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The Pandora’s Box, Risk of Leverage and Zee


The Pandora’s Box that was opened when IL&FS defaulted on inter-corporate deposits and commercial papers (borrowings) worth about Rs.450 crore in June 2018 continues to spread claiming new victims. The latest such company to face a credit squeeze and consequently close to default is the Essel Group.

When we talk of Essel Group, we basically assume that its just Zee Entertainment for it’s one of the most well-known media brand in India.  (Market cap of over 30,000 cr.)  Yes, Essel Propack is part of it, as the largest specialty packaging company but with a market cap of just over 3000 Crores, it’s a pigmy in the scheme of things.

In his acclaimed book, The Outsiders, William N. Thorndike says that based on the definition of success, the Greatest CEO of the last 50 years would be Henry Singleton who ran Teledyne for almost thirty years generating around 20.4% compounded returns to his investors during the time.

The key to delivering stupendous returns lie in good allocation of capital that is generated by the business. Most businesses generate positive cash flow, very few mangers though are able to deploy the same beneficially.

Vijay Mallya’s businesses were throwing out cash like no other, yet bad investments made from the good money killed him though his companies continue to survive and thrive even today. Where does Subhash Chandra fit when you look at his achievements and his recent failure? Let’s dig in

The Subhash Chandra

Subhash Chandra Goel is well known as the promoter of Zee. What is less known is how he started Zee and how it came to dominate the airwaves for decades.

In his Auto-Biography, he recounts his Grandfather’s business which was once a booming one, and was struck by a string of bad trades in Cotton where they lost 50 Lakhs (this in mid 1960’s, where this was a veritable fortune). The cash crunch caused by the trades impacted their working capital requirements elsewhere. This forced the family to close out the Oil Mills and Dal Processing Units they owned.

‘Occhi punji, khasam ko khaye.’ A cash crunch can kill a businessman.

Born in a family that traded Cotton in the early years of Independence, Subhash Chandra struck out on his own when he took control of his family’s dal mill. One of the reasons for striking it out was the fact that his Grandfather had lost money and now the family owed money to creditors.

An interesting point he makes in his Auto-Biography was how he gave 2 options to his creditors. One, take the Principal now if they were willing to forgo the Interest or Two, wait longer for the entire dues. (He seems to be playing the same now with his lenders by asking them to not sell the stock that has been pledged which for many is the only recourse to getting back their money in the hope of a future where he will bring in the money required to pay off all the debt. A nice play on the Prisoner’s Dilemma!)

The Journey Subhash took from Milling of Grains to Essel World to Essel Packing to Zee Telefilms to the ones that has now landed him in trouble – Essel Infratech. They all came primarily due to Hard work combined with very high Risk Temperament and bending of rules wherever necessary and Networking with the right people who could influence – right upto the Prime Minister of India.

For the most part, Zee was the real deal. Chandra built an entertainment channel that truly got to the Hindi heartland, and to a large section of the Indian audience. Keeping it debt free for years, Chandra maintaining it separately from this other businesses.

His entry into Infrastructure came about when his long time friend, Nitin Gadkari introduced him to a entrepreneur who had won a concession for building highways in Maharashtra. What are friends for anyways? And that was the start of the slide downwards.

Zee, Essel and the Issues

For way too long, Infrastructure companies which require long term finance have batted it out with short term finance. The reasoning was simple – short term finance is cheaper than long term and if you can keep refinancing the short term loan, you are able to get access to money for the long term without having to pay a higher interest. (Plus, real long term finance hasn’t really been available)

The key word though is “if you can keep refinancing”. When IL&FS defaulted, it not only sounded out the death knell of itself but of the way loans have been given out by Mutual Funds and Banks to entities, many of which were backed by nothing more than the stock price of their listed company.

Essel Infratech is the infrastructure arm of Subhash Chandra of Zee fame. From Roads to Power Transmission to Hydro Power, there is very little area that hasn’t been touched by the company.

From 2001 to 2015, India saw an increase in Road Length to the tune of 21 Lakh Kilometres. Despite this achievement, the percentage of Roads that are notified as either National Highway or State Highway remains low given our population and the growth we require to bring people out of poverty. ThePrivate Sector started playing a larger role in development of India’s Road Network since 1995 though it was in the boom years of 2002 to 2010 that companies went about building these long gestation projects thanks to availability of finance and what seemed like a durable business.

From Jaiprakash Associates to GMR to GVK, the number of companies that ventured into building infrastructure, specifically roads numbered in hundreds with many a project ending in tears for both the company and those who financed them. Essel is just the latest causality.

