Nilesh Shah of Kotak AMC on the FMP crisis

Kotak AMC has been one of the first AMCs to redeem Fixed Maturity Plans (FMPs) with exposure to the Essel group and has also been quite communicative to investors on this issue. Nilesh Shah, Managing Director, Kotak Asset Management, spoke to Value Research about equity markets and the FMP issue.

Until recently, the Indian mutual fund industry navigated credit risks well, with relatively few defaults, while banks piled up large NPAs. Why are we seeing more defaults in mutual funds cropping up now?
There is a difference between a delay and a default. About 90 to 95 per cent of the mutual fund industry's assets are invested in a high-credit-quality portfolio, which has received payment on time every time. There have been issues only in 5 to 10 per cent of the assets mandated to take credit risks. In the last two years, the shocks have come from IL&FS and the Essel group. In the IL&FS case, the market took a call based on the promoters' pedigree. It was not that the market could not see deterioration in the group's balance sheet. A rights issue to recapitalise IL&FS was expected and that never came through. There's a world of difference between a company with a Rs 6,000 crore net worth and Rs 90,000 crore debt and one with Rs 12,000 net worth and Rs 84,000 crore debt. The rights issue didn't happen for a variety of reasons despite announcement by the company and assurance to rating agencies as well as to the bank which provided bridge finance of Rs 2,000 crore. We will learn our lesson because that was a call on promoter's pedigree, which didn't work out.

In Essel's case, the choice was between sub-optimal recovery or giving the promoter more time to recover full money. There's no point in converting a notional loss into a real loss. That's why, in the collective wisdom of more than seven mutual funds and several other lenders, we decided to refrain from invoking the pledge and selling the shares.

Should promoter loans against shares have figured in low-risk products such as FMPs?
There are FMPs with high credit quality and FMPs that are mandated to take credit risk. If you want a higher yield, then you do need to take on higher risk. There's no free lunch in the markets. Risk and return are two sides of the same coin. There are thousands of FMPs that have matured in the last 10 or 15 years and this is perhaps the first time such events have happened. So you cannot paint all FMPs with the same brush. These FMPs with Essel Group's exposures were specifically mandated to take credit risk. But yes, I think we have a job to do in terms of educating investors on accepting volatility in debt funds, as they do in equity funds.

The risks in debt investing are less understood by investors when compared to risks in equity investing because investors are coming from a fixed-income background.
Absolutely. And it is not just the case with investors but also the ecosystem around them. It is a journey where we have to work with regulators, distributors and media to ensure that investors are appropriately educated to understand the risk and return of debt funds.

You did a conference call with investors on the FMP issue. What was the reaction?
There were concerns and queries at first. But once we explained the whole issue and why we took this decision, the majority of people understood and supported what we are doing.

Could the Essel issue have been communicated in January itself to the FMP investors, when the standstill was reported?
The agreement with Essel Group promoters was signed on April 6, 2019, and we communicated to investors on the same day. It is one thing to start negotiations and another to conclude them. We were negotiating with the promoters for some additional benefits and if we hadn't secured our terms, we may have sold the shares to recover our money. The extension happened, with promoters giving a personal guarantee and agreeing to a nominal profit-sharing if there is a strategic stake sell. So, until we had those promises in writing with us, we didn't want to communicate about the matter.

Promoter lending by mutual funds has been a practice for the last 10 or 15 years and bonds from Tata Sons or Ranbaxy's Oscar Investments have figured in mutual fund portfolios for quite a long time. How has the overall experience of the industry been with these loan arrangements?
They have been very good instruments on a risk-adjusted-return basis for mutual funds. In the last two decades, there has not been a single instance of delay or default on loan against shares. All the delays or defaults in the past were in the non-loan-against-shares category, whether you talk of Amtek, Jindal Steel and Power, Ballarpur or Deccan Chronicle Holdings.

What process do you have at Kotak Mutual Fund for evaluating credit risk and to what extent do you rely on external ratings?
We use ratings as just the starting point. There are three risks to evaluate in bonds: interest-rate risk, credit risk and liquidity risk. You have to manage them to generate an optimum return. We have an independent credit-research department with managers specialising in financial analysis to evaluate credit. They can draw on the experience and analysis of the equity-research team as well. We also have an investment committee evaluating all the investment decisions. In corporate-debt instruments, we need to evaluate not only the ability of the borrower to repay but also his willingness to repay. It's not a perfect science. It is a bit subjective like art. Fund managers manage the interest-rate risk as well as liquidity risk. More importantly, once an investment is done, one has to monitor the credit on a regular basis.

Are there any lessons from the FMP episode on how you manage your debt funds and how you communicate to investors?
On communication, there is a statutory requirement, which we comply in letter as well as spirit. Even media persons have said that we were proactive in reaching out to investors and in explaining the Essel Group exposure. There are probably eight other mutual funds with more than Rs 6,500 crore exposure in the Essel Group. You can see our communication to judge for yourself whether we were ahead of others. However, communication is a journey. I believe that we also need to go beyond the statutory requirement. We will leverage technology and media to the maximum extent possible to communicate the risk and returns of fixed-income funds. However, the caveat is that you cannot wake up a person who is not sleeping. You can only wake up a person who is sleeping.

The second thing is creating improvements in our evaluation processes in terms of learning from this experience. One thing we should have done, but didn't do, was to put a cap on the promoter's aggregate borrowings, which would have restricted the amount of leverage. We will look at capping promoter's borrowing capabilities in the future to prevent excessive leverage.

Could you have limits on aggregate exposure to one group across your schemes to prevent one default from affecting the whole AMC?
There are SEBI limits at the individual security level and group level, which we have adhered to. As to looking at group-level exposure caps, that is a function of the trade-off between risk and returns. Had we taken on another exposure instead of the Essel group, that could have proved even riskier. It's a function of risk and return.

So how should investors look at the stock markets from here on?
There is a lot of focus on stock selection and not enough on asset allocation. One should remember that a major portion of portfolio returns come from asset allocation. This is the time when one should be neutrally invested in equities rather than being over-weight. This is a fair-value-plus market and a neutral allocation to equities is in order. Asset allocation gets ignored in most investors' portfolios. Most people end up taking risk when it is not warranted and shy away when it is worth taking. They hit out at a yorker and try to defend a half volley and that makes their returns lower. You should be defending against a yorker and scoring a six at a half volley.