The Spreading Fire
Anand Adhikari October 15, 2018
"Are you my friend or enemy," Ravi Ramaswamy Parthasarathy, or RP as he was called, often joked when asked about floating an IPO of the three-decade-old Infrastructure Leasing and Financial Services Ltd (IL&FS). Till a few months ago, this Mumbai-headquartered infrastructure financing institution was like a black hole. RP used to share information on a 'need to know' basis with the outside world. Today, this Rs 1 lakh crore-asset size institution is threatening a contagion in the financial market.
Almost a decade ago, when the Lehman Brothers collapse created havoc across the world, India took pride in its banking regulator, the Reserve Bank of India (RBI). IL&FS is no Lehman, but has emerged as a 'too big to fail' institution. At stake is Rs 91,000 crore of debt; nearly two-third of which is from banks. There are short-term commercial papers loaned by big mutual funds and insurers. It has 348 entities under its complex umbrella. This is more than the number of companies listed in the SME exchange. Many are questioning why IL&FS was allowed to continue as a private company for so long. It has marquee names like LIC and SBI as shareholders, Deloitte as auditor and eminent independent directors such as Maruti chairman R.C. Bhargava and former LIC chairman S.B. Mathur. Also, IL&FS was under RBI's watch as a systemically important NBFC for the last seven years.
"The road towards mending the IL&FS mess is more complex than it looks," reasons Uday Kotak, post the first board meeting after taking over as chairman of IL&FS. Kotak is among the half a dozen new directors who have been tasked to preserve the group's value and prepare a roadmap. The immediate task is to prevent the contagion from spreading to the financial market.
The contagion factor is creating nervousness in the market as IL&FS's key lenders are top banks, mutual funds, insurers and pension funds. The IL&FS mess has exposed the dark underbelly of India's Rs 22 lakh crore-shadow banking. NBFCs with high asset concentration in infrastructure, consumer durables, unsecured loans and even mortgages are already wobbling on the bourses. Some NBFCs are rushing to borrowers to rollover short-term funds or raise fresh funds to pay old borrowers, at times, even raising money at over 10 per cent. "NBFC paper subscribed by mutual funds is in the eye of storm, since non-banks have been the most extensive issuers of bonds in the last few years, and naturally the balance sheet leverage is the maximum," explains Arun Thukral, CEO of Axis Securities.
Meanwhile, RBI has stepped in to calm the market by opening credit lines. India's largest bank, State Bank of India, has tripled its target for buying loan portfolio from NBFCs to Rs 45,000 crore. Currently, most money in debt funds is from corporate and high net worth investors. They are not used to seeing losses. Some investors want to redeem units, hoping to avoid the NAV hit in case of a default. "If they redeem in mass, we have a real problem," fears Thukral.
Kotak's new team is on the job to make a fair assessment and act in the interest of stakeholders. "The new team has credibility. It's a positive," says a consultant. In its petition to National Company Law Tribunal (NCLT) for removal of the existing board and management, the government charged that a rosy financial statement was projected.
Balance Sheet Surprises
The new team's first task is to find the true and fair picture of assets and liabilities. There are questions about the quality of earnings due to high level of related party transactions. The standalone income statement of IL&FS had dividend income from subsidiaries crashing from Rs 428 crore in 2016-17 to Rs 200 crore in 2017-18, while at the same time fee-based income (brand fee and consultancy) almost doubled from Rs 108 crore to Rs 212 crore. There are instances of group companies having sold businesses to each other at a profit. The team will also have to find out the correct value of investments in JVs and other unlisted companies.
Then there are liabilities, of Rs 2,014 crore on the books. There are also trade payables or dues to operational creditors. The trade payables of the energy subsidiary, for instance, shot up from Rs 28 crore in 2015-16 to Rs 239 crore in 2016-17. Accounts for 2017-18 are not available. Some suggest that there could be more mess in the SPVs, especially cases of fund diversion. One estimate is that the fund exposure could have touched Rs 1 lakh crore because of interest element. There is also no clarity on the non-fund based exposure of the whole entity.
At the time of going to press, the new board is preparing a blue print which includes restructuring of long-term debt, and meeting redemption requirement of short-term debt to avoid defaults. "The group needed to pay about Rs 800 crore of interest alone each month. This number alone conveys all that was wrong," says Amit Tandon, MD and founder of proxy advisory IiAS. There is no case for a government bailout, say experts. The resolution could be a complete sale of the entity or in parts, or entry of a new strategic investor or one of the existing investors like LIC, SBI, Japan's Orix Corporation and Abu Dhabi Investment Authority.
As a first step, the team has to bring all lenders together under one platform. Economic Affairs Secretary Subhash Chandra Garg had recently said that the IL&FS issue will be substantially resolved in the next six to nine months.
