Two mutual funds have shocked investors in their fixed maturity plans (FMPs).
HDFC Assent Management Company (AMC) has asked investors if they will agree to roll over the redemption date by a year. Kotak AMC has paid lower than expected returns in two funds, and returned lower than principal amount for a third fund, promising, in all cases, that more will be paid when the Essel Group settles the loans taken against shares. A strong statement from Essel Group reassures that all these funds will be able to honour their commitments, sooner rather than later.
But this is not the only case of loans given by mutual funds to promoters against shares. Rating agencies have rated about Rs 40,000 crore worth of debentures backed by promoter shares, and most of these are sitting in one debt fund or the other. So, the question we need to ask is whether mutual funds should be giving loans against shares, at all. Here are several good reasons why they shouldn’t.
Traditionally loans were given against shares ( not promoter shares) by NBFCs on a 2x basis. That is, NBFC gave Rs 100 loan against Rs 200 collateral of shares, and the borrower had to bring in more shares, whenever the market value of the collateral shares dropped.
Mutual funds need to be more careful since they are custodians of small investors. They must hunt for the realisable value from the shares. The method employed usually is to look at the historical movement of the collateral shares over a period of, say 2-3 years , take the average price and take 2x of shares at that value as collateral. Some mutual funds probably did that. The rating agency probably also followed the same math and gave the loan instrument a AA or AAA rating.
But that is clearly inadequate. The MF has to take into account the liquidity of the stock and the impact cost of his selling. If the share concerned is, say Infosys, in which the daily volume is one crore shares, the time needed to sell one lakh share is a day, and the impact on the price is minimal. But, if the share is illiquid, the MF may have to sell over several days. This may well mean even lower realisable value, since the share would fall under the weight of its own selling. Sometimes, even for a liquid share like, say, Reliance Power, the impact of selling could be significant as buyers are scarce for infra stocks. Hence, funds would have been well advised to take a 3x cover.
Again, mutual funds are by nature transparent entities. As word gets around that a fund is selling, the price and, hence the realisable value, will fall further. But the worst is when word gets around that pledged shares of a promoter are getting sold. Everyone knows that the impact on the price is outsized and, hence, the mutual fund should factor in a further cover of, say, 4x.
Even that may be inadequate, if over 50 percent of the shares are pledged. Because other holders of pledged shares will also be rushing to sell, increasing the impact cost even more. Hence, for a loan against share instrument, the fund is safe only if it takes a 4x cover, and also a commitment from the promoter that no further shares will be pledged.
Most mutual funds will probably scoff at this argument as totally out of sync with the market. But funds need to remember they were under no compulsion to accept money if they can’t find quality paper to invest. Haven’t several equity funds stopped accepting fresh funds in the past on the argument that quality shares at fair value are not available? Logically, in 2017 and 2018, when money rushed from bank deposits to debt mutual funds, fund managers instead of being greedy and using that money to give loans to promoters under dubious structures backed by promoter shares, should have refused funds from small investors. Instead they went on a binge with
sahi hai advertisements and invested in instruments that weren’t sahi at all.
In fact, I would venture to say mutual funds, because they get funds at zero cost, have actually spoilt the loans-against-shares market by their recklessness, and driven the more savvy NBFCs out of this market.
NBFCs raise money at a cost and, hence, historically gave loans against shares sparingly. They also strictly implemented the 2x cover by demanding more share cover when prices fell. When mutual funds entered the business they could underprice their risk because of the zero cost of their capital. Recklessness increased as the funds came in gushing and the search for yield got frantic. One learns from the grapevine that some funds have loaned to promoters at far less than 2x. Which brings me to the third point.
Mutual funds are not in the business of loaning. They are in the business of investing. That is, they may invest in the debentures of an Emami Ltd or a IRB Infrastructure after making sure these companies have the cash flows to pay the dividend and principal.
But when a mutual fund gives loans to an Emami or an ADAG (Anil Dhurubhai Ambani Group) against promoter shares, the fund can’t just rest content with valuation of the collateral and the realisable value. It needs to know where its cash is being deployed by the borrowing promoter. In several instances, the promoters were borrowing to bridge a liquidity crunch in an infrastructure project.
Giving them money is tantamount to giving a project loan, whose due diligence and cash flows assessment, the mutual fund is incapable of doing. Indeed by mid-2018, many fund managers were becoming aware of the folly of funding promoter entities. Their worst fears have come true in 2019.
These rules as well apply to the rating agency, which is rating a loan-against-share instrument. It is amazing that rating agencies have given and are continuing to give high ratings to debentures floated by promoter entities that have nil cash flows, and which are only supported by the collateral, and highly inadequate collateral at that. Here again, the rating agencies seem to have not taken into account the impact cost of selling promoter shares in a milieu of high transparency.
Whichever way one looks at it, mutual funds and rating agencies have goofed up seriously on this product. The only good from all this is that debt fund investors have learnt the importance of the tiny legend inscribed at the end of the form: Mutual Funds are subject to market risk. Some investors have also learnt the value of the good old bank deposit.
Market regulator Sebi needs to write strong rules for both funds and rating agencies with respect to promoter loans. Banning the product altogether for mutual funds may be a good idea. For the recklessness already indulged in, may be some penalties are in order.