Foundation — What debt risk, equity risk and investor risk actually look like

6.1 Two ways to measure a return

Financial investments are fraught with risk but the nature and quantum of risk depends, among a host of other factors on the type of instrument, i.e. equity, debt or preference capital.

To calculate returns from such investments there are basically two approaches – (1) metrics that calculate absolute returns and (2) metrics that use the present value of money by discounting future cash flow from the investments at an appropriate risk adjusted rate. While the former approach requires comparison with the opportunity cost on annualised basis, the latter approach does the same on a discounted basis.

Two definitions from the footnotes are examinable in their own right:

Opportunity cost is the benefit foregone in a different alternative for making a particular choice. For e.g. if a person invests a sum of money in a bond providing an interest of 10% p.a. instead of putting the money in a fixed deposit earning an interest of 7%, it makes better sense since the bond yields more than its opportunity cost. The additional return has to be weighed against the additional risk if any from the bond.

Time value of money — Discounting of a future sum of money to arrive at its Present Value is based on the concept that money is worth more today than it will be tomorrow due to inflation. The workbook works it through: at 10 per cent, INR 1,000 due three years hence is worth INR 909 two years hence, INR 826 one year hence, and INR 751 today.

Illustration 6.1 — why absolute returns mislead

If an investment of INR 10,000 is returned after 3 years as INR 19,000, the average returns are INR 3,000 per annum which yields an average annualised return of 30% on the original investment. However, this approach does not consider the timing of the cash flow. If the discounted value of the cash flow is considered, it is possible to compute the rate at which it would be equal to the original investment (therefore proving the returns). This metric is known as the 'internal rate of return' (IRR) which when used in the context of financial returns by the private sector is known as the financial IRR or the FIRR. In the given example, it would work out to 24%.

Thirty per cent by simple arithmetic, 24 per cent by IRR. The gap of six percentage points is the price of ignoring timing — and in a fund where money goes out over two years and comes back over eight, that gap is very much bigger.

And one more name to know: In investment parlance, IRR on an investment is also known as the 'money weighted return'.

In an AIF context, initial contributions go towards the corpus and the returns provided for by the fund are called 'realisations', and the ultimate profitability of a fund is driven by the number and size of these realisations. The understanding of investor risks and the difficulty in computation of returns from realisations is extremely important both from an investor and distributor perspective.

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6.2 The nature of debt investments

Debt investments by AIFs could consist of loan financings to investee companies, unlisted debt securities like non-convertible debentures, listed or to-be-listed debentures and other forms of structured financing such as sub-ordinate debt and mezzanine financing. Some of the debt may also be towards working capital financing of the investee / borrower company.

Real estate, infrastructure and special situation funds could also provide financing against project or control interest in a special purpose vehicle (SPV) or against security receipts / REIT units / InvITs (these are known as 'securitised debt instruments') issued by a securitisation trust or company.

The footnote defines control interest: shareholding or voting rights in a company that provide management control. The minimum such rights are 51% which provide simple majority control. Sometimes, such rights may also be accorded through a specific contract instead of voting rights.

The security may take many forms: These financings may be secured or unsecured against the tangible assets of the company, project rights, intangible assets, bank guarantees for domestic debt, cash or securities escrow or pledge, or trust and retention account or against collaterals such as shares and personal assets of shareholders.

Then comes a warning worth reading twice, because candidates assume security means safety:

Debt investments have inherent credit risk since they are based on an assessment of the borrower's servicing capacity through future cash flow generation in business. Though debt securities may be secured as mentioned above, in many situations, the recovery value of such debt protections are sub-optimal. Furthermore, when the borrower is in a debt trap or distress, the carrying cost of such debt for the investor may be extremely high leading to further loss in value. In most cases, debt resolutions pose difficulty and delays including litigation and court mandated process.

Three separate problems, and each has cost Indian lenders dearly: recovery value is sub-optimal, the carrying cost during distress is extremely high, and resolutions are slow and litigious. A first charge on a factory is worth what somebody will pay for the factory, after four years of court.

In order to understand the risk perception of debt, the debt issuances by companies are usually rated by an external credit rating agency. However, in AIF domain, many debt investments may be unrated and illiquid without a secondary market.

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Table 6.1 — the priority of debt claims

This table is the single most examinable block of definitions in the chapter. Learn each term precisely.

