Financial “WMDs” And Mutual Funds’ “Agnipariksha” - With Nilesh Shah, Anil Singhvi

In the past few months financial markets have had to come to terms with three risks – two new ones and one that's plagued markets in the past as well.The standstills arrived at by the promoters of the Zee Group and the Reliance ADA Group have exposed problems with instruments backed by promoter equity, the risk that mutual funds have taken on when investing in these instruments and age-old issue of promoter pledged shares.BloombergQuint's Ira Dugal and Menaka Doshi discuss the issue with Anil Singhvi, founder of governance advisory firm IiAS and Nilesh Shah, managing director at Kotak Mahindra Asset Management..Watch the full discussion here.Edited excerpts from the discussion..These standstill agreements are perturbing. This is not to suggest MFs should start selling Essel Group company shares but to give up the right to sell seems to be against the interest of MFs and their depositors.Anil SInghvi: I couldn’t agree more. The genesis of this started with IL&FS. In that case the MF industry may not be impacted regarding collateral shares. But the government/NCLT allowing a moratorium for months. It is not even declared an NPA. Matters are going in the direction where even if you are at default then also the borrower is still protected. It is a very wrong practice. We started with IL&FS. Then with Essel and then with Mr Anil Ambani. I don’t know when it will stop, if you have these kind of borrowers and lenders. I would have understood if one bank has lent money to them. But here it is the mutual fund industry and whose money are they managing? They are fiduciaries, trustees (of public money)..The mutual fund industry did not put out any official statements on either standstill. Subhash Chandra issued a statement. Anil Ambani’s company issued a comment. But the mutual fund industry has not gone on record on any of these issues. Unofficially, they say aren’t we doing what is best interest of the investors because standstill has helped shares of these companies recover and that is what MF investors want.Anil Singhvi: Did they have mandate from the investors that should the borrower run into trouble that you would reach this (agreement) and that even if the borrower defaults you will not sell the shares? According to me, they have exceeded (failed) their mandate as a trustee and fiduciary. The collateral is taken (so that) when there is default, to realise it and pay. Then they don’t have to sit in judgement. That X price is right price and Y is wrong price. What is their call on the subject? Have they (MFs) invested in shares? (Suppose) the mutual fund has invested in one of these companies on fixed income side and on equity side they don’t have a single share. Then who is taking a call that now the share price is falling, this is a wrong fall (or that) it will not even fall below that price. Suppose after six months nothing works out on it (Zee stake sale by promoters). and they are unable to monetise what they intend to monetise and if the share price collapses, then? Are they (MFs) underwriting it? .Nilesh, you have argued that what MFs did is the best of two bad options. Do you still stand by it? Your argument has some support right now as Zee shares have stabilised a little bit.Nilesh Shah: There have been a lot of questions about what we have done. When Mr Anil Singhvi is asking that do we have mandate? We are managing within our mandate. Please read offer document before you comment. I am only talking about Zee because we don’t have exposure to any other company which you are talking about. In Zee’s case, if we had sold the shares - by asking for the margins and if they fail to provide the margin then I have option to sell the shares. Suppose, (after share sale) I had recovered 20-30 percent of my value, then you would say how irresponsible we have behaved when the fair value of share is XYZ and you are selling it in discount, and that you(MFs) are behaving in favor of buyer and not unit holders. We have to go through ‘agnipariksha’. When Zee’s share price crashed from Rs 400 to Rs 300, there were four sellers of loan against shares whose margin call was not honored. They sold about Rs 200 crore (worth shares) which resulted in a drop in prices by almost Rs 100 or 30 percent. That precedence gave some indication that if all the lenders of Zee exercise their margin call and start selling the shares, the value that will be recovered will be lower percentage than the loan which we have given. At the same time, most of us believe that the intrinsic value of Zee was far higher than what was quoted in market. From that day when the lender selling pressure started easing off, by virtue of this agreement, prices have recovered from Rs 300 to roughly Rs 477. Today many of the lenders’ margin call is not required because there is adequate security. Many of the lenders’ maturity date hasn’t come. By not acting in panic and selling the shares desperately, which would only have favored the buyer of the shares and not the seller of shares to recover the money, we have now ensured that our value is protected. There was an amount of speculation in media about stake sale (promoter stake sale in Zee) and the process which is going on, and we believe there will be some announcement soon. If that stake sale happens all lenders will be able to recover their dues along with some sharing in upside. Time will tell whether we have taken right decision or not. But I am confident that by desperately selling the shares we would have created unnecessary losses for our unit holders. By giving time to management and so far, our Zee debentures haven’t reached their maturity, there was only a breach in a covenant about margin and (now) price