At the time, there was mystery as to who the buyer was as the JSPL debt papers, it appeared, were bought at a discount, after the second downgrade.
According to Franklin Templeton AMC’s annual report for the year ending September 2016 (October to September calendar), the AMC bought over JSPL’s papers from the debt schemes of Templeton.
When the price of a debt security falls, the net asset value (NAV) of the debt scheme that holds it also goes down.
This is not new in the Indian mutual funds industry. When an underlying scrip of a debt fund defaults—or looks like it might—on its interests and/or principal payments, the AMC buys it from the scheme. But why did Franklin Templeton AMC buy the JSPL debt papers at a discount?
How it unfolded
On 15 February 2016, Crisil downgraded JSPL’s debt rating to BB+/A4+, from BBB+/A3+. This meant that the debt paper fell below investment grade. “Continuous efforts were being made to look for a buyer at all stages in the transaction," said a Franklin Templeton spokesperson.
Franklin Templeton AMC then decided to buy these debt papers. On 29 February, it bought the first tranche of the troubled scrip at a discount of 25% of face value. On 9 March, Crisil again downgraded JSPL debt papers to a “D" rating.
Immediately, the fund house’s valuation committee decided to re-value the debt paper “to reflect the latest downgrade in the credit rating, considering that there was no price available from an external agency for the same", said the spokesperson.
Valuing debt securities is tricky and not as straightforward as valuing equity securities, that are traded and prices are available on the stock exchanges. The debt market is highly illiquid and trades take place off-market. But debt securities must be valued on a daily basis to arrive at a scheme’s NAV. Therefore, capital markets regulator Securities and Exchange Board of India (Sebi) has laid down that fund houses must value their securities fairly. But since two debt fund’s fair price for the same scrip could be different, industry lobby Association of Mutual Funds of India (Amfi) has mandated rating agencies Crisil Ltd and Icra Ltd to issue the prices of all debt securities that all fund houses own, daily. The rating agencies, though, don’t give out any guidance for ‘D’ rated securities. In such situations where the price is not available from an external agency, the AMC applies fair valuation principles as per its own valuation policy and Sebi’s regulations.
In this case, Franklin Templeton’s valuation committee decided to re-value the security at a further 10% mark-down. The paper was now valued at 67.5% of the face value. On 10 March, the AMC itself bought the final tranche at 67.5% of the face value.
“Franklin Templeton AMC was the counterparty for JSPL securities transactions in February and March 2016. The transactions were effected keeping in mind the interest of unitholders and the challenges that could be faced while holding non-investment grade securities in an open end fund structure," said the Franklin Templeton spokesperson.
The question is: if the fund house was going to buy the bad security from the scheme, why did it allow the scheme to mark it down by a further 10%? The mark-down meant that the scheme realised 67.5% of the bond’s face value, instead of 75%. That was a loss to the scheme, and thereby its investors.
Holding a security that is rated “default" or “D" can be hazardous for a fund house as it could trigger further redemptions and the fund manager could be compelled to sell other, albeit, better securities to meet the redemption pressure. “FT purchased JSPL securities in two tranches due to the size of the transaction. The first tranche was purchased on 29 February 2016 when the security was rated BB+ which is below investment grade. However, we had to arrange for funding to purchase the balance, which took normal procedural time. The second tranche was therefore purchased on 10 March 2016. In the interim, the rating agency downgraded JSPL’s long term debt rating from BB+ to Default (D), which required fair valuation of these securities," added the spokesperson.
But the question remains: If Templeton was in the process of buying out the security, the chances of it buying the remaining tranche were quite high. Why did it, then, re-value (or mark down) the security’s value and then bought it? Why did it play the role of the price setter as well as the buyer (at that same price)? It appears that the fund house bought the security at a discount. “The securities were valued in accordance with regulations and fair valuation principles and were purchased by Franklin Templeton at the price at which they were held in the funds," said the Franklin Templeton spokesperson
Back of the envelope calculations show that the schemes suffered a loss of about Rs365.51 crore on account of the fall in scrip prices due to downgrades.
What about future gains?
“The fund house may have ticked all the boxes but this episode raises corporate governance standards. If a security goes bad, the fund house should try its best to recover money. Elsewhere, lenders have gone to the court to recover their money. But calling it fair valuation practice, marking down the price of the security and the fund house buying it and investors not even informed about… it doesn’t look a proper way of doing things," said a chief executive officer of a large fund house, who did not want to be named.
“In this situation, when there is no benchmark for valuing a D-rated security, the fallback is at what rate an asset reconstruction company or stressed asset specialist would buy it. Negotiations would have taken time and the AMC just got it off their back as it was impacting their goodwill," says Joydeep Sen, managing partner, Sen & Apte Consulting Services LLP, a wealth management firm that specializes in mutual funds and bonds.
What if Franklin Templeton recovers the money later? As things stand today, Franklin Templeton AMC still holds the bad paper in its own books. The fund house told us it further provided for a reduction of Rs112 crore in the values of these securities after it had taken them over from the debt schemes. These debt papers will mature between 2018 and 2021. If JSPL’s fortunes recover and it starts paying interest, will the fund house transfer the gains back to the schemes and compensate the investor?
In an interview published in The Economic Times on 10 May, Ravi Uppal, managing director, JSPL said, “…since we are not going to have any more capex (capital expenditure), whatever organic earnings we have are going to be used to pay back loans. We never allowed our company to become a non-performing asset (NPA). Banks are getting more confident of lending to us as they have seen how we turned around in Q3 (third quarter of September-December 2016)."
“For a default rated security, if the mutual fund realises 67.5% of its face value, it’s not a bad deal for the mutual fund scheme. But if the fund house recovers money later, will it return back to the investors? That remains to be seen," says Sen.
When contacted, Franklin Templeton refused to comment.
The Indian mutual fund industry has seen many instances about fund houses taking over bad paper—and losses—on their books. Franklin Templeton AMC too has done the same. But the second (10%) mark-down, even in the name of fair valuation, sounds a bit unfortunate given that it knew that it was in the middle of buying out the entire stock of JSPL from the mutual fund schemes.
Also, what remains a mystery is why the AMC didn’t disclose to the unitholders that it bought over the papers and the process it followed to mark the same down.