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Mutual funds wrap: Is HDFC MF's decision to buy out Essel Group's paper at a fair value?

This conundrum explains why SEBI has now decided to do away with all methods of valuation except mark to market method. This now takes away misuse of discretion out of MF hands.

July 13, 2019 / 06:28 PM IST

Following the Essel group's default on its repayments to mutual fund debt schemes, HDFC Asset Management Company (AMC) offered exits to investors of some fixed-maturity plans (FMPs) by transferring Rs 500 crore worth of their exposure to Essel Group's firms  on to its own books.

These FMPs faced illiquidity due to their exposure to non-convertible debentures (NCDs) issued by Essel group firms — Edisons Infrapower & Multiventures and Sprit Infrapower & Multiventures.

Both HDFC and Kotak mutal funds (MF) had signed a standstill agreement with Essel Group to redeem the default debt papers with a delay till September 2019.

The Securities and Exchange Board of India (SEBI) issued show cause notices to HDFC AMC and Kotak AMC in May and June 2019 for their failure to repay mutual fund investors on the maturity of their debt schemes due to Essel Group's default.

After receiving SEBI's show cause notice, HDFC MF has notified to buyout of default Essel debt by paying Rs 500 crore from the AMC's profit and loss account to its 5 schemes maturing between January 2019 till August 2019. Kotak MF remains with its standstill agreement till date.

This move of HDFC MF taking away default papers from schemes to AMC company instead of selling its collateral to realise cash has not gone well with SEBI.

SEBI's Chairman, after its June 2019 Board meeting, had said that MFs are not banks. In that board meet SEBI issued policy of all valuation by MFs at only mark to market value.

In the past too, Franklin Templeton AMC bought out downgraded Jindal Steel and Power Limited debt paper from its scheme in February-March 2016. This was done promptly when JSPL was downgraded in that period. Templeton took it out at the new downgraded haircut price of 25 percent to AMC, reflecting its then fair present value.

HDFC AMC did not buy out Essel group papers early on and waited till it actually defaulted in January 2019 and also did not opt for selling collateral shares to pay redemptions.

It is yet to be examined whether the panic mode of the HDFC AMC buyout of Essel Group's debt recently was done at present discounted pricing of Essel papers or at historical full price.

If HDFC MF had taken these Essel papers at its present lower price from schemes, scheme investors have lost their capital partially due to harakiri and the much delay in the MF taking action on Essel.

This is possible by an amortization clause which allows to continue valuing debt papers on the lower residual face value (till actual default event).

In contrast, if the MF had adopted mark to market norms from initial stage for Essel papers and should have taken it out of schemes at early stage, the impact of default on scheme NAVs would not have been felt.

This conundrum explains why SEBI has now decided to do away with all methods of valuation except mark to market method. This now takes away misuse of discretion out of MFs' hands.

That improper valuation of problematic debt papers by MFs is an old saga, opined a former SEBI Officer who worked in its mutual fund department.

In a 2010-11 inspection report by SEBI appointed auditor of the then Deutsche Mutual Fund, a few debt funds were found holding default papers of Vishal Retail valued at Rs 50 crore.

On periodic interest defaults, the MF did not take action till it finally defaulted on the principal on redemption when the residual value left was around meagre Rs 3-4 crores.

Then the MF bought out the residual value Vishal  Retail's debt. A separate SEBI inspection found investors losing approximate Rs 15 crore due to a lack of appropriate MF action.

On SEBI’s initiated action, Deustche MF was asked to make good the NAV loss to investors at fair market price at the date the Vishal debt paper carried its first instance of default, which was neglected till it was late for the MF, confirmed the former SEBI Officer.

Whether HDFC MF is playing fair to investors in five schemes where Essel papers are in default, or there is more to it than meets the eye will be known either by an independent audit report of these schemes or by SEBI’s examination of its show cause notice to HDFC MF.

Himadri Buch
first published: Jul 13, 2019 06:27 pm

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