appreciation covenant has been honored..What was the need for such large investments with these kinds of equity collaterals? Nilesh Shah: There was a time, when I joined the fixed income mutual fund industry in 1997 and from 1997 to 2003, we have managed interest rate risk. Our credit risk was bare minimum, and we delivered better returns than equity funds because interest rates where dropping. In 2003-2008, we managed floating rate funds, short term bond funds, money market funds.Over a period of time, there was a need for higher yield. Tha thigher yield could only come in higher credit risk papers. So, slowly (MF) industry gravitated towards credit risk funds. Today in my Rs 1 lakh crore of debt AUM (assets under management) in the mutual fund, only 5 percent is in credit risk funds. When people said debt funds have taken higher credit risk, on 95 percent of fund, I have not taken higher credit risk. It is only on Rs 5,000 crore of credit risk funds where we have taken (such risk). The name itself - ‘credit risk’ - justifies that there is higher credit risk taken to generate higher returns. If you see loans against shares over last 20 years - in the entire mutual fund industry, there has been no delay and default. So, it is a secure mechanism. Once in a while, there would be a delay which potentially can happen, (like) in Zee. But we are confident that there will be recovery of money not only of principal and interest but also some upside sharing..Anil Singhvi: Nilesh is talking about one company and one episode. The other companies which we are talking about, he is not invested. Taking the Zee example and saying that mutual fund industry is safeguarding the (unit holders) interest very well, because the Zee share (price) happened to come back...there is another group which is also engaged in similar kind of situation (standstill). Share prices haven’t recovered.To take the call that I don’t want to sell the shares and realise the money, then you are taking an equity call in a fixed income product. Is this the mandate? That a fixed income guy (fund manager) takes an equity call?When an equity guy (fund manager) invests in a company, does it look at what happens on the interest yield curve or bond of same company? No.You have to look at that you have invested in fixed income bonds. Collateral is shares. Suppose the collateral was something else like real estate. Would you have taken the decision that real estate prices will go up?Today Nilesh says we have only 5 percent (in credit risk funds) and 95 percent is safe. But there could be mutual funds who could have invested 10-15 percent in such products. We are talking about should the mutual fund industry, particularly income funds like these, take a call or view on the underlying asset and work out a deal with lenders..Did MFs which signed up for the standstill with Subhash Chandra agree not to sell their shares only in event of depletion of margin cover or did they also agree not to sell their shares in event of an actual default? Nilesh Shah: I can speak about myself and not others. As per the maturity date, it is still in the future. We have waived margin depletion and which also we have recovered courtesy the price recovery. As of today, there is no breach of covenant even on margin side..Has Mr Subhash Chandra or his companies which are contractually committed to you, committed to an upside agreement with you?Nilesh Shah: Definitely. There has been an agreement where there will be upside sharing provided (if) they are able to sell the shares higher than the realisable value..And the percentage of upside is also determined in that agreement?Nilesh Shah: Yes. One more thing I want to bring to attention (regarding) loan against shares. For one delay, there have been three pre- payments on the loan against shares in the market. We have seen one FMCG company in Calcutta selling shares to pre-pay their loan against shares obligation. We have seen one retail company selling their business to pre-pay their loan against shares obligation. We have seen one more entrepreneur from the medical industry realising other assets to repay loan against shares obligation. One good thing about loan against shares is that there are many borrowers who are now resorting to pre-payment because of all the noise created..What if all lenders start waving margin calls in the hope that asset prices of underlying collateral will recover. Would you in principle agree with that kind of behavior?Anil Singhvi: For some reason if Mr Chandra doesn’t find any buyer for Zee Entertainment and he says that you sell shares as I can’t service the debt, then what will be your share price?.Nilesh Shah: All these things can happen and as a fund manager I have to go through agnipariksha every day. I will have a job when my judgement is right, and I will lose my job if my judgement is bad. If my performance is bad, my investors will suffer and that will be the end of our mutual fund and career. As a fund manager, I want to evaluate the reasonable information available to me.I have taken a call today that intrinsic value of Zee is far higher than the price at which I was going to sell. There are already buyers for Zee loan against shares in market. We have sold certain loans against debentures in markets. There are bidders at higher yield. I am waiting for deal announcements to happen. There is some positive news to come where I can sell it.You may assume that Zee’s value will become zero, I am not subscribing to that view. Let’s see in September whether we have taken right decision or not. If I would have sold any paper below fair value, you would have raised a question who allowed fund manager to sell at these prices. Only time will tell who is right - whether we have acted in