The return of risk capital

As the Indian economy slowly emerges from the havoc of the Covid-induced lockdown, the magnitude of damage and the channels through which it has been sustained by the economy, merit greater examination. While liquidity and cash flow have been the right buzzwords for describing the immediate impact of the lockdown, the true economic impact of Covid is likely to be deeper and more worrisome.

A lockdown does not just impact the cash flows but has a cascading economic impact on the balance sheet, cost structure and incentives for capital formation as well. Government measures to alleviate liquidity distress may help in the short run but, in the absence of focused attempts to repair balance sheets and stimulate risk appetite, those will merely work as a palliative. This is because a lockdown is not merely a cash flow shock. What a lockdown does is that it forces the equity holders of a firm to pay fixed costs of a business with zero revenues thereby eroding equity in a firm. This balancesheet impact of a lockdown has major implications for the capital formation process. 

While the lost cash flows can be substituted by debt (which is now available), it does not change the fact that the equity holders have impaired their capital and the firm is now more leveraged than it was before. The shock of capital loss combined with greater leverage is going to make firms more risk averse as the top priority of equity holders will now be to recover lost capital, repair the balance sheet and bring back the debt-equity ratio to more sustainable levels. 
 

Thus new investment will suffer. Such equity holders will now demand higher IRRs for potential investment projects, thereby forgoing several projects that they would have viably funded before the crisis. Therefore even if firms are able to survive the crisis with liquidity support, fresh investments will be dramatically reduced leading to much subdued capital formation in the economy.

Another channel through which the lockdown is likely to hurt capital formation is the change in a firm’s cost structure in a post-Covid economy. Unless a vaccine is discovered and the whole population quickly inoculated (or the virus mutates to a benign form) most businesses will have to operate with safeguards against the spread of virus in their premises. Instances of limited outbreaks in factories and offices are also likely to happen, leading to production disruptions. These factors will inflate the cost structure of the firm forcing it to look for larger returns in order to offset these costs. Additionally, investors may now demand a “pandemic risk premium”, again inflating the cost of capital and forcing firms to forego projects that would have been viable prior to the crisis.

Therefore, one of the more worrying aspects of the crisis is its impact on the capital formation process. Under the standard assumption that the GDP is the sum of government expenditure, investment, consumption and net exports, a shock to investments will have a serious impact on the GDP — especially given that the stimulus has so far focused on liquidity and not government expenditure (unlike many developed countries). The lack of risk appetite and unwillingness to invest is also going to hobble the Atmanirbhar Bharat programme as firms focus on repairing their balance sheet instead of investing to substitute imports.

In light of these factors, the need of the hour is not just to provide liquidity but also boost IRRs of firms in order to incentivise risk taking and investment. 
 

Here the government can take several direct and indirect measures to boost returns on investment and help firms deal with the inflated cost structure of the post-Covid economy. While blanket tax exemptions have been found to be counterproductive by economists, investment tax credits are an effective tool to promote capital formation in an economy which is far from full employment (Auerbach and Summers, NBER). Accelerated depreciation benefits on new investments can also boost IRRs without distorting the capital allocation process. Among the indirect measures for augmenting returns, a stronger focus on reducing compliance costs and reduction of contracting and legal friction are paramount.

The impact of Covid on the capital formation process cannot be understated. The crisis has wide ranging ramifications on the investment appetite of firms which is likely to be heavily depressed as the economy slowly reopens. The key will be restoring the animal spirits of entrepreneurs and boost incentives for taking risk. Luckily as the recent investments in Reliance Jio and a successful subsequent rights issue in the middle of this pandemic show, capital will always be available if returns are high enough to justify the risk.

The author is a “probabilist” who researches and writes on behavioural finance and economics.