Road to ruin

The government’s late reaction to the IL&FS crisis is likely to achieve little, but the larger question is whether the company deserves to be saved.

Uday Kotak, non-executive chairman of the new IL&FS board, with Vineet Nayyar, vice chairman, at a media briefing in Mumbai after the board meeting on October 4.

ON October 1, after dithering for weeks following a string of defaults that threatened Indian financial markets and institutions, the Union government announced that it was taking control of the beleaguered Infrastructure Leasing & Financial Services Ltd (IL&FS). Although the Finance Ministry termed the decision of the Ministry of Corporate Affairs to move the National Company Law Tribunal (NCLT), Mumbai, as “firm and decisive”, there is little evidence to suggest that a quick resolution to the crisis is in sight.

Much of this arises from the fact that little is known about the company. It is supposed to be a Systemically Important Non-Deposit Accepting Core Investment Company registered with the Reserve Bank of India (RBI), but no one, not even the Finance Ministry, appears to know how many entities constitute this group. More importantly, since it transformed from a financial services company into one that is an active player in the infrastructure business long ago, it has a footprint in the infrastructure business like none other. Thus, its collapse not only has ramifications for financial markets but affects projects across the country. Given the completely opaque nature of the company’s functioning and the complex web of interrelated entities that constitute the group, the general consensus is that sorting out the mess in IL&FS is going to take time, but with the threat of further defaults looming, the question is whether the company has the time it needs. To complicate matters, the government has also asked the Serious Fraud Investigation Office (SFIO) to investigate the companies in the IL&FS group.

The Corporate Affairs Ministry announced that it was superseding the existing management and the NCLT approved its demand for a reconstituted board that included Uday Kotak, managing director (MD) and chief executive officer (CEO) of Kotak Mahindra Bank; Vineet Nayyar, former Indian Administrative Service (IAS) officer and currently executive vice chairman of Tech Mahindra; G.N. Bajpai, former Chairman of the Securities and Exchange Board of India (SEBI); G.C. Chaturvedi, ICICI Bank chairman; Malini Shankar, IAS officer; and Nand Kishore, a retired officer from the Indian Audit and Accounts Service. Vineet Nayyar was appointed vice chairman and MD at the first meeting of the board on October 4. Some of these appointments have already raised questions, especially grave ones about the potential conflict of interest. For instance, questions have been raised about whether the chairmen of the two private banks can steer the company, their competitor in several key areas of project finance, to safety. Proxy advisory firms have also questioned the appointment of Bajpai, alleging that he was being investigated for serious conflict of interest issues during his tenure as an independent director at Kingfisher Airlines. It is alleged that a consultancy closely connected to Bajpai provided services to the now-defunct airline while he was director.

Murky corporate structure

How little the Finance Ministry, or for that matter the general public, was aware of is evident from the following. On October 1, the Ministry said the IL&FS Group consisted of 169 entities, including subsidiaries, associates and joint ventures. The company’s latest annual report confirms this. However, the auditor’s report accompanying the annual report mentions 209 entities, including 135 subsidiaries (of which at least 50 are foreign, located as far apart as Laos and the United States).

Moreover, the group has control of nine investment funds, including the Infrastructure Equity Fund and the Saffron Investment Fund. However, speaking to the media after the first meeting of the board, Uday Kotak put the total number of entities in the group at 348. Uday Kotak also revealed that Rs.835 crore of commercial paper, essentially short-term debt, issued by the group would mature by the end of the current financial year, of which Rs.250 crore would have to be repaid by December 2018. Clearly, the Finance Ministry—and by extension the RBI because it recognises IL&FS as “systemically” significant—were sleeping at the wheel. Uday Kotak also confirmed that unravelling the complex web of interrelated transactions of loans and investments within the group would take time.

In effect, without the basic information of what exactly this group is, who knows when the next landmine is waiting to explode? Significantly, although the stated figure of outstanding loans of the group is reported to be about Rs.91,000 crore, nobody is confirming this yet. In fact, Uday Kotak, in his press conference of October 4, refused to confirm this. However, according to one report, about two-fifth of the group’s outstanding debt is unsecured and thus remains at risk. Significantly, a big portion of the secured loans is earmarked against cash flows that the group earns from projects—from road tolls to water and power projects.