interest of unit holders or not..This - restructuring - is not the job of the mutual fund industry. It is part of corporate restructuring. The distinction of fund and bank is getting blurred in these examples.Anil Singhvi: Do you think it is good product? According to me, it is weapon of mass destruction. Zee may hold you in good state. But there are 10 more examples which are pathetic. Every time if companies are getting a compromise with mutual fund industry, then we are getting a disturbing sign from investors point of view where fixed income products have equity risk..Nilesh Shah: All your concerns are valid. This loan against share papers are trading in market. We have sold Rs 30 crore of Zee loan against shares in market at par value. I am not valuing it at theoretical basis but valuing it as there are buyers.You say banks have capital and see NPAs created by banks. You see banks lined up to raise capital from government system. You compare it with mutual fund track record. In last 17 years, we have given money on loan against shares and recovered it every time. There will be some delays when you go out and lend. But we have recovered all the money. Compare our NPAs vis-à-vis banks.As an industry, we have to learn and evolve. I was the first fund manager in the modern mutual fund industry which has witnessed defaults. When I started my career, we had seen defaults as we pursued high-risk high-return strategy. Now, the learning over the years has worked for us and that’s how we have created our name and reputation. We will definitely learn from these episodes and improve..There are promoter entities which are unlisted opaque entities and are investing in projects which have different levels of risk. They raise debt using equity as collateral, in the case of Essel Group it has debt of Rs 17,000 crore. Is there something broken in this system?Anil Singhvi: If we go back to the Harshad Mehta case in 1992 and now, often we have seen that promoter funding and pledging of shares have been one product which created problem in markets. This is one product which one has to be very careful about.Market cap of Zee is Rs 40,000 crore at current prices and they (promoters) own 40 percent of the company. So, (that’s worth) about Rs 15,000-16,000 crore. Every lender is saying I am secure because I have the (promoter’s) shares. When you take shares as collateral, you may not look at real profitability, cash flows and repayment situations of the borrower because they (lenders) will say I am protected with 40-50 percent collateral that in any point of time I can sell. And the event (default) comes in and you say that you want protection (standstill) for borrower. Are we not protecting twice? I am not referring to Zee alone but across the board. Promoters’ shares have been taken as very safe bet. It is liquid and I can sell it. If that is the case, then sell it when things are bad. .Shouldn’t mutual funds draw a line if more than half the promoter debt is being as collateral?Anil Singhvi: The regulatory requirement should be such that whenever a promoter is pledging shares of a listed company, he or she should disclose underlying company, what purpose it is borrowing, what are the terms of repayment of money that he is borrowing. When larger number of shares are pledged then it is a very disruptive situation. An investor should be aware of it - that one day, if the shares are held by the lenders. for a variety of other reasons they can come in one day offload them. Why did SEBI ask that whenever there is pledge of shares of a listed company it should be disclosed? It is only for this reason - that investor when making a decision should be aware of it. According to me, there should be (disclosures on) total money borrowed and what is the repayment. Put that on (the company) website so that any investor who is buying (the company’s shares) is aware that all of the promoter holding is pledged for five years and the terms of it. He will make a more considered decision..Does an AMC look at exposure of different schemes to different promoter entities at a holistic level and say that I have an exposure limit to the entire group at an AMC level?Nilesh Shah: Undoubtedly, we have to look at it because there are sectoral level (limits). But we have not done a great job in looking at it from a holistic level. I have complied with letter of law, but I needed to be more diligent about the spirit of law. When we are lending loans against shares, we should have put a cap, with the benefit at hindsight, in terms of how much promoters could pledge and going forward that will be the norm in most of the transactions.As of today, our monitoring processes are adequate. There is real time monitoring of all the securities and price movement and whenever there is drop, we switch out instantly to trustees for understanding margin call. On monitoring side, we are doing reasonably adequate. The third thing is purpose where the money has been spent. We have remained comfortable with securities of underlying asset rather than focusing on where the money has been spent and what is the overall leverage. Anil’s suggestion of making the (pledge) disclosures will be pertinent. As an industry, we also should have to stop encouraging shortcuts like non-disposable undertaking. When a promoter is borrowing money with non-disposable undertaking it is one way to circumvent disclosures about pledge. As industry we have to become responsible and ensure that we don’t encourage shortcuts.

Financial “WMDs” And Mutual Funds’ “Agnipariksha” - With Nilesh Shah, Anil Singhvi

Recently, markets have had to come to terms with three risks – two new ones and one that’s plagued markets in the past as well.

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