Capital markets regulator Securities and Exchange Board of India (Sebi) is said to have stepped in to nix a safety net stitched together by lenders to the Essel group, including mutual funds and non-banking finance companies (NBFCs), to throw a lifeline to the beleaguered group. The agreement, in effect, gave an assurance that mutual funds and others holding debt securities issued by the companies of the Essel group would not enforce their rights, including that of liquidating the shares of ZEE Entertainment Enterprises Ltd (ZEEL), pledged as security, till September 2019. The promoters have this time to sell their stake in ZEEL and the proceeds are to be used for repaying the debt of these group companies.
The parties to the agreement claim that it is a win-win situation for all concerned. The share price does not come under pressure from sale by the lenders, the promoters get time to sell the stake without a compromise on the share price and honour their debt obligations and the investors, including mutual funds, avoid a default in their investment. But is the picture as rosy as it is painted out to be?
The root of the problem is not a default or credit rating downgrade in any of these bonds, some of which come up for redemption only in mid-2019 and most in 2020 and 2021. It started with a 33% fall in the price of Zee shares on 25 January 2019, triggered by a news report that a group company was being investigated for laundering money at the time when the demonetisation announcement was made. The fall in price significantly shaved off the security cushion that the lenders, including mutual funds, had to fall back on in the event of a default by the issuers. The bonds all held above investment grade rating. But apart from Essel Lucknow Raebareli Toll Roads Pvt. Ltd, Essel Propacks Ltd and a few others, the rating received depended upon the security of the pledged shares of the promoters and an erosion in the security cover would eventually lead to a downgrade.
The Good and Bad
Investments in debt securities of companies that are generating cash flow may not be at risk from this event. According to A. Balansubramanian, CEO, Aditya Birla Sunlife AMC, “The enterprise value of road projects are much higher than the borrowing in question. They are also generating the cash flows required to service the debt."
The deal is significant for those companies where the cash flows are likely to be inadequate and unless there is infusion of funds from the promoters these bonds are likely to default. But in the event of a stake sale not going through, there is likely to be additional erosion in share prices which will lead to further depletion in the security cover for the lenders, putting the investment at a greater risk than what it is now.
Is that a risk worth taking from the investors point of view? “A panic situation had to be averted and that has been done. Considering the intrinsic value of the underlying shares and the quality of business model, this arrangement was in the best interest of all the stakeholders," said Balasubramanian.
Industry opinion, however, is that mutual funds have a fiduciary responsibility towards the investors and as part of that they should secure their interests first, which they believe has not been done. For example, the terms of issue has a provision for the promoters to bring in additional shares or cash to restore the share cover in the event that it falls below the prescribed levels. With the recent erosion in prices, the cover has fallen to around 1.2 times but the deal entered into does not talk about the promoters bringing in additional assets to secure the original cover envisaged.
As it stands, the schemes are not affected since the debt instruments have not yet seen a downgrade. Most debt securities will come up for redemption in 2020 and 2021.
Not all debt securities of the Essel Group are under a cloud and some may be generating cash flows to meet the debt obligations. But in many others, the mutual funds invested on the basis of the security provided by the parent company with scant regard to the "weak financial risk profile" of the issuing company, according to rating agency Brickwork Ratings. This may be construed as a lapse on the part of the mutual funds.
At the stage of making the deal too, the interest of the investors would have been better served if the Essel group was required to bring in assets to rebuild the eroded security cover. Investors, thus, have reasons to be concerned.
There is also no clarity yet on whether the deal will hold. If it doesn’t, then it may lead to a downgrade or default situation for some of these instruments that maintain their rating on the basis of pledged shares. “The agreement has been approved by the individual lenders/investors through their internal process system such as IC approval or credit committee approval of all the parties concerned and it has been done within the broad framework of what is allowed to manage investments. Regulator briefing is done as part of the normal course of business activities at the industry level," said Balasubrmanian.
Given the uncertainties surrounding the issue and the apparent poor quality of some of these debt securities, investors in open-ended schemes should consider exiting, particularly those having a large exposure. For investors in closed-end schemes, it is another re-enforcement of the importance of evaluating the credit quality of the portfolio before locking up their funds.