Playing fast and loose

Let's talk 'side-pocketing'. The hottest new trend being pursued by mutual funds today, the practice of side-pocketing investors' money and keeping themselves safe is as deeply debated as it is misunderstood. Till a few months back, investors in mutual funds had never heard of the term. But with multiple payment and re-payment defaults in corporate India over the last few months and with banking institutions collapsing like nine-pins, investors are now painfully aware of what side-pocketing means. And they have been paying a heavy price for this lesson — even the most humble of mutual fund investors have lost lakhs of rupees through side-pocketing by mutual funds, with no recourse in sight.

What is side-pocketing? First introduced by market regulator Securities and Exchange Board of India (SEBI) in December 2018, side-pocketing permits asset management companies (read 'Mutual Funds') to separate out a section of their portfolio corresponding to bad debts held by them. Typically, investors receive units in a new separated (read 'segregated') portfolio and these are held independent of the initial investment. This is all legal and as per SEBI's provisions.

But the alarming trend, one that is likely to have a telling impact on the future fortunes of the mutual fund industry, is that they are not just segregating their ailing investments anymore — they are increasingly marking these portfolios down to zero.

To understand this better, let's take the case of the recent verdict by the Hon'ble Supreme Court in the matter of Adjusted Gross Revenue (AGR) payments to be made by telecom operators to the Department of Telecommunications (DoT). The Supreme Court ordered telecom operators Bharti Airtel, Vodafone Idea, Tata Teleservices and Reliance Communications, amongst others, to cough up Rs 92,000 crore in AGR dues to DoT. As per DoT's estimate, the liability of Bharti Airtel Group is around Rs 62,000 crore and Vodafone Idea Rs 54,000 crore, amongst others.

The judgment came on a Thursday afternoon in January. While the telcos got into a huddle through the evening to figure out their next move, MF houses with exposure to Vodafone Idea worked even harder, through the night. The result was that Friday morning saw panic and mayhem amongst investors, as MF companies such as Franklin Templeton marked down their investment values to zero. The entire exposure to Vodafone Idea was written off from the investors' portfolios, even though Vodafone Idea had not defaulted in any manner. While some said this defied logic, others countered that it was within the ambit of the law.

Nonetheless, SEBI sought an explanation from Franklin Templeton on this massive erosion in investor wealth without any instance of default by Vodafone Idea. Franklin Templeton has the highest exposure to the telco out of Vodafone Idea's total liabilities of around Rs 3,500 crore. A Franklin Templeton spokesperson later said the MF house "continues to act in accordance with SEBI regulations and (in) the best interest of our investors, and (we) are happy to provide any further information that SEBI may seek in the future".

In the case of Vodafone Idea, UTI Mutual Fund followed Franklin Templeton's footsteps, creating segregated portfolios in five debt schemes, shortly after the telecom company's debentures were marked down to 'below-investment' grade. Subject to board approval, this would be done in UTI Credit Risk Fund, UTI Bond Fund, UTI Regular Savings Fund, UTI Dynamic Bond Fund and UTI Medium Term Fund, it said.

Back to the retail investor… today, two months later, the value of this part of any investor's portfolio remains zero. In essence, MF houses have safeguarded themselves against any future losses or redemption by investors, while investors are left holding a candle.

An offbeat, one-off instance would be understandable, even though unacceptable to most. But a scary phenomenon is that this is now becoming the norm.

In November 2019, Aditya Birla Sun Life Mutual Fund (ABSL) segregated Rs 787 crore of Adilink Infra & Multitrading debentures that three of its schemes held, following a payment default by the Essel Group company. ABSL Medium Term Plan, with assets of Rs 6,007 crore, had a 7.5 per cent exposure to the debentures. Other MF houses soon followed suit, side-pocketing the exposure.

The recent Yes Bank collapse has seen similar action by mutual fund companies such as UTI MF, Nippon India MF and PGIM India MF, which announced moves to segregate (read 'side-pocket') their exposure to the bonds of the troubled private sector bank. Shortly after, Franklin Templeton MF and Baroda MF also decided to side-pocket their exposure to Yes Bank following a rating downgrade. Questioned about this move, the MF houses said the move was "aimed at preventing these distressed assets from damaging the returns generated from more liquid and better-performing assets". The side-pocketing, again, saw investors in the scheme looking at another zero.

The Yes Bank case was peculiar as the Reserve Bank of India while outlining plans to restructure the ailing bank along with the State Bank of India, announced that it would write down the perpetual bonds issued by Yes Bank. This caused consternation in the MF industry, with Nippon India Mutual Fund terming the RBI's proposal to write-down the perpetual bonds as "unprecedented", expressing concerns about its implications on investors.

RBI had proposed that the Additional Tier-1 bonds (read 'perpetual bonds') issued by the bank would be completely and permanently written down. Perpetual bonds are bonds with no maturity date. Therefore, they cannot be written down. Though not redeemable, their major benefit is that they pay a steady stream of interest payments forever.

Following this impasse, Nippon India MF, Axis Debenture Trustee and some other mutual funds filed a petition before the Bombay High Court, challenging the RBI move to write off the Rs 8,920-crore worth AT-1 bonds.

And there is the case of Altico Capital. On September 12, 2019, real estate lender Altico failed to pay interest demands of around Rs 20 crore on its External Commercial Borrowings (ECB) to Mashreq Bank of the United Arab Emirates. Altico was immediately downgraded to 'below investment' grade. It was UTI Mutual Fund that first announced the creation of a side-pocket this case. Subsequently, Reliance Mutual Fund suspended inflows into its funds. Another zero.

The list goes on. A final cog in this wheel, the first announcement of side-pocketing by a mutual fund in India, by Tata Mutual Fund. Tata MF amended the Scheme Information Documents (SID) of 11 debt schemes and introduced side-pocketing in mid-2019. However, they provided a window for investors to exit the scheme if they so desired. That was not a zero.

The crux of the matter is that while it is under the ambit of the law, MF companies are now increasingly resorting to side-pocketing of their exposure to companies at the first sign of trouble. Admittedly, side-pocketing of funds prevents investors from exiting the said instrument and protects the well-being of safer investments. However, and foremost, it protects the fund house from any redemption and other risks. If a company fails to meet stipulated

payment schedules, MF houses still make money. The investor stares at a numbing zero. And if that particular company does make the payment on time, MF houses again make money. In the latter case, the investor may get back part of his investment through redemptions.

Every investor in India today knows that mutual funds and other instruments that rely on market movements and corporate performance carry an element of risk. It is only now though that investors are realising that a large part, if not all, of the risk, is being transferred to their shoulders and is not being shared by the concerned MF house, which is the one that makes the day-to-day investment decisions in the first place, on the investors' behalf.

Unless this is put right, there will be more and more investors who will someday soon begin questioning the well-known tag-line — "Mutual Fund Sahi Hai".

Views expressed are strictly personal