Investigation: Shattered!

THE CRISIS
	The value of the equity holdings of US-64, which account for 64 per cent of its portfolio, has been eroded by 33.43 per cent, from Rs 12, 407 crore to Rs 8,200 crore!	Its income will contribute only Rs 2,800 crore that it will need to meet its dividend payouts for 1998-89. Where will the rest come from?	When investors realise that the NAV of the scheme is below par, US-64 will face a redemption crisis that will require the government to bail it out...

It's the beginning of the end. Of the Unit Trust of India (UTI), the mutual funds, and of the stockmarkets as we know them. When-not if-India's first and largest mutual fund, the UTI 's Unit Scheme 64 (US-64) collapses, taking with it whatever is left of the Rs 19,000 crore committed to it by 2.10 crore investors, the entire universe at whose centre it stands will have to face a Big Crunch.

The plunge of 224 points in the Bombay Stock Exchange (BSE) Sensitivity Index (Sensex) on October 5, 1998-second only to the crash of 570 points on April 28, 1992, that followed the felling of another mythical Big Bull-was just a pale preview of what could ensue. Says P.S. Subramanyam, 56, Chairman, UTI, who promptly launched a damage-control exercise through newspaper advertisements acknowledging the problems but downplaying their impact: ''Two crore investors come to the UTI with safety and income expectations.'' Unfortunately, those expectations are turning out to have been utterly misplaced.

For, the truth is that US-64 is in deep, deep trouble. Its enormous investments are losing value by the day. And the tradition of high dividend-payout that it is striving to continue into 1998-99 could wipe it out completely-and set off a tsunami that will drown investors and institutions, stockmarkets and corporates, money managers and mutual funds, you and us. Says a BSE broker, who also handles deals for the UTI: ''It will scorch everybody-corporates, small investors, and the markets.''

The initial panic following Subramanyam's apparently innocuous statement-that US-64 would reduce the proportion of its equity vis-à-vis debt and other assets, which had changed from 28:72 in 1991-92 to 64:36 in 1997-98-may have taken the form of a bear hug on the bourses and a long queue of redemption-seeking investors. Actually, the real paranoia has barely begun. And its cause lies elsewhere.

To be precise, in the data obtained exclusively by BT, providing the details of the complete portfolio of US-64 as it stood on June 30, 1998-comprising equity investments in 1,412 scrips with an acquisition value of Rs 12,407 crore; and debt and fixed assets estimated at Rs 6,918 crore-totalling Rs 19,325 crore. What emerged from a study of the data-and from interviews with over 2 dozen analysts, stockbrokers, and former UTI insiders, most of whom revealed their thoughts on the condition of anonymity-was a can of worms masquerading as an investment portfolio.

Has The US-64 Portfolio Been Reduced To Junk?
No. But its equity holdings are losing value rapidly.

As a comparison of the acquisition price with the current price reveals, US-64 is worth far less than its original value today-and is being devalued at a furious pace. The proof: the market value of the equity component of the US-64's portfolio stood at Rs 8,200 crore on October 6, 1998-a stunning Rs 4,208 crore lower than its acquisition price. This translates into a 33.34 per cent erosion in the value of 64 per cent of the US-64 corpus, or, an overall loss of 21.34 per cent. With the rest of the corpus, comprising debt and real estate, earning an average return of 12 per cent per year, the effective Net Asset Value (NAV) of US-64-a closely-guarded secret that has never been revealed in the UTI's 34 years of existence, and, many say, never been calculated-is a mere Rs 9.68, according to BT's calculations. And the NAV of its equity component is a shocking Rs 8.20. The basis of the computation: adding Rs 6,532 crore as the value of the debt holdings-as estimated by BT-and Rs 386 crore for real estate to the Rs 8,200-crore current market value of the US-64's equity, the total value works out to Rs 15,118 crore. With 1,562 crore units outstanding, that translates into a NAV of Rs 9.68.

The implication is frightening. For, the US-64 units were being sold at Rs 14.55 and repurchased at Rs 14.25 in October, 1998-50 and 47 per cent, respectively, above their estimated NAV. So long as they do not actually know where the NAV stands, investors might not respond by pulling out their money-but once they do, and the UTI lowers the repurchase and sale prices to a level closer to the NAV, investors will transfer their cash elsewhere. After all, declaring its NAV and lowering its unit prices will trigger off precisely the kind of panic that will force a run on US-64-making that alternative a virtual fait accompli. Says a Mumbai-based mutual funds analyst: ''The UTI might have stood for confidence once. But today, there are equally good options which function more transparently.''

Counters Subramanyam: ''US-64 is not NAV-driven in any case. Whatever premium there is above the NAV is for brand UTI, which means security and safety to investors.''At one level, that's a clear acknowledgement of the fact that the NAV of US-64 falls well short of the price of its unit. Even more important is the ignorance of investor motivation it betrays: nobody will hold on to a piece of paper which is not worth even its par value.

So, as investors demand their money back, just how will US-64, which will also be under pressure to continue its 20 per cent dividend payout, meet the demand? One option it has already exhausted: thanks to an ever-widening gap between dividend payouts and net income-the shortfall screamed up to Rs 2,113 crore in 1997-98 from Rs 815 crore in 1994-95-its reserves stand at the alarming level of -Rs 1,098.49 crore.

