Hard Underwriting - To be or Not to be

Securities Exchange Board of India’s (SEBI), recently suggested that all IPOs be accompanied by mandatory hard underwriting. According to the regulator, there is a lack of quality control in terms of equity paper being issued via IPOs, pricing can tend to be aggressive and there needs to be more through vetting of the business and the risks involved. All this in SEBI’s opinion can be rectified by placing the onus and risk solely on the lead manager via hard underwriting. I would beg to differ. Not only does hard underwriting further complicate the already warped Indian investment banking, it offers no long term solution at all.

Investment banking landscape in India lacks depth. There are very few institutions capable of executing meaningful transactions and still fewer with adequate capitalization to hard underwrite issues. Thus with hard underwriting we risk placing a big chunk of Indian equity in a few hands. What happens in situations akin to the current volatile markets? There is a high probability that the underwritten stocks (if not already placed) would be sold at any level at which a bid was available. Result – a significant freefall of the Indian equity markets. Biggest losers – retail investors. In bull markets it is those investment banks with deep pockets that would undercut competition, resulting in IPOs being concentrated in a few hands. This would further curb any deepening of the Indian financial system. So from a macro view, hard underwriting will not serve the nation well.

The key phases involved in an IPO are due diligence, preparation of research and the finally pricing and allocation. Due diligence is a process whereby the lead manager (or the underwriter) assesses the suitability of the company to list on an exchange and verifies the facts presented. In order to ensure thorough vetting of the company and its risk factors, this process should be “independent”. Research subsequently constitutes of an “objective” presentation of the business and the valuation methodology. This is undertaken by sector experts to produce a comprehensive report. Valuation of the company should not be “influenced” by the views of the issuer or of the corporate financiers working on the mandate. Given the increased risk for a lead manager in a hard underwritten issue and the absence of Chinese walls in Indian banking system, this independence absolutely stands to be blurred and maybe significantly. Thus instead of advocating hard underwriting, SEBI should work towards strengthening Chinese walls in Indian investment banking to ensure systematic evaluation of businesses. At the same time efforts should be made to enforce arms length dealings between the issuer, investment banks and the individuals in these two fraternities.

The next key step is that of pricing and allocation. Majority of an IPO is subscribed to by institutional investors. These are sophisticated investors with global experience and access to information and tools which enable them to take well informed decisions. Not only do institutional investors meet the management to evaluate merit of the company but also conduct their own valuation exercise. The research provided by the lead manager is only a starting point. It is the institutional investors' own analysis that finally decides whether they will participate in the IPO and if yes at what terms. When hard underwriting a transaction, lead managers keep a buffer as protection against any price or demand mismatch. This leads to potentially underpriced issues, causing a loss for the issuer (notwithstanding the higher fee charged for hard underwritten deals). However, price discovery achieved via an offering to institutional investors (as a bookbuilding proposition) leads to optimal pricing and sizing as dictated by markets. (This is obviously assuming independence of investors from the issuer and the issue itself.) Bookbuilding thus offers a more relevant and sustainable solution to achieving reasonable pricing.

Last is the point of quality, which can be quite subjective. The quality of business is not just defined by its profitability but also by its management and shareholders. With most Indian firms being family owned, management is not where one can have immediate influence. However, SEBI can influence the shareholding pattern of Indian corporates. Given the thriving mutual fund industry in India, SEBI should consider curbing direct retail participation in IPOs (currently 30% - 35% of an IPO is reserved for the retail investor and a further 10% - 15% for HNIs). This will not only protect retail investors (mutual funds tend to be less volatile than equity markets) but also avoid participation from seemingly unrelated (to the issuer) but actually in-concert investors. In addition, the minimum dilution levels for promoters should be increased; thus increasing true free float and hopefully leading to improved corporate governance (with increased institutional participation).

Instead of looking at a quick fix, SEBI needs to consider the process as a whole and attack each problematic step in cohesion. There needs to be increased accountability and responsibility placed on each of the involved entities– the issuer, the investment banks, the investors and the regulator itself. Only then will we witness sustained discipline in primary Indian equity market.

Has India Really Arrived?

