen. 64% said there were lapses in the initial borrower due diligence (pre-sanction) and 43% blamed change in political/ regulatory environment leading to business loss. According to the report, the overall level of stressed loans—or the sum of gross NPAs and gross restructured assets—went to over 11% in March 2015, from 9.2% in March 2013. Similarly, gross NPAs rose to 4.6% from 3.4% in the same period.

At 39 listed banks, gross NPAs rose 27.69% to Rs.3.21 trillion on 30 June 2015 from Rs.2.51 trillion a year earlier.

Although diversion and misuse of funds is still a major reason but in this article we will not discuss it as it comes in the category of fraud and require forensic accounting discussion. The authors will limit their discussion to discovering hitherto unknown causes in case where projects have derailed due to high debt component of the project costs. In most of the cases, the promoters have cited adverse economic conditions for the projects going bad. The authors think otherwise.

The authors studied this phenomenon through some case studies in their recently published book The VUCA Company (Jaico, Aug 2015). It is the authors’ contention that a large part of the rising NPAs is due to financing projects with high leverage, a very high debt: equity ratio. In a VUCA environment, where the future is uncertain, and so is cash flow, the funds for servicing debts can diminish or vanish suddenly, creating NPAs. Professor Ram Charan has very rightly underlined “cash is king ;cash is blood supply” in times of business uncertainty. 1

The question arises as to why these promoters who were highly competent, with good track record of running profitable companies such as Renuka Sugar, Kingfisher Airlines and many Andhra based infrastructure companies etc. under took projects with such high leverage in an uncertain business environment. The answer may be sought in behavioural sciences and should be a lesson to all those who might be thinking of taking the same route to grow and diversify.

After the unshackling of the economy in the 1990s, there was a huge euphoria about the capabilities of a new generation of entrepreneurs that they are invincible, no doubt fuelled by their initial successes. These intial success made them take more and more risk to grow fast. Let us take the case of Leela Ventures. Its debt equity ratio has been steadily rising from 3.9 in March 2011 to a staggering 17.78 in March 2014. The sudden deterioration is, no doubt, due to loss of valuation of equity, but still the ratio is much higher than a prudent ratio of 2:1.

Leela’s financial woes started with the construction of Leela Place at New Delhi. At that time Late Captain C.P. Krishnan Nair, the chairman of The Leela Palaces, Hotels and Resorts, said cost was no consideration when building the hotel. He added karma will help them breakeven.2 The per unit cost is estimated to be Rs 6 crore (with land cost) or Rs 3.5 crore (without land). This is way above the average per unit cost range of Rs 75 lakh to Rs 1.8 crore for a five-star deluxe property, according to the Federation of Hotel and Restaurant Association of India (FHRAI).3 It means cost of construction was 100% higher than the most luxurious cost estimate in India. To recover this cost, in 2011, when the hotel opened, the lowest room rent was Rs.25,000 per night, which was progressively reduced and is Rs.14000 today, a drop of 40%.4 This coupled with low room occupancy, as a report by property consultants Cushman & Wakefield estimated occupancy in the five star category hotels of top six cities of India in the first half of 2012 at 58 per cent.5

When cost of construction is 100% higher, room rate 40% lower and occupancy is less than 60%, the cash flow goes for a toss. The now much restricted cash flow has adverse consequences to service loans and fund future projects, which further restrict access to additional loans and private equity, a sort of cyclone spiral with ever- increasing velocity. "The economics of building properties is the key to profitability," says Timmy Khanduri of PricewaterHouseCoopers. "This is applicable to any hotel group. If you can't justify the spend on a room with the charge you are going to fix for that, that is a recipe for disaster”. Hotel Leela Venture is sitting on a debt eight times its annual revenues of 2011. "Backing such expensive properties with debt alone is a flawed formula," says a Chennai-based hospitality consultant.6

This has resulted in the company trying to sell Chennai and Goa properties to repay over Rs. Rs.5,033.81 crore in loans as on 31 March 2015. On 20 September 2015, the company announced the sale of Goa property for Rs.725 crore. It has already sold its luxury hotel, Leela Kovalam, in Kerala for Rs.500 crore and its IT Park Building in Chennai for Rs.170.17 crore. It is also looking for strategic investors to buy 24% stake in the company. At one time, it was considering selling Delhi property too but valuations were very low. Properties are the most valuable assets of a hotel chain and when you start selling prime hotel property, its time to seriously take stock and learn lessons.

It is fruitless to blame all problems on the external business environment. One has to seek causes elsewhere such as untested assumptions and fixed mindsets working to bring a successful company to such as sorry state of affairs. The authors’ contention is that it is the result of a dysfunctional corrosive behaviour pattern which sets in those who have led successful ventures in the past.

We are now operating in a VUCA business environment. It is characterized by Volatility, Uncertainty, Complexity and Ambiguity. All businesses are affected by the VUCA phenomenon irrespective of whether it is a political, an economic, a business, a natural or a social environment.

