Not since the Nirav Modi affair has a story of alleged financial shenanigans captured the public imagination in quite the same manner that the IL&FS narrative has done. And this is a far more complex, more layered narrative than the scandal around the fugitive diamantaire.
Modi’s exploits revolved around a straightforward fraud, but the amount of literature produced on the IL&FS crisis over the past two weeks shows that this is a more nuanced tale, with quite many subplots. Some commentators have brought out how India’s premier credit rating companies neglected to do even the very basic due diligence on IL&FS’ corporate structure, its financial fundamentals, its cash flows and the feasibility of its business plan. Had these companies managed to shrug off some of their indolence and self-complacency, they could easily have picked up the warning signs and put the market wise to the goings-on inside IL&FS at some point, thereby staunching the flow of fresh cash into IL&FS’ coffers.
But what really was happening on the rating agencies’ watch? By now we have a fair idea about the symptoms of the disease – mounting losses, credit defaults and a CEO who abandoned the sinking ship – but what, indeed, was the disease? What triggered it in a once-robust, seemingly-strong organisational setup that was the envy of many of its peers? And, finally, even given the exposure to the contagion, wasn’t there any way for IL&FS to stay reasonably healthy? At any rate, couldn’t the rot have been stemmed somewhat earlier?
IL&FS’s original mandate
IL&FS’s original mandate was to finance the building and maintenance of infrastructure projects that were meant to be commercially viable in the long run (for example, toll roads, ports, power generation and/or distribution facilities and so on). At its inception in 1987 as a ‘core investment company’ registered with the RBI, it could look mainly at private sector ventures, because the public-private-partnership (PPP) model had not really gained much traction yet.
Its original stakeholders were UTI, HDFC and the Central Bank of India, and its original senior appointees included private-sector managers like Ravi Parthasarathy, an ex-Citibanker. It was thus a somewhat curious animal – a government-sponsored enterprise in the private sector. The glamour of a slick private-sector business and the heft of a government-owned company combined in IL&FS’ DNA, as anyone who happened to have dealt with IL&FS would testify.
Over the decades, the company reinvented itself in every which way imaginable. When UTI was confronted with its own existential crisis, the government induced LIC to step into the beleaguered fund’s shoes, even as other high-profile investors like the Mitsubishi group (via the ORIX Corporation) and the Abu Dhabi Investment Authority bought into the company’s equity.
State Bank of India followed suit and, at last count, the shareholding pattern (in % terms) looked broadly like this:
|Stakeholders||Shareholding Pattern (%)|
|IL&FS Employees’ Welfare Trust||12|
The company had also outgrown its original mission, mutating into a major infrastructure player itself, no longer content with financing of infrastructure alone.
“From concept to execution” became its byword and the focus shifted from sponsoring a project to facilitating, even actually implementing it. Its operating model was also a giddy amalgam of subsidiaries, associates and special purpose vehicles (SPVs) many of which were set up around a specific project, such as a road, a bridge or the celebrated Chenani-Nashri Highway Tunnel, the country’s longest (9.3) road tunnel on NH 44 in J&K which has reduced the travel time between Jammu and Srinagar by a spectacular two hours.
In the process, the IL&FS group grew into a true behemoth, formidable but also unwieldy and extremely complicated in its architecture, comprising over 200 business units/arms each of which drew sustenance from the parent/holding company (IL&FS Ltd) but did not easily lend itself to a close examination. Only three of IL&FS’ subsidiaries are listed companies – none of the SPVs is a listed entity – and the intermeshing of their financials makes the group quite opaque to any meaningful scrutiny.
The holding company managed to show itself in good light even as the group as a whole had been sinking under the dead weight of unfinished projects and dramatically rising liabilities. Over the three years from FY 2014-15 to FY 2017-18, consolidated debt rose 44% to nearly $13 billion and the debt-to-net worth ratio climbed to a staggering 13:1. Analysts have indeed shown that even these numbers may be off the mark, that the group’s net worth (or, owned funds) may have completely eroded if we factor in all the intangible (dud or irrecoverable) assets and the quasi-equity funds that have been generously treated on par with equity in the group’s balance sheet.
At FY 17-18, the net group loss was Rs 21 billion while, in the same year, short-term debt (payable within 12 months) alone went up by Rs 136 billion. The holding company’s reputation/market standing (a significant part of which, it needs to be said, was not really earned) was leveraged by every subsidiary and each SPV to raise more and resources at a steady clip.
The crux of the problem
Here we come to the crux of IL&FS’s problems: the nature of its overly ambitious business plan.
Infrastructure financing is a tough enough job at the best of times and when it is coupled with dirtying one’s own hands by actually executing infrastructure projects, the problems could only multiply manifold.
All infrastructure projects typically come loaded with a generous basket of risks that most other business ventures manage to steer clear of: long and protracted implementation; natural calamities or some other unforeseen contingencies; delayed/withheld regulatory approvals; escalation of costs well beyond the original estimates and the need for mobilising and servicing of additional debt; inadequate, or at any rate slow revenue/cash generation; and finally, often a change in the business environment that nobody ever anticipated.
I have known of a 350+ km road project that was held up for several years because a 10-km stretch abutted on an army cantonment and the promoters had not factored in the army’s views on the project. Gigantic coal-driven power projects were conceived keeping in mind a certain per-unit cost of imported coal, but the actual cost has now gone way beyond those estimates.