The July 9th edition of the Economist carried an article with the title “Overconfident India”, claiming that “Indians are complacent about the perils of multi-lateral diplomacy, and much else”. The article which had a very condescending tone evoked a variety of responses from the Indian diaspora in London. There were some who felt that recently the Economist has taken a holier than thou approach towards emerging markets (recently the publication carried a similar article on Russia) which should soften. A few opined that the general judgemental nature of the bi-weekly magazine is on a rise and creating a bad taste in their mouths. Strangely some people I met were indifferent to this article as in their view it made no difference what the Economist had to say, India had arrived. And then there was a bunch, admittedly a minority, which did think the article was based on strong arguments and stating only the obvious albeit a little too abrasively.

After having read and re-read the article and having discussed it with a number of people, I have been trying to figure out where is it that I stand. I am not sure that the tone of the article is acceptable but then the truth of the content cannot be ignored either. As difficult as it is for me to admit, I have to be truthful and say that I do believe that we Indians have let the bull markets drive our confidence to a point where it is now bordering on arrogance. Like the group of indifferent Indians we would like to believe that India has arrived on the global map and we can demand the moon and the stars and the world should deliver.

However, is it really true that we can still tempt global investors to pump their money into our country which desperately needs foreign investment? Is FDI in India still as viable an opportunity? Will FII money get the same returns in India as opposed to say the Middle East? Has India Inc generated sufficient confidence with investors to back them in difficult times? Have our regulators worked with a larger view in mind? Is our legal framework strong enough to handout timely judicious decisions? These are questions that need some honest answers in order for us to be able to really review as to how truly India has arrived.

In the last few years, it is a fact; India has received a record amount of foreign investment. While lower than some other emerging markets, the capital inflow into India had been rising until the credit crunch started. However, if one inspects more closely, most of that investment came as all global investors wanted a piece of the action. The numbers also justify this. From April 2007 – March 2008, while the FDI in the country was c. USD 29.89bn, net FII into the country was also similar at c. USD 29.40bn. In fact this FII figure would have been higher had the market not tanked in 2008 when foreign investors were net sellers of c. USD 10.64bn in the months of February and March. Hence my conclusion that investors came into India to gain from an upward momentum in the stock market not with an intention to invest from a long term basis. This in itself should indicate that we as a country have not arrived. People are not buying into our long term strategy yet.

An infrastructure deficit country, representing a USD 500bn opportunity in the next four years, India should be able to attract a lot more FDI. What is rather interesting is that the highest FDI has come into the services sector (financial and non-financial) which is almost 2.5x that of infrastructure inflow. In fact the cumulative FDI figures from April 2000 – March 2008 indicate that the most attractive investment proposition has been the services sector with 22.64% (financial and non-financial) share of the entire pool, with infrastructure accounting only for 9.35%. There has to be a reason for foreign investors not putting money into Indian infrastructure. Yes, initially infrastructure was a closed sector; however, even with 100% ownership being permitted the sector is not attracting investors. Is it the absence of independent regulators? Is it the fear of governments not being able to fund annuities? Is it the absence of quality strategic partners? There needs to be a reason for this slow moving inflow. And we need to address this. In the absence of a domestic corporate debt market and limited availability of bank funding currently (both domestically and internationally) are we planning to fund the entire spend via equity markets, PE funds and sovereign reserves?

Well it can be proposed that infrastructure and FDI represent areas where interest is just beginning to develop and so over the coming years there is tremendous potential. I will buy that for a while. Let us turn our attention to India Inc in that case and see if we as a country have given the world enough confidence to invest in our propositions because that is the key to unlocking the dollar inflow. Indians are well known for their entrepreneurship and that has never been of any concern. However, corporate governance in India has questionable for quite some time now. To quote our premier Dr Singh from his recent (July 01, 2008) speech at the Jubilee year celebration of the Institute of Chartered Accountants of India, “….I do not find adequate attention being given to corporate governance. Unless Indian firms come to be recognized world wide for good corporate governance they will not be able to compete globally in an increasingly interdependent integrated world. In the era of protectionism few bothered about corporate governance and transparency in accounting and management. Such laxity, however, is no longer possible.” For the head of the nation to say this is publicly indicates that corporate governance is indeed an issue which needs to be addressed. The question is how are we addressing this.

