IL&FS is a great magic trick. A massive illusion till the method is revealed. That’s when it all seems so obvious. So obvious that the sages of the Indian financial system, the bankers, the regulators and the company’s big-daddy shareholders — LIC, Orix, and HDFC — should have seen this coming six years ago.
Now, with the perfect vision of hindsight, it is clear why this did not happen. A strong and charismatic leader, Ravi Parthasarathy, and his clutch of key lieutenants ran IL&FS like classic Indian promoters. “A group of seven or eight people controlled key decisions. Either you were in or out. It was a fairly tough environment,” says a private-equity fund manager who has co-invested with IL&FS since its early days.
Almost everyone ET Prime spoke to for this story acknowledges that Parthasarathy is astute. One of them says he is “on an intellect level, brilliant”. His father was a senior bureaucrat, and that gave him good connections in North Block even in the early years. A hard negotiator, he was too smart for the bankers. No wonder they kept lending to him. He was a strong personality, and you either liked him or hated him. He acted as if he owned IL&FS, and for most people, he was IL&FS.
One story goes that while the iconic IL&FS building at Mumbai’s Bandra Kurla Complex (BKC) was being built, he was on a visit to Japan and the Mitsubishi elevators in an office there caught his fancy. Some enthusiastic employees ordered the lifts even before the building was ready, and they lay in Mumbai port for months. IL&FS paid a huge demurrage, probably higher than the cost of the lifts.
Parthasarathy is wealthy. He made good money selling his stake in 20th Century Finance, which he was part of before IL&FS. He was always seen with his pipe in the IL&FS building in BKC, which is now up for sale.
Ambitions that make a man grand
Inside every lender there is a small and afraid equity risk-taker waiting to come out. IL&FS, like, say, IDFC, began life as a structured-lending institution, doing last-mile financing or cost-overrun financing. Till it stuck to this approach, all was fine, but at some point around the turn of the century, it decided to become a developer. It was essentially a lender wanting to capture full equity value.
Take for instance, IDFC, which in the past was a lender, and then became a successful private-equity fund (when Luis Miranda was running it) focusing on infrastructure. The PE fund added the equity kicker to the lending returns. At some point, IDFC tried to do a few control deals where it would have a majority share. That’s adding more equity returns to the portfolio.
IL&FS went the full distance, with subsidiaries operating projects in diverse infrastructure segments: roads, power, airports, education, water services, and even tunnels.
Till FY08, infrastructure was a great sector to be in, with companies such as GMR and GVK flying high. In 2010, IL&FS was able to list its subsidiary, IL&FS Transportation Network Limited (ITNL), with an INR700 crore public issue. On the day of listing, March 30, 2010, ITNL opened 12.4% higher than the issue price. At the close of the market, the price was INR295.
Over the next eight years, what happened to ITNL captures IL&FS’ troubles. In FY09, the company had INR1,850 crore as debt, which went up continuously for the next nine years to INR34,544 crore. Debt isn’t a problem if the company has money to service it. ITNL was good at it till 2012, after which there was a steady decline in its ability to service this debt.
This can be seen in the interest cover ratio slipping from 2.7 to just 0.8. Since the company was unable to service the long-term debt, it increased the short-term debt as well. The net-profit margin was never too great. It was 8% in 2013 and plummeted to 2%. On September 27, 2018, ITNL’s share price ended the day at INR23.35, less than one-tenth of the closing price on the day of the listing.Across the IL&FS portfolio, this story repeats itself. The infrastructure projects (like many in the sector that fell prey to policy paralysis or over estimation of traffic) are either badly chosen or do not match revenue estimates. The shortfall is met through an equity infusion by the holding company. The holding company itself has no cash cow — no business which is generating so much money that it can be used to infuse equity into the subsidiary. What’s the solution? The holding company raises debt, which it then infuses as equity in its subsidiaries. This can be seen in the debt-to-equity ratio at the holding company, which is now two times the level it was in FY14. “IL&FS has been facing issues for the past five to seven years. But they were able to manage the situation by transferring funds from one company to another group company. Now it has come to the point that they have no source of raising funds internally, as in raising debt from one entity for use in another. No one will finance them now,” says an investment banker who has worked with IL&FS.
ET Prime’s e-mailed questions to IL&FS went unanswered till the time of publishing this story.
