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A Swap with No Magic

A Swap with No Magic
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Above: Jet Airways, India’s second largest carrier, has piled up debts of over Rs 8,500 crore/Photo: UNI

The move by banks to take over the airline’s debts in return for equity may not change the quality of its assets. Short-term pain may lead to long-term risk. Was there pressure to make this deal?

By Sanjiv Bhatia

When Richard Branson, the owner of Virgin Atlantic Airways, was asked how to become a millionaire, he had a quick answer: “There’s really nothing to it. Start as a billionaire and then buy an airline.”

Airlines are capital-intensive, low-margin, highly competitive businesses. They have an insatiable demand for capital, and thus many investors, like the legendary Warren Buffet, prefer not to invest in them. Google “List of defunct airlines” and you’ll find hundreds of airlines that have gone bankrupt across the world. Since 1980, there have been 81 airline bankruptcies in the US alone. Even in a growing market like India, Kingfisher, Deccan, Vayudoot, Modi­luft and Air Sahara are among the 30 or so airlines that have gone bankrupt.

Now Jet Airways is in trouble. It has defaulted on its debt repayments to numerous banks and piled up debts of over Rs 8,500 crore. It posted a loss of Rs 588 crore in the third quarter on top of the Rs 1,297 crore loss it posted in the second quarter of this financial year. Estimates are that the airline requires $300 million in working capital just to pay off its short-term debts, including salaries to employees.

The largest creditor of Jet Airways is the State Bank of India, which is owed about Rs 2,000 crore. The bank, along with other public sector lenders, has made an offer to swap its debt for shares of Jet Airways. The proposal, which was approved by the Jet Airways Board, gives 51 percent control to a consortium of public sector banks and the National Investment and Infrastructure Fund (NIIF), an investor-owned fund anchored by the Government of India. The deal calls for the number of shares outstanding of Jet Airways to be doubled from 113.5 million to 227.5 million, with the consortium getting 114 million shares or a 50.1 percent majority. After this restructuring, Jet Airways will effectively be controlled by the Government of India (through its public sector proxies). Etihad Airlines, which is owned by the government of Abu Dhabi, will own 24.9 percent of Jet Airways’ equity and Naresh Goyal (the current majority stockholder) will see his stake fall to 20 percent, as a result of which he will lose managerial control.

In a typical debt-for-equity swap, the lender agrees to cancel some (or all) of a company’s debt in exchange for shares (ownership) in the company. Such a swap is quite common when companies are in financial trouble and cannot service their debt. Assume a bank has loaned a company Rs 1,00,000, which the latter is unable to service. The bank has three choices: it can restructure the debt at lower rates and extended terms; it can allow the company to declare bankruptcy and then attempt to recover the debt from the sale of its assets; or it can exchange the debt for shares in the company. Assuming the company is publicly listed and each share costs Rs 10, then in a debt-equity swap, the bank can cancel the debt in return for 10,000 shares of the company.

Both the company and the bank can potentially benefit from this debt-equity swap. The company removes Rs 1,00,000 of liability from its balance sheet and gets relief from having to make interest payments (which improves its cash flow). The bank gets to become an active participant in the company’s operations (by getting seats on the board or forcing a change in management). If the company turns around and becomes profitable, the bank can potentially sell its shares at a higher price and recover its capital (and even make a profit).

Debt for equity swaps have been successfully used when companies are poorly managed and the swap results in a change of ownership. The lenders, by acquiring equity, effectively become owners of the business and can put their own people on the board of directors. This allows them to recover their capital through large dividends to themselves or through share buybacks, and by selling portions of the company’s assets.

In June 2015, the Reserve Bank of India (RBI), in an attempt to address the bad loan (NPA) problem and alleviate stress on the banking system, came up with the strategic debt restructuring (SDR) scheme. It allowed banks to convert the debt owed to them by defaulting corporates into equity. It also allowed banks to take a controlling stake in stressed companies and thereby effect a change in ownership when the existing management was non-performing or non-cooperating.

