Explaining the hole in Sri Lanka’s ETI Finance balance sheet
(ECHELON MAGAZINE) – The Central Bank has imposed new restrictions on ETI Finance, a non-bank subprime lender, to stop the erosion of capital and encourage new investment into the troubled company, after falling global gold prices blew a crater in its balance sheet, exacerbating existing problems over regulatory governance, management and compliance.
ETI is a classic example of what happens to family controlled businesses; and when lending institutions grow their deposits at a fast pace, lend unwisely, invest in illiquid asset properties that don’t generate steady income flows and fail to ring-fence their operations against related groups of companies.
ETI Finance is controlled by family-held EAP Group of Companies. EAP Edirisinghe built his empire with a pawning license in the 1930s with the establishment of Edirisinge Trust Investments Limited (ETI), and soon expanded into deposit-taking. ETI profits were used to diversify and acquire new businesses and prime commercial property. After his demise 30 years ago, the businesses and assets of ETI went to his four children, which became a problematic situation leading to several shortcomings in regulatory compliance, management and governance.
The hole in ETI’s balance sheet was Rs17.5 billion as at end-March 2017; just six years ago, the company’s net book value was a negative Rs454 million. It holds 90% in listed Swarnamahal Financial Services, which has a negative book value of Rs1 billion. However, Swarnamahal is in ETI’s books as a Rs495 million asset. ETI’s financial statements filed with the registrar of companies are not consolidated—it has other subsidiaries listed as assets—and the firm’s auditor, KPMG, says this is problematic because the exact extent of ETI’s problems are not known.
However, Central Bank Governor Indrajit Coomaraswamy told a press conference in January 2018 that ETI (and Swarnamahal) poses a minuscule risk to the financial system, given that its assets represent just 2% of total assets of the licenced finance company industry, at Rs1.1 trillion.
The two companies faced a run on deposits in December 2017 after media reports raised concerns about a foreign investor negotiating a deal to take over ETI’s subsidiaries, the Central Bank governor says.
In December 2017, the Sunday Times newspaper said Malaysia’s Straits Grid led by Sudhir Jayaram had offered to buy out ETI’s subsidiaries for $60 million (Rs9.2 billion), calling into question the credibility of the investor over alleged money laundering activities.
“ETI’s subsidiaries had enough assets and is not insolvent,” Coomaraswamy said, calling a press conference at the Central Bank to avoid the run on ETI spreading to the rest of the financial sector.
The banking regulator appointed new management to ETI Finance and its subsidiary Swarnamahal Financial Services, restricting withdrawals—maturing deposits renewed a further six months—and ensuring interest payments to depositors. ETI’s deposit base is nearly Rs35 billion and Swarnamahal’s Rs3.5 billion.
The regulator, in a public statement, said ETI can finalise negotiations with perspective investors while it facilitates the process. The regulator restricted the two finance companies from mobilising new deposits and giving new loans. A Rs4 billion liquidity facility will also be arranged with a bank, guaranteed by the Central Bank.
ETI’s other subsidiaries are 100% in EAP Broadcasting, which controls several television and radio channels; EAP Films and Theatres, which produces and distributes movies; Swarnamahal Jewellers; and 98% in Hotel Sapphire.
Coomaraswamy said another investor with a company incorporated in Sri Lanka had offered around Rs12 billion for ETI’s nine subsidiaries and properties. The Central Bank has done due diligence, and independent auditors have valued the assets from Rs5-15 billion, he said. The potential investor had already infused Rs400 million over the last few months.
However, the regulator believes Rs13 billion could be raised if some other assets were included, Coomaraswamy said.
ETI’s subsidiaries’ combined book value and property is worth Rs8 billion as at end-March 2017: The television and radio broadcasting business was valued at Rs2.6 billion, the movie business at Rs1.7 billion, Hotel Sapphire at Rs860 million, Swarnamahal Financial Services at Rs495 million and the jewellers at Rs130 million. Rent income-generating investment properties, valued by an independent valuer, was at Rs2 billion. It has Rs1.2 billion invested in government securities.
The sale of subsidiaries, properties, treasury securities and even the unlikely recover of all Rs7.3 billion loans will make Rs18.5 billion.
Coomaraswamy alleges serious mismanagement at ETI. It got into this mess paying an inordinate amount as interest to depositors compared to what it earns by lending. Another part of the problem is being overexposed to gold-backed lending.
Each business under EAP Group was managed by a different member of the Edirisinghe family. Firewalls were not in place, with too many inter-group borrowings, assets were in various names, books not being properly kept and audits delayed, Mano Tittawala, who took over as chairman to restructure the group in 2015, told Echelon in an interview that year. He declined to be interviewed for this story.
ETI was not spared the 2008 financial crisis that was triggered by the Rs26 billion Golden Key Credit Card Company going bust, collapsing the Ceylinco Group that it belonged to. The group had a bank and several finance companies—Seylan Bank was quickly restored to normalcy with Central Bank intervention, several finance companies are yet being wound down and others like listed The Finance Company are still trying to recover from the shock. The run-on deposits spread from Ceylinco Group to other subprime lenders.