Even the servicing cost of a bank loan may have risen significantly, because bank loans are benchmarked to some underlyings which may change dramatically in course of the project’s implementation/debt servicing. Despite carrying the best possible credit ratings, IL&FS needed to raise a Rs 85 billion corpus of preference shares at 16% per annum, not a cheap borrowing by any means. Even the group’s much-admired tunnel project was delayed by a whole year (by 18 months, reckoning IL&FS’ own internal target), and the cost went up by a whopping 50%! The November 2016 demonetisation misadventure is also understood to have impacted the final stage of the implementation.
The financing of infrastructure is often plagued by all these risks, because if the project cash flows are low or delayed, debt servicing cannot help being tardy or erratic. But even more importantly, there is a fundamental flaw in India’s funding of infrastructure, where the lion’s share of the financing is accounted for by commercial banks. Now, project loans are typically long-duration exposures, while an Indian bank’s corpus of funds has an average maturity of no more than three years today. (Longer-term fixed deposits are no longer preferred because of uncertain interest rate outlooks and, in any case, a substantial portion of bank deposits – between 25-45% – is not fixed-duration, but can be taken out anytime, at the depositors’ convenience.)
This mismatch between the sources and the utilisations of bank funds is fraught with serious liquidity risks (also some manner of interest rate risk) and our banks have been living with these unconscionable risks for decades now. This gridlock additionally creates interest rate uncertainties for the projects also. And delinquencies in infrastructure loans have been the single most important cause of bank NPAs in recent years.
India’s development financial institutions
Till the 1980s, India had what were then called ‘Development Financial Institutions’ – like the IDBI, the ICICI or the IFCI – that had been set up primarily as vehicles of project funding. Traditionally, the commercial banks were engaged in financing short-term (mainly working capital) needs while the resources of these DFIs were harnessed for longer-term loans. These institutions were funded by equity, long-term deposits and debentures.
Later, corporations like the Infrastructure Development Finance Corporations were created so as to cater for long-gestation projects and for refinancing bank loans to infra projects. Slowly, however, all these institutions were attracted by the idea of ‘universal banking’, and eventually all of them transformed into commercial banks. (Their own funding issues, discussed a little later here, also proved to be a trigger.) Incredibly, as India entered the era of aggressive expansion of infrastructure, she did not have an enabling funding model that could help the projects along.
All developed economies have active bond markets which are a reliable source of long-duration, mostly fixed-cost funds. For a variety of issues – and, of course, governmental and regulatory laziness – India’s bond markets developed neither the depth nor the breadth to sustain financial ventures which need long-term support. So, commercial banks – which are hardly the ideal provider of long-term financing – have turned out to be the only real fall-back for project funding, with unsavoury , often disastrous, consequences all round. It is quite a shame that this state of affairs continues to this day, when India aspires to be counted among one of the world’s top economies.
The irony is, IL&FS seems to have walked into this welter of problems with eyes wide open. As an infrastructure financier for many years, it could not but have been acutely aware of the many serious problems the whole infra sector is laden with. Incredibly, however, it plunged headlong into the turbulence itself, daring it do its worst, as it were. It must have been seriously self-delusional to pretend – as IL&FS seemed to do when it transitioned from financing to holistic project development – that the problems lay with the developers alone and that it had the answers to all the problems it observed while playing the role of a major financier over many years.
The board’s role
It is here that the company’s board comes into sharp focus. It is always the board’s brief to direct policy as well as to oversee the implementation of agreed policy. It is completely unbelievable that a board packed supposedly with some of the best and brightest in business (R.C. Bhargava, Michael Pinto, Jaithirth Rao, S.B. Mathur, Rina Kamath) failed so outrageously in its basic duties.
- It is always the board’s brief to direct policy as well as to oversee the implementation of agreed policy.
Apparently the board whole-heartedly agreed when IL&FS senior management went for a wholesale change in its business model. It also seems to have believed that the CEO’s personal charms would ensure a work-around in every tight spot and IL&FS’ image would make sure that a virtual ponzi scheme could be called upon at any time to deliver more credit lines at the company’s door-step. Indeed, the board was so self-indulgent that its risk management committee never thought it necessary to meet after July, 2015. So, as IL&FS hurtled towards disaster, the cosy boys’ club of its directors gave up all pretence at corporate governance.
Most tellingly, the board had nominees of SBI, LIC and CBI as well. It is inconceivable how these institutional directors – who, incidentally, were expected to keep an eye out for both the shareholders’ and the lenders’ interests – merely looked on as the senior management played ducks and drakes with the public’s money (for, after all, it was the public’s money that was at play here). A more egregious example of collective failure and collective venality of a self-important bunch of people is hard to imagine.
The impasse at IL&FS is unlikely to be resolved soon, or with just about minimal loss to the stakeholders. But some day some manner of closure will be achieved to the current imbroglio. What will get away with barely a scratch, though, is India Inc’s supreme arrogance, its unmatched capacity for self-aggrandisement. And the rest of us will all crow over the ease of doing business in India – especially the IL&FS variety of business.
Based out of Bangalore, Anjan Basu commentates on a wide range of issues. He can be reached at email@example.com