There’s trouble brewing in the infrastructure sector. IL&FS, or Infrastructure Leasing & Financial Services Ltd, one of India’s key shadow banks, is facing something of an existential threat.
As we noted in an earlier report, Moody’s said the company is credit negative for banks and debt market in India. Yesterday, on our Story of the Day, we spoke about the terror of a contagion in the markets, and also discussed the events of Freaky Friday.
We did devote considerable time to understanding what the IL&FS story in relation to the events of last Friday were. But we must dig deeper to examine the story of IL&FS, and that is what we will do on this edition of Digging Deeper.
Recent defaults by IL&FS
The 30-year-old company that was incorporated to fund to fund infrastructure projects has been pushed to the brink, with a debt of approximately Rs 91,000 crore or over $12 billion. BloombergQuint reported that IL&FS Financial Services also has around $500 million of repayment obligations over the next six months.
The business news website also reported earlier this month that the Reserve Bank had initiated a special audit on IL&FS after the company defaulted on the repayment of approximately Rs 250 crore worth of inter-corporate deposits to Small Industries Development Bank of India (SIDBI).
Bloomberg claimed that, according to sources, IL&FS defaulted on the first tranche worth Rs 100 crore on August 27, and then defaulted on more such tranches. The total amount is now around Rs 250 crore. These defaults forced SIDBI to approach the RBI.
IL&FS also defaulted on short-term borrowings known as inter-corporate deposits. An inter-corporate deposit is basically an unsecured borrowing between corporates. SIDBI has inter-corporate deposits worth Rs 500 crore with IL&FS, and an additional deposit worth Rs 500 crore parked with its non-banking finance company IL&FS Financial Services Ltd.
The deposits parked with IL&FS Financial services are due in November this year. Moneycontrol also reported on September 19th that IL&FS had defaulted on a short-term loan of Rs 1,000 crore from SIDBI, while a subsidiary also defaulted on Rs 500 crore it owed to the bank.
Business Standard reported that, as of 31 March, IL&FS had outstanding debentures and commercial papers, which accounted for 1 percent and 2 percent, respectively, of India's domestic corporate debt market. Sixty-one percent of the company’s borrowings are loans from financial institutions.
How does the IL&FS crisis impact the larger debt market?
So why does this crisis at IL&FS matter? Here’s why: The defaults caused ripple effects in equity stock markets, with the BSE which crashing to nearly 1,500 points on September 212. There is concern that it could lead to a collapse in the stock prices of some non-banking financial companies (NBFCs) and make bond sales tougher.
The company claims it is a pioneer of public private partnerships, or PPPs. IL&FS says it has helped develop and finance infrastructure projects worth $25 billion. These include standout projects like the country’s longest road tunnel - the 9-km long Chenani-Nashri tunnel.
IL&FS claims it has a portfolio of about 13,100 km of roads in India. Its investors, in order of stake held, are LIC, Japan’s Orix Corp, SBI, Japan’s Orix Corp and the Abu Dhabi Investment Authority. So yes, this company is what is called a core investment company, or CIC.
A Moneycontrol report described IL&FS as a company that was at the forefront of infrastructure funding.
Questions are now being raised about the affordability of some of Prime Minister Narendra Modi’s infrastructure projects - these include awarding works of around 20,000 km of national highways and ring roads in 28 cities this fiscal. Investors are worried about leverage at other shadow banks, giving rise to increased volatility among financial stocks.
Moody’s said the defaults would impact mutual funds, pension funds and insurance companies. This also affects individual investors because some of IL&FS’s missed payments were on commercial paper, or short-term unsecured debt. Bloomberg explains that commercial paper is a major component of money-market mutual funds, which have surged in popularity following low bank deposit rates and inflation.
Money managers have marked down holdings of IL&FS debt and one financial company temporarily halted inflows into some affected funds. Banks, mutual and pension fund managers, insurers and individuals are bracing for further losses. One concern for investors is that IL&FS has made loans to its own units. As mentioned earlier, the company has also defaulted on inter-corporate deposits.