The government’s takeover of IL&FS was immediately compared to the takeover of Satyam Computers Services in 2009, but this time it is different. For one, Satyam’s collapse did not pose a systemic risk simply because it had no debts. Moreover, felony has not yet been established in the IL&FS case, as was immediately evident in the Satyam case following the promoter’s admission of misstating revenues.

The delayed action of the government, some would say, delayed by several years, is possibly explained by the initial idea of using the ever-available bailout institution, Life Insurance Corporation (LIC), and State Bank of India (SBI), to organise an escape for IL&FS from default. But as the extent of the required bailout as well as the extent to which a default would spook markets became apparent, it appears the government turned tack, which resulted in the takeover.

However, there is not much time. The NCLT wants a turnaround plan to be submitted by the end of October, an obviously arduous task given the fact that those at the helm have just learnt about the constituents of the group.

Both the RBI and the Finance Ministry ought to have been aware by May 2018 that IL&FS was fast approaching a crash. In the year ending March 2018, it reported a loss of Rs.2,200 crore, which meant the erosion of the company’s book value by at least one-fifth within a year. More importantly, its interest payments in the year were 10 per cent more than its earnings, not inclusive of the interest earned, depreciation and the taxes paid. Clearly, no company in such a state appeared viable. On the basis of available data, there is evidence to indicate that IL&FS was using short-term borrowings to fund infrastructure projects, a practice that accountants and economists would term a sure recipe for a looming asset-liability mismatch. While repayments would devolve soon, the asset (infrastructure projects with longer gestation periods) would take considerably longer to yield dividends.

This is exactly what happened: the IL&FS’ issue of commercial paper increased by 300 per cent between fiscal 2017 and 2018; during the same period, its borrowings from the inter-corporate debt market increased by 140 per cent. Both these instruments are short term and are meant to tide over immediate liquidity problems. In fact, the company’s annual report reveals that its share of short-term borrowings in overall borrowings jumped from a little over one-tenth in 2016-17 to more than one-fifth within a year. It ought to have been evident to anybody watching the company that a crisis was looming thick and fast.

The mother of all PPPs

How did IL&FS reach where it is now? The company was promoted in 1987 by Unit Trust of India and Central Bank of India. After the collapse of UTI in 2001 during the tenure of the National Democratic Alliance, LIC, the current dominant shareholder, started getting a stake in the company. Initially, as its name suggests, IL&FS’ primary focus was leasing business. But, it soon started arranging finance for infrastructure projects that were aided and abetted by successive governments’ unwillingness to build roads, transportation facilities, provide water and sanitation facilities and establish publicly funded power projects. All this happened under the broad umbrella of what we term liberalisation. But the real flood of opportunities came IL&FS’ way when the government started aggressively wooing investors into infrastructure projects under the public-private partnership (PPP) model. These opaque and, in many cases costly, projects were now being thrust on State governments, especially since the middle of the last decade (“The Trojan horse”, Frontline , February 5, 2016). This is when IL&FS’ second switch in focus happened: it became a facilitator of such projects instead of a promoter of such projects. And, as the several controversies about its role in such projects testify, it began drawing the ire of victims of these costly projects.

Typically, hard-pressed State governments would align with IL&FS because it would display its public sector shareholders as proof of its robust status. With a tiny shareholding in project, the IL&FS would get a toehold in the company, while the State government would invest in the company and also provide all kinds of subsidies (such as land and tax breaks) to it. IL&FS would levy a range of fees and commissions for the project—loan syndication fees, merchant banking fees, project management fees, fees for commissioning environmental impact studies or project feasibility and a plethora of other fees.

In fact, these fees were often more than the company’s initial investment. Just one example of this would suffice: New Tirupur Area Development Corporation Limited project, which was implemented in PPP mode in 2006 (“Costly alliance”, Frontline , April 21, 2006). The project, which angered the people in and around Tiruppur because of the high cost of water and which resulted in prolonged litigation, prompted the Madras High Court to observe that the deductions that IL&FS made were excessive. It noted that the company had deducted Rs.41.24 crore out of a total disbursement of Rs.140 crore (almost 30 per cent) citing various fees and commissions.

