IL&FS, DHFL, ….Who’s next?

This Article was originally published in The Global Analyst

The idea of this article is not to speculate a name that is likely to fail next. That can at best be a speculation.

Corporate failures suck and financial corporate failures suck big time. Remember the case of Global Financial Crisis(GFC) and the role financial firms played to create that crisis. Even after a decade, we are still seeing books being published with titles like “Lessons learnt from GFC” or “What lead to GFC”. Financial crisis leave a grim foot mark that is hard to erase easily. Countries rocked by financial company failures should worry more as they have many connecting dots and impacting points.

IL&FS is a company engaged in infrastructure financing and whose structure is hard to understand with more than 250 subsidiaries and not so clear ownership structures. Though the company was initially started by Central Bank of India, HDFC and UTI, over time the ownership changed in favor of LIC, Orix and Abu Dhabi Investment Authority (ADIA). Such a presence of globally reputed institutional investors among owners should actually give more comfort and pave way for better corporate governance, On the contrary, the executive management of IL&FS used its complicated structure to bestow themselves with generous compensations and misplaced incentives leading to the saga of default that had a humble start in June 2018. At that time it started off as a delay in repayment of INR 450 crores of inter corporate deposits from SIDBI. Though credit rating agencies downgraded the rating as a consequence, the market barely noticed. Unable to conceal the problem, over subsequent months, IL&FS defaulted on several crores of loans leading SEBI to fire the board and institute a new board under the chairmanship of Uday Kotak. In short, it is a story of poor corporate governance unnoticed by some of the most sophisticated global investors!

Dewan Housing Finance Corporation Ltd (DHFL) has a different background but with the same story line. DHFL is a deposit taking housing finance company whose business model is predicated on enabling affordable housing to middle income people and is spearheaded by Kapil Wadhwan. The trouble started in September 2018 when DSP Mutual Fund sold INR 300 cr of DHFL papers at 11% in the secondary market, way higher than the traded rates sparking speculation of liquidity crunch. However, the real problem started when Cobrapost alleged in Jan 2019 that DHFL promoters lent money worth INR 31,500 crores to shell companies which was used to buy assets abroad. As expected, DHFL refuted the claim through a clarification provided to Bombay Stock Exchange and rating agencies were quick to reaffirm high safety rating to DHFL. It is only in May 2019 that Care (rating agency) downgraded the Fixed Deposit Program worth INR 20,000 crs from “A” to “BBB” post which DHFL stopped accepting and renewing fixed deposits and premature withdrawals. DHFL then delayed interest payment on its bonds and bond repayments worth INR 960 crores and is now busy selling assets to meet the promised repayments. This is yet again another story of corporate governance failure though of a different flavor.

These failures as well as bank episodes (thanks to NPA) has negatively impacted both stock markets and bond markets. For the stock market, we can see from Table 1 banks and non-banks with poor performance and good performance. The downfall is quite significant to note since such negative performances are observed only in a deep bear market.

However, the impact these had on the bond market is really significant which is summarized in Table 2. Out of approximately 1,900 fund universe, nearly 105 mutual funds got affected through their exposure to DHFL paper accounting for about 2.5% of total assets.

From an asset value perspective, I will not panic at this number but it warrants caution among mutual fund managers. India has been experiencing strong inflows both into equity and debt funds by foreign institutional investors during the past few years. This has increased competition among funds to outperform the benchmark which warrants them to take risk to pick up the additional yield. That is when they venture into papers like DHFL and IL&FS, especially corporate bond funds. Bond funds have significant exposure to other low rated papers by finance companies (in search of yield) and hence I believe they may now reduce their exposure to high risk papers which will bring down the yield of these funds going forward.

From a portfolio investment perspective, a key question is: Which is riskier banks or non-banks. While banks borrow money from retail and lend to wholesale (businesses) non-banks borrow money from wholesale and lend retail. So when banks go bust, the losses will be significant, while non-banks may be slightly better off given their exposure to retail. However, the broader premise is one of corporate governance both in banks and non-banks. Well governed banks and non-banks do perform well in the stock market even in these testing times. Hence, research should focus on unravelling this qualitative element rather than laboring on quarterly statements that can easily be doctored. In the case of IL&FS, major lapses on the part of Deloitte (auditors) were noticed.

With each major crisis, regulators tighten the screws that reduces the intensity of future crisis. In general, I would say that banks and non-banks regulations are far more advanced today than they were some two decades before. However, regulators have to always do a catch up act more than preempting crisis. Also, they tend to over react and over regulate that imposes huge costs and kills market growth. Calibration is the key word in terms of structuring regulations to minimize failures and where it happens, containing the contagion effect.

The beauty of such financial company failures is that it can make available well governed companies at attractive valuations. Use every such opportunity to build on quality franchise.

Happy investing!

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