Once a debt-equity swap is invoked, it allows the bank to kick the “bad loan” down the road. In the absence of a swap, the debt would have to be classified as a non-payable loan on the bank’s books. This would require it to set aside money to cover the risk of default. This provisioning for bad loans hurts a bank’s profitability because it blocks capital that can otherwise be lent. With a debt-equity swap, the bank eliminates the debt and removes the need to classify the loan as a bad debt on its books. In addition, under the SDR scheme, banks get 18 months to sell the stock they acquired in the swap. In other words, a debt-equity swap allows banks to postpone classification of a loan for 18 months.

Banks loved the SDR scheme and soon began to misuse it. A debt-equity swap works best when it is used as a tool to effect a change in ownership when the company is poorly managed. But banks started to use it even in cases where the company’s stress was due to the external environment. And since loan classification could be pushed down for 18 months, banks used SDR to game the system and camouflage their problems.

Many large bankrupt companies were brought under the SDR provision—Electrosteel Steels Ltd, Gammon India Ltd, IVRCL Ltd, Lanco Teesta Hydro Power, VISA Steel, Jyoti Structures and Monnet Ispat, to name a few. But banks had difficulties in either finalising the swap arrangement because of disagreement over valuations, or finding buyers for the company stock. Eventually, in 2018, the RBI abandoned SDR in favour of using the Insolvency and Bankruptcy Code as the primary tool to deal with defaulters.

SBI’s move to swap its loan for shares in Jet Airways is, therefore, a surprise move for several reasons. Firstly, it is not clear how a bunch of public sector bankers can run Jet Airways more proficiently than a savvy airline veteran like Goyal. In general, companies are better aware of market circumstances and business operations than banks. Jet Airways is facing tough external factors like intense pricing competition, a weak rupee and rising fuel costs, which are unlikely to abate in the near future. It is extremely doubtful that a change in ownership will increase the value of Jet’s stock which has tumbled from a high of Rs 1,320 in 2005 to its current price of  Rs 232 per share. The debt-equity swap that will give the banks ownership interest will not guarantee dividends if the company consistently loses money, and might make it even more difficult for the banks to transfer their holdings and receive cash in the future.

Secondly, the proposed debt-equity swap would require the banks as equity owners to put in more money to pay salaries to pilots, repay existing debts to lessors and vendors, and keep the airline running. The lending to Jet Airways won’t completely stop and the banks will have to provide working capital finance and fresh loans so that the airline can continue to operate.

The NIIF has agreed to infuse Rs 1,400 crore as working capital. But it appears to be a case of putting good money after bad. What is worrisome is that Jet Airways is now effectively a Government of India airline as its majority owners are government-controlled entities. Will it become another Air India which has been losing money for over a decade and sucking up taxpayer money? The benevolent Indian government gives about Rs 4,600 crore every year from the public exchequer to keep Air India running.

Thirdly, if Jet Airways goes bankrupt, then the debt-equity swap makes it even more difficult for the banks to recover their money. Under bankruptcy law, there is a hierarchy of how the assets of a liquidating firm are to be allocated. If banks had remained as senior creditors, they would have had first claim on the proceeds, but now that they have swapped their debt for equity, they would be at the bottom of the pecking order. If SBI and the other government banks are counting on eventually selling off Jet Airways and recouping their capital, they need to remember the recent experience of both Kingfisher and Air India, neither of whom found any buyers.

Finally, the debt-equity swap is not a magic wand. The swap is only a matter of change in the books, and will not necessarily change the quality of Jet’s assets. By swapping delayed interest payments for an uncertain dividend, the banks are merely shifting short-term pain to long-term risk and increasing the period required to recover their capital.

It’s been widely reported that the other lenders opposed this SBI-led proposal. As one banker involved with the negotiations said: “This is a plan proposed by the SBI, and we have nothing to do with it. The idea to take a majority stake in the company is also SBI’s. We don’t think this is the best deal that can be worked out. It seems the SBI is under pressure to make some sort of a deal.”

It appears that the Modi government does not want Jet Airways to fail three months before an election. The optics of the country’s second-largest airline declaring bankruptcy would be difficult to sell for a government that promised acchhe din. The secretly and hastily cobbled deal using government-controlled entities to take over a declining airline could end up costing taxpayers down the road.

—The writer is a financial economist and founder,

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  1. Looks like things are going just like you state in this article. And it appears two mysterious buyers (any bets on who they could be) have joined hands with SBI to run the airline. Nice going Mr Bhatia. Great article.

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