BOOK EXCERPT: Never Too Big To Fail—The collapse of IL&FS

It was a lesson well learnt by Ravi Parthasarathy.

Early in the business, he had recognised that his ability to raise funds for his then-fledgling outfit depended on the single parameter of trust. A lesson he honed and refined in the organisation he ran, to embed as two critical parameters of unquestioned delivery—the audited accounts of financial results and the institutional credit rating. It had been a cornerstone of his philosophy to maintain an AAA credit rating for his ‘institution’ right from its inception, and achieve a set of audited results that would also deliver that rating.

The two had been non-negotiable features of IL&FS’s existence. They were to be maintained at all costs as the bluest-of-the-bluechip and creditworthy firms commanding not only respect and access to large-scale funds at the cheapest cost from financial markets and banks, but also in all aspects of its businesses, ranging from investment management to infrastructure advisory and projects to its dealings with governments.

It was the AAA rating that had enabled IL&FS to raise monies for its financial services business at competitive rates from banks and money markets. The rating also helped it on-lend profitably for promoter funding and other investment banking activities when it was a single consolidated entity.

In its shift to the new architecture of converting IL&FS to a holding company structure—besides reorganizing the business and having sectoral companies to stand on their own feet—was also a logic of protecting its AAA credit rating status as well.

The sprawling agglomeration of all businesses at various stages of development or maturity under the earlier single entity, and particularly the infrastructure project companies, were beginning to act as a drag on the financials and parameters of risk assessment and potentially on the credit rating of the company.

The migration to the holding company architecture, thereby transferring all the operational businesses with their large assets and liabilities into subsidiary companies, enabled IL&FS to limit and ring-fence its contractual liabilities to only those on its now much-reduced balance sheet.

IL&FS would now engage only in the business of investments and loans to subsidiary companies while having revenues from interest on loans, fee income and dividends. This would reduce the requirements of revenues and profitability needed for it to service its own debt and equity, and thereby continue to maintain its AAA status.

It would also advantageously extend the implicit umbrella of its own AAA rating to other downstream subsidiaries. This was to facilitate their large borrowings on competitive terms, thus offering comfort to lenders of their blue blood rating pedigree. None took any particular note of this change or its implications at the credit rating agencies or in the financial or lending markets.

Indian markets and banks, long inured to the financial and accounting indiscipline and even fraud of Indian corporate borrowers in managing or routing funds between a company and individual benefit accounts, relied to a large extent on ‘name’ lending.

Financial institutions and banks, as also markets, tended to rely more on the ‘reputation’ of the group that a company belonged to, rather than the strength of its own performance or balance sheet. With the fungibility of funds between group companies then rampant, there was little sanctity of either the balance sheets or the accounts presented for appraisal, to be relied upon for the assessment of creditworthiness.

There was a tacit understanding, particularly for large and reputed groups, that irrespective of the group’s company undertaking the borrowing, the loan was the liability of the group and to be repaid from either the company or group resources.

The AAA status of the parent, therefore, tended to reflect in the credit rating of its subsidiaries.

In most cases, the parent company was larger, and therefore, there was an assurance to be drawn from its support.

In the case of IL&FS, as time progressed and the business and projects of its subsidiaries grew, it became a case of a smaller AAA tail wagging the larger dog of non-AAA credit where the real risks for the Group lay. Yet, all of IL&FS subsidiaries continued to enjoy higher ratings than they would have as standalone companies. All credit rating agencies cited ‘strong strategic and operational linkages with its parent, Infrastructure Leasing & Financial Services Limited (IL&FS “IND AAA/Stable”)’, ‘sharing IL&FS brand name’ and ‘parent support’.

Even as debt ballooned to over Rs 91,000 crore across more than 340 subsidiaries, credit rating agencies were still citing the IL&FS AAA rating and ‘parent support’ to retain previous ratings for individual companies and the Group. That their ratings were not downgraded to ‘D’ default status even after the default of key subsidiaries such as ITNL, again citing the IL&FS rating and ‘parent support’, only illustrates how deeply entrenched this line of thinking had become even in the face of evidence and numbers to the contrary.

In the case of IL&FS, this rating also had a lot to do with the perception of the Group and its own perceived parentage, a perception that prevailed and dominated the groupthink in the market.

To the lenders and market alike, IL&FS was of a similar pedigree as its highly rated and eminent cousins, ICICI and HDFC. The quasi-institutional setup of public-sector shareholders, its history in pioneering iconic infrastructure projects with government support and blessings, its role in shaping PPP as infrastructure policy in the country, its close linkages with the bureaucracy, the bilateral concessions it negotiated with state governments, all pointed to an informal government backing to its infrastructure efforts. Efforts that helped catalyse private investments and add to the government’s efforts in the rollout of key public infrastructure than it otherwise would be able to in its constrained fiscal situation.

That the infrastructure sector was a difficult one, beset with time and cost overruns, and difficulties in implementation with disputes regarding land acquisitions, environmental clearances, inadequate funding for the cost and tenure required, and multiple other risks, was a well-known fact. However, IL&FS was seen by most as the icebreaker, navigating and pioneering across frozen seas of infrastructure, and backstopped by the government.

It was largely this perception that propelled both banks and markets to lend to the Group while retaining an AAA credit rating for the parent. This was even as debt ballooned beyond proportion and on which the plug, in the case of any other private promoter, would have been pulled long back. It was a repeat of the fragmentation of credit rating across multiple levels of subsidiaries in the revised group architecture, as was the case of the powers of the holding company board.