That has already raised the spectre of a sell-off of stocks, fuelled by Subramanyam's statement: ''We will reduce the equity component of US-64 from 64 to 60 per cent over a 1-3-year period. The proportion of equity could, eventually, come down to 50 per cent.'' And as Black Monday revealed, the impact on the stockmarkets will be staggering. After all, the equity portfolio of US-64 accounts for 10.30 per cent of the floating stock of the BSE Sensex scrips, large enough for it to quake the markets significantly. Says a BSE broker: ''A US-64 problem will have a multiplying effect on the market. It's a microcosm of the entire equity and debt market of the country. If US-64 bleeds, the markets will haemorrhage too.'' Or even go into a coma. Predicts the country manager of one of the largest foreign institutional investors operating in India: ''The options are clear: either there will be a sudden death of US-64. Or there will be a delayed death.''

Joining it on the funeral pyre could be the UTI too, which may be deprived of investors overnight for all of its 42 income schemes, which collectively manage Rs 28,149.76 crore in equity funds, and control some 8 per cent of the market capitalisation of the companies traded on the BSE. For, US-64 alone accounts for 32 per cent of the UTI's entire corpus, and will, inevitably, pull the other schemes down if it does go under.

Dead, too, will be investor confidence, which had fed on the unstated, but near-inviolate, assumption that US-64, contrary to all canons of the mutual fund business, offers assured dividends-guaranteed by history, if not by law. It was an assumption that US-64 stoked happily in its regular annual bids to attract more investments. Says a former UTI executive: ''Every chairman of the UTI wanted to prove himself by collecting increasingly larger amounts of money to US-64, and declaring higher dividends.''

This overarching ambition, however, made US-64 forget its identity as an income scheme, whose mandate is to provide fixed, regular returns to its investors by putting their pooled money primarily into debt instruments. In fact, even the typical balanced fund usually puts no more than 30 per cent of its entire corpus into equity. However, eager to capitalise on the stockmarket boom of 1994, US-64 recklessly increased its equity holdings.

Of course, being forced to sell large chunks of debt to meet the redemption pressure caused by corporate withdrawals in 1995-96, following a drying up of liquidity, also skewed its portfolio further towards equity. Moreover, successive governments had used the UTI as their instrument for intervention in the stockmarkets to influence share prices. Now, as the quantum of withdrawals threatens to match the quantum of investments, all its past sins are weighing down US-64, leading it down the road to damnation, and taking the markets with it.

Can US-64 Meet Its Dividend Commitments?
Only if it can find someone to bail it out with cash.

Will US-64 earn enough to maintain its 20 per cent dividend-level, which will amount to Rs 2,800 crore if there is no unusual redemption pressure, but will add up to Rs 5,023 crore-the cost of dividend payment-plus-repurchase-if a run were to reduce its unit capital by even 10 per cent? As things stand, it cannot expect gains from trading in shares to help it pay its dividends. For, any profits that it does make from the process will only help mitigate the losses it has already run up by virtue of the erosion in the value of its equity portfolio. Its own sources of funds comprise interest income from its debt and dividend income from its equity holdings. Even these have to be balanced against its expenses before actual profits can be generated and dividends paid. The alternative, as was the case in 1997-98: a dip into the reserves.

Will that change when it's time to declare the dividends for 1998-99? US-64's dividend yield stood at 2.50 per cent on the total acquisition cost of its equity portfolio in 1996-97. Applying the same rate, earnings work out to Rs 310 crore, but the drop in corporate dividends that is almost inevitable in 1998-99 may well lower that yield closer to 2 per cent-or, Rs 248 crore. Adds Vineet Agarwal, 34, CEO, Acumen Financial Services: ''The US-64 portfolio, despite its vast size, is not geared to pick out the winners in terms of dividends.'' As for the interest income, even assuming a continuation of the 12.78 per cent rate of return registered in 1996-97, it will stand at Rs 835 crore in 1998-99. Considering the fall of interest rates since then, a more realistic estimate pegs the figure at Rs 783 crore.

That leaves only one source for the gap of Rs 1,717 crore that this implies between earnings and the dividend payout target: profits from equity trading. That, in turn, needs 2 pre-conditions: a market with crests and troughs, and savvy fund-managers. Recommends S.A. Dave, 63, former chairman of the UTI: ''The fund- managers have to be more active, and every wave must be considered a profit opportunity.'' Sure, but just how high is the probability of earning a return of 14 per cent in 1998-99-as it must to make profits of Rs 1,717 crore-considering that the value of the equity portfolio dropped by 34 per cent in the first 3 months alone?

The benchmarks: between June 30, 1996 and June 30, 1997, when the Sensex rose by 11.60 per cent, US-64 earned Rs 1,641 crore from equity trading. To repeat that performance, either the markets must climb to a similar extent, or the US-64 fund-managers must perform the impossible task of making money in a falling market. No fund has found it easy to do that. Why, between April 1, 1997 and March 31, 1998, while the Sensex climbed by 14.59 per cent, the average equity fund still logged a return of only 8.59 per cent.

