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Infrastructure Leasing & Financial Services Ltd (IL&FS), is credited with financing the construction of some of India’s smoothest roads such as the Delhi-Noida toll bridge and Chennai-Nashri tunnel (India’s longest road tunnel at 9 km). Ironically, it itself is now treading on a road full of big potholes. With assets over ₹1,15,000 crore and debt over ₹ 91,000 and 169 subsidiaries, IL&FS has been listed as ‘systemically important’ by Reserve Bank of India. It means an entity which has strong interlinkages with other players in the financial market. Hence, its smooth functioning is imperative for the financial system. The company has defaulted on a ₹1,000 crore term loan, and its subsidiary has failed to honour its loan commitment of ₹500 crore to SIDBI in early September. ICRA, CARE and Brickwork Ratings downgraded the group’s various long and short-term borrowing programmes worth over ₹12,000 crore to ‘junk’ grades. During the first week of August, IL&FS’ borrowing programmes enjoyed ‘AAA’ rating from ICRA which fell to ‘D’ by the first week of September. The conglomerate, that was the apple of the eyes of rating agencies till August, has now been removed from their rating watch.

This extremely steep fall of ratings raises question whether IL&FS is India’s ‘Lehman moment’. Lehman Brothers was an investment-banking firm that collapsed during sub-prime crisis in US in 2008 despite enjoying highest ratings. It has the dubious distinction of being the biggest bankruptcy in the history. Its fall rocked the global markets.

 

 

Is IL&FS India’s Lehman moment?

Experts believe that the 3L’s that killed Lehman were – Leverage, Liquidity and Losses. These plague IL&FS too.

1. Leverage

“Leverage is an investment strategy of using borrowed money – specifically, the use of various financial instruments or borrowed capital – to increase the potential return of an investment. Leverage can also refer to the amount of debt a firm uses to finance assets.”             

Potential returns can increase only when leverage is optimal. Just before the crisis, Lehman’s leverage was 44 i.e. its debt was 44 times its equity, and that of Merrill Lynch was at 26.9. Such a high leverage led to issues related to servicing of debt and its eventual bankruptcy.

IL&FS is also highly leveraged. In just one year, its debt-equity ratio has already risen from 10.6 as on 31st March 2017 to a whopping 16.8 as on 31st March 2018, which is three times the industry average. Such a steep rise in leverage, if not controlled, may spell doom for any business.

2. Liquidity

Liquidity refers to a business’ ability to convert assets such as investments, accounts receivable and inventory into cash, without much loss in the value of the asset. It is important because it ensures the business is able to meet its cash commitment in a timely manner. Cash is the grease, which keeps the wheel of business moving.

Lehman as well as IL&FS had an impressive asset base but lacked ready liquidity. Once a default happens, lenders lose market confidence and pull the credit lines immediately. This leads to further worsening of liquidity situation.

The gestation period of road, power, water and port projects financed by IL&FS is very long. JM Financial, a broking firm, has said that IL&FS has an ‘aggressive asset liability management profile.’ The payback period of the projects (the time taken to recover the investment made) funded by it is generally 20-25 years. Banks provide finance for these projects through loans that need to be repaid in 8-10 years. This has led to huge asset-liability maturity mismatch, and has put strain on cash flows. This implies that revenue from its projects are skewed towards longer periods, but its debt is to be serviced in near term.

3. Losses

Lehman Brothers provided underwriting services to many banks in US for housing loans extended by them in 2007. According to Wikipedia, “Underwriting services are provided by some large specialist financial institutions, such as banks, insurance or investment houses, whereby they guarantee payment in case of damage or financial loss and accept the financial risk for liability arising from such guarantee.”

 

It was bullish on the housing sector. Banks were extending loans even to people with low credibility. As the prices of real estate crashed in 2006-07 and number of defaults skyrocketed, it incurred huge losses. Lehman’s total announced losses in September 2008 stood at a staggering $6.5 billion, and soon it filed for bankruptcy.

 

As per the report prepared by Ministry of Finance, IL&FS Group’s losses for the financial year 2017-18 as shown in the consolidated balance sheet stood at ₹2,670 crore. Losses for a business imply that net owned funds of the entity are being wiped out. As a result, the equity of the company reduces further, and sale proceeds of the assets remain the only way to pay the liabilities. Since IL&FS has high leverage, even if its assets are liquidated, they may still not be sufficient to repay the liabilities. IL&FS may face solvency issues and become bankrupt.

A wake-up call for the Government

IL&FS has strong interlinkages with other players in the financial markets- banks, mutual funds, NBFCs and other infrastructure players. Its failure will have large-scale cascading impact. The Ministry of Finance report has stated that mutual funds have invested about ₹2,800 crore in IL&FS bonds and if it fails, they would be faced with redemption pressure, which will worsen the liquidity situation in the market. As IL&FS is a big NBFC, its worsening situation has a negative impact on the entire sector. Prices of equity of other Non-Bank Finance Companies (NBFCs) are falling steeply since the first week of September, and banks are refusing loans to them. Already facing slow growth, infrastructure sector may go into recession as the sources of funds will dry further. With Government’s focus to improve infrastructure to attract foreign investment, IL&FS situation is of immense concern to it. LIC chairperson, Mr. V.K. Sharma and SBI’s chairperson, Mr. Rajnish Kumar have investors and creditors that IL&FS will not be allowed to fail.

Realising the importance of keeping IL&FS afloat and to protect the financial markets, the Government of India finally intervened in the ongoing crisis on 1st October. It superseded the company’s Board of Directors, appointed six new directors and chose Uday Kotak as chairperson, to lift the beleaguered behemoth out of bankruptcy. These efforts may result in significant losses to exchequer and burden will certainly fall on common man. In order to arrange long-term funds for infrastructure development, RBI and the Centre need to do some brainstorming as to how to deepen the debt market.  As of now, IL&FS conundrum may not be India’s Lehman moment, but it certainly has become the poster child of everything that is wrong with infrastructure finance in the country.

By Manya Manushi.