In response, the Central Bank tightened regulations on finance companies, requiring them to improve governance, management and capital structures. As part of this process, all lending and deposit liabilities of EAP Group were brought into ETI’s books; even shareholder family members had to bring in their properties. Two years later, these assets, then valued by Ernst and Young, gave ETI a Rs4 billion net book value.
According to the financial statements for years ending March 2013 to 2017 audited by the Colombo office of global audit firm KPMG, ETI last reported an annual profit in March 2012 at Rs116 million. Net interest income—the difference between interest earned from loans and interest paid to depositors, the equivalent of gross profit for any other business—was Rs969 million. That year, its deposit base grew by Rs15.4 billion—more than doubling to Rs27 billion. However, it created new loans amounting to only Rs2.4 billion, its lending book growing to Rs10.5 billion. ETI also invested Rs14.7 billion in subsidiaries.
Swarnamahal Financial Services was then valued at Rs2 billion and the jewellery business at Rs3.3 billion. Hotel Sapphire was valued at Rs747 million and Concord at Rs754 million (which is no longer in the books).
It was a fresh start for the group. There was still a lot of restructuring to be done, but in October 2012, gold prices began to slide and ETI took a big hit. In ETI’s last good year, pawning made up 72% of its loan book, accounting for 80% of its interest income. It had to write off huge chunks of gold-backed loans from its books, and as a result, ETI’s Rs4 billion net book value was wiped out. By end-March 2013, its net book value was a negative Rs454 million. With more write-offs to follow, the hole in ETI’s balance sheet blew into a Rs3.8 billion crater by the next year.
To make matters worse, ETI’s property investments and subsidiaries were not generating sufficient income to keep up with the 20% deposit growth in the five years to end-March 2017. Around 82% of deposits mature within a year, placing considerable stress on the finance company.
Meanwhile, the investment subsidiaries lost 61% of their balance sheet value by 2017 (from Rs14 billion in 2012): EAP Films and Theatres lost half a billion rupees in value, EAP Broadcasting lost Rs3 billion, Swarnamahal Financial Services lost Rs1.6 billion and Swarnamahal Jewellers Rs3.1 billion. Without income growth, net interest expenses averaged Rs2 billion annually. As losses accumulated, ETI’s net book value deteriorated steadily to a negative Rs17.5 billion in 2017.
During 2013-17, Jeewaka Edirisinghe was chairman of ETI and Sameera Ganegoda its chief executive. The company declined a request to be interviewed for the story.
ETI’s audited financial statements from 2013-17 make it clear enough that its underlying problem—and that of Swarnamahal Financial Services—was overexposure to gold-backed loans. At end-March 2012, pawning accounted for 72% of ETI’s total loans, and its share has fallen to 47% by 2017.
However, with regard to ETI’s subsidiaries and property investments, the details are fuzzy and controversy-prone. Because ETI is a private company, there’s limited access to information.
Echelon relied on ETI’s financial statements for years ending March 2013 to 2017 filed with the Registrar of Companies, disclosures made to the Colombo Stock Exchange by its listed subsidiary Swarnamahal Financial Services, and directives issued by the Central Bank and capital market regulator the Securities and Exchange Commission of Sri Lanka. The management of ETI declined to be interviewed, as did the Central Bank’s Supervision of Non-Bank Financial Institutions Department on grounds of secrecy.
ETI’s investments in subsidiaries and related party transactions appear fuzzy, even to the company’s auditors KPMG.
In its audit note for the year ending March 2013, KPMG says ETI had accounted subsidiaries as fully owned entities and overstated assets by Rs8 billion. The company has also failed to prepare consolidated statements, a charge it repeats up to 2017.
KPMG has also cast doubt on ETI’s ability to continue in business and realise assets to discharge its liabilities. It also noted that ETI was non-compliant with Central Bank rules on deposit protection and minimum capital requirements. The audit firm said ETI-valued properties based on rental values were significantly higher. The valuations were based on market rent income that can be earned on these properties rather than the actual rates based on their current use. "This indicates that the company had rented these properties at preferential rates to related parties without approval from the Central Bank," KPMG said.
Related party transactions also got ETI in a spot of bother.
In a stock exchange filing in 2015, EAP Holdings, which controls ETI Finance, said the finance company will get a Rs2.8 billion cash infusion from property sold to related companies via EAP Broadcasting, which was planning a Rs3 billion debt issue.
How subsidiaries are structured is not clear.
At the time of the proposed debenture issue in 2015, ETI held 100% of Swarnamahal Jewellers Limited, which in turn held 81% of EAP Films and Theatres, with ETI Finance directly holding the balance 19%. EAP Films held 100% of EAP Broadcasting Company, which runs television stations.
