It’s over six months since the new management took over the reins of Infrastructure Leasing & Financial Services Limited (IL&FS) and the outlook is only getting murkier. The flagship lending unit, IL&FS Financial Services Ltd (IFIN) GNPAs (gross NPA) have already crossed 90 percent. As part of SFIO’s investigation into IL&FS and its group entities, the former vice-chairman and Managing Director of IL&FS Hari Sankaran and former IFIN CEO and MD Ramesh Bawa have been arrested. The Serious Fraud Investigation Office (SFIO) has initiated another probe-based upon a whistleblower complaint by a Deloitte employee that auditors deliberately ignored red flags in the company’s books and had a quid pro quo with the management. So what went wrong? Let’s try to unravel the mystery behind the incredible rise and the inevitable collapse of IL&FS.
IL&FS is the story about the unfettered growth of a shadow bank which over a period of time became too big to fail. If Satyam was like riding a tiger, IL&FS feels like riding an elephant in a desert. This epic story also reflects failures on multiple fronts: rating agencies, regulators, auditors, corporate governance, etc. While the story of the 2008 sub-prime crisis was that of credit derivatives which multiplied exposures far in excess of available assets underlying the derivatives, the IL&FS narrative is about real infrastructure assets financed with excessive borrowing and little capital cushion. So let’s analyze what went wrong triggering the downfall of the IL&FS empire. First, a little brief about the visible and not so visible fault lines in India’s fragile financial landscape:
Faultlines in India’s Fragile Financial System
The long, dark shadow of banks
No doubt, India’s Non-banking Finance Companies (NBFCs) nestling under the shadow of banks have played a greater role to meet credit needs not catered to by the formal banking sector thereby providing financial inclusion and depth to the financial markets. During the last few years, NBFCs have started growing at a faster pace than traditional banks (grappling with NPAs) providing grease to keep the economy functioning smoothly. But as shadow banking is undertaken with less transparency and regulation than conventional banking, it creates opportunities for regulatory arbitrage. Due to a lack of regulatory oversight, shadow banks indulge in excessive risk-taking through higher leverage. This increases the vulnerability to shocks and can become a cause for financial crises that can easily spread to traditional banking and the broader economy. With an increase in gearing over a period of time, IL&FS debt-equity ratio (excluding minority interest) went up to 16.8x at the end of March 2018 against 10.6x a year ago. High leverage by borrowing Rs 16 for every rupee of equity is not business but a high-risk gamble.
Short-termism in a long term game
In the hindsight, it appears that the conversion of Development Finance Institutions (DFIs) such as ICICI, and IDBI into commercial banks was a big mistake as there is nobody to finance India’s growing need for infrastructure in the absence of term-lending institutions.
Not just for NBFCs, Asset Liability Mismatch (ALM) is the second major issue (after NPAs) plaguing the Indian banking system with deposit tenures getting shorter while that of loans is getting longer creating instability in banks’ balance sheets. So long as one is able to roll-over the existing debt or raise new funding to meet the present payment obligations, everything is fine but the moment there is a liquidity squeeze, it can turn into a crisis.
In the IL&FS story, this is what exactly happened. As banks became reluctant to refinance 10-year loans, IL&FS resorted to short term borrowings through Commercial papers (CPs) which made the situation even more precarious in the absence of capital infusion and negative cash flows.
Where is Bond Street?
Unlike the government security market, which is very liquid, the corporate bond market is shallow and opaque and is in a private placement domain. India badly needs a market not just for investment-grade paper rated above BBB- but also for paper rated below-investment grade called junk-bonds. If investing in AAA paper involves credit risk, why not invest in junk bonds and at least earn a higher yield (can be as high as 4-5% over G-Secs) to compensate for the higher default risk? Junk bonds can provide a new window for distressed borrowers to climb out of their debt trap by raising fresh high yield debt to pay off old loans.
Who moved my ratings?
Unlike Satyam, where an audit firm was pulled up for its role in India’s biggest accounting scam, in the IL&FS case, the role of rating agencies is questionable? The sudden and swift downgrade of IL&FS ratings all in a matter of days raises questions about the credit rating process. Why did it take CRAs so long to identify and red-flag the default risk? In their self-complacency, India’s premier credit rating agencies (CRAs) failed to do even the basic due diligence about IL&FS cash flows and the feasibility of its business operations. In fact, the IL&FS is not the first glaring example of their ineptitude. Earlier, it was Amtek Auto in September 2015 which also triggered a redemption crisis at JPMorgan Mutual fund.
Other Chinks in The IL&FS Armour
Missing Raj Dharma
As per the Secretarial Audit Report, IL&FS is a professionally managed company with no identifiable promoters. And, surprisingly, despite having had so many luminaries of the business world including MD of LIC, former chairman of LIC, ex-MD and current chairman of Maruti Suzuki, founder and former CEO of Mphasis Corporation, the IL&FS board failed miserably in discharging its duty.
