Mutual fund (MF) investors have learnt over the past two months that many Indian promoters have relied heavily on pledging their shares and raised money from their MFs to support core and non-core business activities.

It's all started with Essel Group when the company defaulted in pay its debt.

Later the company had reached an agreement with the lenders — comprising mutual funds, NBFCs and banks — to keep it afloat, under which it gets time to deleverage or pare its debt.

Several NBFCs, including L&T Finance and certain entities of Edelweiss Group, have invoked pledge of listed shares of Anil Ambani-led Reliance group and sold shares worth approximately Rs 400 crore in the open market in February, as there was a sharp drop in the prices of Reliance ADAG group shares, which led to further erosion in the collateral value.

The sharp fall in the prices of pledged shares has resulted in a huge problem for mutual funds and non-banking financial companies (NBFC). These mutual funds and NBFCs who have invested in promoter related instruments have been forced to give a commitment, to Zee and ADAG, to not sell the underlying shares because it will lead to all-round value destruction, both for the promoters and for the mutual funds.

The hope is that the problem will be solved if the promoters can raise money from outside and honour their commitments. However, what if they cannot? It can only appears to have been pushed down the line to harvest a bigger problem.

In an interview to CNBC-TV18, Sandeep Parekh, founder, Finsec Law Advisors; JN Gupta, former ED, Sebi; Nilesh Shah, MD, Kotak Mahindra AMC and Amit Tandon, founder and MD, IIAS, decipher what are the risks involved for the markets with the sharp fall in pledged shares prices and what problems are in-line for the mutual funds sector and NBFCs.

Parekh said, “Many of the problems that we see today are completely unexpected. In any given scenario, if you look at any of the largest 100 companies two decades back in the US, there are very few even relevant today and large numbers have ceased to exist. This is a process of creative destruction and yes, mutual funds and other lenders would be investing in many of these ventures as they would invest in 95 percent which are not going to default over certain period of time. I think it is a bit too hasty to come to a judgement that mutual funds have adopted too much risk.”

Shah said, “Let us focus on how are we managing our credit risk. In terms of our track record, over last 15-20 years, has banking sector done better than us? Answer is clearly no. Has insurance sector done better than us? Answer is clearly no. Has provident fund sector, pension fund sector done better than us? Answer is clearly no. You give me a benchmark which I should copy and I will be more than happy to do it. Do we have to learn? Of course, we have to learn; there is no doubt about it. We have to learn from our experiences, our mistakes and we have to take corrective action. However, while taking corrective action we should remember that entrepreneurs of India requires risk capital and there is no free lunch."

Gupta said, “We would not have debated this had Zee not happened, had Reliance Communications issue not happened, had DHFL and IL&FS not happened. Since all those four things happened, there is a time to relook at it. The first thing is look at what is our system. Credit rating which AAA yesterday becomes D today; now that is a totally unreliable system.