In 2014, the Madras High Court observed that the State government’s contribution had only been “to service the debt with a pre-condition that the money will not even be used to improve the infrastructure”. “Investing more money just for the purpose of servicing a debt is neither a prudent business decision nor in the interest of the public,” it said. Similar practices were adopted by IL&FS in the case of the Tamil Nadu Road Development Company (TNRDC), a special purpose vehicle structured to build the IT corridor. The company was a 50:50 joint venture between IL&FS and the Tamil Nadu government. IL&FS’ profit-gouging tactics led to the government eventually ousting it from the TNRDC.

A similar fate was reserved for NOIDA Toll Bridge Company Ltd, again a company in which IL&FS was a partner. IL&FS gave itself an assured return of 20 per cent on its investment, unthinkable even in the eyes of capitalist logic. More shockingly, the concession period of the project was extended from 30 years to 100 years even as the cost of the project escalated by 150 per cent. Eventually, public ire and the courts forced the scrapping of the project.

What is common to these projects—as is the case with most PPPs—is that the projects commence on the premise that a private investor must undertake them because the government does not have the wherewithal. But as soon as the project starts—even before they start yielding any results—IL&FS’ cost meter is already ticking, with fees and charges loaded onto the project which the state (State governments or state-owned companies) has to pay. Moreover, enormous hidden subsidies in the form of land, tax breaks and other concessions are doled out to these so-called joint venture companies. For example, as pointed out by the financial journalist Sucheta Dalal, in the case of the Gujarat International Finance Tec-City project, land was provided at Rs.2 an acre, which amounted to more than Rs.440 crore as a giveaway. To make matters worse, these PPPs masquerade as private companies although they draw from public funds and then cite their right to maintain confidentiality.

Case for a bailout?

Financial markets appear to have a surreal life of their own. They give the impression that the world of finance has a life of its own, far away from the real world of real issues, real livelihoods and the real economy. Iimplicit in this construct of the world of finance is the suggestion that lesser mortals cannot fathom what happens in this world. Nothing could be further from reality. The IL&FS crisis was initially presented as a problem of the markets, later, as a problem for the banks, and still later as a problem for the entire financial system. But the real problem with the IL&FS story pertains to the reality, the reality of profit gouging, which has resulted in costlier water, costlier road tolls, costlier power tariffs and a generalised perpetuation of opacity that remains unaccountable to common folk across the country in the hundreds of projects that IL&FS has a hand in. This is where the real world meets the world of finance.

There have been reports that a wider fallout of the IL&FS crisis needs to be prevented in order to ensure that it does not envelop financial markets. The argument is that a full-blown default by IL&FS would not only set off a collapse of other stressed banks and financial institutions but trigger a wider crisis in the debt and equity markets. There is also the unstated fear that such a collapse would result in surging interest rates, which would jeopardise the Narendra Modi government’s borrowing programme as it enters an election year. Implicit in this train of logic is the demand for a bailout, which raises several questions.

Does IL&FS’ track record indicate that the company serves the public interest in any meaningful way? If that is not so, as all evidence from the negligently run company shows, the answer to what ought to be done can be broken down into simpler parts. First, it ought to be recognised that IL&FS is a notoriously unique company. There is none like it in the land; there is no other company that finances infrastructure while acting as an investor on the scale that it does. Given the fact that many infrastructure companies have come to grief in the past few years, mostly because of their unwillingness to bring in equity to match their high levels of borrowings (mainly from public sector banks), why should IL&FS get special treatment?

As for the question of what would happen to IL&FS’ many projects, it would appear that a far better solution would be to let the State governments or other governmental entities reacquire control over these projects. After all, the state would be in a far better position to ensure that public good is served rather than a private entity that functions in a grossly opaque manner. Of course, this would require IL&FS to sell these assets at a discount, a distress sale of sorts. But if the government (States as well as the Union) is getting back control of the project, what could be the objection to a reckless private company now having to suffer a haircut?