A file photograph of a person holding paper work. (Photographer: Krisztian Bocsi/Bloomberg)

Anil Ambani To Subhash Chandra — Promoter Debt Risk Ignored By Some Rating Agencies?

In late January, a surprising bit of news emerged from India’s mutual fund industry. Some of the country’s most prominent mutual funds reached a ‘stand-still’ agreement with the Subhash Chandra-promoted Essel Group, which meant they would not sell shares of group companies pledged with them.

Mutual funds had invested in bonds issued by the group’s promoter entities, backed by equity shares of listed group companies in the form of collateral. The terms of the bond said that if the equity-cover falls below a certain level due to a fall in the share price, mutual funds could either demand a ‘top up’ of equity or sell the shares they already held.

But the funds decided to do neither. They realised that a sudden sale of shares would only hurt investors more and the promoter was either not willing or able to give fresh equity immediately. And so they agreed to a ‘stand-still’ for a period of time.

A one-off peculiar case? Maybe not.

Within a month, another such instance came to light with mutual funds supposedly agreeing to a ‘stand-still’ with promoter companies of the Anil Ambani group.

The two instances have highlighted the risk in equity-backed-bonds issued by a number of promoter groups in recent years. This category of instruments is separate from loan-against-shares given by banks and non-banks.

The quantum of outstanding equity-backed-bonds, which are rated and listed, is estimated at a little over Rs 40,000 crore, according to market participants and rating agency officials. BloombergQuint validated these estimates through rating filings.

Who Rated These Instruments?

A break-up of such bonds issued and outstanding shows that they are rated almost entirely by two rating agencies — Brickworks Ratings India Pvt. Ltd. and Infomerics Valuation and Rating Pvt. Ltd.

Together, Brickworks and Infomerics have rated 95.6 percent of these structures.

According to Brickwork’s own estimates, it has rated around Rs 30,000 crore worth of listed debt instruments that are backed by pledged shares. The agency, however, estimates that it has a market share of about 50 percent in this segment.

Infomerics did not respond to queries sent by BloombergQuint.

Over 75 percent of such issues were rated above ‘BBB’, with a majority of ratings concentrated in the A and AA categories. Such a rating profile allowed for these instruments to find their way into the debt portfolios of mutual funds who were looking to expand their investments into corporate debt.

Also read: Credit Ratings: Need For New Regulation Or Tighter Supervision?

How These Structures Were Rated?

The question being raised, in the aftermath of the recent incidents, is whether these rating agencies managed to capture the risk in instruments backed intrinsically volatile equity shares.

How do you even begin to rate them?

These instruments are fundamentally ‘un-rateable’, said Amit Tandon, co-founder and managing director of proxy advisory firm Institutional Investor Advisory Services (IiAS).

“Some of the most stable stocks have a 20 percent variation between high and low, while for others it is higher, so how do credit rating agencies factor this? What this means is an equity cover of about 1.5 times is not good enough,” said Tandon while adding that a number of rating agencies have stayed away from rating such structures because of these concerns.

In response to a BloombergQuint query, Brickworks explained that the rating is based on the following parameters:

  • Rating of the underlying company whose shares have been pledged
  • Size of the security cover
  • Volatility of the stock
  • Cushion of shares with the promoter which is expected at around 40 percent

The final rating of these structured obligations is capped at the credit rating of the underlying company whose shares are pledged, regardless of the size of the cover given, explained Brickworks.

As a part of our regular criteria review, we evaluate all the factors that drive the rating of share pledge transactions and decide if any changes are required. We also look for better availability of data and adequate disclosures on the value of promoter pledged shares and shares that have a lien or other encumbrances.
Brickworks Ratings

However, judging the extent of promoter pledged shares isn’t always easy.

A senior rating executive, who spoke on condition of anonymity, said that there is a masking of the true extent of pledged shares in some cases, which is misleading rating agencies and investors.

This executive explained that some debt securities are backed by corporate guarantees. This corporate guarantee, in turn, is secured through pledged shares by the promoter. As part of the terms, the company gives a “no disposal undertaking” to the lenders and the promoters continue to disclose shareholding as un-pledged in their public. This ‘camouflaged’ way of raising debt, without an explicit pledge of shares is misleading for market participants, said this executive.

Even if the rating agencies did correctly rate these instruments, the timeliness with which ratings have responsed to recent incidents is questionable.

For instance, in the Essel Group case, the rating agencies failed to capture the rising debt levels across the group. Brickworks only downgraded ratings of various promoter entities by one notch on Feb.18, well after the standstill agreement had revealed vulnerability in the group. Explaining the downgrade of one of these entities, the rating agency said that it took into account the pledge levels of promoter shares and the volatility in the share price.

Even after these downgrades, the entities are rated between BBB and AA-.

Also read: Are Essel Group’s Mutual Fund And NBFC Lenders Living In Denial?

Mutual Funds: Victims Or Accomplice?

While rating agencies like Brickworks and Infomerics may have failed to rate these structures appropriately, questions must also be asked of mutual fund managers who overlooked possible risks to their investors.

Mutual funds want a good rating for these instruments because they are investing in them, said another senior rating executive who spoke on condition of anonymity. This person added that mutual funds have earned an additional 50-60 basis points on these investment compared to regular debt investments.

There are other issues too.

Typically, for a Rs 100 crore NCD issuance, the usual standard for the security cover is at 1.5-2x, which means that upto Rs 200 crore for with promoter shares will be ‘pledged’ to lenders and investors. In case of a default, the lenders and investors can off-load these pledged shares and recover their dues.

Another senior executive at a rating agency, who spoke on condition of anonymity, said this kind of equity cover may not prove to be enough of a buffer for mutual funds. This executive drew a comparison with loans-against-shares offered by banks and non-bank lenders. Apart from retaining an equity cover, lenders also have a capital cushion that they maintain. Mutual funds have none of this, which means a direct hit to investors should something go wrong.

The problem for mutual funds occurs when there is a “virtuous cycle of a free-fall in share prices which sends every fund into a huddle. If stock prices fell any further, they would be left without a cover,” said Dhirendra Kumar, chief executive officer of Value Research. But he added that mutual funds have made only small losses due to their exposure to the companies in question as compared to their overall fund size. The new side-pocketing facility can also help them account for losses in a more efficient manner.

Tandon, however, sees a broader risk in the willingness of rating agencies to rate such structures and mutual funds to invest in them. The issue is that promoters are encouraged to do more of these transactions by pledging shares and raising debt, which is highly risky, he said.