The Importance Of Associates

There are several reasons for setting up associate companies and subsidiaries. One long-time purpose has been to serve as a conduit for siphoning off group funds by the family. Creating subsidiaries or associates also helps keep up appearances in the parent's balance sheet. The proliferation of associate finance companies, for instance, allows the main company to show a good receivables position, while shifting the burden of collecting them to the finance company. It allows companies flexibility in dividends, since the subsidiary is under no compulsion to pay dividends, while the parent company will have to make its usual pay-out to keep shareholders happy.

 

There are other, more honest reasons. With globalisation, Indian companies have been exposed to the chill winds of competition from companies which are world leaders in their own fields, and which have considerable economies of scale. If Indian companies have to compete, they too will have to focus on core competences.

Some companies, for example Bilt and Ceat, have divested themselves of non-core businesses in the recent past. Others have been loath to let go completely, preferring instead to transfer these products to subsidiaries, tie up with world leaders, and seek to reap the benefits. Yet others have, rather desperately, sold their brands, while keeping their manufacturing facilities. Take Lakme, or Nocil selling off Teepol to Reckitt & Colman, or Duke's selling off its brands to Pepsi. Some companies have started new companies for software and finance, where the wage structure is much higher than in the parent company. When SBI took over BCCI's Mumbai branch, it formed a separate company for the purpose, with salaries much higher than in the parent bank.

This kind of restructuring can result in significant efficiencies for the corporate group. The associate companies can access technology as well as finance from their foreign collaborators. Some foreign corporates are wary of losing control, and a joint venture with a 51 per cent stake is often a pre-requisite for parting with both technology as well as funds. Associates can raise money without the necessity of diluting equity in the main company. Diverting money from cash-rich group companies to associates which are not doing too well results in the associates getting cash cheap. Restructuring could become an excuse for modernisation and rationalisation, and an opportunity for pruning a bloated workforce.

These advantages outweigh the debits. On the debit side, creating subsidiaries may result in double taxation (offset, however, by Section 80M benefits). If the parent has excess depreciation, the subsidiary cannot use its parent's tax shield.

But what is good for the group need not be good for the shareholder in the parent company. The shareholder has no ready access to the balance sheet of an associate company. More importantly, when a division is hived off, the shareholder's immediate benefit is reduced to the dividend paid by the subsidiary or the associate to the parent. Note that had the division not been spun off, its entire profits would have been available to shareholders for distribution. The shareholder also loses control, since the subsidiary or associate is not answerable to himfor what it does with its money. The shareholder could however be given sops in the form of preferential allotments in group companies, but that is unlikely if it is a foreign joint venture. The crux of the matter is that while the shareholders' money is used, the returns need not necessarily accrue to them.

It has been argued that a company should stick to its core competence, and portfolio diversification is to be done by the individual shareholder, rather than the company. If I invest in a cement company, for example, I have chosen to invest because I am convinced about that company's skills in manufacturing cement, and because I want an exposure to the cement industry. If the company now diversifies into say, glass manufacture, that may not suit me, since I am not bullish about the prospects of glass. Even if I do want to invest in glass, there may be better bargains in the market. In terms of this theory, all surpluses, other than needed for expansion in a company's core business, should be returned to the shareholder.

The problem with such a theory is that it places the shareholder at the centre of the wealth creation process, rather than the entrepreneur. The aim of the shareholder is to maximise earnings in the short run, as that determines earnings per share, and consequently the price of the scrip. Higher payouts are also welcomed by shareholders. In contrast, projects with long gestation periods may be looked at askance. It is frequently necessary, while launching new products, to keep profits in abeyance while market share is increased. The market has often been accused of having a short-term outlook, particularly when the performance of fund managers are monitored very closely and they are under pressure to maximise short-term gains.

Under Indian conditions, when the lack of volumes in several scrips causes stock market prices frequently to diverge from the fundamentals, putting returns to the shareholder as the goal may not be optimum for growth. Countries such as Japan and South Korea have not