Building in protective covenants and not deviating from processes helped Axis Mutual Fund navigate the share-backed non-convertible debenture (NCD) storm that has hit the debt fund space. The fund house likes these instruments for their superior liquidity, unlike NCDs that have fixed assets as security. “Among the types of secured transactions, be it corporate guarantees, property or others, shares as security are the most liquid and safe as long as you put in place the enhancements that will shield you if the price falls," said R. Sivakumar, head of fixed income, Axis MF.
One way for mutual funds to protect themselves in such transactions is to have a cap on the extent of borrowing against shares by the promoter group. This helps avoid the situation of a drastic fall in share prices if some lenders decide to sell the shares. Axis MF, for example, has a total debt cap for the promoter across the group relative to the market capitalisation of the promoter’s shares. “We have a low threshold for this to be breached. If the group indebtedness rises and we are uncomfortable with it, we take steps to correct our positions since our policy does not allow us to hold on to those papers," said Sivakumar.
Another protective covenant that can be built into a share-backed transaction is provision for top-up if the cover provided by the collateral comes down with a fall in price. For example, in Axis MF, if the cover falls as a result of the fall in price below a threshold, then the compensatory top-up collateral to maintain the cover is accepted not in additional shares but only in cash, so that there is no dilution and further illiquidity. “We only do such transactions in A group companies," said Sivakumar. This ensures liquidity in the collateral.
“We limit our share-backed transactions to a tenor of a few months to a little over a year. Over a longer term, the chance of an event that can cause a fall in the share price are higher," he said.
Following the process and sticking to the norms does help. Sivakumar does not see the fund house’s decision to exit from Essel Group companies in the middle of last year as a result of any foresight. “It is just that the numbers did not add up and we exercised our option to exit early," he said.
Keeping it simple
The ability of borrowers to honour their obligations to pay interest and return the capital borrowed is at the root of all investment decisions and fund houses have stringent processes in place to vet this.
Mahendra Jajoo, head, fixed income, Mirae Asset Management Co., identifies adequate cash flow as a key criterion to consider a debt paper. “Companies that have adequate cash flow to service debt from their own operational cash flows are by and large considered, as a standard practice," he said. That is an important factor that helped Mirae stay away from share-backed transactions. “Most of these transactions on maturity have to be refinanced and whenever the refinance will become a challenge, issues will come up. This was our assessment and that is exactly what has happened in a few cases," he added.
Jajoo believes in keeping the investments simple. “We have invested, as a thumb rule, only in plain-vanilla instruments without any major complications. Straight- forward instruments of companies that one will in most cases recognize easily are generally considered for our portfolio. This has helped us stay in line," he said.
One of the reasons why mutual funds end up having very high concentration in group companies is because the fund raising happens through complicated instruments, he said. Limits on exposure are considered in terms of the percentage of the fund’s assets under management (AUM) as well as the percentage of the borrower’s net worth and the borrowing size. “We generally don’t want a situation where we are the only lenders and cases where information available in the public domain is very limited," said Jajoo.
Stick to the basics
At DSP Mutual Fund, Saurabh Bhatia, head, fixed income, gives full credit to the analyst team for identifying the risks in the Essel Group and other papers that turned bad and staying away from them. “Although the promoter or group provides an overreaching comfort, we prefer fundamentally sound businesses with potential to generate stable cash flows in addition to parameters such as debt and interest coverage and a big Ebidta (earnings before interest, depreciation, taxation and amortization) to cash conversion ratio," he said. Visibility on cash flow and the impact of market liquidity on it are identified as key parameters in evaluating the suitability of an investment. “It is important to assess the ability of companies to refinance debt through banks or capital markets," Bhatia added.
The fund house also considers the structuring of the instrument in a way that provides greater security to the lender. This includes ring-fencing of assured cash flows, priority payments through waterfall structure and cash kept aside for subsequent debt obligations in a separate account. “Covenants also ensure that the credit quality of the investment does not drastically change over the tenor of the investment," said Bhatia.
The fund house believes that a positive growth momentum and lower cost of money are essential preconditions for credit calls to play out. In the absence of these, the risk-reward equation becomes unfavourable to the investor. Except for its credit risk fund, the fund house’s other schemes are predominantly invested in AAA and equivalent quality of papers.
A cursory glance at data shows that fund houses that have come under scrutiny for the investments made in Essel Group companies have launched a large number of fixed maturity plans (FMPs) in the last few years. FMPs have always been the hunting ground for funds in the AUM race. The sacrifice of quality for quantity was but a natural progression for funds that had collected the money from investors and faced a paucity of good papers to deploy this money. But the experience of the fund houses that have kept their nose clean proves that sticking to processes, focusing on quality and paying heed to deviations does work in the investors’ interests.