The cost of Tata group’s implicit loan guarantees
While Indian banks prepare for large haircuts on loans to most small telcos, Tata Teleservices Ltd stands out. Backed by parent company Tata Sons Ltd, the firm is in talks with lenders to repay its loans early, and that too without any haircut, according to a report in Business Standard.
A decision to honour all the debt obligations of its telecom subsidiary will reinforce the general belief that the parent company’s implicit guarantee for loans of group firms is backed by action.
This is a boon not only for banks that deal with the group, but also for minority shareholders and joint venture partners, who benefit from lower interest costs thanks to the guarantees, without having to share any of the downside associated with honouring those obligations. Rather than let others have a free ride, the Tata group should extract more value from its guarantees.
In the past, news reports have suggested that group executives told bankers that operating firms stand on their own feet, and that assuming otherwise is a mistake. On occasion, such as with Tata Steel Ltd subsidiary Tata Robins Fraser Ltd, a troubled firm, has even been referred to the Board for Industrial and Financial Reconstruction (BIFR). BIFR would determine whether so-called sick firms can be revived.
But that’s an exception. The general assumption is that the Tata group won’t let its large operating firms enter bankruptcy proceedings, and will make good on obligations to banks. One purported reason is that since the group has a high amount of debt across all its firms—close to Rs2.5 trillion—a large default can have repercussions for all other group companies. Evidently, a default will mean that borrowing costs will rise for others; more so for the highly leveraged firms in the group.
Effectively, this means minority shareholders and joint venture partners can enjoy the benefit of lower borrowing costs, without having to bear the costs of providing a guarantee on the debt. One can argue that they may also end up paying a premium acquiring shares of Tata group firms, although that can be barely seen as adequate compensation for the high costs the group bears in providing its guarantees. In Tata Teleservices’ case, for instance, the Business Standard report says the fund infusion will be as much as Rs30,000 crore, largely to repay debt.
Robert C. Merton of Harvard University says in a paper On the Management of Financial Guarantees that although guarantees do not appear on the balance sheet of the parent company, their economic value can be very large. “The management of those guarantees can therefore be an important part of the parent company’s financial managers,” states the report. Merton says that the difference in the market value of bonds/debt of a subsidiary firm with and without a parent company’s guarantee is the value that can be ascribed to the guarantee. While this value isn’t visible in traditional balance sheets, ignoring it can lead to flawed results while monitoring the guarantees. The true asset value of a subsidiary in a parent company’s balance sheet, according to Merton, will be the value of its equity plus the value of the guarantee. Ignoring this can mean bloated assumptions on return ratios, for instance.
Additionally, an implicit guarantee, typically in the form of a comfort letter by a parent/holding company, earns no remuneration, even though it results in a tangible benefit for the subsidiary firm. Ideally, guarantees should also be monitored closely, so that liabilities are matched with assets or at least hedged. But none of this will be closely followed when there is no explicit guarantee.
In sum, while the Tata group may be doing the honourable thing by stepping in to help its troubled telecom subsidiary, in hindsight, its interests would be better served if the guarantee was more explicit. That way, it could have earned a commensurate fee for its guarantee, as well as been better-positioned to monitor risks and take appropriate and timely action when the telco business started floundering.