On defaults and downgrades: interview with Arvind Chari

Why is the debt-fund industry seeing a sudden surge in defaults? How could funds have handled the recent credit events better? Should SEBI step in to curb mutual funds funding their promoter firms? Arvind Chari, Head, Fixed Income & Alternatives, Quantum Advisors Private Limited, takes such tough questions head on in this frank chat with Value Research. Why have we seen so many default and downgrade events crop up with debt funds lately? If you see the pattern of credit events in the Indian market, it was banking which felt the first major impact. From 2012 to 2017, the banking system faced fairly bad credit outcomes. Now, we are seeing this playing out more selectively in the case of NBFCs and debt mutual funds as they have increased their share of lending to lower-rated corporates. You need to see these events in the backdrop of the subdued economic environment that has hurt corporate earnings in recent years. Lower and volatile commodity prices have had a negative impact on material and resource companies. Infrastructure companies have struggled on account of policy logjams impacting cash flows. Leverage levels have risen across corporate India and still remain very high. The profitability of companies has been neither consistent nor good in recent years and Sensex earnings have been flat over four years. Any risk-taking in this environment is likely to lead to credit events. This is contributing to more credit events. Promoter lending by mutual funds is not a new phenomenon and debt funds in India have been doing it for over a decade. So, what went wrong with such deals this time around? It was NBFCs which used to be quite active in promoter lending earlier and mutual funds have come in at a later stage. Such deals typically work well in bull markets as they deliver high yields with rising value of collateral for the lenders. Typically, in extending promoter loans, lenders try to figure out the end-use of that money. They evaluate whether the promoter would use the money to invest in new projects or needs it to repay old debt. In the ordinary course, loan against shares is a pretty simple product. You extend a loan and ensure that you have two or 2.5 times cover in terms of promoter shares pledged with you. Compared to other forms of collateral, equity shares are quite liquid and the collateral can be easily liquidated. The shares are available in an escrow where the trustees and lenders have access to them. But the recent episodes like Essel highlight that tracking the total extent of leverage taken on by the promoter is also important. After all, the basic point in holding any security/collateral is to use it when things go wrong. Therefore, any c