THE STILL ATTRACTIVE FUND RAISING ALTERNATIVE –
GLOBAL CONVERTIBLE BOND MARKET

In the last twelve months most CFO- banker meetings have had one common point of discussion – Foreign Currency Convertible Bonds (FCCB). Given that over USD 6.4bn worth is due via FCCB redemption in 2012; the elevated interest in the asset class is not surprising.

What is fascinating; however, is the claim of companies that raised five year unsecured money without ongoing interest servicing requirements that this is expensive financing, notwithstanding that there has been no conversion into equity. Of similar nature are discussions on how the instrument should be non-dilutive or cause minimal dilution in case debt servicing is provided. These viewpoints highlight the lack of FCCB structure clarity. Sensational media attention and certain investor actions have led to maybe unnecessary negative perceptions. Stressful as they maybe, these are essential interactions so that after nine years and USD 24.4bn fund raise India can demystify FCCB.

Brief Overview of Global Convertible History

Convertible Bonds a.k.a CB (as FCCB are known typically) trace their origin back to 1880s, the era of American railroads. Getting debt for construction was expensive and there were few takers of uncovered equity risk. Financiers thus engineered an instrument which allowed companies to borrow cheaper money by permitting lenders to convert debt into equity and participate in the upside. In case the business and hence the equity did not perform, the debt was to be repaid at a fixed cost after a predefined tenor. It was a win-win situation. In Europe, the French, the master craftsmen of derivatives saw the agility of the asset class and had legal framework for CB issuance by 1950s. The global CB market saw a real flurry of activities starting in 1980s. Until 2008, United States and Japan were the two most important global CB markets while France and Germany ruled the roost in Europe. Most Asian issuance came from Korea and Taiwan. However, post Lehman, Japanese issuance dwindled while Asia-ex gained prominence.

Indian FCCB Market 2003 - 2011

India by then had tasted the varied flavours of the CB world. Until 2003 CB issuance from India was sporadic with only large firms tapping this market (e.g. Tata Steel, Mahindra & Mahindra, etc). In 2004 there were few Indian issues but by 2006 this product saw repeat issuers from India. 2007 could not contain the excitement of India Inc. Firms large and small, household names and little known firms all used the CB market to raise war chest funds, capex money or expansion financing.

However, as the economic crisis deepened and the decoupling theory lost ground, cracks appeared in the Indian CB world. Investors became credit sensitive and Indian issuers had to accept that India is a BBB- rated sovereign making majority Indian issuers high yield entities. Indian firms could no longer avail zero coupon benfits. At the same time the exuberance of Indian equity markets faded and Indian promoters could not convince investors that their stocks would return 70% plus in 3 – 5 years. Thus new issuance from India became sporadic.

What happened to outstanding FCCB was more interesting. In the days post September 15 2008, the cornerstone CB investors, the hedge funds, started facing redemptions and margin calls. They were selling any asset class that fetched them liquidity. With pressure not only on equity and debt markets but also fire sale of CB, the global CB index plummeted. Indian FCCB in their high yield stride took massive beatings. Bonds were trading anywhere from 10 cents to 50 cents to the dollar. While investors coped with the carnage, corporate India had respite in buying back paper they sold a couple of years ago at significant discounts.

So the question arises – if companies raised money that was not serviced either in dividend or coupon while they invested it in business to improve top lines and then earned profit by buying these securities back at bargain prices (Sine 2009, companies have bought back FCCBs worth USD 1.7bn – 19% of the issued amount); why is there an environment today that FCCB fund raise has wrecked havoc? The answer to this stressful question is perhaps simple – expectation mis-management.

CB STRUCTURE AND GLOBAL ISSUANCE PARAMETERS

The global CB market has a market capitalization of c.USD 500bn. Over 55% of issuers with outstanding paper are small and mid cap companies who raised growth financing via CB investors. Their issue parameters did not witness significant alternation post the economic slowdown. Average premiums remained around 25% and most issues carried upfront coupons of 3.5% - 5.0%.