What are shadow banks?
We used the phrase “shadow banks” earlier to describe the sort of financial entity IL&FS is. So let’s define that in simpler terms. ‘Shadow banking’ is a phrase encompassing risky investment products, pawnshop and loan-shark operations and so-called peer-to-peer lending between individuals and businesses.
BloombergQuint noted that such products and practices flourish outside the regular banking system, often beyond the reach of regulators. For instance, the most damaging runs during the 2008 crisis were not on bank deposits but on shadow banks like Lehman Brothers (which was a broker-dealer), and money-market funds.
The reason shadow banking exists must be clear by now: free from regulatory burdens, it funnels money to where it is required. Understandably, even the Economic Times had a column by Andy Mukherjee who called this India’s own mini-Lehman moment.
Worldwide, shadow banking assets have only increased, thanks to investors who desperately seek higher returns in a world of low interest rates, world as well as companies and local governments that are starved of loans. The Financial Stability Board, an international body established in 2009 to monitors and make recommendations regarding the global financial system, estimates that shadow banking assets that pose risks to the financial system grew 7.6 percent to $45 trillion in 2016.
Governments cannot regulate shadow banking - practices like borrowing from money-market funds or derivative transactions with hedge funds- because of what Bloomberg labeled ‘fierce lobbying by the financial industry’. In many countries, shadow-banking is the grease that keeps the economy functioning smoothly. Small businesses get the loans they require and savers get better returns. Regulating it, while sound policy, slows down growth and raises short-term risks.
However, in the case of IL&FS, Rs 17,000 crore in claims under acquisition, thanks to the Land Acquisition, Rehabilitation and Resettlement Bill, have led to serious problems - cost escalation and incomplete projects. As India went about building thousands of kilometres of roads, innumerable power plants and many ports by acquiring private land, the debate about fair compensation also took off.
In 2013, parliament passed the Land Acquisition, Rehabilitation and Resettlement Bill that included the Right to Fair Compensation and Transparency. This Act made many of IL&FS’s projects unviable. Hundreds of investors, banks and mutual funds were also pushed to the brink.
The situation is so bad that the company which owns over 13,000 km of roads in 30 projects has not participated in a single build, operate and transfer project since 2015 because of potential losses. Further, since it no longer carries an investment grade rating, it will be difficult for the company to raise money from the markets.
Krishnamurthy Subramanian, professor at the Indian School of Business in Hyderabad, said, “It was a poorly designed legislation....It was a clear opportunity for rent seeking...You don’t have so many local land experts. When you involve a third party, you are giving him an opportunity to extract his pound of flesh.”
R Shankar Raman, CFO with at Larsen & Toubro, India’s biggest infrastructure builder, said, “The government’s role in the PPP wasn’t understood properly. The concessionaire assumed that everything would be smooth — that all clearances would come through and there won’t be any public interest litigation. It was a complete misreading by all.”
In fact, as IL&FS sank deeper into the mess, Larsen & Toubro’s Chennai Tada Tollway surrendered a project in September 2015 for similar reasons. The infra major shifted its strategy to an asset light model.
IL&FS - A brief history of defaults
When IL&FS began operations in 1987, it started with equity from the Central Bank of India, Unit Trust of India and Housing Development Finance Co to fund infrastructure projects. As infrastructure became a central theme in the last twenty years, the company used its first mover advantage to lap up projects.
The Economic Times reported that IL&FS built up a debt-to-equity ratio of 18.7. This was 11.5 just over a year ago. The IL&FS group, with approximately 24 direct subsidiaries, 135 indirect subsidiaries, six joint ventures and four associate companies, has a debt of about Rs 91,000 crore. Nearly 60,000 crore of this debt is at project level - meaning road, power and water projects.