 What Went Wrong?

When the stock price of Zee Telefilms crashed nearly 30% on 25th, it was just one leg of a story that had its start months earlier. In November 2018, the news article that hit the headline was about Zee promoters looking to sell upto 50% of their stake to strategic investors. Promoters don’t sell out their stakes unless they are in a mess from which they find no other way to extract themselves from and in hindsight, this seems to the case with Zee too.

Chandra kept Zee debt free, but the shares that he owned in the company were incredibly valuable. With 41% of a company valued at over 30,000 cr. he was rich, on paper at least. Was there a way to get money for those shares without selling them?

Loan against Shares is something that is provided by every Bank and Non-Banking Financial Company and isn’t very new. Loan against Shares offers the investor the benefit of short term financing without having to let go of the stocks.

Loan against shares command a higher interest rate and hence is seen as a short term bridge to finance for if the requirement is for the longer term, it makes eminent sense to just “pledge” half the holding for most loans require collateral close to 2 times the loan amount.

Promoters have for long offered Shares held by them as additional collateral for Banks to ensure that the Bank has higher comfort in disbursing loans their company requires. These days though, we are seeing a new style of financing by companies who use stock held by the promoters to raise money for themselves for longer tenures by issuing Zero Coupon Bonds.

Zero Coupon Bonds are Cumulative Bonds where no interest in paid during the tenure of the Bond with Principal and Interest paid all at once at the end. This suits promoters since they need not worry about the continuous payment of interest while for the buyer of the bonds, these bonds pay out a higher interest rate thus offering them higher reward for the risk borne. When the time comes to repay, all they have to do is refinance with another bond issue to pay back the earlier one.

The problem comes though when there is no way to refinance. The Bond defaults because it can’t pay. The owner of the bond, the lender, can sell out the stock that has been pledged against the loan, But it ain’t so easy to sell hundreds if not thousands of crores of stock without the sale having a major impact on the price of the stock. Look at what happened – just about 2.4 cr. shares of Zee were sold, in total, on the 25th and 28th of January 2019, by Edelweiss and IIFL, holders of collateral. And the stock fell 30%!

In other words, as much as they seem to be secured, when the time really comes to call it in, they turn out to be not so secured after all.

Let put this in perspective of Zee. Zee promoters hold 41% of the company and have pledged 60% of their stake. The total number of shares pledged by the promoters is nearly 24 crore shares. Zee over the last one year has seen a median volume of 18 lakh shares. If at all the lenders need to get rid of all the shares pledged, it would account to 133 times the normal volume.

In other words, the lenders rather being secured are at the mercy of the promoter. Sell those shares and get pittance for there is literally no willing buyer out there to absorb Ten Thousand Crores worth of Shares at current market rates. Don’t sell and hope that the promoter pays up the amount without it requiring you to sell his shares. You cannot manage to get lenders in a smaller box than this.

And this is exactly what has happened with the promoters entering into an agreement with the lenders not to invoke / sell any shares even though promoters are not offering any more shares to make up the deficit with only a promise by the promoters to work towards a speedy resolution through a strategic sale in a time bound manner. Fund managers left with no other option seem to have accepted the same though there is no way this can be approved by SEBI or any other regulator.

As the saying goes,

If you owe the bank £100, that’s your problem. If you owe the bank £100m, that’s the bank’s problem.

How much Does Zee Owe?

Zee, the actual company is has around 1200 Crore of Debt, but the issue has not been with debt of Zee. The problem which has erupted is with regard to the fact that the promoters have used shares of Zee as collateral to raise money for projects outside of Zee and are now finding it tough to pay it back.

Here is the list of Companies and the amount of Debt they have.
The Pandora's Box, Risk of Leverage and Zee

The promoters owe around 11 thousand crores which while big is still well within their ability to pay for they own 40% of Zee which is worth even 16 thousand crores without considering the premium a buyer would need to fork out at 16 thousand crores. But no promoter would give away his company build by taking incredible risks without a fight and therein lies the problem.

Of the total debt, nearly 4,700 Crores have been raised by companies which are purely holding companies and have no operating income. In other words, were these companies to default and the shares offered not make up to the amount receivable, the lenders have little recourse since they don’t hold any other asset.

The largest borrower is Essel Infraprojects Ltd which is the company that is spearheading the move into infrastructure for Essel group. Essel Infraprojects has 14 road projects in its portfolio, of which six are national highways and the rest state highways.

