SEBI approval for side-pocketing in mutual funds spells good news for old and new investors

Mutual fund houses in India are still licking their wounds from what has turned out to be in hindsight their embarrassing investments in Infrastructure Leasing & Financial Services Ltd (IL&FS) which had been amiss in meeting its commitments to creditors and lenders after running up a whopping Rs 91,000 crore liabilities through a myriad of labyrinthine subsidiaries and associates.

The massive liabilities were not transparently shown in the group accounts but surfaced only when all hell broke out. The government has since ordered a Satyam-type turnaround by superseding the board of directors of IL&FS and replacing it with an expert pro-term board of directors with the redoubtable Uday Kotak at the helm.

For mutual fund industry in particular, the funds blocked in IL&FS is particularly embarrassing because mutual funds are supposed to have a formidable research infrastructure that should have alerted it not to touch IL&FS debt instruments even with a barge pole. Not for it is the excuse that it got foxed by the labyrinthine structure of IL&FS.

The mutual fund industry’s ineptitude has been compounded by the negligence of credit rating agencies which had blithely awarded top ratings for the IL&FS group papers, obviously doing shoddy research themselves. The two then had combined to let down the mutual fund investors. Of course, mutual fund investments are subject to market risks. But these were credit risks that could have been red-flagged by credit rating agencies as well as by the in-house research teams of mutual fund houses.

Representational image. Reuters

Side-pocketing is common in hedge funds. This is done to ring fence the new investors. Hedge funds invest for high net worth individuals and other super rich categories of investors in all sorts of risky investments including land and unlisted companies.

When something goes wrong with an investment, they ring fence it so that new entrants are not put off by such investments gone sour. But the old investors get to share the spoils of such bad investments if and when recovery is made. This is called side-pocketing.

Previously, SEBI was not in favor of allowing mutual funds to side-pocket or segregate their bad units. In 2016 -- post-the JP Morgan Asset Management (India)'s investments in Amtek Auto going sour and the fund house trying to resort to side-pocketing in vain at that time -- the Association of Mutual Funds of India (AMFI) had approached SEBI to set rules for creation of side-pockets when faced with an adverse credit event.

At that time, SEBI had rejected the request. However, in a board meet held on 12 December 2018 in Mumbai, SEBI, in a change of heart and perception, accepted the recommendations to allow side-pocketing made by the SEBI's mutual fund advisory committee.

Earlier this year, debt fund investors in many schemes saw a sharp fall in their NAVs after these schemes' investments in (IL&FS) and some of its subsidiaries saw credit rating downgrades following the group floundering in repayment of its debts. Evidently, the SEBI change of heart was brought about by the looming shadow of IL&FS fiasco and in the interest of small investors.

While mutual fund houses have by and large welcomed this thaw in SEBI’s perception, there are critics who wonder if this would encourage brinkmanship on the part of fund houses, secure in the knowledge that should something go wrong, they can always side-pocket the bad debt investments and ring fence the newcomers from their downside risks. Be that as it may, the SEBI has made it clear that the permission to side-pocket is entirely optional and the trustees must pass a resolution each time they want to use this optional regime.

What side-pocketing means and spells can be understood with an example. Suppose, a debt scheme has net assets, which is nothing but the market value of its investments at the end of each day, of Rs 52 crore enuring for 2 crore units. That gives NAV of Rs 26 per unit. NAV is the basis for redemption as well as entry post new fund offer (NFO) in an open-ended scheme. To and from NAV, entry and exit loads are added and deducted respectively.

Suppose this scheme had an exposure of Rs 2 crore to IL&FS debt instruments. Now it has the option to keep Rs 2 crore out of its net assets. The bottom line would be its NAV would be Rs 25 down by a rupee. It is at once a fair regime both to the new entrants and the old investors.

The new investors are not exposed to the toxic investments nor do they pay for them but the old investors have to grin and bear. The old investors, if they want to exit, would get only Rs 25 per unit less the exit load but they would get their share of the toxic asset if and when realised.

(The author is a senior columnist and tweets @smurlidharan)