Secured Debt — a borrowing that are protected by a specific charge on assets or cash flow or contractual rights of the borrower. Assets can be fixed or current or intangible or all or in any combination thereof. All claims provided to lenders are commonly known as 'security' which can therefore mean a variety of claims arising from various charges created in favour of lenders. This process is legally protected through a process called 'security creation'.

Lien — a legal right of the lender over the borrower's assets till such time the debt is not repaid in full. Unlike security creation which requires a process of documentation, lien can be created even by law. For e.g. a banker has lien over a depositor's money kept in the bank by law. If not expressly covered by law in a given case, a lien is created when the security creation process is complete. A general lien ranks lower than a specific charge.

Note the two ways a lien arises — by law or on completion of security creation — and the ranking rule: a general lien ranks lower than a specific charge.

Ranking within secured debt — Secured debt will be ranked on the basis of the charge created – for e.g. debts with first and paramount charge will rank senior-most. They are followed by secured debt with second charge and so on.

Pari passu charge — When there are multiple lenders requiring the same level of charge, a common charge is created on the same pool of securities. This is known as 'pari passu charge'.

The registration tie-breaker — If two secured borrowings are charged on the same asset(s) with the same level of charge, the one that has been registered first becomes senior to the other.

Fixed versus floating charge — Fixed charges need to be enforced against specific assets while floating charge extends to the entire group of assets under charge. Floating charge does not take effect until it is crystallised by a due process. In the event of crystallisation, if there are existing fixed charges on the same assets, they take priority over floating charge.

Read the last sentence carefully. It is not that a fixed charge always beats a floating charge in the abstract — it is that on crystallisation, existing fixed charges on the same assets take priority.

Sub-Ordinate Debt — All borrowings that rank less than secured debt with first charge are called sub-ordinate debt. Therefore, sub-ordinated debt can be with second or any subsequent charge.

Unsecured debt — A borrowing that is not secured by any fixed or floating charge or a lien is an unsecured debt. It ranks lowest in enforceability in the list of debt obligations of the borrower.

Priority of claims — the ladder:

1. Secured Senior debt has the first and highest claim on the borrower but the priority of claims within all secured debts is enforced on the basis of the seniority of charge created.
2. Secured Sub-ordinated debt ranks next but the priority of claims is again decided on the basis of seniority of the charge within the overall category.
3. Unsecured debt ranks lowest among all debt. It is paid out only after claims of all secured debt is satisfied in full.

And the note that completes the ladder below debt:

All debt claims irrespective of whether they are secured or not have priority over preference capital which ranks higher than equity capital. Equity only has residual claim on the company after preference shareholders' claims are fully satisfied.

So the full order, top to bottom: secured senior debt → secured sub-ordinated debt → unsecured debt → preference capital → equity. Equity is the residual claim, and this single fact explains why equity returns are volatile and debt returns are not.

Also note the language of section 6.2 on seniority: 'Senior or secured debt' is the name given to the debt that has priority over all other debt when it comes to receiving interest, or to receiving the proceeds from asset sales in insolvency. Senior debt has first charge on such claims. This seniority gives lenders the ability to negotiate better or expect better outcome in a resolution or liquidation process. 'Sub-ordinated debt' or 'Junior debt' ranks after the senior debt with claims ranging from second charges to residual charges.

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Mezzanine capital — the layer between

AIFs also invest in mezzanine capital financings. Mezzanine finance comes in many forms. Venture capital funds finance a significant amount of debt to early stage companies (known as 'venture debt') which takes the form of mezzanine financing.

The defining sentence: The common features of all mezzanine instruments and products are that they offer a risk/return profile that lies above that of debt and below that of equity.

Mezzanine is used to finance a company where the banks have no appetite to lend further senior debt but there is still more capacity for introducing long-term unsecured borrowings. Such a situation may arise when the security provided by the assets of the company is fully utilised to support the senior debt package, but the cash flows will support further borrowings. An AIF will therefore wish to receive a higher yield on the instrument that has no underlying asset security.

Understand that situation exactly, because it is the whole logic of mezzanine. A company has Rs 100 crore of assets, already charged to the bank for a Rs 70 crore term loan. There is no security left. But the business generates Rs 30 crore of cash a year, which can comfortably service more debt. The bank cannot lend — it lends against security. The mezzanine fund can — it lends against cash flow, and charges for the missing security.

