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Does your fund house lend to promoters

Since ratings of these structures tend to be lower, they earn a higher coupon. But investors may have to bear the brunt in case of default

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Mutual funds, like non-banking finance companies, have been financing well-known promoters against their shareholdings in prime group companies. Such lending by a few fund houses recently came under intense scrutiny after the shares that were taken as security against such loans, faced a sharp decline. This prompted many to speculate that mutual fund schemes could take a hit.

Coming on the back of the IL&FS saga that resulted in some debt mutual fund schemes taking a big hit, there has been considerable fear about MF lending to promoters due to lack of understanding and awareness, say experts that DNA Money spoke to. It is the dose that makes the poison. So, retail investors do need to be cautious of schemes that have a large exposure to such type of assets. Let's find out more on this.

Modus operandi

Debt MFs tap a wide variety of investment opportunities. One of them are bonds that are secured by a pledge of shares of listed company promoters. Kaustubh Belapurkar, Director Manager Research, Morningstar, says that investing in holding companies/group companies backed by a pledge of promoter shares or promoter guarantee, are reasonably common structures.

Do note that these are not simple loan against shares. Usually, a debt security is issued with a collateral of pledge of equity shares. Since ratings of these structures tend to be lower, they earn a higher coupon for the investor, he adds.

These companies typically don't have strong financials and cash flows of their own and rely on the strength of the operating company. The backing/security cover of these bonds are good.

"Structure likes these if backed by liquid collateral like promoter shares with a cover of 2-2.5 times are quite easily liquidated in case the borrower delays on payments," says Belapurkar.

If the share price falls, there are helpful clauses in the agreement that provides for protection by giving more shares to pledge or giving some other security. "There are covenants in place that provide protection to the fund house," says R Sivakumar, head of fixed income, Axis Mutual Fund.

Other fund managers agree that while this type of lending does involve some risk, promoters do not want to let go of their shares that are in top firms.

Risks and rewards

MFs are expected to generate the best risk-reward based on the schemes' investment mandate and in ultimate good faith of the investor. Such debt covenants, as they are termed, offer a unique investment proposition.

"However, in most cases, MF have been the sole buyers. Thus, apart from the default risk (in most cases the shareholdings are not formally pledged) this also raises the issue of a liquidity risk. Because if the fund house needs to sell the security before maturity, due to redemption pressures or otherwise, there would be a lack of buyers in the market. Most of the securities are maturing in 2020 or later, hence, the liquidity risk is discernible," says Jason Monteiro, AVP - Mutual Funds Research & Content, Prabhudas Lilladher.

While MF lending to promoters may be a standard industry practice, retail investors may have to bear the brunt of these investment decisions if the promoter companies are unable to pay up, he says. "Recently, we saw the IL&FS crisis wiping off an entire years gain for certain Liquid Funds that invested heavily in the ill-fated securities. Thus, investors need to be cautious of schemes that have a large exposure to such type of assets," advises Monteiro.

However, not everybody thinks such lending is risky. "Lending to a holding company backed by a marquee group (example Tata) is one of the key ways for AMCs to generate steady accrual income for its assets. These holding companies are NBFCs and also governed by regulations," says Vidya Bala, Head, Mutual Fund Research, FundsIndia.

For a debt investor seeking MFs to generate slightly higher returns than Fixed Deposits, a small probability of risk is par for the course and needs to be understood. However, in categories such as liquid funds, regulations, as well as rating agencies, play a key role in mitigating risks as much as possible given that the money that comes into this category is very short-term money. "For the rest of the categories, a need for awareness on the nature of risk in debt funds is required. When a debt fund holds some papers a few downgrades and a few upgrades is nothing new. However, currently, there is little distinction being made about a single notch downgrade versus a default, thanks to the sensationalism of such events," Bala argues.

Due diligence

Aditya Bajaj, head - investments, BankBazaar.com says that such investments offer higher yields as compared to similarly rated (credit rating) instruments and hence could give better returns to investors. Apart from being illiquid, these instruments can have risks related to the value of the shares which could be completely unrelated to the business of the company which is invested in, he added.

Industry veterans feel that the hullaballoo around fund-houses lending to promoters is more of scare-mongering than real risk. A Balasubramanian, CEO, Aditya Birla Sun Life AMC, says: "An individual borrows against their cash flows. Similarly, a promoter borrows against his/her expected cash flows and realisable value of the assets. Asset value can go up and down depending upon the market sentiment. Your assets may not be saleable today, but could be saleable tomorrow. The bottom line is that these assets never disappear. Most of the promoter lending is done in line with these principles. Plus, promoters receive dividends from the company, which enhances their cashflows. So, in that way it is well ring-fenced."

Balasubramanian agrees that fund managers need to be cautious. "As long as assets are good and have higher realisable value than what you have lent, it is all okay. There is no need to worry," he adds

MUTUAL FUNDS LENDING AGAINST SECURITIES

  • MFs commonly invest in bonds that are secured by a pledge of shares of listed company promoters
     
  • These companies rely on the strength of the parent company
     
  • Such investments offer higher yields as compared to similarly rated instruments and hence could give better returns to investors
     
  • Investors may have to bear the brunt if the promoter companies are unable to pay up
     
  • Since promoters receive dividends from the company, their cash flows are enhanced
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