The assumptions and mindsets which lead to such poor decision making is due to our poor understanding of complex, uncertain and chaotic business ecology. The reality is that the world is a complex ecosystem where the future is unpredictable and chaotic. The companies which model themselves on mechanical systems where future is an extension of the past are doomed to failure. The mechanistic model is deeply embedded in traditional business practices because it has produced so many successes. It is rooted in successes of the Industrial Age and heavily influenced by Taylor’s scientific management to move the modern world out of a feudal agrarian state into the prosperity of industrial age.

In 1958, S&P 500 index companies survived on an average of 61 years. By 1980, this figure had dropped to 25 years and by 2011 to only 18 years. Companies fell off the index as they declined in market value, were acquired by others or were threatened by bankruptcy.

As management guru Guy Hamel says “The seeds of failure are usually sown at the heights of greatness”. Eight months prior to the filing of bankruptcy, General Motors’s then-chairman, Rick Wagoner, boasted that his company was “ready to lead for 100 years to come” —a comment that only could have been made by someone who was either naively optimistic or hopelessly delusional. GM has been getting better for a very long time—but it’s been 40 years since it was the best. 7 GM committed suicide in degrees. Success robs us of our learning capabilities and it is when the company is at the height of success, it should question its assumptions and practices. Kodak, 25 years back had 90% of marketshare in US and 60% gross margin. Today, it is bankrupt. Failure is a slow process even in a fast changing VUCA environment. This transformation can only come when we possess a learning mindset.

Success comes at a cost. We stop questioning assumptions, become complacent and start believing in our invulnerability.

According to Tim Irwin in his book Derailed8, where he charted the highs and lows of six CEOs, there are four qualities which are tied to failure:

Authenticity - Alignment between inner and outer person. What you say and what you do regarding beliefs, values and behaviour. Creating real value — enduring, meaningful, authentic value — isn't about theatre.

Self-Management - Insight, sensitivity, impulse control, optimism and persistence.

Humility - Chaneling one’s ambition into excellence in performance rather than self- promotion. One journalist reported that Carly Fiorina, the ousted CEO of HP, used the word “I” 129 times in a 30 minutes talk. She took over most of the decision-making roles at HP rendering the position of COO superfluous. No doubt, she was fired unceremoniously at Chicago Airport.

Courage - Choosing to do the right thing under difficult circumstances.

The absence of any of these characteristics can lead to failure and the chances increase as the number of these characteristics increase in an individual.

The authors of The VUCA Company took 12 companies which failed after opening of the Indian economy in the 90s, many of them due to high debt expansion, acquisitions etc. and studied the impact of these four characteristics on these companies. The conclusion was that though the people were smart, they suffered from behavioural black holes, which led to severe setbacks. Some like Vijay Mallya suffered from the absence of all four qualities.

Napoleon, took his successful warfare strategy to the Russian campaign. He received many warnings from his generals and also when the Russians refused to take a stand and fight, he should have made a strategic retreat or be satisfied with a part of the Russian territory which he had captured before winter set in. However, he slowly lost sight of the four characteristics of failure due to his spectacular 32 victories out of 35 battles prior to Russian campaign. He ended up losing his entire army in Russia which started his eventual downfall culminating in his final defeat at Waterloo and ignominious death as a prisoner.

Like Napoleon, Dr. Mallya extended his debt led acquisition model which was very successful in liquor business, to acquire unrelated businesses such as airline, Formula One racing team and IPL cricket club, all in quick succession and running all these as a CEO. At one time he had ordered over 100 aeroplanes including five dreamliners for Kingfisher Airlines. His jettisoning of top personnel in quick succession, shows that his talent pipeline was inadequate. He was given several warnings not only by his close associates but also experts in external agencies such as DGCA.

Alfred Binet, the inventor of the IQ test, said, that “It is not always the people who start out the smartest who end up the smartest.” These are people whom Carol Dweck in her book Mindset termed as those with fixed mindsets9, also sometimes called the CEO disease suffered by a majority of CEOs in our case studies, as against those with learning mindsets.

Those with fixed mindsets live in a world with fixed traits and success is about proving you’re smart or talented, validating yourself. In the other – the world of changing qualities – it’s about stretching yourself to learn something new, to develop yourself. To people with fixed mindsets, failure is a setback, showing that you are not smart or talented. In other words, failure is about not growing, not reaching for the things you value, not fulfilling your potential. When people focus on improvement rather than on whether they’re smart, they learn a lot more. Scientists are learning that people have more capacity for life-long learning and brain development than they ever thought.

