Revathi Asset Management

Nothing new under the sun

Everyone in the world has heard of the 2008 mortgage crisis in the US. But how many have heard about a comparable version of credit risk in India?

Infrastructure Leasing and Financial Services Limited (IL&FS) was a systemically important investment company. It was operating as a Non-Banking Finance Company (NBFC) registered under the Reserve Bank of India (RBI) and had helped fund some of the largest infrastructure projects in India including, but not limited to, the Chenani-Nashri tunnel, the Delhi-Noida Toll Bridge, and Gujarat International Finance Tech (GIFT) City.

ILFS was engaged in the business of making loans, advances, and investments in its group companies. These were spread across various sectors such as energy, transportation and financial services. On the surface of it, modern finance advises taking on such diversified credit risk, so that a lender is not disproportionately exposed to one single sector of the economy. Modern finance also recommends packaging off the finance arms of such projects/companies into separate entities. Under the convoluted logic of financial engineering, these new entities have lower risk than the original one because they are legally separate companies; this is essentially the same idea as the Special Purpose Vehicle (SPV) that many troubled firms such as AIG and Lehman abused in the US during 2006-2008 to clean up their balance sheets for audit purposes.

The idea is simple: if a certain infra project and its financing are kept under one entity, it’s clear where the risk to lenders originates from. However, if you separate the infra project and the financing, then the financiers argue that risk has decreased. If the new financing entity then lends to multiple projects, they further claim that the risk has been diversified and thereby further lowered. So, for example, what was originally 4 high-risk projects, has been turned into 4 projects plus one low-risk, well-diversified lender. This was exactly the setup behind the US mortgage crisis; the industry argument was that 1000 CCC-rated loans, when packaged together became 1 big AAA-rated loan.

Counterparty risk and corporate governance issues

IL&FS was originally started by government-controlled entities, including the Central Bank of India, Unit Trust of India and the Housing Development Finance Corp in the 1980s. Over time, its largest shareholders came to include names like Life Insurance Corporation (LIC), State Bank of India (SBI), and Japan’s Orix Corporation. With the reputational backing and connections that these massive public sector companies afforded, IL&FS was able to expand from financing small roads to financing some of the country’s largest infra projects. IL&FS held a AAA rating right until the very end. Thus, it gained an undue advantage from being able to borrow at lower rates than other market participants because of its governmental association.

However, the public sector had little control over the day-to-day operations of IL&FS. And that was its undoing. For a certain water treatment project, IL&FS released less than INR 1 Bn instead of the committed INR 1.4 Bn raised through equity, senior and subordinate debt. There was a massive, fraudulent “commitment fee” charged by IL&FS of about INR50 Mn, or about 3.5%. The remainder money was carrying losses, sitting in other accounts for undisclosed purposes. Thus, investors and lenders were losing money before any project-related work even began.

Public-private partnership gone wrong

The crisis unfolded as it became clear than IL&FS hadn’t disclosed bad loans on its books for years. It eventually came out that IL&FS had lent to insolvent entities. The auditors found deficiencies but failed to issue any warnings or bring them to the government’s or public’s attention. The RBI had done an inspection and found IL&FS to be over-leveraged, but the auditors did not flag this either.

The aftermath was that almost INR 850,000 Cr of investor’s wealth was wiped out across the debt and equity markets. All other housing finance and infra companies wiped off 60% from their share prices. The IL&FS default led to panic in the debt markets, which dried up liquidity in the whole system and seized up the Indian capital markets for almost 2 years.

In the end, the Indian government was forced to pay up on its sovereign guarantees relating to IL&FS, since IL&FS was unable to pay. Such government guarantees, once again, exposed the moral hazard and corruption that thrive in any public-private partnership. It operated with the authority and reach of a government organisation but with the incentives and opacity of the private sector. It was found that IL&FS executives had drawn high salaries and perks at the cost of the company while journalists unmasked a network of compromised officers within the Indian Administrative Service.

With the Indian government and LIC footing the bill, however, it was inevitably the broad public that was made to pay for this debacle, not unlike the massive bailouts after the 2008 housing crisis in the US. While such events raise obvious questions about culpability and regulation, investors should look at them from a different, practical point of view.

Conflicting stakeholder goals

The point is not why it happened and how it could have been prevented; the point is that it did happen and how to identify it beforehand when it happens again. The most obvious lesson is that public-private partnerships can never work in practice. The two partners are inimical to each other and have opposing goals – the public partner, at least on paper, aims to benefit the people while the private partner aims to benefit a select few comprising its executives and maybe its shareholders. The long-term goals of each partner come at the expense of their counterpart – the government aims to make things fair, equal, and affordable while the private sector aims to extract profit.

In the long run, investors are not paid for being idealists; investors have to focus on cold, hard reality and make the best of it. Such events of fraud, corporate mis-governance, and corruption happen everywhere in the world so neither does it make sense to penalise any one country for it. The US itself has been the source of the biggest and most famous frauds: LTCM collapse, Bear Sterns, the 2008 housing crisis, and Enron, to name a few.

What events like this show, especially in a country like India, is that public-private partnerships are best avoided from investor portfolios. In a country of 1.4 billion people and counting in 2025, it would be absurd to believe that the government can be a legitimate partner in a capitalistic venture. The government and the RBI have certainly learnt the lessons from the IL&FSevent, but there are still many government entities in the listed equity space that may tempt the unwary investor. The first question I had when I started studying and trading in the equity markets was why a whole host of public sector units (PSUs) traded at 4-6 P/E multiples despite running near, if not outright, monopolies. We now know why.

It also shows that lending companies fall into 2 broad categories:

1. Commercial or retail-lenders
2. Public, infrastructure lenders

The second category is significantly different from the first in that the first is operating for-profit, whereas any public infra NBFC is merely an SPV that helps finance government infrastructure projects. Such public infra NBFCs have no business operating like private limited companies in the sense that their executives should be treated exactly like any other government employee. If IL&FS was borrowing under sovereign guarantees, its corporate governance should have been just like that of any other public sector company.

More importantly, as a private investor, you have almost no reason to be investing in such public infra NBFCs even though many are still listed today and even if they have cleaned up their corporate governance issues. This is because a huge part of the fundamental problem has not been solved: a private shareholder in a public enterprise is neither here nor there. In good times, the government entity will not pay him out like a private shareholder deserves and in bad times, the private shareholder will be made to foot the bill. This is an asymmetrical risk that significantly harms the private investor in the long run.

This difference in risk and performance can be seen in the banking sector itself. The private bank index has massively outperformed the public bank index, with much higher returns at a lower realised volatility over almost 20 years. Private banks returned over 18.2% CAGR vs 9.2% for the public banks, with lower volatility and max drawdowns.

A rule for portfolio construction

While the example of an NBFC may be the most straightforward out there when it comes to explaining the problem with public-private partnerships, the point extends to any endeavour in almost any sector. Wherever it occurs, in the best case, the government and the private sector will be at a crossroads on objectives and methods. In the worst case, the partnership will be rife with moral hazard, lack of corporate governance, and fraud.

Thus, from a private investor’s lens, we see that:

1. Major public-private scandals have occurred in India as well, just as they have in countries like the US.
2. Corporate governance issues arise from a lack of clarity about a company’s objective.
3. All public-private partnerships may be doomed from the beginning.
4. Private investors are not rewarded for investing in state-run enterprises.