Why Do Mutual Funds Lend To Promoters?

After the banking crisis, the Indian capital markets are facing another dire situation. It has recently come to light that many mutual funds have been lending money to promoters of companies.

It needs to be understood that these loans are not being made to companies but rather to promoters of companies. The problem is that some of these loans may have turned bad. This is causing panic amongst mutual fund investors, many of whom had no idea that they had exposure to companies such as IL&FS and DHFL! In this article, we will have a closer look at the loans being sanctioned by fund houses as well their economic impact.

How Mutual Funds Lend to Promoters?

Many times promoters are in need of cash. Perhaps they want to expand their business or have to meet working capital requirements. However, after the NPA crisis, not many public sector banks are willing to lend money to corporations until they have a rock solid credit rating and also provide adequate collateral. Many banks do not accept equity shares as collateral.

This is where debt based mutual funds come in. These mutual funds do not have to adhere to regulations like banks have to. Hence, they are free to lend money to corporations or individuals if they are reasonably confident that they will be paid back.

Mutual funds often fund promoters by forming separate structures. They provide loans only against the shares of blue chip companies. Also, since shares are believed to be extremely volatile, they only finance up to 50% of the market value of the shares. At least in theory, this gives the lenders enough margin to cut their losses in the event of a downturn. It is also known that the securities work like margin loans. For instance, if the value of the collateral drops, then mutual funds have the right to insist on more shares or liquid securities. The idea is to avoid as much risk as possible.

Why Do Mutual Funds Lend To Promoters?

The real reason why mutual funds lend to promoters is that they want to earn a higher return on their investment. Debt funds are under constant pressure to outperform their peers. Outperforming is not easy if the fundís portfolio only consists of publicly traded securities. Promoters do not have a very high credit rating. Also, their collateral also fluctuates in value. This is the reason why they are willing to pay higher interest rates. In the past few years, this higher rate has been the reason that some funds have outperformed the others.

The Problem with Such Loans

There is nothing inherently illegal or immoral about these promoter loans. However, it needs to be understood that these loans are actually quite risky. Hence, it is the responsibility of mutual funds to explain the risks to their investors. Some of the risks related to mutual funds have been listed down as follows.

  • Default Risk: Just like with any loan, there is obviously a risk of default with loans to promoters as well. However, it needs to be understood that markets react very badly when they find out that the promoters have pledged their shares. As a result, it is likely that the prices of the shares may drop very rapidly. This could happen because of two reasons.

    Firstly, it signals to the markets that the promoter who happens to be an insider to the business is trying to exit it! Also, promoters own huge blocks of shares.

    When these huge blocks are put on the market for sale, they tend to increase the supply without any corresponding increase in the demand. As a result, the price plummets rapidly. These scenarios may seem far-fetched but a few Indian mutual funds have found themselves stuck with promoter debt. They are being forced to enter into agreements with promoters since they cannot really afford to sell the debt without risking losing a significant part of their investment.

  • Liquidity Risk: There is another major problem with promoter loans. These loans are bilateral agreements between two parties. There isnít really an active market where such contracts are traded. Hence, in short, there is no secondary market for such agreements. As a result, when a fund house lends money to a promoter, it has no option but to obtain that money back from the promoter itself. The funds house will be forced to hold the loan till maturity. They cannot really sell their loan to third parties without taking a substantial haircut.
  • Problem With Due Diligence: Lastly, fund houses do not have the infrastructure required to conduct due diligence for loans that they give out. For instance, a promoter may want to pledge his shares in one company, raise money and then invest in another business. The problem is that the fund house has no idea about the viability of the other business. Most of the times, they are trusting the judgement of the people that they are lending to. Obviously from a lending point of view, this cannot be considered to be a good practice.

The bottom line is that mutual funds lending money to promoters is nothing new. However, given the current environment, there is unnecessary scaremongering over such loans. Mutual funds only need to make their investors aware that such loans may be riskier than others which is why they provide better returns too!

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