It is in this respect that Indian issuance pre 2008 was different. Issuance from most Indian corporate irrespective of market capitalization carried premiums in the range of 30% - 40% (Average premium was 38.7%, 31.7% and 30.4% for 2005, 2006 and 2007 respectively) and there was no annual coupon. All interest was back-ended. In addition, while global companies restrict fund raising to an issue size to market cap ratio of typically below 30%, Indian issuers raised in excess of 30% of their market cap via FCCB.

Each one of the above mentioned considerations impacts the issuer’s financials and the investors’ return. The subsidized convertible debt for the issuer is because of the embedded equity option in the bond. The value of this option is determined inter alia by the conversion price (determined by the conversion premium), the time at which conversion may occur (American or European option) and the dividend paid on the stock. The lower the conversion price the higher the dilution (EPS and absolute) for the issuing entity, but the probability of conversion and possible return for the investor are also higher. Consequently a lower premium structure is more equity like with a larger debt subsidy. The more flexible the conversion right, higher are the chances that in case of a good share price run the debt will convert into equity before maturity; making the option more valuable for the investor and providing more equity like structure for the company. A low dividend also favours the probability of conversion and hence adds to the equity like nature of the instrument. Another important component of the issue is the size of the issue compared to the market cap and more importantly the free float of the company. If the number of shares that the bond converts into significantly increases the number of outstanding shares then there is a very likely negative share price pressure that can be caused at conversion. Thus this aspect needs to be monitored closely at the time of issuance.

The fixed interest rate determines the cash outflow required by the balance sheet in case of no conversion and the minimum return and a downside protection for the investor. Higher the interest rate, higher is the cash outflow for the company and minimum return for the investor. This makes the instrument more debt like. An annual coupon paid (part or whole of this interest cost) reduces the one time repayment burden on the balance sheet and also compensates the investor for the dividend loss reducing some of the debt like nature of the instrument.

Given these parameters, a balanced CB has a profile which offers the company some relief in interest rate and the investors a good possibility of participating in the upside of equity. This is the reason that the global CB universe has an average premium of ~25% and c. 90% of the issues pay annual interest rather than a zero coupon structure like Indian FCCBs.

THE STRUCUTRAL HICCUPS OF INDIAN FCCB AND THE UNNECESSARY SENSATIONALISATION

The problem with the structure of the Indian FCCB is that at the high conversion prices and low running coupons, the structure is more akin to debt than equity. Yet the instrument was sold as quasi-equity to issuers who did not provide for redemption dues and hoped for conversion.

 In addition, investors did not factor in the possibility that the market may fall and consequently the issue size to market cap ratio may become highly skewed against the issuers making it difficult for them to raise repayment funds.

The headline news attributed to FCCB redemptions, restructurings and rollovers is probably overplayed given that the money would anyway had to be returned to investors had it not converted. This is the implicit rule of the instrument. Annually multifold of this amount is part of bank rollover and restructurings. That does not attract as much attention as the money is understood to be repaid. A few investor actions (e.g. Wockhardt, Zenith Infotech) has made the market overlook the successful restructurings that investors participated in (e.g. Suzlon, Amtek)

All woes aside, the truth is that the CB investor base provided c.USD 25bn to India Inc, money which would not have come via the global equity or debt investors. In fact this is the most non discriminatory investor base which lent without rating or significant covenant requirements to companies across sectors and market capitalizations.

CASH RICH INVESTORS LOOKING AT INVESTMENT OPPORTUNITIES

Post Lehman the global convertible bond investor base has seen a shift towards the long only convertible bond investors. These investors raised new money in 2009 when the asset class was trading close to historical lows. However, since then the global CB issuance has reduced (given the economic slowdown) and most outstanding paper has matured. Thus the funds are today sitting on cash positions, looking for deployment opportunities. In fact it was these investors who anchored issues since 2009, including the Welspun issue which reopened the FCCB marketin September 2009. This stable investor base has ensured that in weak market sentiment there has been no fire sale of FCCB, leading to a better performance of FCCB vs. underlying equity.