Moreover, any major sell-off by the US-64 will trigger off a downfall in prices, as the 224-point drop in the Sensex on October 5, 1998, merely in response to such a fear, proves. And that will only put trading profits even further out of reach. Nor does the composition of the US-64 equity portfolio offer much hope of its meeting its trading profits target. On October 6, 1998, a whopping 89 per cent of the scrips in its portfolio, accounting for 95 per cent of the value of its total equity holdings, were trading at a discount to the average cost at which US-64 acquired them. Worse, the sectors that dominate its holdings are more likely to lag, rather than lead, any recovery.

For instance, the sectors with the heaviest representation in the UTI's portfolio terms of original acquisition cost-iron and steel (11.54 per cent), refineries (10.73 per cent), petrochemicals and plastics (9.29 per cent), diversified (8.53 per cent), and oil products and drilling (5.65 per cent)-represent industries and genres with question-marks over their short-term future. These sectors have been among the biggest losers in the US-64's portfolio, dropping by 63 per cent, 26 per cent, 27 per cent, 54 per cent, and 43 per cent, respectively. Likewise, US-64's Public Sector Undertaking (PSU) scrips, accounting for 31 per cent of the total equity investment, are unlikely to bring in gains, having lost 37 per cent of their value-and contributing 33.40 per cent to the erosion in the equity portfolio.

Selling the debt portfolio, amounting to 36 per cent, or Rs 6,532 crore, will only skew the equation further in favour of equity. The inescapable conclusion: the prospects of generating profits through trading couldn't be dimmer. Ergo, the unstated rule that US-64 will offer a 20 per cent dividend should, by all financial logic, be a casualty. But then, that's not what Subramanyam, for one, is willing to concede. ''The UTI will try to maintain the dividend to be declared next June at the previous year's level,'' says he.

Could US-64 Collapse Under Redemptions?
With real yields dropping, a run is the logical outcome.

The pressure of redemption is mounting. In just 4 days between October 5 and October 7, 1998, investors pulled out Rs 550 crore-Rs 50 crore more than the total redemption in the June-September, 1998 quarter-amounting to 2 per cent of the corpus. If this trend develops into a full-fledged run, the UTI may be forced to repurchase upto 25 per cent of the US-64 units-the bill for which will be a cool Rs 5,557.50 crore. As part of his damage-control strategy, Subramanyam has requested corporates, who hold about 30 per cent of the units of US-64, not to sell. Says he: ''Corporates have assured us that they will not sell, and they have requested us not to sell their shares.'' However, the Rs 3,447.80-crore Bajaj Auto and the Industrial Development Bank of India (1997-98 income: Rs 6,109 crore), among others, have stated their intention to redeem their US-64 units.

Union Finance Secretary Vijay Kelkar's promise of a line of credit from the Reserve Bank of India (RBI) to ensure that US-64 doesn't go bust-a reprise of the RBI's pledge back in 1965 to ensure that investors didn't lose even if the repurchase price fell below par-may help stave off some of the redemption pressure. So might the exemption from income-tax that North Block is planning for dividend earnings from the UTI's schemes. But the entire episode will force investors to re-examine their real returns from US-64-and they won't be happy with their discovery. For, returns are diminishing steadily if the estimated fall of 10 percentage points-from 20 to 10 per cent-is combined with the steady fall in the repurchase price, at an average rate of Re 1 a year for the past 3 years. If this trend continues, it will effectively peg the yield in 1998-99 at 10.34 per cent, and at 8.00 per cent per annum in 2000-01, according to BT's calculations. Yields will actually decline the most sharply for investors who bought their units at the progressively higher sale price that the UTI set for US-64 units between 1992-93 and 1994-95, when unit prices soared from Rs 14.90 to Rs 17.

As they realise these facts, investors could force down the size of US-64 to an alarming degree. Over the past 2 years, the unit capital of US-64 has gone up by 7.50 per cent. But a large-scale withdrawal of money will force the scheme to fork out much more cash than its negative reserves, value-eroded equity holdings, and largely-illiquid debt will permit. Among the short-term responses could be a massive reduction in its repurchase price, forcing investors to wait instead of incurring losses. Or, as in 1993, even a complete ban on sale and repurchase-which would only confirm people's worst fears-could ensue. Says Nitin Jain, 33, Director, Cipher Securities: ''There are few options that the UTI has. Declaring its NAV will cause panic among investors and in the stockmarkets.''

If that leaves a bailout-bankruptcy is probably ruled out-as the only alternative, it still begs the question of whether the exchequer can afford to foot the bill. To be precise, since it will probably have no choice, the real issue to be considered is the cost of saving US-64. Whatever be the final face-saving formula, no investor will be fooled into believing that all's well with the scheme even if her money is returned. That may doom not just US-64, but the UTI as a whole, creating havoc not just in the capital markets, but also in the very framework of financial institutions, corporate finance, and the country's economy. It will, indeed, be the death of an institution-and of the trust reposed in it, and in its peers, by millions of bitter, poorer, and wiser investors.
researched by Dilip Maitra.