Refinance or bust
Then there is the classic asset-liability mismatch problem. Rohit Chauhan, an investment analyst, deconstructs the IL&FS situation on his blog devoted to value investing.
According to Chauhan, here is what the situation looks like:
Let’s look at the case of IL&FS.
The company has a short-term borrowing of around INR25,000 crore out of a total borrowing of INR91,000 crore. This means that the company has to renew this borrowing on a regular basis.
The company does not break out the asset-side duration, but if you look at the balance sheet, almost 80% of the assets are long dated in the form of infrastructure assets and receivable claims, etc.
This kind of a balance sheet works till the financial institution can refinance its debt on a regular basis. In the case of IL&FS, they have been facing cash-flow issues and losses due to various projects being stuck at different stages of completion, with claims pending with the government. At the same time, the short-term debt and interest has to be paid when it comes due.
In the recent months, the company started facing liquidity issues and has not been able to make payment on its interest obligations, as it cannot liquidate its assets quickly to make these payments (keep in mind the nature of assets such as roads and bridges, which cannot be sold quickly).
As the company defaulted in the last few weeks, the debt held by mutual funds and other lenders had to be marked down. This has led to a cascade effect where these funds have had to liquidate other instruments to meet their liquidity requirements.
“What has happened to this company is that there is a ‘pyramiding’ of debt. There is excess debt at every level,” says a former advisor to IL&FS.
Where is the equity?
The only way to control the debt was bringing in equity. “There were so many discussions that IL&FS should go public. Ravi was of the opinion that infrastructure as a business is not suited for quarterly disclosures due to unpredictable cash flows. That’s why every IPO plan was ultimately shot down,” says the advisor.
People who have done business with IL&FS also say that taking the holding company public would have exposed it to scrutiny. So, the primary method of equity infusion was sale of businesses. In FY08 it sold off its brokerage business Investmart to HSBC for USD261 million. Then there was the ITNL IPO and sale of some real-estate assets.
After that, the only occasion when the holding company saw any equity transaction was when the Abu Dhabi Investment Authority (ADIA) bought a stake in IL&FS. (ADIA had acquired shares from the employee trust of IL&FS in 2007, so the proceeds didn’t go to the company. IL&FS did receive some project-specific financing from another Abu Dhabi government entity around 2008.)
In FY15, IL&FS attempted to get an investment from Piramal Enterprises. That deal never came through. After that it was only a matter of time.
The most amazing thing is that even with ever increasing levels of debt and worsening profitability, the rating agencies never saw this coming. Just three months prior to the default on its short-term debt, IL&FS was able to raise INR780 crore through issue of debentures.
A senior official who had rated the company’s papers says, “IL&FS has been trying to sell some of these projects for nearly two years now. A lot of group funds are stuck there.”
The official says that the documentation for the rights issue was in place. Some term sheets were also shown to ET Prime, suggesting the monetisation of some projects was at an advanced stage. “Under these conditions, we did not see any reason to fear that these would not go through.”
When asked if he did not see the event of Parthasarathy quitting as a big risk, he says, “Ravi was unwell for some time now. And, it is true of large organisations that they are dependent on a charismatic leader. But there were people like Hari (Sankaran) and Bawa.”
For most analysts as well as investors, IL&FS presented the face of a government-backed company. It did not help that the IL&FS accounts are a maze. The latest balance sheet shows 24 direct subsidiaries and 135 indirect subsidiaries. The idea is to operate through subsidiaries to isolate the holding company from future liabilities and defaults by subsidiaries. Market watchers have often spoken about IL&FS Financial Services as the vehicle that moves money from one subsidiary to the other, since IL&FS rarely invests its own money and depends on borrowings. In case of any problems, it is the lenders who will lose.
The company subverted corporate governance through pliable directors, cooperating government officials, and past or present bureaucrats. IL&FS roped in governments as partners, letting the firm avoid public scrutiny by simply not permitting CAG audits and replying to RTI queries.
The resignation of Parthasarathy (on account of severe illness) in July this year could have been the moment that the illusion was broken.
With the amount of counter-party risk that the company is carrying (mutual funds alone hold more than INR3,000 crore of IL&FS paper), it is unlikely that the government will let it collapse.
But it will prove once again, as in the case of the energy company Enron, that the “smartest guys in the room” can hold the financial system to ransom. Again.
(With inputs from Pravin Palande and Shishir Prasad)