Some investors of fixed maturity plans (FMPs) issued by HDFC Mutual Fund can finally breathe a sigh of relief. On 17 June, HDFC Asset Management Co. Ltd, India’s largest asset manager, announced the acquisition of troubled debt issued by Essel Group companies up to ₹500 crore from the books of HDFC schemes. This will allow FMP investors to withdraw their assets on maturity.
However, it seems the cost of this bailout may be borne by shareholders of HDFC AMC. If the full Essel debt goes bad, more than half of the AMC’s profit after tax (PAT) will get wiped out. The AMC’s trailing 12-month PAT is ₹931 crore, according to data from Value Research.
Moreover, the announcement applies only to FMPs that matured in April or those maturing before 30 September. The latter is the date on which the “standstill agreement" between Essel (Zee Group) and its consortium of lenders (including mutual funds) comes to an end. Under the agreement, lenders agreed to refrain from selling the collateral against the debt securities issued by Essel group companies to give the conglomerate some time to repay.
FMPs mature on specified dates and their structure does not allow investors to wait indefinitely for the values to recover, hence these investors are vulnerable to debt downgrades or defaults. On the other hand, open-ended funds allow investors to enter or exit any time, which means they can wait for a possible recovery in any distressed paper. Fund houses can also undertake side-pocketing or separating bad debt from the rest of the portfolio; this allows investors to liquidate other holdings and get money against the bad debt later when it recovers.
About a month ago, the Securities and Exchange Board of India (Sebi) sent notices to HDFC AMC and Kotak Mahindra Asset Management Co. Ltd with regard to the bad debt affecting their FMPs and commenced adjudication proceedings against them (read more here). This process typically involves a monetary penalty on the defaulting party.
A fund manager, who did not wish to be named, said that the HDFC AMC’s move seems to be a response to the notice.
In 2016, Franklin Templeton Asset Management had taken bad debt issued by Jindal Steel and Power Ltd on to its own book, laying down a precedent for HDFC AMC’s action.
HDFC AMC’s announcement places other fund houses with FMPs containing bad debt, in a quandary. Eighty-seven schemes, including FMPs and open-ended debt funds, across nine fund houses are exposed to securities of Essel Group firms. The fund houses have lent a combined ₹7,000 crore against Essel group’s debt securities (as of April 2019).
While some fund houses like Reliance Nippon Life Asset Management Co. have reduced or eliminated exposure to Essel group, those that are still exposed to Essel’s securities may come under pressure from their holders and Sebi to make similar moves.
Interestingly, in a note issue in April 2019, HDFC AMC gave two different options to its investors. Under the first option, it said it will distribute the FMP proceeds at maturity, excluding the value of debt exposures to the Essel Group. The residual amount of the maturity proceeds would be paid on receipt of dues from Essel. The same approach was followed by Kotak AMC with its Essel-exposed FMPs.
In the second option, HDFC AMC said it would roll over the scheme (extend the maturity date), thereby extending the time for possible repayment. It sought investors’ written consent for such a rollover, adding that investors who don’t consent to the rollover would get back their money at the prevailing NAV.
Out of purview
Other MF investors: The move has raised questions about equitable treatment to all investors. There are several categories of investors that will not benefit from the current bailout.
One, the move does nothing for FMPs maturing after 30 September. Two, it won’t benefit investors of the scheme the fund house rolled over in April this year. HDFC AMC rolled over HDFC Fixed Maturity Plan (issued in February 2016 for 1,168 days), which was due for maturity on 15 April 2019, to 29 April 2020. This FMP had roughly 20% exposure to Essel Group companies. Three, investors in open-ended schemes with exposure to the group will not benefit.
This may open up the HDFC AMC decision to legal challenges.
Shareholders: In its exchange filing, HDFC AMC indicated that it was acquiring non-convertible debentures (NCDs) issued by the Essel Group companies at the “prevailing valuation on the respective maturity/purchase dates". This means that shareholders of HDFC AMC will be burdened with debt with little upside and much downside.
“Investors in FMPs knowingly took the risks. There is no logical basis for transferring this risk to shareholders who have not signed up for the bad debt in question. It also sets a precedent. If a bigger loss crops up tomorrow, it can wipe out the company’s entire equity capital," said Shriram Subramanian, managing director, InGovern Research Services, a corporate governance advisory firm.
However some market analysts took a more sanguine view of the transfer of debt. “It’s a goodwill gesture that is likely to protect the future cash flows of the company as confidence of mutual fund investors gets restored. Even if there is no recovery against the debt, the amount is not large from the point of view of the market cap of the company," said Vinit Bolinjkar, head of research at Ventura Securities, a brokerage. HDFC AMC has a market cap of around ₹39,000 crore. The stock of the company closed 6.34% lower at ₹1,809.10 on the Nifty on Tuesday.
The message from India’s largest mutual fund by asset size is a positive one for mutual fund investors. Their interest has largely been protected by this move. On the flip side, shareholders of AMCs have new risks to take into account.
However, this may also mean that mutual fund investors may now gravitate more towards large asset managers, who are able to absorb losses in times of crisis, accentuating concentration of market share in the industry. “There is a risk that distributors may recommend schemes on the basis that the sponsor or AMC will step in, in case of a default," said Prakash Praharaj, founder of MaxSecure Financial Planners, a financial planning firm.