'The IL&FS crisis was a Lehman moment for India'

How did debt fund managers miss the problems of IL&FS, when there was evidence in its books of high leverage and low interest cover?
I won't say everyone in the industry missed it. For instance, at Aditya Birla Sun Life, our exposures were not to the parent company but to the operating companies, where we took a call on state-government receivables. These were secured against power-plant assets. While some AMCs lent to such operating companies, others lent to the parent company or to the financial services or transportation subsidiary. But the overall industry exposure was still not very large. It is, in fact, an indication of the maturity level of the industry that of 2,300 fixed-income schemes, only 45 odd schemes had exposure to IL&FS, despite it being such a large entity.

Secondly, historically, India has never seen a default in short-term P1-plus rated paper. In the case of commercial-paper investments, most fund managers go by rating agencies' opinion. It is mainly for longer-term exposure that AMCs use their in-house teams to make a more detailed assessment. In this case, the rating was AAA and the paper was rated by not one but three different agencies. Relying on ratings for short-term lending is not only something mutual fund managers did but also all other institutional investors who bet on IL&FS. So, rating agencies need to reassess their rating parameters and the risk factors they take into account after this episode.

Thirdly, I believe that the entire picture of debt at the various group companies was not reflected in the consolidated books of IL&FS, which was a problem.

Was this because rating agencies and others gave too much weightage to IL&FS' parentage - its well-known promoter companies?
No, I think they would have looked at the individual company's cash flows and ability to service debt. When you assess credit, there are many factors to consider - the company's ability to manage resource mobilisation, its cash flows in the form of dividends from operating companies or the ability to monetise assets. The management of a leveraged company is also expected to put the brakes on expansion when there's a constraint on fund raising.

Given that we've also had previous episodes of sharp rating downgrades on the bonds of Amtek Auto, Ballarpur Industries, JSPL, etc., shouldn't debt funds stop relying on rating agencies, even for short-term paper and make their own assessment?
Yes, we cannot completely rely on them. But I do believe that IL&FS was a unique case on the ratings front. Usually, there are downgrades to long-term paper. The mutual fund industry, too, is vigilant and reduces its exposure where there are signs of trouble. It had, for instance, steadily reduced its exposure to Ballarpur and JSPL before sharp downgrades happened; very few funds continued to hold them. In Amtek Auto, only one fund had an exposure. IL&FS was a case where the credit quality remained P1 plus and AAA for very long and the downgrade happened only after the firm defaulted! Had IL&FS borrowed at a high cost from debt markets, the signals would have gone out but they borrowed via preference shares.

Are your debt funds continuing to receive repayments on time from IL&FS operating companies? And have you taken NAV write-downs despite this?
Yes, we are receiving timely payments as of now. These companies are part of the list of assets that are likely to be monetised. When the sale happens, either we will get back our loan or we may choose to stay with the new buyer if their credentials are good. But we have taken NAV write-downs based on our internal valuation metrics because there have been rating downgrades.

We did this because we are keen to protect the investors who stay with us for the long term. By making sure that the current NAV reflects the marked-down value, we would like to protect long-term investors. People who panic and withdraw now should not be hurting those who stay back, by getting to exit at a higher NAV.

Why did different fund houses take varying approaches to valuing IL&FS after the downgrade? We found different schemes taking hits at different times. Is there no standard practice on how much of a bond should be written off in case of a downgrade?
There is a standard practice but IL&FS was an unusual case because of its structure. The first issue was which IL&FS entity each AMC owned. If you owned operating assets, like us, the downgrades were not to default grade, and so you did not need to take a full haircut. But if you owned direct exposure to IL&FS entities that became 'default' grade, you had to go by the assessment of your valuation committee and trustees. Fund trustees did not take a uniform view on IL&FS valuation across the industry and that's why you saw those differences in timing. Later SEBI advised that it was prudent to take a complete write-down and so everyone complied.

But that poses a dilemma, too. If you take a 100 per cent write-down today and that reflects in the NAV, new investors who come into the fund may benefit later if the asset is partly recovered. This is unfair.

This creates the problem of whether a debt fund should stop new inflows after a downgrade. How do you solve this problem?
We have suggested that the moment a bond or paper falls below BBB or investment grade, there's a probability of default. So, it would be good if this investment is carved out into a side pocket, with proportionate units allotted to investors who were in the fund at the time of the downgrade. This will help such investors benefit if there is a recovery and also allow fund flows to continue as usual. This is better than stopping inflows. The fund should also issue a press release when a side pocket is created.

Is it an exaggeration that the IL&FS crisis was India's Lehman moment?
I do believe it was a Lehman moment for India and the problem is not entirely resolved even now. The problem is that IL&FS, unlike manufacturing companies like Amtek Auto or JSPL, had dealings with a lot of other entities, being a large financial firm. So, people initially underestimated its contagion effect.

If you look at the loss in market cap across banks, NBFCs and others after the IL&FS episode, the aggregate loss in market cap has been in excess of `4 lakh crore. This is a very large amount. This market-cap loss takes away the ability of NBFCs to raise new equity or debt to sustain their credit growth. This can cause a vicious cycle. With PSU banks withdrawing from the market, it was NBFCs that funded credit needs of industry, consumers, affordable housing, etc. This is a key issue for the economy.

What are the lessons for the mutual fund industry from this?
One, risk management will have to become more important. Second, if one is taking exposure to a business which is not cash-flow-backed, one has to figure out where the cash will come from. Mere financial strength is not enough. Three, sector exposures in debt funds have to be restricted. But apart from this, the current framework for debt funds is pretty tight and not much more needs to be done. After every crisis in the past, debt funds have tightened their risk controls.

Mutual funds have not been the creator of the IL&FS or NBFC crisis. This is a systemic problem. When events like this happen, the impact on the mutual fund industry is very visible because this is a very transparent industry. Nevertheless, we are taking several ideas to SEBI for resolving some of the issues we have seen.

What should an individual investor do when faced with a credit downgrade in a fund he owns?
He should hold on for the simple reason that once a mark-down in NAV happens, the loss is taken and the risk is off the table. One, this loss is not taken by one individual but by all investors. Two, when the NAV drops, the yield on the residual portfolio rises. Finally, in some cases, a mark-down may not lead to a total loss. The possibility of a recovery exists, which can later improve the NAV. So, as long as your horizon is three years, it makes sense to simply hold on to the investment.