Though side pockets was one of the tactics used by hedge funds during the credit crisis in 2008, India had its first brush with it in 2015. That was when JP Morgan India Treasury Fund and JP Morgan India Short Term Income Fund side pocketed their exposure to Amtek Auto.
According to the Securities and Exchange Board of India (SEBI), a segregated portfolio can be created in the case of a credit event at the issuer level. So far, SEBI has come out with two circulars on the creation and segregation of mutual funds.
The December 2018 circular clearly states that mutual fund needs to start the process of creating a segregated portfolio on the day of the event. Almost a year later, SEBI issued a second notification allowing for the creation of a segregated portfolio for unrated papers.
To make side-pocketing effective, changes need to be incorporated in the Scheme Information Document, or SID, of the fund, which then requires investors to be given a 30-day load free exit window.
Aditya Birla Mutual Fund chose to create a segregated portfolio for three of its funds:
- Aditya BSL Credit Fund
- Aditya BSL Dynamic Bond Fund
- Aditya BSL Medium Term Fund
How it was done:
Aditya Birla Sun Life Mutual Fund holds an exposure of around Rs 780 crores towards an Essel Group company by the name of Adilink Infra & Multitrading Pvt Ltd. The underlying paper is unrated and the fund company opted to create a side pocket for this paper in line with SEBI regulations on the day the credit event took place.
How the credit event took place:
Payments from Adilink Infra & Multitrading Pvt Ltd. were due to a minority investor as this particular investor chose to exercise the Put Option on his investments. The issuer was unable to meet his payment obligation on November 25, 2019. Consequently, fund house having considered this as a credit event chose to create a side pocket by segregating their exposure to the Adilink papers.
The asset management company, or AMC, has followed all the procedures as prescribed by SEBI in doing so and issues a press release to this effect.
How it impacts the portfolio:
The AMC had preemptively taken a 35% markdown on the stressed paper almost 3 weeks prior to the segregation of the portfolio. Post segregation, the value of the main portfolio would come down by the extent of the value of the Adilink Security held in the segregated portfolio. However, the aggregated portfolio will continue to have the same valuation as at the day of the segregation event.
In effect, the combined portfolio values will not see any impact. Investors, however, will not be able to redeem from the segregated portfolio, as per SEBI’s directive. Technically, if and when the recovery happens, subject to the recovery amount, investors would receive their monies.
Update on other holdings:
The AMC has been working on a resolution with respect to the other stressed assets and has made good progress on many of them.
Jharkhand Road Projects Implementation Co. Ltd.: The NCLAT order converted the rating on their holding in the IL&FS SPV of Jharkhand Road Projects Implementation Company from amber to green, as a result of which they have been accruing interest payments on this holding.
Group companies of IL&FS were classified according to their financial health and ability to meet payment obligations. GREEN referred to those able to meet all payment obligations of secured and unsecured creditors, AMBER were only able to meet operational payments and secured debt obligations, the rest were RED. The latter were in no position to pay any creditor.
They also have an exposure to the education business of IL&FS which is in the process of being bought out Career Point. Career Point will now get 80% ownership in IL&FS Skills Development Corp., held by Schoolnet India
Their exposure to Spirit Infra & Multiventures Ltd., another Essel Group Company has also reached a resolution with the mutual fund receiving payments towards the same. Their exposure is now zero.
With respect to the unrated security – Adilink Infra & Multitrading Pvt Ltd., despite having created a segregated portfolio, they have received the first tranche of payment that was due to them from Adilink. The payment for the second tranche is only due by the first quarter of 2020. Moreover, Adilink papers are secured against a few road assets from Essel Infraprojects. Essel Group is in discussions with prospective buyers sell their road projects and monetise these assets. If these discussions go through, they may be able to make a prepayment towards the NCD’s of Adilink Infra & Multitrading Pvt Ltd.
How it impacts the investor:
We think that the segregation of the portfolio is in the best interests of all the stakeholders, considering that a resolution in this particular case could take a little longer as compared to the ones that we have witnesses in the past (given that payments from Adilink Infra & Multitrading are only due in March 2020).
We think that side pocketing is a good way to protect investor interest. While in theory one would expect investors to behave rationally, their psychology might prompt them to redeem their investment from the main portfolio once available, to prevent any potential future losses and still have the optionality of the side pocket yielding some value. But in doing so, investors will convert their mark to market losses into real losses should they chose to exit the fund at this point in time.
It’s important to look at the underlying reasons and the likelihood of the AMC reaching a resolution with respect to the downgraded papers, rather than exiting them in a hurry.
