Jumping to conclusions

Use restraint when applying the limited amount of company data out there to draw conclusions about Dutch corporate health.

Today’s front page article in the FD contains some conclusions that are quite remarkable to say the least.

Bankruptcy as a panacea?

The article starts out with the bold statement that bankruptcies would actually benefit the economy by freeing up human resources that would otherwise not be available to other companies. That is a peculiar assumption as it would seem to suggest that a company that goes bankrupt could not have been adding value to the state of the economy, neglecting to address the actual cause of a bankruptcy in the process.

The article continues by stating that the number of bankruptcies currently is still at a historical low, furthermore adding that this number is not expected to go up substantially in the short term. COVID related government support is referenced as the cause, the aid having had a positive effect on companies’ health. As an indicator for enterprise health the article furthermore refers to the fact that risk ratings (measure for the risk of bankruptcy) in general actually seem to have improved.

This conclusion feels somewhat awkward.

First, what is being suggested? Are bankruptcies actually a blessing in disguise for labor mobility or not? Or is the implicit message that the number of bankruptcies is artificially low due to government support and therefore any aid is to be ceased in order for companies to die from a “natural” cause?

Lack of (reliable) company data

Secondly, the reliance on the improved risk ratings in determining the health of companies begs the question, what information are these risk ratings actually based upon? Reliable company data is scarce and has been for some time. Particularly in relation to small enterprises (the vast majority of SMEs in The Netherlands), data is often outdated, lacking detail and has not been audited. Hence, particular caution is required when interpreting ratings that use such a limited data source as input. In other words, a risk rating in itself is not exactly the sharpest tool in the shed when it comes to determining corporate health.

As mentioned before, this is not a new phenomena. A call to action has been instigated on several instances. Earlier this year a recommendation was made to the Dutch Ministry of Economics and Climate (EZK) for setting up a SME credit register, in order to develop the granularity and the quality of company data, serving to improve the reliability of the risk ratings as a result. Lawmakers would do well to pick up this gauntlet if serious about improving conditions for SME finance in The Netherlands.

Funding gap

SME finance capability (or lack thereof) is actually one of the most relevant and worrying indicators in predicting future bankruptcies or voluntary closures.

The problem is that due to the retreat of traditional credit providers, ever since the last crisis, SMEs have not been presented with alternatives that can meet their demand for growth capital. Solid enterprises have been capable of staying afloat during the last crisis and the pandemic, however with flat or ever decreasing financial margins.

Without a genuine effort to shore up finance capacity for SMEs, to bridge the gap that is currently out there, the number of bankruptcies can indeed be expected to rise over time. Hopefully there will be plenty of enterprises left to employ all available staff.

The article would be correct in stating that due to a combination of corporate resilience and government support, companies in general are more or less in the same position as before the pandemic. However, that was really not such a good starting point to begin with.

Too many hats

Banks can play a vital role in post-pandemic recovery……in their capacity as creditors.

An article in today’s FD caught my attention: “Banken willen belang nemen in worstelende bedrijven” (Banks are looking to  invest in equity of companies that are struggling).

In short, banks are in talks with the Ministry of Finance and Economic Affairs and are contemplating the establishment of a “recovery fund” that is capable of boosting SME solvency. Moreover institutional, governmental as well as retail resources are being considered to join the effort.

The term “recovery fund” sounds very promising indeed, a much needed helping hand in these incredibly challenging times for entrepreneurs.

However, what is surprising is that this fund would a) solely cater for equity investment, b) focus on larger SMEs and c) select only those enterprises that have a bright future ahead, once the pandemic has subsided.

Although there is nothing wrong with depicting viable businesses, the approach by the banks raises a couple of serious questions.

A number of things to unpack here:

Conflicting roles

The most important aspect is the potential for a conflict of interest. The role of a creditor differs vastly from that of a shareholder, in terms of control, governance, risk & reward and accountability, to name but a few items. A single person or organisation is hardly capable of managing both roles, switching hats continuously in the process. Even having these assets managed at arms length is a considerable challenge for any bank. Trying to manage both roles nonetheless carries the risk of an opportunistic approach (not to be confused with opportunity risk). Potential investors should be very much aware of this. After all, equity investors, shareholders, commonly take the first hit if things turn out differently than expected. For instance, when viable businesses turn out not to be so viable after all.

Viable business – in or out?

In the article, risk assessment is being praised (by the banks) as being one of the virtues of bank involvement. The message, banks are perfectly capable of selecting viable businesses to invest in. That raises a couple of questions as well.

First, if banks are indeed eminently suitable for picking the winners, wouldn’t they have done so already? After all, why would there be a need for a selection, if the risk assessment has been right so far?

Secondly, how does one select viable business cases? A recent publication by the IMF that also explored the possibilities of solvency support, explicitly mentioned the challenge of making a meaningful selection, stating that banks and investors would have difficulty in identifying “viable firms under high uncertainty”.  It would be interesting to learn how the initiating banks have resolved this challenge and what eligibility criteria they will be looking to apply.

Sizing up

The intention is to focus on larger enterprises, given the importance of their contribution to employment. That is admirable. However, the majority of enterprises does not fall into this category. The question is, if employment is such an important consideration, then why are smaller enterprises not being considered?

Banking on “capacity”

A genuine effort for recovery is worthy of praise. More importantly, banks can play a tremendously vital role in such an effort, in their capacity as  creditors. This can be achieved by means of debt relief, debt restructuring and business support in the short term. Going forward, banks should be working alongside institutional investment in developing risk assessments and providing SMEs (small and large) access to finance.  This will help develop a healthy, innovative and diverse entrepreneurial landscape, that can make a sustainable contribution to employment.

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