There is legal complexity too. IL&FS, which is an NBFC, cannot be dragged to NCLT because of its financial services nature. The task would be to get a moratorium from the court for the rest of the subsidiaries against bankruptcies. In the immediate future, they also have to speed up asset sale of road projects. The centre and state governments should also pitch in by paying up their pending dues.
New management teams have to be placed at subsidiaries. "There will be a set of professionals motivated to be part of a company if there is a turnaround or restructuring in place. We don't know whether there will be checks and balances put by the government in terms of the compensation structure," says K. Sudarshan, Regional Managing Partner at recruiting firm EMA Partners.
A lot of the problem has to do with how the company's top management behaved. RP, 67, kept a low profile. "He believed that if they don't know you, they cannot hurt you," say people close to him. IL&FS, where RP was CEO since its inception in 1989, was his baby. The reasons for not coming out with an IPO probably lies in the complex structure RP built. In the late 2000s, he reinvented IL&FS as a holding company with dozens of subsidiaries and hundreds of SPVs. While an IPO committee was set up four years ago, no serious effort was made to prepare the ground work.
"He believed in cronyism," say insiders. The top team comprised of Hari Sankaran, 57, Vice Chairman and MD, who was the second in command. Then there was Arun Kumar Saha, 62, Joint MD and CEO; K. Ramchand, 64, project executor; Ramesh Bawa, 63, who was good in raising resources; and Vaibhav Kapoor, 63, who handled investments. "These yes men were doing almost the same job for decades. There was no job rotation or succession planning in place," says a market player.
For decades, RP was the face of IL&FS. He championed new ideas and concepts. In the 90s, he convinced bankers to invest in Motorola's Iridium project for global mobile wireless. He also worked tirelessly for Tirupur water supply project to bring water from the Cauvery river to the town. In the late 90s, IL&FS created the Noida Toll Bridge under a public private partnership. Some ambitious projects failed, but RP moved on with new ideas. Be it the Zojila Tunnel in J&K or joining Gujarat's Gift City financial centre as co-developer and anchor investor or taking big bets in the Centre's solar energy dream of creating 100 gigawatts of renewable energy by 2020, IL&FS was a bankable name.
Clearly, RP is a tricky angle to the IL&FS saga. He remained in the executive post for almost three decades. After the last chairman M. Damodaran - former UTI and Sebi chief - left in 2006, RP took on the dual role of MD and non-executive chairman. Over the years, he became more insular. A chain smoker who graduated to smoking a pipe, RP would often dine and holiday with senior team members. "He saw himself as a karta of the Hindu Undivided Family," reveals a former IL&FS employee. Over the last decade and a half, there were no senior level departures. The board and auditors were also almost the same. "This cozy club helped RP manage everyone in the chain from company to board," says an insider. This style of functioning helped RP carry on without doing a single meeting of the crucial risk management committee last year.
In hindsight, all stakeholders seem to have been blindsided to the growing size of IL&FS in a short time. RP probably knew that listing would mean disclosure pressure and scrutiny from investors. Investment banking sources say the company was not IPO ready as there was no consistency in strategy. "It was switching from one sector to another and from one project to another. There was no solid proof of concept either at subsidiary or SPV level to unlock the value or monetise infra assets," say I-banking sources.
The IL&FS model was to build projects under subsidiaries and SPVs, monetise them and then take on new projects. But the expansion was haphazard, with heavy reliance on debt from public sector banks, and even short-term debt to fund long gestation projects. "RP also created too much conflict of interest internally," says a consultant. For instance, IL&FS was the sponsor of projects, an equity contributor, and also a developer or contractor.
"His idea was to skim money at every stage of the project, but what is coming out now is a faulty architecture," adds the consultant. Cracks in the business model started to surface about three years ago when funding from banks began to choke. Half a dozen banks that had a relationship with IL&FS came under RBI's Prompt Corrective Action (PCA), including the company's lead bank, Central Bank of India. During this, the mandatory requirement to publish consolidated accounts brought out the true financial picture of IL&FS. There was no escape for RP, who started looking out for a white knight to bail them out.
In 2015, billionaire Ajay Piramal was close to sealing a deal to buy IL&FS, but key shareholders, especially LIC, which had a 24 per cent stake, had price differences. Later, two large well known conglomerates also looked at IL&FS, but did not buy it.
IL&FS, too, failed to monetise assets at the SPV level. It managed to get US-based Lone Star on board for distressed asset play in India, but the deal has yet to happen. The noose was tightening and the man who had scaled up the model, was suddenly conspicuous by his absence in social circuits. He visited the Mumbai headquarters less frequently, citing health issues. People who know him say he is undergoing treatment in London, but BT is not able to verify this information.
