Lessons from IL&FS saga

Don't invest in companies that have complex balance sheets, despite government backing

The Infrastructure Leasing & Financial Services fiasco holds many lessons for investors, and policymakers as well. The non-banking financial company (NBFC) has always been treated as a quasi-government agency rather than a high-risk financial player with glaring asset-liability mismatches.  Most investors ignored the incredibly complicated balance sheet with its multitude of subsidiaries and special purpose vehicles. The implicit comfort was the apparent sovereign guarantee.  

When the liquidity problems surfaced, a bailout was assumed.  The defaults have resulted in nervousness in the bond market and there will be a cascading effect if the obligations cannot be met. 

The majority shareholders will probably need to organise a bailout and Life Insurance Corporation of India (LIC) is meeting the Reserve Bank of India to discuss the specifics. This means finding Rs 45 billion (bn) or more to tide over the current obligations, and it may mean more in future, given that the debt overhang is around Rs 900 bn.

A bailout will result in some stress for the shareholders who participate in rescuing the NBFC. State Bank of India (SBI) can ill afford this at the moment, and it cannot be healthy for LIC to be used as the eternal rescuer. Central Bank of India is bankrupt and cannot possibly help. Overseas shareholders will probably take their cues from LIC. HDFC's decision, either way, will be watched with interest.  

The long-term problems remain. The balance sheet is hard to decipher and it's not clear what can be sold to deleverage, or how much any such sales will realise.  Apart from structural complexity, the high exposure to infrastructure projects lends itself to opacity. Which projects are at what stage of completion? Any valuer would have to make guesses as to the timeframe in which various assets would start becoming productive.  

Asset-liability mismatches are guaranteed when it comes to project financing. Infra projects are capital-intensive and have long time frames by their very nature. There is no cash-flow until the project is up and running and that could be several years in the case of a road, or a power station, or a port terminal. 

At the same time, sources of funding in India are medium-term at best, with most banks incapable of lending for tenures of over five years. To add to the problems, India has a high degree of project failure and time overruns.

The obvious solution to this situation would be a strong secondary market for bonds. In that case, project finance could be raised by floating bonds, which in turn, could be structured for back-ended cash flows. Assuming a liquid secondary market, bondholders would also be able to offset risk by selling off their holdings at discount, if necessary. However, India doesn't have a secondary bond market of anywhere near the necessary depth and liquidity for this to be a scenario. 

Another potential source of funds for long-gestation projects is the insurance sector. Insurers, in theory, raise long-term capital extremely cheap or free. That money can be put into long-gestation project financing without fear of an asset-liability mismatch. However, insurers have to keep cash on hand to meet claims and there can be huge losses in case there's a catastrophe.  Regulation in the insurance sector must be reviewed before insurers can safely be allowed into project financing. 

The defaults should also have drawn regulatory attention to the NBFC sector as a whole. Standards here are more lax than in conventional banking and India’s banks are struggling to cope with over Rs 10 trillion in non-performing assets. The ratio of non-performing assets (NPAs) in the NBFC sector could be higher, given the presence of hundreds of small lenders and easier accounting standards. At the same time, NBFCs drive private consumption and small-scale businesses and thus, perform a vital role. From the policy perspective, cleaning up the NBFC sector should be high-priority on the agenda.  Otherwise, the bank crisis will be compounded by an NBFC crisis. Without getting alarmist, the situation in the sector could get worse before it improves. 

From the investor's perspective, all one can say is, don't invest in a company with a balance sheet that requires a PhD in Finance to unravel with any confidence. It doesn't matter if the government (or government-owned institutions) is the majority shareholder.  In fact, that could make things worse since the government has a history of treating minority shareholders badly.