Twenty years from now, it is unlikely the general public will remember Infrastructure Leasing & Financial Services (IL&FS) and the fiasco that unfolded there. But business schools will ensure a permanent place for the infrastructure major in the corporate hall of shame: It’s a textbook example of how not to run a company.

Rampant misreporting of income, dubious transactions, conflict of interest, ever-greening of loans and personal enrichment of key personnel—for the past 10 years or so, IL&FS has been running in complete violation of good management practices. The outcome was grave—the policies and actions virtually decimated IL&FS, which is No. 83 on the Fortune India 500 list (its subsidiaries, IL&FS Transportation Network or ITNL, and IL&FS Engineering & Construction have been regulars on the list since 2014). The shock waves also froze the credit market, with banks and mutual funds refusing to finance even blue chip non-banking financial companies (NBFCs), sending the entire financial sector into a tizzy. And its reverberations were felt in countries as far off as Ethiopia, Botswana, and Singapore, among others.

The house of cards started crumbling with a series of defaults by IL&FS group firms in August and September on commercial papers, short-term deposits, inter-corporate deposits and the like. This, and the resulting downgrades by rating agencies, led to serious redemption pressure on mutual funds and impacted sentiment on the stock, money, and debt markets. The debt market shocks were passed on to the equity market, sparking sell-offs, particularly in NBFC stocks and sectors linked with NBFC financing. The sudden discovery of a bankrupt IL&FS, with debts of ₹91,000 crore, was difficult for the Indian financial markets to handle.

The government was forced to step in. It disbanded the existing board, replacing it with a new one headed by billionaire banker Uday Kotak. “Continuance of the present board,’’ said the government in a statement, “had become prejudicial to the interests of the company and its members… and their continuation was having an adverse impact on financial stability and capital markets.”

For the government, restoring the confidence of the money-, debt-, and capital markets, and banks and financial institutions in the credibility and financial solvency of the IL&FS Group had assumed utmost importance. Especially after receiving formal letters urging the finance minister to “prevent the world’s fastest growing economy from plunging into a recession”. Hence, on September 30, the government sent a confidential note to the Ministry of Corporate Affairs, recommending that the National Company Law Tribunal (NCLT) be approached for the “reconstitution of the IL&FS board”. The new board was set up the very next day.

Nine former key IL&FS decision-makers are in the government’s firing line “for misstating profits to hide the group’s poor financial health to obtain higher credit ratings, raise debts and reap personal benefits by way of high managerial remuneration”, the board said. Despite IL&FS reporting a loss of ₹1,887 crore in FY18 from a profit of ₹142 crore in FY17 according to Capitaline data, the salary of then chairman Ravi Parthasarathy was raised from ₹10.8 crore to ₹20.5 crore, propelling him to No. 47 on Fortune India’s list of 50 highest paid execs.

While the epic proportions of the fiasco are bewildering, the question that has experts scratching their heads is: How was the deteriorating health of the group kept a secret for so long? And how did it escape the scrutiny of a battery of external and internal auditors, numerous audit committees, credit rating agencies and a board that had on its rolls representatives from the Life Insurance Corporation and State Bank of India, besides those from the Abu Dhabi Investment Authority and Japan’s ORIX Corporation?

The answer, perhaps, lies in the complex structure of the company with its maze of holding and co-holding companies, subsidiaries, joint ventures, associate subsidiaries and the like, and the cross-holding funding pattern between the various group firms. At the first meeting of the new board, it clarified that IL&FS had as many as 348 subsidiaries (and not 169 as claimed by the earlier board), and that it was still figuring out their financial linkages, and the money these firms owed to lenders.

“The structure of the IL&FS Group was so complicated and large that the right hand did not know what the left hand was doing. The financing of the SPVs [special purpose vehicles] was done in such a way that all the risks were backed either by the co-holding or the holding companies of IL&FS,” says a senior official at a credit rating agency, who did not want to be identified. Such backing gave a lot of confidence to investors and others. “And since it was not possible for a single agency to rate all the SPVs or find the correct inter-linkages, many of us missed the danger signals.”

The official also points out that unlike Kingfisher Airlines, which offered bankers only a brand as collateral, the IL&FS debt is backed by underlying assets. But many of these assets may be in distress, especially those in the power sector, because of problems such as lack of working capital, absence of power purchase agreements and fuel contracts, and delays in getting clearances. However, the company also has completed projects, which can be easily monetised.

Sanjiv Bhasin, executive vice-president, markets & corporate affairs at finance and investment firm IIFL, says one of the reasons IL&FS escaped scrutiny was the fact that there was a powerful group of people at its helm, who enjoyed a lot of privileges that went unchecked. IL&FS had projects like road and bridge building, with long gestation periods, he says, adding, “But they had gone the short-term route for liquidity with commercial papers. As yields started to rise, it hurt them.”