With many of these roadways being operating assets – for example, they acquired and run Navayuga Devanahalli Tollway Private Limited which operates the toll road that connects Bangalore with its International Airport, it shouldn’t be a tough sell. Then again, when the seller is in distress, the valuations of assets that can be sold off aren’t at the higher end of the spectrum. With infra companies in a mess, the availability of such projects has been more in recent times. Its a Buyers market out there

Split of how much loans are held by what kind of Company

The Pandora's Box, Risk of Leverage and Zee

Shell Companies refer to companies which don’t own any shareholding but have raised money based on pledge by a 3rd Company. Adilink Infra & Multitrading Private Ltd has raised 1000 Crores by this method with the issue being un-rated.

This brings us to the Rating which enabled these companies to raise funds. Here is the break-up of who provided the ratings as % of the total amount raised.

The Pandora's Box, Risk of Leverage and Zee

77% of the borrowings were raised by issues rated by Brickwork Ratings. If you have not heard of Brickwork before, that is because they command just around 4% of market share.

Based on a One Year default rate, Brickworks had the highest number of defaults for those it rated at AA and second highest for those it rated A.

The Pandora's Box, Risk of Leverage and Zee

Image Source: Economic Times

The Mutual Fund Angle: The Hunt for Yield

Of the total borrowings, nearly 8000 Crores were lent by Mutual Funds. Wait, when did Mutual Fund become lenders and of such substantial amounts you may wonder and the answer lies in the booming inflows that Mutual Funds have seen over the last few years.

Equity funds are generally well known, its Debt funds that are actually bigger in size. While the biggest active equity fund is Kotak Standard Multicap fund with assets of 21 thousand crores, the biggest active debt fund is HDFC Liquid with assets under its management being to the tune of 78 thousand crores.

Much of the flow in debt comes from Corporates who park excess cash in Liquid funds but over time we have seen other funds which are primarily targeted at retail investors grow in size as well.

Take for instance HDFC Credit Risk fund which has assets under management of nearly 17 thousand crores. Credit-risk funds invest in securities with lower rating and hence can generate a higher return than liquid which for most part is supposed to go into safe securities like treasury bonds.

Yet, assets chase returns and this has meant that fund managers are always out there to see if they can generate a bit more return for a risk they hope won’t come back to bite.

HDFC Bank, the premier most bank when it comes to Non-Performing Assets has advanced 7.8 Lakh Crores and has accounted for 10,800 Crores as Non-Performing Assets as of December 2018. Given this, how can Mutual Funds which manage Debt funds of thousands of crores not suffer from bad debts? IL&FS was not the first such bad debt to hit mutual funds either. Earlier, we saw funds take hits on funds extended to Amtek Auto, Jindal Steel & Power and Ballarpur Industries were the major ones that impacted portfolio returns of debt fund investors.

The Amtek Auto default impacted JP Morgan funds which lost 66% of AUM and in a way hastened the exit of JP Morgan from the AMC  business. We had written on Ballarpur Debt and how the funds were impacted by it. One of the funds we had recommended for exit, DHFL Pramerica Low Duration Fund currently has the highest exposure to DHFL, another company that is witnessing rapid deterioration in its share price accompanied by noise about the quality of assets it holds.

We had written about the very same Zee issue as a potential problem in 2016, when Franklin Templeton funds were heavily invested in these Zee promoter companies. (Read our post) A little prophetic, we might say! Thankfully, the FT funds avoided much of the debacle as their exposure is now relatively smaller.

Debt Funds aren’t Risk Free

A growing trend has been to compare Fixed Deposits with Debt funds and trying to showcase that Debt funds are a better alternative to Fixed Deposits. This is true if you are paying taxes at the top of the bracket for Fixed Deposits are taxed as Normal Income while if you don’t sell Debt funds for a minimum of 3 years, you qualify for Long Term Gains which are at 20% and Indexed.

But Risk is not the same – Debt funds carry a higher risk of short term reversals due to defaults on papers it owns. While on the longer term, these small blips may not really impact the final return, if the hit is big owing to a larger weight of the fund being deployed in such securities, the dip may take a very long time to make it whole.

In a fixed deposit, your risk is that the bank goes down. In a mutual fund, your risk is that the eventual investment fails. You are in fact, as a debt fund investor, lending to the Zee promoter, if your fund has invested in these Zee promoter bonds. It is no wonder that you are going to see some damage if they don’t pay back.

Concentration Risk

In Equity, one is asked to concentrate the portfolio to generate higher returns. In Debt, smoother returns are best generated with larger portfolios. Larger the portfolio, lower the impact from a bad paper.

