Implied Dividend Growth Rate
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Cross Border Credit Reporting
The geographical boundaries drawn by nation states are blurring in the 21st century. In many parts of the world, free movement of goods, services, and even personnel have become a norm. However, strangely, the concept of credit and loans is still dependent upon national boundaries. The H1B visa system of America is a testimony to […]
Interbank Lending Markets and Repurchase Agreements
Banks have to lend money in accordance with the amount of reserves that they have on hand. However, there is no way of finding out the exact amount of loans that a bank can give out while still complying with the reserve requirements because taking deposits and making loans happen simultaneously. Therefore, it is impossible […]
A Primer on Bills of Exchange
What are Bills of Exchange? A bill of exchange is a promissory note that is usually issued by the buyer to the seller of goods in return for the goods. The seller would like to sell their goods for cash. However, in certain cases, the buyer may not have cash immediately at the moment. However, […]
Market Value, Intrinsic Value and Investment Value
Equity valuation or the valuation of any asset is an art. Valuation is not a perfect science and there is no single correct answer to what the value of a security ought to be. Valuation is at best, an informed guess or an informed opinion. As such, when analysts use the term value, they might […]
After the banking crisis, the Indian capital markets are facing another dire situation. It has recently come to light that many mutual funds have been lending money to promoters of companies.
It needs to be understood that these loans are not being made to companies but rather to promoters of companies. The problem is that some of these loans may have turned bad. This is causing panic amongst mutual fund investors, many of whom had no idea that they had exposure to companies such as IL&FS and DHFL! In this article, we will have a closer look at the loans being sanctioned by fund houses as well their economic impact.
Many times promoters are in need of cash. Perhaps they want to expand their business or have to meet working capital requirements. However, after the NPA crisis, not many public sector banks are willing to lend money to corporations until they have a rock solid credit rating and also provide adequate collateral. Many banks do not accept equity shares as collateral.
This is where debt based mutual funds come in. These mutual funds do not have to adhere to regulations like banks have to. Hence, they are free to lend money to corporations or individuals if they are reasonably confident that they will be paid back.
Mutual funds often fund promoters by forming separate structures. They provide loans only against the shares of blue chip companies. Also, since shares are believed to be extremely volatile, they only finance up to 50% of the market value of the shares. At least in theory, this gives the lenders enough margin to cut their losses in the event of a downturn. It is also known that the securities work like margin loans. For instance, if the value of the collateral drops, then mutual funds have the right to insist on more shares or liquid securities. The idea is to avoid as much risk as possible.
The real reason why mutual funds lend to promoters is that they want to earn a higher return on their investment. Debt funds are under constant pressure to outperform their peers. Outperforming is not easy if the funds portfolio only consists of publicly traded securities. Promoters do not have a very high credit rating. Also, their collateral also fluctuates in value. This is the reason why they are willing to pay higher interest rates. In the past few years, this higher rate has been the reason that some funds have outperformed the others.
There is nothing inherently illegal or immoral about these promoter loans. However, it needs to be understood that these loans are actually quite risky. Hence, it is the responsibility of mutual funds to explain the risks to their investors. Some of the risks related to mutual funds have been listed down as follows.
Firstly, it signals to the markets that the promoter who happens to be an insider to the business is trying to exit it! Also, promoters own huge blocks of shares.
When these huge blocks are put on the market for sale, they tend to increase the supply without any corresponding increase in the demand. As a result, the price plummets rapidly. These scenarios may seem far-fetched but a few Indian mutual funds have found themselves stuck with promoter debt. They are being forced to enter into agreements with promoters since they cannot really afford to sell the debt without risking losing a significant part of their investment.
The bottom line is that mutual funds lending money to promoters is nothing new. However, given the current environment, there is unnecessary scaremongering over such loans. Mutual funds only need to make their investors aware that such loans may be riskier than others which is why they provide better returns too!
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