In the last article I had wrote, I had promised the next article on a different subject. Apologies if I disappointed anyone, but digressing for an article to discuss a key development which as usual, the mainstream media (even business) seems to have missed.

A couple of weeks back, there was a brief snippet on CNBC TV18 about the Reserve Bank of India (RBI) treating Compulsorily Convertible Preference Shares (CCPS) with fixed exit prices as debt. (I don’t know if this is correct or not; I have not been able to locate a RBI notification or a circular to that effect; in case anybody has seen one, please pass it on). Yesterday, the RBI prevented DE Shaw from selling its stake held through CCPS in DLF Assets Limited (DAL) through the exercise of a put option at a fixed return of 27%. Surprisingly, there haven’t been a lot of discussions on this. Surprising for the following reason; for the first time, there has been an attempt to define debt and equity in terms of economics rather than accounting; which in my opinion is an important distinction.

Why would the RBI consider banning CCPS with fixed exit prices? A CCPS is a share which carries a specified dividend and which is compulsorily convertible, i.e. it converts into normal equity at a particular price generally at the option of the holder.  A fixed exit price allows the holder of the CCPS to sell his shares at a predetermined price or a predetermined return on investment. The RBI is essentially making the point that a fixed exit price instrument is in the nature of debt and should be treated as such even if it is classified explicitly as equity.

Before you label the RBI as draconian and anti-investor trying to sabotage a well-deserved economic recovery, think again. It just might have a brilliant point to make. Most people would consider debt and equity as two diammetrically opposite concepts and therefore easy to distinguish making this debate about the nature of debt and equity a rather esoteric one. I want to try and understand the fundamental difference between the two and illustrate why our tendency to try to be too precise can make us overlook the true character of things.

So, what is equity? How is it different from debt? The only fundamental difference, according to me, lies in the extent of risk taken. A debt holder is contractually guaranteed recovery of amount invested (principal) whereas the equity holder takes the risk of losing part/all of his investment (Well, there is risk of default for debt as well, but the risk intrinsic in debt would always be lower than equity and the debt holder has rights over assets of the defaulter as well). In order to compensate for this risk (which is lower than equity) and the time value of money (due to inflation), a debt holder gets compensated through what is called “interest”. What about the equity holder? He gets a right over the possible increase in value of his investment and this increase theoretically has no limit. Therefore, an equity holder has a much higher upside. And why does an equity holder have a claim over this upside? Because he exhibits a willingness to take the risk of losing all of his investment.

This distinction is at the heart of the difference between debt and equity. Everything else is semantics.

The origins of this distinction lie in the Knightian concept of uncertainty as opposed to risk. There is always a possibility/ chance that a specified event(s) might not occur as desired/ expected. The deviation(s) can occur due to a variety of reasons – some of these can be isolated, quantified and even predicted with reasonable accuracy. The loss due to the occurence of such deviations can often be diversified. These are in the nature of “Risk”. On the other hand, deviations might occur due to entirely unpredictable reasons or reasons which are intrinsic to the nature of the transaction causing losses which cannot be avoided and therefore diversified. Such deviations are a result of (and the cause of)  “Uncertainty”.

Think about an employee versus an entrepreneur who employs him. What “risk”  is the employee taking? Essentially, the possibility of the entrepreneur not compensating the employee for his efforts. Can the causes of these event be ennumerated? Yes; due to malafide intent or the business not doing well etc. Can this risk be diversified or avoided? Of course; the employee is after all guaranteed legal protection of his right to be compensated (which greatly minimizes the risk), he can take unemployment insurance (for the eventuality of losing his job) etc. The risk cannot be eliminated , but is reasonably minimized. Now, think about the entrepreneur. What is his risk? The possibility that the business does not do well. This is a possibility that is intrinsic to the very idea of doing business and this risk cannot be diversified.  Nobody but the entrepreneur himself can take the risk of consumers not buying the product/service provided by the entrepreneur. This is Uncertainty.

This is also the reason why the employee earns a “wage” and the entrepreneur a”profit”.

The RBI therefore philosophically has a very valid point to make. If the investor is guaranteed (in whatever form) a fixed return, then the investment is in the nature of debt. Period.

This brings us to the question of why would such a confusion arise in the first place? One can only speculate. My theory is the following:

• Over the last decade or so, the belief of investors and analysts that they could predict and model everything reached astounding proportions. (This has been beaten to death by all researchers and commentators while discussing the subprime crisis and therefore, I won’t elaborate)
• This belief led one to the conclusion that if one makes an accurate enough model, all risks can be wished/diversified away.
• What happens when all risks are diversified? One gets a “guaranteed” return. Now, if you are a private equity investor with the capacity (perceived) to analyze everything, then you are destined to get a guaranteed return and therefore, you start demanding it.
• How do you do this? By entering into contracts with put-call options containing instruments like preference shares with fixed exit prices, or by drafting contracts that give you all the benefits of the upside (after all, no model ever puts a cap on the upside!) and at the same time guaranteeing you a base return.

Such behavioral biases are not only mis-guided, these are even counterproductive. If you draft blatantly one-sided contracts, you can be sure they’ll not be honored. If you draft contracts that give you all the rewards of ownership while giving somebody else the risks, I am willing to bet that person will walk away and leave you in the lurch (remember Subhiksha). There is also an adverse selection problem here; the only counterparties willing to enter such contracts might be struggling, desperate for funds businesses or promoters with questionable motives.  And the presence of such businesses might be a serious systemic risk.

Removing this veil over debt has other significance. Once, these investments get classified as debt, they’ll be treated as External Commercial Borrowings (ECB) and be subject to end-use and other restrictions. One can debate the effects of having a whole ton of instruments reclassified as debt, but the logic behind the reclassification should not be brushed aside.

All that the RBI is saying is this: If something looks, feels, smells and tastes like debt, it probably is!

(I’ll continue the series on reforms by writing about financial sector reforms next and run a couple of articles on the Union Budget in India in the coming week.)

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