Long only CB funds typically do not hedge equity or credit exposures and are in the investment for the long haul (3 – 5 years). However, in return for backing managements they like balanced structures which allow them a reasonable opportunity to participate in the upside. India Inc in this market of expensive domestic debt and challenging equity fund raise thus has a friendly investor base waiting to provide growth and incremental financing, albeit in a form such that neither the balance sheet nor the returns are unduly harmed.

Foreign Currency Convertible Bonds - It is Debt At Issuance

In the recent months there has been a lot of discussion in India around Foreign Currency Convertible Bonds (FCCBs) and how potential upcoming redemptions may “erode corporate profits”. While it is true that some of these bonds might not convert into underlying equity, it is an overstatement that ensuing redemptions will “erode” corporate profits.

At the time of issuance FCCB is debt. For an FCCB issuer, like any other credit obligation there is a cost of debt attached (ongoing fixed or variable cost), which the company has to pay either through the life of the instrument or at maturity. The capital repayment for an investor is through redemptions at maturity. The redemption can be in cash (akin to a bond) or in the form of shares. The instrument also allows an issuer to defer interest payments. In case of deferral of interest payments to maturity, redemption is done at a premium (premium equivalent to accrued interest) resulting in a balloon bullet repayment due at maturity. Thus for FCCB issuers who potentially have to redeem outstanding bonds at a premium in a couple of years, the redemption does not truly surmount to profit erosion as the debt would have been serviced in any eventuality. Instead of the issuer having to service the debt on an ongoing basis, it is now serviced as a lump sum at the end of the financing which can in many cases be a positive for the issuer from a time value standpoint.

As stated above, in case of FCCBs, investors have an option to get their money back in shares (of the issuing company). The number of shares per bond is fixed at issuance. As share price rallies, the value of shares per bond starts to increase. With a continuous increase in share price, there comes a point when it becomes more economical for investors to convert into shares (since the number of shares available per bond x share price is greater than initial amount invested in the bond, even with accrued interest) rather than redeem the bonds (which only generate a fixed return).

The above mentioned option to participate in the upside of the company’s equity has value for an investor. It has value for the issuer by subsidizing and granting flexibility to defer the interest payable on an FCCB in comparison with straight debt of the same entity. It will thus be fair to say that issuers who raised debt via FCCBs did so at lower rates vis-à-vis unsecured straight bond public placements in capital markets. These issuers had access to the much lower rates providing much needed free cashflows, particularly during their investment phase. Another benefit availed by these entities has been diversification of investor base away from the classic equity holders and banks, as is typical for most Indian corporates.

Given that FCCBs are hybrid instruments, accounting for FCCBs should reflect the debt and equity characteristics adequately. The net present value of the cash flows for the FCCBs gives the bond floor of the instrument. At issuance, the bond floor should be accounted for debt and only the difference between the FCCB amount and the bond floor should be booked as equity. Further, through the life of the instrument, the debt should accrete such that at maturity it is accounted for at par; fairly representing the liability. The rate of accretion should be taken as the effective interest rate (and not just the cash coupon). This interest rate should be charged to the P&L. Upon conversion the amortised debt is retired and replaced with corresponding equity. (as recommended in the exposure draft AS (30))

One concern with regards to FCCB issuance is that issuers have not accounted for the debt as described above. While the face value of the debt has been booked, the accretion has not been accounted for. At redemption when the premium is paid to the investor there will be an accounting mismatch causing a potential “loss” of value. However, the redemption in itself is not corrosive.

Bulk of FCCB issuance in India took place in 2006 and 2007. These instruments typically have a maturity of 5 years implying that most of the debt will be due for redemption / conversion in 2011 and 2012. With a recovery in the markets in the coming 3 – 4 years, it is quite probable that the share price of FCCB issuing companies will rally to levels such that investors will be better off converting into shares rather than asking for redemption. Thus it would not be prudent to make any judgement about value erosion at this point in time. However, it is advisable that companies with outstanding FCCBs follow the exposure draft on accounting standard AS (30) to avoid any surprises at redemption.