The Securities and Exchange Board of India (Sebi) has shot a six-point letter to mutual funds (MFs) to ensure that unitholders' interests are not getting compromised due to rise 'complex' debt investments of MFs to promoter entities.

The regulator has directed the MF trustees, "To review the risk management policy of the MF including the aspects like cap on such exposure (exposure to promoter entities), adequate cover, legal risk, market risk, liquidity risk, etc. to ascertain that the interest of unitholders are protected at all points of time."

According to industry sources, Sebi also wants to assess if MFs have taken high-levels of exposures to promoters, which have already pledged a large part of their shares. "Promoters with excess pledging would have limited ability to pledge additional shares to restore equity cover in case of sharp price fall," said a fund manager, requesting anonymity.

The market regulator has asked MF trustees to have a report ready by end of this month, which reviews total exposure through such structures "during the last two years i.e. from January, 2017 onwards including outstanding exposure as on date."

According to sources, the regulator wants to know whether MFs have proper contingency plans in place as despite being debt instruments, volatility in equity markets has a bearing on the credit quality of these exposures.

According to a recent note by CRISIL, "around 90 per cent of the rated pledge debt of Rs 38,000 crore had cover of less than two-times – even as low as 1.2 or 1.3 times."

This is lower than what the Reserve Bank of India (RBI) stipulates for non-banking financial companies (NBFCs) that lend against shares.

The RBI stipulates that all NBFCs with more than Rs 100 crore asset size need to maintain a loan-to-value (LTV) of 50 per cent where listed shares are placed as collateral.

An LTV of 50 per cent means that for a Rs 50,000 loan, the market value of the collateral shares needs to be Rs 1 lakh. This translates into two times share cover.

The CRISIL note points out that low equity cover heightens the risks for MFs and other investors as unlike NBFCs and banks, they don't have enough capital buffers.

"Considering high equity volatility, low covers of 1.2 or 1.3-times may not be able to provide adequate cushion and avert a default on the debt. While NBFCs and banks have capital cushion to absorb risks as per regulatory capital adequacy norms, others do not have any such leeway," the note read.

The industry officials say the inherent risk in such structures stems from the fact that there is no underlying cash flow.

“Promoter-funding structures such as LAS have no real cash flows. A typical promoter company only gets dividend income. These structures are largely built around refinance,” said Amandeep Chopra, group president and head of fixed income at UTI MF.

The risks have got exacerbated as such structures are finding limited sources of funding in the current environment of tight liquidity.

“With NBFCs becoming wary of doing roll-overs for such structures, these could see a continued build-up of stress,” Chopra added.

The strain in loan-against-shares structures had prompted MFs to enter into standstill agreement with the promoters as selling the pledged shares could trigger downgrade and negatively impact the exposed funds’ net asset value.

Sebi had earlier sought details of MFs’ debt exposure to Essel group companies after both sides entered into an agreement to hold back selling of the promoter entities' pledged shares.

According to reports, the RBI is also looking at the recent cases of ‘standstill’ agreements between the borrowers and the lenders.