The largest fund, HDFC Liquid fund for instance has 254 securities which can help spread the risk a lot better than say DHFL Pramerica Ultra Short Term Fund which holds just 10 securities with the largest being Dewan Housing Finance Corporation 2019 with a weight of 33.78%.

While number of securities is also a function of size of the fund, smaller funds which are exposed to corporate bonds are at a much higher risk than smaller funds which are exposed only to say Treasury Paper and bonds of Public Sector Enterprises.


While defaults and their being written off is definitely a bad thing for investors, it also opens up opportunities.

When a company’s bond is downgraded to D, all funds need to write off the investment into that paper. But, what if in future some part of the amount is recovered? As long as the bond remains on the books, any inflow gets added to the NAV. If you buy such funds after the downgrade, you basically buy into a fund that has a bond valued at 0. If any money comes in from that bond (recovery or voluntary payback) you stand to benefit – you bought when the value of one of the investments was zero!

It’s for this reason that most funds close fund for fresh inflows since the hot money that will come in is basically for taking advantage of the arbitrage opportunity so presented.

With SEBI allowing mutual funds to separate the distressed securities, the opportunity is now no longer there unless a fund decides not to side-pocket the bad paper.

What is Side Pocketing?

Side Pocketing is a term used to denote the practice when a mutual fund separates the bad paper from the rest of the portfolio while rest of the investment continue to remain in the fund.

You have a fund with, say, 5% of Zee promoter paper, and the NAV is 100. Zee promoter paper defaults. The fund decides to side-pocket. So your NAV will fall to 95 on the fund. You will get another fund with an NAV equivalent to the remaining 5. The second fund is the side pocket – you can’t buy or sell units, but you will get money as and when the fund recovers money.

What this does is ensure that the fund need not close the fund to eliminate risk of arbitrage seeking hot money flow while at the same time ensuing that those who were invested in the fund and suffered due to the impact of the bad paper have an ability to claw back any monies that could be available in the future.

What to do with Zee Linked Mutual Funds?

A lot of funds own Zee promoter paper. And that includes the likes of HDFC Mutual fund and Aditya Birla Mutual fund, so it’s notjust the small guys.

None of the funds have downgraded any of this paper or taken a hit. Meaning: they continue to believe that the Zee promoters will pay up. Given the circumstance, they don’t have a coupon and must wait till maturity, so there is no event of “default”.

But there might be a breach of “covenant”, where a bond requires 1.5x cover in Zee shares, but doesn’t have it. A breach requires that if the promoters don’t do well, the fund must sell the paper. Indeed, Credit Suisse and Bank of Baroda did sell about 74 lakh shares of Zee a few days back. But none of the mutual funds are selling.

The sale of the Zee shares by Subhash Chandra can easily take six months, so if something matures by then, there can be an event of actual default. So, the sequence will be:

  • a bond comes up for maturity – there’s a few coming up in the second half of March.
  • The ZEE promoters are unable to pay or rollover or refinance.
  • The bond then goes into “default” which means a likely downgrade to D
  • That downgrade will ensure that all the funds that hold this bond have to mark it down at least 50%.

Some funds that are holding this paper will see a drop in NAV.

However there could be a situation where the downgrade doesn’t happen or funds are forced to refinance the Zee paper, but we think this is unlikely anymore.

Given that, it makes sense to blindly exit if your fund is part of the list that holds Zee promoter paper. Why wait till March?


IL&FS / DHFL and now Zee are not the outliers, they rather are the new normal. Yet if you are in the 30%+ tax bracket, Debt funds the best way to invest in Debt as long as they stick to funds that are either large in size and hence see a smaller impact in case of bad papers or funds that stick to mostly treasury papers and public sector bonds.

We don’t know how the Zee hungama will play out, but as long as it’s not recognized or paid, it makes sense to shift out of funds which have a greater exposure to Essel Group. Morningstar has put out the list of funds and the percentage of money locked into the group. Exit before the door closes

The larger questions, though, are:

  • As mutual fund investors, shouldn’t we be aware that there will be losses? It is of course the job of fund managers to attempt to diversify, but in the end losses will be there.
  • Should a deal be struck by mutual fund houses with the Zee promoters that ensure they don’t sell shares even if there is a default? There is definite fiduciary irresponsibility on their part.
  • Is that promoter pledge situation going to rattle other promoter cages, where there is also a lot of share-based loans and little other cash flow?

We’ll know the answer soon enough but it does look like Mutual funds have been chastised and arent likely to lend on the basis of only collateral, any quick time in the future.



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