The Securities and Exchange Board of India does not seem to have understood the enormity of what funds have been up to.
If Sebi does not crack down on mutual funds using cooked-up credit ratings to hide behind promoter funding, this is bound to grow into a systemic menace, says Debashis Basu.
Illustration: Uttam Ghosh/Rediff.com
A few days ago, Aditya Birla Mutual Fund posted a message on its website about the Essel group, including Zee, gushing and extolling their brilliance as stock research reports generally do.
“Zee is amongst the largest producers of Hindi programming in the world … library of 100,000 hours of content, reach of 670 million viewers … group is also vertically integrated, from program production, to broadcast to distribution.
"The Essel Group also has … a portfolio of roads, solar, transmission and waste management projects…”
The reason for the praise was that this fund house and many others were in a tight spot.
They had lent money to an unlisted company, Essel Infrastructure, against the pledge of listed and unlisted shares of Zee/Essel promoters, and also against the cash flows of two road projects.
Now, the Zee/Essel promoter was running short of cash.
In late January, shares of every Zee/Essel group company swooned.
Notwithstanding the effusive characterisation above, by a fund house that should have known better, Zee/Essel was about to default.
This set off a panic among dozens of other fund managers who were either holding these stocks or had lent money.
They formed a “committee of lenders” and agreed not to sell the shares of Zee/Essel group although there was no additional collateral forthcoming.
Funds (with an exposure of Rs 8,000 crore to Zee/Essel) argued that they acted in the best interests of their investors.
Actually, all their actions and investment decisions are highly irresponsible.
Here is another example. I had first exposed in Moneylife, how Wadhawan Global Capital (WGCL), the personal holding company of the promoters of Dewan Housing and Finance Ltd, raised Rs 2,125 crore through zero-coupon bonds from Aditya Birla Mutual Fund and Franklin Templeton Mutual Fund.
Franklin had also lent money to Rana Kapoor’s holding company, YES Capital, which holds 3.27 per cent of Kapoor’s YES Bank stake, again through zero-coupon bonds.
IDBI Mutual Fund even put this highly risky product in its liquid fund, while Franklin India Debt Fund has put 8.27 per cent of its assets in these bonds.
These transactions are even more scandalous than the Zee/Essel one.
Mutual funds are holding the fig-leaf of the debt paper of the holding company with no other assets.
They do not even have recourse to the promoters’ shares -- the only asset of the holding company -- because these are not pledged to the mutual funds!
What’s wrong with these investments?
In Zee/Essel, Dewan and YES Bank and many others, debt funds have acted as reckless lenders and not prudent investors.
Clearly, debt funds are run at a very fundamental level.
Anyone with a basic knowledge of financial markets would know the basic difference between banks and debt funds.
Banks are lenders. Debt mutual funds are investors. Their functions and skillsets are different.
Good lenders have to do two things.
One, make an assessment of the future of the business that they are lending to, but also its promoters, based on their track record of responsible behaviour.
Two, they are supposed to secure themselves by ensuring a specific collateral against the money lent.
Lenders have no easy exit from a business that goes bad. Rarely can they fully encash the asset against which money was lent.
The lending business usually has a very small upside potential (regular interest income) and a large downside potential (principal not coming back).
So, accurate risk assessment is the main objective and key result area for lenders.
Debt funds usually do not lend money to borrowers directly against collateral.
They are not skilled to do so. They buy debt paper as investment.
This money rarely flows into the coffers of the issuer (borrower); debt funds buy debt paper from other investors usually.
This makes them (secondary) investors, not (primary) lenders.
As investors, debt funds are not playing for interest income alone; they are also looking for capital gains.
An overwhelming proportion of gains made by mutual funds comes from capital gains arising from falling interest rates.
When interest rates are rising, bond funds make very little money.
In effect, they are not supposed to be stuck with borrowers like lenders; they can sell their debt paper at a loss and walk away.
The most crucial difference, however, is their fiduciary role.
Debt funds pool the money of tens of thousands of investors and act on their behalf.
These investors have trusted the funds with their money to make investment decisions of high quality, not to use dubious means to offer unsecured loans to promoters for risky projects.
In the bull market that followed demonetisation, the coffers of mutual funds were overflowing, when investors were lured with a campaign 'Mutual funds sahi hain'.
But while the investments of equity funds are fairly transparent, debt funds had a lot of leeway to hide their more irregular investments from the eyes of the regulator, fund analysts and retail investors.
They decided to become lenders without the legal backing to secure themselves, or the skillset to assess lending risk.
At the time of writing this piece, the Securities and Exchange Board of India (SEBI) does not seem to have understood the enormity of what funds have been up to.
If Sebi does not crack down on mutual funds using cooked-up credit ratings to hide behind promoter funding, this is bound to grow into a systemic menace.
We don’t know how widespread it is even today.
The least Sebi should do is to punish rating agencies and fund companies involved in such lending by barring them from accepting new business for one year.
It can make this a direct punishment or “advise” them to voluntarily punish themselves.
Debashis Basu is the editor of www.moneylife.in