Another situation could be when there are large forecast of cash flows contingent on the unlocking of value from a new project or business plan or corporate restructuring and Leveraged Buyouts or LBOs. In such a situation, the mezzanine financier may take the view to lend against these future lumpy cash flows, but require an adequate return to reflect the additional risk. This is often achieved by attaching warrants (options) to the mezzanine debt or by providing some conversion option into equity which would enable the mezzanine fund to share in the equity value of the business at exit.

Warrants and conversion options are the mezzanine lender's way of getting paid for equity-like risk without waiting for equity-like time. Remember the phrase future lumpy cash flows — lumpy, because they arrive all at once when the project completes or the restructuring succeeds, not evenly month by month.

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6.3 The nature of equity investments

While debt investments are about credit risk and adequacy of cash flow, equity investments are positioned to benefit from the upside of growth and valuation of the investee company.

Two rules that govern equity returns, both stated plainly:

Accordingly, the earlier the investment in a growth oriented company, the better are the equity returns, albeit with higher risk.

A lot also depends upon the entry valuation for the investor in the company. The higher the entry price, the lower would be the returns.

Earlier is better but riskier. Cheaper is better, full stop. The second point is why the vintage year matters so much — a fund that deploys at the top of a boom has paid high entry prices for everything it owns.

Equity investments may also generate periodic returns in the form of dividend distributions in cash or in stock (known as bonus shares). Equity investments may also entail follow-on funding to provide continuous growth capital to the company which are known as Series A, B and C in VC/PE industry terminology.

And the mapping of category to stage, which is a favourite exam question:

Category I AIFs are ideally positioned to take early stage risks in equity investments (typically series A) while Category II AIFs are about later stage investments (typically series B and C) wherein the ticket size of financings are larger but the risk is moderated with comparatively lower returns.

Buyouts: Equity investments may also be positioned for taking controlling positions in investee companies. Sometimes AIFs co-invest in control acquisitions or finance acquirers of other companies with debt or mezzanine capital. Such transactions are known as 'buyouts' and if leverage is used, they are known as Leveraged Buy-Outs (LBOs).

Listed versus unlisted: Some part of AIF investments could also be deployed in listed equities which provide liquidity and growth. However, these are subject to market risks on an on-going basis. Unlisted stocks are the primary domain of Category I and II AIFs which entail apart from normal equity risks, illiquidity risk for investors.

And now a distinction the exam loves:

In financial parlance, investment risks in listed markets are known as 'systematic risk' while investing risk in alternative assets which have higher risk concentration is known as 'unsystematic risk'. Category I and Category II funds are about primarily taking unsystematic risk in financial investments. Therefore, their return expectations are higher than those investors taking systematic risks.

Follow the logic all the way through. Systematic risk is market-wide and cannot be diversified away — every listed stock carries it. Unsystematic risk is specific and concentrated. Category I and II funds take unsystematic risk, and therefore their return expectations are higher. The higher return is not a bonus; it is the compensation demanded for accepting concentration.

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6.4 The six investor-level risk factors

When an AIF issues a PPM to investors seeking capital commitments, there are different types of risks associated with such investments. All risks can be either at the investor level or at the fund level.

1. Risk of Adverse Selection — Choosing the right fund manager is a difficult task for investors. Fund PPMs sometimes make forward looking statements or show a manager track record that may not be an assurance of future performance. The risk of adverse selection of a manager would mean either sub-optimal returns or moral hazards for investors.

2. Illiquidity and Uncertainty — Under the AIF Regulations, Category I and II AIFs need to be close ended funds because such investments are primarily illiquid. Illiquidity refers to the inability of the fund to sell its investments reasonably at proper exit valuations within the life cycle of the fund. In the case of AIF investments, illiquidity can be especially severe when a fund has remaining capital calls or when an investor attempts to liquidate a position before its termination. Secondary market for AIFs is not well-developed in India due to which investors may not be able to exit the fund till winding up and distributions are completed in full. In times of market stress, the fund would also find it difficult to make exits from its investment at optimal value. Similarly, when fund cycle does not permit extensions, exits may be ill-timed or under-valued.

Note the two moments when illiquidity bites hardest: when a fund has remaining capital calls — you still owe money you cannot get out of — or when an investor attempts to liquidate a position before its termination.