Adding to the cost overruns it incurred, thanks to delays in land acquisition and approvals, IL&FS also began feeling the strain of interest rates which have soared to multi-year highs for short-term borrowings.
Bloomberg reported that as much as Rs 90 billion of payments owed to it by the government have been locked due to disputes over contracts. The company’s head, Ravi Parthasarathy, the man at the helm of the group since its inception, resigned due to health reasons in July this year.
This repayment crisis is raising borrowing costs in India’s credit markets, with the average yield on one-year corporate notes jumping to the highest since 2015.
As a Moneycontrol report noted, the stress on the company’s books was clear before it even defaulted. However, risk managers, debt fund managers and rating agencies failed to see the writing on the wall. The commercial papers and bonds of IL&FS were downgraded only after the default happened.
It must be said that, as IL&FS’s business model shifted over the years, the complexity of its structure only deepened. The company shifted its focus from project sponsorship to project advisory and facilitation for the development and implementation of projects. Essentially, from a financier of projects, it moved to owning projects and building them.
Shishir Asthana wrote in a Moneycontrol piece that such a complex model creates an asset-liability mismatch. Such a mismatch happens when a company has funded long-term assets with the help of short-term liabilities.
This means repayment is due before you get the cash from the assets. Building and owning a big infrastructure project has a different risk profile compared to financing a portion of a project. As an owner of the project, any delay would result in cost overruns which need to be funded either by the parent company or through borrowing from the market.
In the case of IL&FS, its projects resided in special purpose vehicles. What that means is, these entities depended on the parent company for funding. The source for such funds were cash flows from its operations, borrowing from the market, and concessions that the government granted on projects.
While IL&FS stretched itself on generating funds and raising money from the market to sustain its subsidiaries, it claims it was let down by the government when it came to releasing funds as part of the concessions. It put the blame squarely on the government in its 2017-18 annual report, saying, “Another hurdle has been the delay in decision making/passing of the buck at the relevant Authorities, especially with regards to compensating the Concessionaire / Contractor for delays and defaults on part of Authority.” It also claimed that IL&FS Transportation Network, or ITNL, did not receive funds owed to it from arbitration and settlement awards.
For instance, it claimed recently that several government owned concession-granting authorities owe it Rs 16,000 crore which, if cleared, would help solve its liquidity problems - like the NHAI, or the National Highways Authority of India. IL&FS raised claims for about Rs 4,000 crore from NHAI which are currently under arbitration. But the NHAI countered these claims, saying it owes only Rs 425 crore to the company.
The Economic Times quoted a senior government official who said NHAI has agreed to pay Rs 425 crore only, because of cost overruns in the Moradabad-Bareilly Expressway project. What could add to IL&FS’s woes is the general trend in such payments. The same Economic Times report quoted a leading infra consultant who said over the years companies only receive an average of 25-30 percent of the overall claim in the arbitration. So, IL&FS can realistically hope to recover around Rs 1,200 crore in this instance.
The company also puts the blame on the Land Acquisition, Rehabilitation and Resettlement Bill in its annual report. It said, “The introduction of the new land acquisition Act has prompted many owners whose lands were acquired under the earlier Act to seek for additional compensation in line with the amended Act, leading to further unanticipated delays. ..ITNL has incurred huge cost overruns in its projects as a result of these delays on part of authority for which it has filed claims and in few cases arbitration/settlement awards were received in favour of ITNL.”
As we noted earlier, this isn’t IL&FS’ problem alone. Even infrastructure giant L&T has surrendered projects and shifted its business model.
IL&FS had a lifeline for getting out of this mess back in 2014, when Ajay Piramal expressed interest in the company. He had made Rs 17,000 crore from the sale of his pharmaceutical business to Abbot Inc, and discussed acquiring a a controlling stake in IL&FS. The company had a debt of Rs 55,000 crore and a net worth of Rs 9,000 crore at the time.
