The Surgical Strike On Adani
In all the noise and fury of the past two weeks post the Hindenburg bomb, I felt it was best to let the froth of opinions – most of them political – subside before we could dispassionately look beyond the multivariate range of emotions which cloud the judgement necessary for an unbiased analysis of what is unarguably a very complex situation.
To my mind, there are five central issues to this saga. It would be best not to conflate entrepreneurial zeal and a risk-taking approach with fraud. I would, thus, group the pertinent issues under five heads: business model risk, capital efficiency, stock manipulation, governance ( institutions and corporate) and crony capitalism. I will leave politics out of it though it is juicy enough to have warranted attention.
Many of the points raised in the report are with respect to the risk perception of the company’s business model and its over-dependence on high leverage. Though not uncommon for infrastructure companies, current ratios of below 1 are concerning from a risk perspective, but are in no way related to fraud. Declining operating margins ( from 7% + to 3.6% ) accompanied by a significantly higher revenue growth ( 25% to 110% +) and declining capital efficiency (15% to 3%) exacerbate the potential risk posed by low current ratios, and indicate an urgent need for capital ( preferably by equity and not debt). It is imminently possible that driving its exponential growth over the last few years is the combination of the low prices it quotes to consistently win projects over competition, and the high prices it pays in rapidly acquiring huge infrastructure assets on sale. Such a business model will necessarily impact financial strength unless the group demonstrates its ability to progressively raise larger amounts of capital and extend the payback period. This is key to its financial survival over a longer period of time. Such a business model could be deemed risky, but not fraudulent.
In this context, the stupendous rise of its market capitalization over the last three years ( appx 800% + ) culminating in a FPO of INR 20,000 crores at these elevated levels of market capitalization seems to part of a carefully crafted strategy to raise capital. The fact that this rise was not accompanied by strengthening financials, was massively out of sync with global multiples for similar companies, and has been through relatively low trading volumes on the markets with investments from a very small group of investors ( possibly shell companies in tax havens) - and common across the group companies - raises genuine questions of stock manipulation. Proving it, though, is a matter of investigation.
To understand the potential for fraud in this saga, we need to start by understanding the instruments and mechanisms of global financial markets, and loopholes in our own regulations. As we had observed during the Global Financial Crisis of 2008, derivatives of structured products are packaged and sold globally by international banks and brokerages for Ultra HNIs in offshore jurisdictions on a wide variety of “themes”, “asset classes” and strategies like “total return swaps”. The ultimate ownership remains opaque in such cases. The Participatory Notes (PN ) regime, which is permitted in India for decades, is very similar and convenient to channel such instruments into our markets.
Hence, with a PN regime for FPI’s still open in India, this has been a loophole waiting to be exploited by investors from across the shores…..both on the way up and the way down.
If indeed the Adani stocks were deliberately inflated pre the FPO as part of the capital raising strategy, then PNs would have been very convenient, apart from multi-layered investment structures through the Mauritius route. Only the scale in this case ( rise of 800% + in market capitalisation in 3 years) has been humongous in comparison to the distortions created by similar PN investments since early 2000s – but then it is not in Adani’s DNA to think small !
Similarly, there can be no doubt that this was the mechanism used on the way down too to explode the Adani bomb with the Hindenburg report being the proverbial trigger.
Unfortunately, such is life in a free market ! PN flows can work both ways which probably the Adani group did not consider in its assessment of risk whilst following this strategy of raising capital. Since Adani controls about 75% of the shares ( plus 10% to 15% more thru friends, associates and passive institutions like LIC), the logical inference that the attack came in coordination from overseas participants ( ie thru PNs) would seem obvious. Such enormous short selling thru PNs has no precedence in India. Furthermore, activist analyst reports which call for shorting stocks are not infrequent, but they do not impact actual prices unless it is timed to perfection with large short sell orders on the market by market participants who are willing to bet on the short side. Who could that market participant be, though, remains a billion dollar question.
Furthermore, given the illiquidity of the stocks in the Indian markets, futures contracts, put options and deep out of the money put options are bound to have been the domestic instruments of choice used to both profit and hedge the overseas exposure of these brokerages. The details of these including their beneficial owners should be easily available.
All these issues lie within the purview of SEBI and the RBI and we should wait for answers from them.
This brings us to the issue of regulation. One of the core reasons why Adani shares reached stratospheric levels, without an accompanying change in fundamentals or without any relevance to globally listed comparables, is because India does not allow short selling of stocks ( except through a thinly used and cumbersome securities borrowing and lending mechanism called SLB ) apart from stock derivatives. India is primarily a “long only” market for most. For all the misplaced hatred we have towards short sellers, it must be understood that short sellers have a balancing role in financial markets for precisely these sort of situations. Hence, I would argue structural gaps in our regulation allow for what happened. Both Adani and overseas investors merely used these loopholes to their advantage – one to potentially inflate stock prices to optimise its capital raising plans, and the other to exploit the arbitrage thrown up by the obvious mispricing of Adani shares in the Indian markets – of course, at the cost of some Indian investors.