3. Fund Monitoring — Monitoring AIF progress and performance during its life may provide relatively diminished benefits because an investor's options in Category I and II funds are more limited than in the case of Category III funds. There is also limited control over managers in an AIF. Lack of proper investment opportunities may sometimes curtail fund performance. Nevertheless, monitoring is advisable and investors can play valuable roles in working with fund managers. As the fund managers are likely to launch a new scheme or fund in future, this monitoring activity can be quite valuable.

The workbook does not simply say monitoring is useless. It says the benefits are diminished because you cannot act on what you learn — and then gives a forward-looking reason to do it anyway: the fund managers are likely to launch a new scheme or fund in future. What you learn in fund I decides whether you commit to fund II.

4. Cash Management — Uncertain capital calls and uncertain exits (with regard to both size and timing) raise substantial cash management issues for AIF investors. Because it is unclear when the committed capital will be called and how much cash will be generated in the interim in the form of distributions from previous investments, it is difficult for an investor to predict and control the cash flow. An institutional investor that sets aside large amounts of cash to meet potential calls runs the risk of diluting performance by compromising returns due to idle cash. Institutional investors often pursue an over-commitment strategy in which forecasted capital calls on outstanding commitments exceed current cash balances.

Over-commitment strategy is a term to memorise — forecasted capital calls on outstanding commitments exceed current cash balances. It is a deliberate, calculated bet that not everything will be called at once. It solves the idle-cash problem and creates a default-in-drawdown problem.

5. Underlying Investment Risks — when an AIF invests its capital in underlying investee companies, it takes a variety of investment risks as well as business risks of investee companies. These could relate to a variety of areas such as policy and regulatory risks, state of economy, financial markets, interest rates, foreign exchange risks for offshore investors, reliance on service providers, industry risks of a sector, governance risks in investee companies, litigation, tax law inconsistency etc.

In Category I funds, investments are made early due to which, they could be the risk of adverse selection, infant mortality and lack of step-up in value. Category II funds may make some investments in listed equity and debt which are subject to capital market risks.

Three early-stage-specific risks worth remembering as a set: adverse selection, infant mortality and lack of step-up in value. Infant mortality is the start-up that simply dies. Lack of step-up is the one that survives but never raises at a higher valuation — no death, no gain.

6. Debt Financing Related Risks — Many Category I and II investments could be in debt securities and financings include pure debt funds and special situation funds that address stressed company financings, LBOs among others. Debt financing is subject to credit risk which would consist mainly of interest rate risk and default risk. Some debt funds are sectoral funds for assets in real estate and infrastructure sectors which could have long gestation and other project risks along with cash flow problems. There could be risk in recovery of interest as well as capital in such investments arising from default, illiquidity and debt resolution process.

Note the composition given: credit risk which would consist mainly of interest rate risk and default risk.

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6.4.1 The three fund-level risk categories

These are a part of the risk factors that investors assume which are distinct from the underlying risks faced by investee companies that are automatically subsumed by the fund due to its exposure to them.

1. Structure and governance — fiduciary duty. The risks associated with fund structure and governance form the most important part of fund level risks, widely known as Fiduciary duty. Since the fund is governed with a structure that places reliance on the trustee, manager, other decision-making committees and services of outside service providers like valuation agencies and auditors, the competence, integrity and standards of governance exhibited by these participants are crucial to fund performance. The lack of transparency in fund matters and reporting, related party transactions or unethical practices in fund governance can pose immense moral hazards.

The most important part of fund level risks — remember that ranking; the exam asks it.

2. Fund management related risks. The ability of managers to find quality investments, concentration risks arising from sectoral exposures to particular types of businesses, sub-optimal structuring of investment contracts with investee companies, the quality of investment management thereof, sub-optimal exits from investee companies etc. are typical of investment management risks that the scheme / fund is exposed to at the entity level.

3. Macro-level and general risks. such as regulatory risks, currency risks, economic factors, changes in tax provisions etc. form the third category of fund level risks that can affect fund performance. Some of these changes could be adverse on fund returns. For e.g. a significant currency depreciation could impact the returns of foreign AIF investors when they repatriate the proceeds in foreign currency. Similarly, a slowdown in the general economy could impact businesses of underlying investee companies. This may have an adverse effect on fund valuations and exits that would in turn adversely affect investor returns.

That third category answers workbook sample question 4 directly. Macro factors emphatically do affect AIF performance — a currency depreciation hits repatriating foreign investors, and an economic slowdown hits the businesses the fund owns.