The events that have unfolded over the past couple of years have been unprecedented in the debt mutual fund industry. It has been a phase of learning for all stakeholders: fund managers, investors, distributors and the regulator SEBI. The defaults that have happened, given their numbers and the scale, starting with IL&FS, have never been witnessed before. The responses of various AMCs to the challenge have been different in their own way. Since these events create a precedence, let’s debate the pros and cons of some of the actions.
Should the regulator allow flexibility on an action which would maximise value for investors? This is not the traditional debate between the letter and the spirit of law, because both are meant for investor protection. The debate is about an action which may, to a certain extent, be on the wrong side of the law, but would ultimately give higher value to investors.
Case 1: Standstill agreement on Essel Group LAS deals
Loans against Securities or Loans against Shares (LAS) deals are where the investor, the Mutual Fund in this case, invests in bonds that have equity shares as collateral. The shares may be of the company issuing the bond or a group firm if those shares are more liquid or if the issuing entity is not listed.
Quite a few AMCs invested a small part of a few debt fund portfolios in LAS deals, as these would fetch higher returns than usual bonds. The reason for higher returns is that a blue-chip company, for raising funds for the flagship company, would not pledge its shares. Either a lesser-known company, or a smaller firm belonging to an otherwise well-known group, would pledge promoter shares.
The issue was that in the LAS deals of certain Essel group companies – secured by a cover of approximately two times of Zee’s or Dish’s equity shares’ value – there was a steep fall in share price of ZEE on a particular day in January 2019. There was no fundamental reason for this fall in price; equity analysts had buy calls on Zee. For LAS deals in open-ended debt mutual funds, it was not a major issue as the bonds had not yet matured. But technically, it was a default because the share coverage fell to less-than-agreed levels, and the issuer was not replenishing with shares/cash. The major issue was in FMPs of two MF houses, as they had a maturity date of March 31, 2019. The dilemma was, if they sold the shares, on which they had a lien, they would receive less than the amount due on the bond.
In this situation, various MFs and NBFCs came to an agreement with the promoter of Essel group – they would not sell the shares in the secondary market, as that may dilute the share price (referred to as standstill in the caption). The promoter was expected to honour the obligation. Essel group asked for an extended deadline of September 30, 2019. One AMC allowed its FMPs to mature on their due date and whatever amount was remaining, to the extent of LAS in the portfolio, was paid later, but before September 30, 2019, by selling the shares in the market. Another AMC extended the maturity of the FMP by one year.
SEBI did not take kindly to these moves, because they violated the law. The violations were: (a) if the security cover is lower than the agreed value, for e.g., two times the amount due, it should be sold off as it is a breach of covenant if the promoter does not replenish shares/cash. It is ultra vires the fund manager to grant extra time to the promoter; and (b) all securities held by an FMP should mature within the maturity date of the FMP. By agreeing to wait for some more time, FMP regulations are being breached.
The point of debate here is, on the one hand, it did violate the word of law. On the other hand, going by value for investors, the AMCs with holdings in open-ended and close-ended funds sold the shares later, i.e., between March 31 and September 30, 2019, and realised the amount due, by virtue of recovery in the share price and part payment by the promoter.
One AMC shifted the security from the books of the FMP to the books of the AMC. If the AMCs went strictly by the law and sold on the day of the breach of covenant, they would have realized less than the amount due. Selling later proved to be beneficial for unit-holders. Later on, SEBI passed a regulation that for LAS deals in mutual funds, the minimum cover should be four times.
Case 2: Debate on Franklin Templeton
Why rake up the old case now? There is a similarity with the earlier instance, on the debate between the word of law and maximizing unit-holder benefit. Had FT not shut the funds, redemptions would have continued, and the portfolio credit quality would become inferior. While selling the non-blue-chip holdings, they would have realised less than fair market value, given the tight market for lower-than-AAA rated papers.
This would have resulted in sub-optimal realization for unitholders. Moreover, those who did not exit now, would have remained with an inferior portfolio quality, as the relatively better securities would have been sold. By shutting the funds, the fund house has closed liquidity for investors who require cashflows. But, by waiting till maturity, they would realize face value plus interest on the securities, provided there is no default. Arguably, this decision is better than the distress sale of credit exposures at less than optimal price. However, unit-holders are aggrieved as it breaches their understanding that they invested in open-ended funds with liquidity available.
The debate would be, if there is a similar case in future, which side should SEBI to take: word of law or flexibility to maximize value, and set the record straight later?(The writer is founder, wiseinvestor.in)