EAP Broadcasting controlled Colombo Communications, which runs radio stations, and Galaxy Landmarks Limited, a property company. However, financial accounts filed with the Registrar of Companies shows ETI holding 100% in all these companies, which is problematic, according to the auditors.
"Had the subsidiaries been consolidated, many elements in the financial statements would have been materially affected," KPMG said in 2017, adding that the departure from Sri Lanka Accounting Standards are material and pervasive, and not been quantified.
EAP Broadcasting’s Rs3 billion debenture issue was to be invested in Galaxy Landmarks as equity (Rs1 billion) and an intercompany loan of Rs2 billion at 12% interest to be settled after the sale of the building at the end of seven years. In turn, Galaxy intended to pay Rs2.8 billion for a series of properties owned by ET Finance: a 109-perch Galle Road property housing Swarnamahal Jewellers and broadcasting complex, two cinema properties (Impala and Roxy), a Borella property where EAP Restaurant is located, and Concord Hotel in Dehiwala.
However, the debenture issue took place after the SEC disqualified EAP Broadcasting’s debenture credit rating from Lanka Credit Agency over a conflict of interest: two of its board members were also on the board of Lanka Ratings Agency.
With ownership and control not quite clear, regulators soon intervened to restrict related-party transactions.
In January 2017, capital market watchdog the SEC issued a directive to ETI’s listed Swarnamahal Financial Services against "extensive related party transactions without required checks and balances". The SEC prohibited Swarnamhal from entering into any related party transactions, including any write-offs of outstanding loans.
During the year to end-March 2017, Swarnamahal Financial Services was imposed a penalty of Rs7 million for violating Central Bank rules on prudential capital requirements and failing to implement a deposit reduction plan, recover all related party loans, reduce pawning to below 50% of total loans and appoint independent non-executive directors to its board.
When Echelon spoke EAP Holdings Chairman Mano Tittawella in 2015, the group had a recovery plan in place.
He had joined the group in early 2015 after ETI reported a negative net book value of Rs9.8 billion. Other businesses in the EAP Group were making enough to keep the group in business, and cash was not an issue, Tittawella said then.
He took up the assignment only when he was convinced the Edirisinghe family was serious about reforms; they had little choice because the Central Bank was on their case. One of the first tasks was regularising bookkeeping, followed by improving regulatory compliance. Around 600 people were let-off, and new management was brought in. Edirisinghe family members were made non-executive directors.
He was hoping to raise equity and venture capital amounting to Rs10 billion to clean up ETI’s balance sheet, and was negotiating with two international financial institutions to infuse Rs6 billion in fresh capital. Tittawella expected ETI to have a positive book value by 2017.
However, after the debenture issue and foreign investment not going according to plan, the Central Bank had to intervene with tighter controls. Tittawella didn’t want to be interviewed to talk about the recent developments saying he was never in the ETI or Swarnamahal Financial Services boards. "ETI is an asset-rich company. It has not defaulted on any payments as yet. But, there is a liquidity problem, which is why we have taken regulatory action to create time and space for this liquidity constrains to be overcome," Coomaraswamy told the press in January 2018.
Coomaraswamy is rightly setting fraught nerves at ease. ETI’s problems could spread to the rest of the subprime lending industry, and then to banks, like what happened when the Golden Key Credit Card Company went bust. ETI is a bigger risk, with public deposits worth Rs35 billion.
The governor also said there had been shortcomings in how the Central Bank regulated financial institutions, but that was a thing of the past. A rule-based framework is being developed to oversee finance companies, with early warning and faster resolution, he said. A new resolution department was also been set up and technical assistance sought from the US. But that may not be enough; rules on publishing credit ratings and financial results are weakly enforced. They are important to keep finance companies on their toes.
In research done by Echelon in 2015, a third of the 48 registered finance companies weren’t transparent with their financial performance, and 19 of them hadn’t published a credit rating. Neither the finance companies’ websites, websites of the three credit rating agencies nor Echelon’s team visiting the head offices of these 19 firms were able to figure if they currently had a credit rating.
Back then, all we knew was of two finance companies with negative net book values—The Finance and Swarnamahal; that too because they’re listed on the stock exchange and publishing financial results quarterly is mandatory. Now we know ETI should have been on the list. Two other finance companies were not accepting deposits as they were restructuring, and another, CIFL was being unraveled in court for alleged fraud. In January 2014, the Central Bank claimed that eight out of ten finance companies had weak compliance with regulatory directions.
Finance companies were required to increase minimum core capital to Rs400 million by January 2015. ETI, Swarnamahal and The Finance, with negative book values, didn’t meet this requirement. It’s not known how many others did.
The Central Bank has raised the minimum core capital requirement to Rs1 billion this year (and Rs2.5 billion by 2020), and nine companies have fallen short of this requirement. They may be ordered to stop raising new deposits.
Coomaraswamy, who inherited the problem of too many weak financial intuitions in the system, is not keen on delaying reforms any longer. "A line has to be drawn somewhere," he said.