Neuroscience research suggests that an assumption that what worked in the past would also work in the future, can become a major obstacle to high performance. As Steven Snyder explains in his book Leadership and the Art of Struggle, the real secret of success resides in people’s mind-set. He shows how a “fixed” mind-set that ascribes success to innate qualities is less resilient and adaptable than a “growth” mind-set that connects achievement to continuous learning and persistence.10

We should keep in mind that our brain is not our friend. Thanks to behavioural scientists like Cordelia Fine, we are learning some unflattering things about our brain. In her book A Mind Of Its Own 11, she asserts that our brain manipulates, distorts, and censors evidence to fashion a more palatable version of reality for itself. It is prone to wild irrationalities, stubbornlyclose-minded, it finds evidence for its pre-established beliefs where none exists and blinds itself to counter-evidence with the help of strategically selective powers of reason and

memory. Blinkered by self-love, it indulges in ego-inflating vanities and self-serving fictions. It short, it deludes you and success feeds this delusional behaviour.

Possibly, during early formation of human brain, when the early human was learning to live on ground and walk on two feet, he had few tools or weapons to hunt. He had only his courage. The brain boosted his ego to gather courage to hunt. This behaviour is implanted in our brain even though our days of hunter-gatherer are long gone. Our brain highlights our smallest successes and finds justification for our biggest mistakes. It is stubborn and deceitful.

However, with conscious determination, we are capable of seeing the world more accurately. Although we can never entirely cast off the brain's distortions and deceptions, we do have some means for mitigating their effects.

Coming back to Leela Ventures, hunger for growth should have been tempered with desire for maintaining a positive cash flow. The leaders should have learnt lessons from the decline of Mughal Empire which started with Shah Jahan’s extravagant building excesses such as Taj Mahal which diverted a large chuck of the kingdom’s revenue to unproductive areas, draining it of funds to keep the kingdom intact.

The high cost of construction of Delhi Leela Palace turned out to be unproductive draining cash flow. It was the result of a lack of self-discipline and control of impulsive behaviour, not lack of competency or experience in managing luxury hotels. If Leela’s leaders had paused to reflect on the four qualities mentioned above, they would have realised the folly of building a Taj Mahal and instead built a hotel where the cost could be recovered with competitive pricing and hence they would not be drowning in the financial mess they are now. Leelaventure now plans to sign contracts with hotel owners to operate their properties under the Leela brand, under so-called management contracts. At this juncture, this is the right course of action to take, as such expansion does not add to debt.

Unshakable Assumptions and beliefs are a result of a successful past. Some psychologists call it crystallized intelligence. Intelligence was once thought of as a single concept, until psychologist Raymond Cattell introduced the notions of fluid and crystallized intelligence in his research.12 The two types of intelligences are governed by separate entities within the brain and serve different functions. Crystallized intelligence is defined as the ability to use learned knowledge, skills and experience. As against this, there is fluid intelligence which is the ability to solve new problems, use logic in new situations, and identify patterns, something which young people excel at as they do not have much experience and most situations are novel.

Changes in Fluid and Crystallized Intelligence

As people grow older, they acquire more of crystallized intelligence and start losing fluid intelligence. Successful people are more prone to untested assumptions and fixed mindsets as they start believing that they have somehow discovered the formula for success. They continue to carry out strategies and practices which brought them success in the past. They don’t pause to test these assumptions and create new knowledge. A fatal error in the VUCA world. ***************************************Suhayl Abidi is a practitioner in Organisational Learning and Knowledge Management with over 25 years of corporate experience including Reliance Industries, Essar and Piramal Group. He has co-authored one book “The VUCA Company” and several articles in Indian business media.

Dr. Manoj Joshi is Professor of Strategy, Entrepreneurship and Innovation at Amity Business School, Lucknow. He is a PhD in business strategy and co-author of The VUCA Company. He has published a large number of articles in Indian and foreign management journals. He is also on the Editorial Board of several international peer reviewed journals including International Journal of Entrepreneurship and Innovation, IP Publishing, Journal of Family Business Management, Emerald, International Journal of Strategic Business Alliances.

References1. Cash is King. Cash is Blood Supply: Ram Charan, Forbes,15 January 20142. India’s Most Expensive Hotels, Wall Street Journal, 22 April 20113. Rs 1600cr hotel to open in city, Times of India,15 Sep 2010 4. www.agoda.com accessed on 16 Sep 20155. After economic slowdown, Delhi hotels hit hard as room occupancy drops by up to 15

per cent, India Today, 10 March 20136. Why Captain Nair, chief of Leela Hotels, is so confident about his future, Economic

Times,20 May 20127. Hamel,Gary:Why companies fail? Wall Street Journal,8 June 20098. Irwin,Tim: Derailed, Thomas Nelson,20099. Dweck, Carol: Mindset, 10. Snyder,Steve: Leadership and the Art of Struggle, Barrett-Koehler Publishers, 201211. Fine,Cordelia: A Mind Of Its Own, Icon Books, 2005

12. The Difference Between Fluid Intelligence and Crystallized Intelligence, http://examinedexistence.com