But shouldn’t rating agencies and auditors have spotted the signs? Shriram Subramanian, founder and managing director of corporate advisory firm InGovern, believes the fault lies largely with the management, board of directors, and auditors. “Internal and external auditors are supposed to point out and flag such gaps and the board is expected to take appropriate action. The board should have at least taken cognisance of what was happening instead of paying out huge salaries to the management and declaring dividends,” he says. J.N. Gupta, former executive director of the Securities and Exchange Board of India and co-founder and managing director of Stakeholder Empowerment Services, says the danger signals were there for all to see. For example, he says, the current ratio of assets to liability “being less than one indicated that liquidity mismatch was there and any change in market or the slightest change in rating could have spelt trouble”. Proof of that was the liquidity crisis faced by NBFCs just after the default.

Some point to the fact that the auditors and others ignored issues of conflict of interest and how a financier of projects became a contractor. IL&FS was incorporated as a large “systemically important non-deposit accepting core investment company” by the Reserve Bank of India for financing long-term infrastructure projects. But over the years, the fine line between financier and executor became blurred and the company became a full-fledged infrastructure player with all its associated problems.

Another reason IL&FS stayed below the radar of authorities was its unique business model. Under the SPV model, the company would typically contribute 50% of the equity while an equal amount came from the government. According to law, such SPVs are private companies. “As a result, the company could spend public money as if it were private money,” says a government official. Moreover, by nominating the secretary of a central ministry or the chief secretary of a state government as chairperson, while ensuring that the post of the managing director remained with an IL&FS nominee, the company exercised real power and control and gave it the façade of a government project.

An interim report of the Serious Fraud Investigation Office (SFIO), presented to the NCLT this December, decoded the modus operandi. The group had been working on an “unsustainable pyramidal model”, in which the holding company and the subsidiaries borrowed shortterm funds from the market, and lent to various SPVs implementing the projects at much higher rates of interest. The holding company further burdened the SPVs with things like brand fees, consultancy fees, project guarantees, and advisory fees. It meant that while the debt of the SPVs kept mounting, the holding company and its key subsidiaries had strong balance sheets, at least on paper. In a particular project (read SPV), the IL&FS Group charged brand and advisory fees, its subsidiary IL&FS Financial Services charged loan syndication fees, merchant banking fees and success fees, while ITNL charged project management fees and claim management fees, the report says. It was easy for IL&FS to impose such fees on the SPVs since the same individual was present “on different companies’ decision-making positions, including company’s directors”, the SFIO report says. No wonder, the company’s revenue, which rose from ₹64.6 crore in 2015-16 to ₹212.3 crore in 2017-18 accruing from brand fees, consultancy fees, and the like, was described by the SFIO as “fabricated, inflated or not real”.

Another tactic adopted by the company to hide its real financial position was through ever-greening of SPV loans. The SFIO found that borrowers from its financial arm were extended “additional credit facility so that they could service their outstanding interest and principal repayment obligations and avoid defaulting or classifying the assets as a non-performing asset”.

The report also highlights the “fraudulent and irresponsible conduct of key managerial and executive persons for using the company’s Employees Welfare Trust as a vehicle for enrichment, a trust whose dealings seemed to have been ignored by everyone”—including auditors, rating agencies, and audit committees. The trust, with outstanding loans of ₹500 crore, holds a 12% stake in IL&FS. Investigations revealed how the key personnel had amassed movable and immovable properties worth crores. For instance, Parthasarathy had declared ₹98.98 crore of moveable properties, besides four immovable properties.

Thankfully, the process of rescuing IL&FS has already started. The new board has begun the slow and long process of identifying assets to monetise and raise funds to help with its turnaround plan. In November, the company announced that it had received a strong response to its asset monetisation process with over a dozen expressions of interest coming in for the company’s stake in IL&FS Securities Services (ISSL), ISSL Settlement & Transaction Services, and IL&FS Education and Technology Services. It also said that it had initiated the process of exploring the sale of controlling stake held by IL&FS Group in renewable energy assets/businesses. These assets include operating wind power generating plants with an aggregate capacity of 873.5 MW, as well as under-construction wind power plants with aggregate capacity of 104 MW. Solar power plants with a total capacity of 300 MW, which are under development, were also being looked at.

Classifying various projects according to their monetising viability was the only solution for a bankrupt company like IL&FS, points out a senior official of a consulting firm. The first category will hold assets that already generate cash like many of its completed road and other projects; in the second are good assets yet to generate revenues; and the third will house unfinished and poor-to-average projects that might find few takers. An example of the third are the stalled power projects, for which the banks might have to take haircuts of 40-75%. Despite optimism from the board, some experts are of the view that any significant developments in the asset monetisation process will take time. “A large part of the projects are not very liquid so it will be difficult to sell them,” says Bhasin of IIFL.

The answer to funding such large infrastructure projects, with gestation periods of 20-30 years, is to develop a strong and vibrant corporate bond market with the participation of pension and insurance funds, which are willing to lend long-term. Only then will the asset-liability mismatch issue (for example, IL&FS was borrowing short and lending long) be resolved. Till then, India should prepare itself for similar shocks that not only threaten the country’s financial markets and its economy, but force the taxpayer to pay for someone else’s mistakes.

This was originally published in the Dec. 15 - Mar. 15 special issue of the magazine.

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