Is the House of Debt crumbling?

Highly leveraged companies have been going through a tough time since the financial crisis in 2008, with some already collapsing under its weight. Essar Steel is the latest victim, with creditors contemplating converting their debt to equity if the company is not able to monetize its assets or bring in a strategic partner.

For an unlisted company like Essar Steel, converting debt to equity will barely serve any purpose as exits for the creditors will not be easy. As a creditor, in case of liquidation, the bankers will at least have a senior right on the company’s assets ahead of equity holders.

Converting to equity is only done as a measure of last resort for the bankers. Unfortunately we might be witnessing many such conversions in the near future, especially among the bigger companies.

Credit Suisse had come out with a report titled ‘House of Debt’ nearly three years ago and has been updating it every year. The report points out the high level of debts held by some top corporate houses which can turn toxic. Among the groups mentioned in the report are Adani, Essar, GVK, GMR, Jaypee, JSW, Lanco, Reliance ADAG, Vedanta and Videocon.

Over the past three years, these highly-leveraged companies have made attempts to reduce their debt by selling assets or cutting back on their expansion plans but have not been able to improve their overall situation. In fact, financial stress at these groups has intensified further, says the Credit Suisse report.

All the groups saw further increases in debt in FY15, which has now gone up seven times over the past eight years. The reason this is a serious matter is because these loans account for 12% of the banking system loans, which are yet to be treated as non-performing in most of the cases.

A cause of immediate worry is that between 35-65% of the debt of four groups (Jaypee, Lanco, Essar and GMR) have been downgraded to default grade by rating agency.

Ability to repay their debt as measured by interest coverage has fallen to 0.8 times in FY15 as compared to 0.9 times in FY14. A number below 1.5 times is considered risky. These groups as not earning enough to meet their interest payment.

Some of the companies have 5-50% of long-term debt maturing within the next year and will need refinancing. Also, 5-37% of their debt is short term that needs to be rolled over. Given the drop in ratings, these firms will have a tough time being refinanced and rolling it over.

Financial stress has impacted share prices of these companies. Credit Suisse points out that the continued sharp contraction in their market cap reflects the pressure on the financials of these groups. While debt levels are up to 2-17% over the past year, debt-to-market cap has increased by 20-150% for a large number of the companies. Debt-to-market cap for some of the groups is now 15-30 times, indicating the difficulty in raising money through the equity route.

The writing has been on the wall for these groups for the last several years, even though Credit Suisse highlighted it over last three years. It is just a matter of time when drastic steps will have to be taken. Such steps have been started with Essar Steel, for most others it might follow soon.