Structurally too, the Adani group stocks represented an almost perfect opportunity for the mayhem we witnessed. It has very low floating stock as officially promoter holdings are all around 70% to 74% ( except for the cement twins ACC and Ambuja). At a reasonable guess, associates and friends would have at least 5% - 7% and passive institutions like the LIC about 5 %. This would leave about 10% - 15% for active trading in the markets. Such a capital structure in illiquid, listed entities creates a protective shield in favor of the promoters in case of hostile takeovers. But such securities can be very volatile too due to the low floating stock should there be interested, and concentrated , buying or selling - and thus open to charges of stock manipulation. This is the charge Hindenburg leveled when the stock was rising – and, therefore, the same rationale must be applied when the stock witnessed a bear hammering. The point, though, is such movements in stocks need what in market parlance is called a “jockey” – a person who drives the initial move and creates a momentum on the way up or down. It will simply not happen on its own. The example of blue blooded companies of immaculate governance standards like Wipro bear testimony to this where the promoters, associates and trusts hold more than 85% to 90% of the stock for decades – and have never seen wild gyrations either on the way up or down. This is simply because of one critically important ingredient in Wipro – promoter credibility and impeccable trust in the financial statements.
The precision and total secrecy of this strike was nothing short of a military operation. What would have taken Adani offguard in this carefully planned, immaculately timed and brilliantly executed kamikaze attack was the fact that no one in India would have dared to stand against the group for known reasons. And ultimately it was this brazenness, or over confidence, which led to them caught napping in this surgical strike from foreign shores. Though it would be of paramount importance to know who the “jockey” was, more significantly this episode introduces India to the dangers of such moves in its financial markets, and opens up possibilities for the future too for other entities with similar characteristics. Regulation, therefore, on the P- Notes regime will necessarily be need to tightened if not eliminated. As would the accountability of the regulators role for allowing phase I of this saga to proceed for three years in broad daylight.
I would not be too worried about the issue of corporate governance at a country level though. Very well governed markets like the US and Europe have had many instances of businesses gaming the system. The list from Enron to Bernie Madoff, Theranos and Wirecard is endless. What is of critical importance, though, is the political will to plug loopholes and fix accountability for allowing this to happen over last many years. Questions have been consistently raised in Parliament on the unnatural appreciation of the Adani stock price, and repeated letters to SEBI, ED, CVC and other agencies by our feisty MP, Mahua Mitra – who did what a parliamentarian is supposed to do but sadly most do not - have been simply ignored since 2019. That this should be even feasible in a democracy is a concerning comment on the supremacy of our parliamentary system in demanding accountability. The Adani Board and the CFO/CEO claiming blissful ignorance of related party transactions and opaque investors is difficult to fathom, though technically they may not be non-compliant.
On the matter of crony capitalism, the Parliament is seized of the issue and it is best it is resolved there.
The damage, though, from the Hindenburg episode is done. For Adani, it will create hurdles for capital raising globally – both equity and debt - mainly through downgrades by credit agencies, and exclusion from passive indices like the MSCI. And given it’s business model dependence on the flow of capital, its future growth and returns expectations will need to be significantly moderated. To its advantage it has cash flow-positive businesses and huge assets on the ground - the efficiency in their management will be key to the rocky consolidation journey ahead. This will reflect in its stock prices over the medium term which will settle significantly lower than the levels they had reached before the Hindenburg report.
As regards politics, this will not alter political outcomes given the fact that the Modi government has indeed excelled in difficult times on multiple parameters ranging from deft handling of foreign policy, the economy and social policies for the upliftment of the poor and marginalized.
The implications on the overall market will be severe, at least in the medium term as and when the PN regime is eliminated or substantially modified. Given our high valuations and the rising cost of capital, this would be the third headwind to restrict market upsides. Though I must admit in a country where bearer bonds are legally allowed to fund political parties, it seems highly improbable that any drastic measure to curb opaque instruments like PNs – convenient to evade taxes, ownerships and linkages - will be taken. Short selling too is unlikely to be permitted at scale anytime soon given our collective political and corporate stake in “bull markets”. Hence, the casino in our markets will continue as we are simply incapable of, or unwilling to, handling the truth we all know !
To maintain his clean image and the plank to eliminate corruption, PM Modi will have to be seen to act decisively as is his style – and I do expect tangible action on this in the coming weeks from the Government and the regulators. Whether it is credible enough to do justice to our otherwise hallowed institutions is a matter which will be settled only over time.
On that will depend on whether we are willing to learn lessons from this episode. And have the collective courage to deal with the truth.
Till then, the effects of Hindenburg bomb on Adani will linger on…..in more ways than one.
The author is a Sloan Fellow of the London Business School, non executive director, and an advisor to chairmen, of corporate boards.