The IL&FS odyssey raises many intriguing issues about corporate dharma. First, what is the purpose of the appointment of Independent Directors? Why India Inc board room discussions don’t go beyond the quarterly results? Why the remuneration package of senior management is de-linked from the performance? And above all, what is the fiduciary responsibility of nominee directors?
The hidden signs that can reveal a fake photo
A look at the annual report of the company for the FY 2017-18 suggests that Ravi Parthasarathy (erstwhile Chairman) got a 144 percent jump in the salary. The pay ratio i.e., the ratio of his remuneration to the median remuneration of all employees of the company went up from 54.94 in 2016-17 to 140.97 in 2017-18 (and that too with fewer and obviously high paid permanent employees totaling 131).
This was despite the dismissal performance of the group. The consolidated profit of 142 Cr in 2017-18 got converted to a loss of 1887 Cr. The free cash flow (FCF) (i.e., cash flow from operations minus Capex) also show weak financials: while Rs. 4.2K Cr net cash was burned in operating activities, Rs. 7K Cr net cash was guzzled by investing activities. The total negative free cash flow (FCF) of nearly 11K Cr was financed by net additional borrowings including the short term. Investing in future growth despite operating losses does not bode well for an over-leveraged company. And despite having weak financials and strain on cash flows, it went ahead with not just salary increments but also dividend declaration. What can be the justification for paying dividends out of borrowings?
Further, as per the 2018 Annual Report, there was one common member of the Audit Committee, Remuneration Committee, and Risk Management Committee. While he attended all six meetings of the remuneration committee, could spare time only for two of the audit committee meetings and no time for Risk Management Committee. Does it mean that the management remuneration issue was far more important than discussing either audit matters or risk management? But why blame him alone when no meeting of the Risk Management Committee was held for the last three years. The only plausible explanation can be that everything was going fine and there was no sense of imminent danger, so why waste time in a meeting.
The Machiavellian Prince
The universal truth is that power, whether political or business, always has a corrupting influence on those who possess it. This fascinating adventure tale – The Chronicles of Ravi Parthasarathy, is also about how power can corrupt leaders.
As succinctly analyzed by Gajendra Haldea, former Principal advisor (infrastructure) in the erstwhile Planning Commission, in his blog gajendrahaldea.in the IL&FS exposes the dark and dirty underbelly of corporate and political governance. The ploy to game the system involved deft use of the SPV route (to use the public money without the accompanying checks and restrictions ), employment of several serving and retired bureaucrats, managing the governments and the financial institutions, and winning the public infrastructure projects on a platter without the mandatory competitive bidding. Mr. Haldea has also elaborated how he managed to save one SPV called DMIC (Delhi Mumbai Industrial Corridor) from the clutches of IL&FS.
The mystery behind The Non-Barking Dogs
Unlike the Sherlock Holmes story ‘Silver Blaze’, in the case of IL&FS, there was not one but many watchdogs. The mystery is: Why did all of them keep silent instead of barking or howling?
Actually, instead of barking, dogs were busy licking the juicy bones and wagging their tails. But why? Technically, it is called a conflict of interest. Let us ask this way: Who foots the rating bills? And who pays the independent directors & Auditors? However, the more plausible explanation is that CRAs were in awe of the monolith and its exalted parentage in addition to sovereign backing. Till the end, they remained under the false impression that nothing can go wrong because dominant shareholders are always there to infuse funds in case of cash deficiency. As far as IDs are concerned, the term independent directors is a misnomer because there’s hardly any independence associated with the designation.
However, despite all the above shortcomings, there was something else which led to the fall of monolith/juggernaut
Structural Design Flaw in IL&FS Equation: The Genesis of the Problem
There were obvious fatal architectural design flaws in the business model and operating structure of IL&FS. If banks and other finance companies are not allowed to venture into non-finance business, why IL&FS, a Systematically Important Non-Deposit Accepting Core Investment Company (CIC-ND-SI), was allowed to outgrew its original mandate of infra financing and get into the business of executing infrastructure projects? The mix of infra-financing with infra execution (both high-risk business) became a deadly cocktail. Now combine this toxic business model with the operating model of having a complex web of subsidiaries, associates, and SPVs (Special Purpose vehicle) making it unwieldy to manage. Let’s go a little further and add one more variable of the opacity of IL&FS financials & operations (masking growing liquidity problems), being an unlisted entity. Now let’s represent it in the form of an equation:
Rise of IL&FS Megacity=Toxicity+Complexity+Opacity
Next, let’s look at the shareholding pattern. It is a quasi-government entity with marquee investors like LIC, SBI, HDFC and Orix Corporation Japan which created a feeling that nothing can go wrong. Adding this variable, the modified equation is
Decline of IL&FS Megacity=Toxicity+Complexity+Opacity+Complacency
Now that investigations are undergoing by SFIO (Serious Fraud & Investigation Office), another variable ‘Complicity’ gets added and the following new equation emerges:
Collapse of IL&FS Mega-Scam City = Toxicity+Complexity+Opacity+Complacency+Complicity
The end of IL&FS Odyssey!