Had it merged with the financial services unit of Piramal Enterprises, the combined entity would have had a net worth of Rs 16,000 crore and total debt of Rs 62,000 crore with a leverage ratio of 4. The deal looked set to go through, with the board agreeing to a share price of Rs 750 as valued by SBI Caps. But it was not to be. LIC stepped in and demanded, one day before the board meeting, a price of Rs 1,100 per share. Piramal walked away from the deal.
An IL&FS executive, on condition of anonymity, told the Economic Times, “If only we had got the deal done, we wouldn’t be in the current mess.”
Back to the present, and Karthik Srinivasan, an analyst at ICRA, a unit of Moody’s Investor Services, said the company has to address the liquidity issue quickly. He said, “The company says it is putting up assets for sale. We have to see whether it is able to raise funds.”
He’s referring to the desperate straits that IL&FS finds itself in. The company has put its Mumbai headquarters, valued at Rs 1,300 crore, up for sale. It has also identified 25 projects for sale, including some road and power projects. According to sources, it has received offers for 14 of these. Should the asset sale go through, it could bring the debt down by around Rs 30,000 crore. But there’s a catch. The completion of such deals could take up to 18 months.
The claims from the government could also take between two to three years, and cannot be expedited because if the government paid IL&FS before others, that could invite litigation.
So, even as investment bankers line up for its assets, it is not clear whether IL&FS will get the valuation that it would have under normal circumstances. Srinivasan says, “IL&FS’ investment portfolio remains relatively illiquid with large investments in group companies engaged in long gestation and capital-intensive projects.”
The Economic Times report states that, as things stand, IL&FS is facing serious liquidity problems. The absence of a quick strategy from the regulator and the government could become a solvency issue that cascades into a domestic credit crisis which could bleed banks and mutual funds. At this point, you’re probably thinking - how did a company in the business of financial advisory in the infrastructure space not heed its own advice?
One likely answer could be that the company did not want to let go of the growth opportunities which presented themselves. Experts have called for heads to roll and we might see that happen yet. As the Moneycontrol report says, if a risk manager from SIDBI can lose his job for not raising the red flag, why should the board of IL&FS be allowed to continue managing a company which it ran into the ground?
It is not just a new office that IL&FS requires, it also needs a new business model.
One senior analyst said, “IL&FS is fundamentally sound, but it will experience temporary pain. They had plans to monetize assets but they have money stuck with the government..., if they manage to get a good price for their assets, they can assure the investors who can bring in money at this moment.” That’s a glass half full approach.
In the latest significant developments in this saga, the Reserve Bank has summoned two large shareholders of the company, Life Insurance Corporation and State Bank of India, for a meeting on 28th September. LIC holds a 25.34 percent stake in the company. Bloomberg reported that the meeting will include discussions on the repayment defaults as well as a capital infusion plan.
One senior banker told Moneycontrol, “The only way the situation can be salvaged is if LIC (Life Insurance Corporation of India) and other lenders come in with Rs 4,000 - 5,000 crore worth of liquidity infusion. This will give reassurance to the market that large institutions will come forward to bail them out.”
Some reports have claimed that LIC might infuse around Rs 800 crore as part of the Rs 3,000 crore-fund raising proposal. Another banker, part of one of the large shareholders, said, they had planned to sell their stake as part of non-core asset sale. He added, “We will definitely not lend more, but will have to wait and watch what the RBI says on Friday.”
Meanwhile, Ramesh C Bawa, MD and CEO of IL&FS Financial Services, has resigned with immediate effect. Four other independent directors Renu Challu, Shubhalakshmi Panse, Uday Ved and SS Kohli, as well as non-executive director Vibhav Kapoor, also stepped down from the board.
The group has filed an application with the National Company Law Tribunal seeking accommodations for itself and 40 units under the Companies Act (NCLT), as it seeks a compromise with creditors outside the insolvency courts.