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Vi and Segregated Portfolios
14th August 2021
Reading time ~ 3 minutes
Hi there,
Last week, we talked about the never-ending struggles and the ever-rising mountain of problems for Vi. When an extraordinary circumstance (like that faced by Vi) takes place, it also affects our mutual funds - at least those that have lent to such companies. In today's blog, we'll talk more about how mutual funds deal with these situations, and why you as an investor should know that.
If you haven't already, check out Part 1 of the post here.
In order to understand how mutual funds deal with situations like that of Vi, let's first look at how debt investments work with mutual funds.
Say today you had to lend 1000 bucks to your friend Aisha, who wants to start a cafe. How would you decide whether Aisha will be able to pay back the 1000 bucks, along with some interest on it? i.e. how would you decide her credit rating or her credit worthiness?
Well, for starters, you'll probably look into her existing income - how much money is already coming in or potentially could come in. You'd then check if that inflow would be enough to pay off the loan. You might also want to check her history - if she's taken loans before and whether she's paid them off on time? Also, does she have any assets would cover the amount of the loan, in case she does not have funds to pay it? In essence, you'll figure out the risk of lending to Aisha, and based on that take a call whether that risk is worth taking or not.
Obviously, even after doing good risk analysis, things don't always go too well. It's possible you lent to her in Dec 2019, and then Covid hits - now her Cafe is shut down, and she has little to no inflow of cash to pay you back. This doesn't have much to do with her capabilities, but it's because of extraordinary circumstances that were not in her control. What do you do next? You downgrade the quality of the loan (i.e you mark it as a loan that has a high risk of not getting paid), and then move on. Alternatively, you can also try to transfer the loan to someone who might be willing to buy it. You take a small loss for yourself, but with the upside of getting cash today.
Mutual funds also do something similar. They'll lend to governments and companies. Each loan has a credit rating associated with it which defines the risk of lending to that particular entity. If the entity is well-rated, that means the risk of not getting the money back is low.
So now, take the case of UTI Regular Savings Fund. Its portfolio included loans given to Vi. In 2019, when Vi was asked by the Supreme court to pay the AGR dues in full, the fund basically realized that there is little to no chance that Vi will now be able to pay these loans off, given the ginormous AGR burden that it now has to settle. In Feb 2020, rating agencies went ahead and downgraded the credit quality of the loans owed by Vi. Subsequently, the value of UTI's fund fell, because now they had loans in their portfolio that would likely not be paid back.
Why did this happen?
Say you've lent INR 100 to 5 friends (i.e INR 20 to each). Tomorrow, one of your friends says they can't pay you back. Now, instead of the INR 100 + interest that you were going to get, you'll only get INR 80 + interest. The value of your portfolio thus decreases. Right?
Let's understand the above with terminology used by Mutual Funds.
We know that MFs have something called a NAV (the Net Asset Value of the fund). It's basically the value of one unit of a mutual fund, i.e. the total value of all the shares or loans that the mutual fund has invested in divided by the total number of units of the fund. Think of one unit as a block of ownership in the fund - very similar to owning shares in a company.
Now, when a company's loan is downgraded, the NAV (or the value) of the fund decreases and a couple of things can happen:
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Existing investors might panic and redeem their funds (possibly at a loss)
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New investors might see this as an opportunity and invest in the fund (they could be optimistic that the loan will be recovered; They'll get more units in the fund than if the NAV hadn't decreased)
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Some existing investors will stay invested
Now, say the fund is able to recover the loan. The value of the fund increases again - new investors will benefit from this increase - while existing investors will have to share the gains with folks who did not bear the decrease in NAV. Not a very fair game!
So, SEBI came up with a policy of a "Segregated Portfolio." What this means is that when a mutual fund has lent to a company that is not able to pay back the loan, it will simply take that entire loan amount and keep it on the side - as a segregated portfolio. This portfolio functions separately from the regular fund - it will have its own valuation and only existing investors will get a pie of it. So, when new investors enter the fund, they will only get units in the regular portfolio (not the segregated portfolio), and will not reap the benefits if and when the loan is recovered. Further, this will also help prevent any panic exits from existing investors who might feel like the value of their funds will further decrease.
As an existing investor who might have been affected by situations like what happened with Vi, you'll be given units in the segregated portfolio and the mutual fund will then conduct proceedings to recover the loan. The NAV of the regular portfolio will still fall, but if and when the loan is recovered, the gains will only be credited to those investors who were affected by the bad loan.
The concept of Segregated Portfolios is pretty recent, so it's good to be aware of what happens in such situations and know the next steps.
If you're wondering how to assess the risk in such situations, make sure to check out our explainer on debt funds here.
Thoughts or questions? Let us know at rujgupta@laana.club
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