This left Sankaran to do the fire fighting. What made things worse was the huge loss of Rs 1,886 crore for fiscal 2018. In June 2018, the first signs of a liquidity crisis surfaced when the transportation subsidiary delayed repayment of inter-corporate deposits (ICD) to SIDBI (Small Industries Development Bank of India). The news spread like wild fire in the market which further spooked the company's plan to raise resources. A month later, RP abandoned the sinking ship. Soon, there were a series of defaults by IL&FS and its subsidiaries and downgrades by rating agencies. (See: 'Slow Burn'). As the default increased and a fall became imminent, the board cleared a Rs 4,500 crore-rights offer with a plan to monetise assets valued at Rs 25,000 crore. "IL&FS was trying to do now what could have been the solution when the institution was small," say experts.
The Rot At The Subsidiaries
IL&FS, perceived as a quasi-government institution, expanded haphazardly in roads, power and ports. "RP mastered the art of converting serving and retired bureaucrats into collaborators," say people in the infrastructure field. The biggest concentration of assets was in roads and power. The Rs 37,000 crore debt at the transportation subsidiary - spread over many SPVs in roads, tunnels and bridges - is nearly half of IL&FS's total debt. Many now question the strategy of holding on to good road assets with toll and annuity and taking up new large projects.
Currently, the company has two dozen BOT (build, operate, transfer) projects valued by it at over Rs 20,000 crore. But in the last three years, the overall environment has turned challenging - liquidity squeeze on road projects, lower toll realisation, shift in the government policy from BOT and EPC (engineering, procurement and construction) to HAM (hybrid annuity model). HAM is a mix of EPC and BOT. For IL&FS, HAM would mean 40 per cent of the money being released based on project completion and the rest raised through debt and equity with annuity payment from the government.
"We often resorted to short-term borrowings to fund cost overruns," says an insider. These overruns were challenged by authorities in the arbitration panel. The transportation subsidiary got a Rs 550 crore-arbitration award in November 2017 after an almost one-and-a-half-year fight, but NHAI challenged it in the tribunal. Efforts to monetise road projects through infra investment trusts (InvIT) also became unattractive due to tax issues. US-based Lone Star and Italy's Atlanta also looked at the assets but failed to complete the deal. With defaults rising at the transport subsidiary, many suggested that assets be sold in parts or to rope in NHAI to buy it out.
The energy subsidiary, IL&FS Energy Development, has some 3,000 MW of operational capacity and 15,000 MW under development. However, the power sector is in a bad shape with excess capacity, falling tariffs, absence of coal linkages and discoms not signing long-term power purchase agreements. Banks and cash-rich lenders are wary of lending to power producers. A major chunk - almost 5,000 MW of the subsidiary's power capacity - is coming up in solar, where tariffs have fallen. In April last year, Sunil Wadhwa, the energy subsidiary's MD, quietly left the company. It would be difficult to get buyers for power projects, and banks will have to take big hair cuts to make projects viable.
The biggest surprises could, however, come from the financial services subsidiary, IL&FS Financial Services, where RBI smelt a rat few years ago. This subsidiary has lent large sums to group companies, well over the RBI's exposure norms. The central bank had directed IL&FS to reduce group exposure from their net owned funds or raise more capital to increase net worth and capital adequacy. This change in the accounting treatment meant lower capital adequacy and reduced net owned funds. There was also massive deterioration in its asset quality with gross NPAs exceeding 5 per cent. "There are fears of underreporting of NPAs," say experts. In September, the subsidiary's CEO Ramesh Bawa and the entire board resigned. IL&FS even put the entire subsidiary on sale, but found no buyers.
The maritime business was yet another instance of IL&FS stretching beyond its means. The entire loan to this subsidiary is from the parent and financial services subsidiary. After setting up projects in logistics, it expanded in ports. In March 2018, one operational creditor dragged Dighi Port, jointly developed by IL&FS and a private partner, to the bankruptcy court for default in payments. The company doesn't have much financial support from banks to develop long gestation port projects. A few years ago, to get money from investors, it projected a rosy picture. According to documents, the subsidiary projected a profit of Rs 36 crore in 2017-18 when it actually had a loss of Rs 317 crore. The projected profit in the current fiscal is Rs 57 crore. Early this year, IL&FS even proposed a conversion of its term loan into convertible debentures to lighten its burden. But now any solution to this subsidiary looks remote.
Looking for a solution
The new team has to look for longer-term solutions. Insurers and pension funds with long-term money could provide a steady flow of capital. There are also suggestions of merging IL&FS with government-backed India Infrastructure Finance Company, but in the past development financial institutions have found it difficult to survive. The rescue plan will have to address the present as well as future issues.
It is also time to fix accountability. It's not just credit rating agencies that were at fault; the government, regulators, banks, the board and shareholders were in the dark. If IL&FS was identified as a systemically important NBFC, why was RBI not able to notice the huge asset liability mismatches? The auditors, too, failed to give any qualifications. "More often than not there is a 'CEO capture' in a professionally run company. The board then becomes near redundant," says a rating agency head.