Corporate governance depends on the commitment of managements towards integrity and transparency in business. The legal support provided by the judiciary also goes a long way in determining corporate governance standards in a county. Most of our businesses are promoter backed businesses with decision centres being at the helm of the family. While professionals are employed, in a number of cases, these individuals do not have the authority to make judgement calls. Why talk only about the corporates. Even Indian banks (public and private sector) which have offshore branches have a system where by all decisions are made by the same central committee in India. This decision making process behind closed doors does not suggest sufficient transparency. With a lack of autonomy and accountability it is difficult to retain talent which impairs management quality. With families owning majority of the voting rights in corporate India, sometimes via cross holdings, achieving an impartial vote is difficult. Concentrated shareholding also greys the area between generating shareholder value and creating personal wealth. It becomes even more critical, in countries like India, for the law of the land to protect rights of the shareholders. The English common law legal system, which India follows, could come to our rescue here. India in fact ranks highest in the shareholders’ rights index with a score of 5. However, the rule of law index which measures the implementation of written law shows a different picture. India ranks 41st out of 49 countries ahead only of Nigeria, Sri Lanka, Pakistan, Zimbabwe, Colombia, Indonesia, Peru and Philippines. In fact our judiciary has limited capacity to deal with securities cases. While High Courts of Delhi, Mumbai, Kolkatta and Chennai are equipped to deal with such cases, they can only deal with the cases that belong within their territorial jurisdiction and only if the claim is above a certain threshold.

India’s ranking in the global corruption perception index is not spectacular either. As a nation we rank 74th, down four positions from 2006. That does not sound like progress. In fact Transparency international reports that Indians below the poverty level cough up almost INR 9bn annually to pay for basic necessities such as electricity. In addition, recently the attitude of the Indian government toward the German government offering free information on un-accounted money belonging to Indians, lying in Liechtenstein, has raised eyebrows. While other nations have taken the information provided, Indian government has taken no action and only maintained silence. This does not speak well about our attitude towards transparency and curbing corruption.

Corruption can be cleansed with time and corporate governance can be developed with time. These arguments could be put forth. Well then let us see how our regulators stack up. As opposed to dealing with one or two regulators, Indian corporates need to deal with the government of India, the Reserve Bank of India (RBI) and Securities and Exchange Board of India (SEBI). While the government formulates big picture policies, the RBI and SEBI are responsible for implementation and execution. There is a clear lack of co-operation and co-ordination between the government and the regulatory bodies. Take for example the 2007 budget speech of the finance minister. He announced that post the February 2007 budget, short selling for institutional investors would be permitted. There was no action taken by SEBI until late 2007 when it was announced that short selling would come in effect on 21 February, 2008, however, there is still no sign of this being put into operation anytime soon. Similarly, the same budget spoke about exchangeable bond issuance being permitted. The RBI published the guidelines only in early 2008 and even then the execution framework has not been detailed. For a country that is looking to invite investors these delays just seems too long and irresponsible. And while these are just two instances, many more such examples exist. Investors do not wait for anyone but the right opportunity and if when the cash is available our policies are not, the country will lose out as it has in the past. In fact with multiple bodies governing inflows into India, it is already tedious to set up vehicles investing in the country.

When investigated closely, there is not a single stakeholder of the Indian economy totally developed and ready to take on responsibilities and accountabilities full on. There is still a long way to go for each party involved. How can we then claim that India has arrived?

India is indeed on a growth path, a path that will lead us towards prosperity. However, it is naïve to assume that we have arrived simply because we have been seeing witnessing inflows of capital. It is presumptuous and pretentious. Since the economy has only opened 16 years ago we have only started seeing the colour of money in the recent times. This does not illustrate our supremacy in any way. If we want to continue on the growth path then as a country we need to come out of the current very difficult environment. The global financial markets are in turmoil. Domestic inflation is increasing rapidly caused by the rally in oil prices. A net importer of oil, with subsidies on oil, Indian deficit is only widening. To curb the inflation we need to increase domestic rates which in turn will slow the growth. And a net import economy we have a weak rupee (the rupee depreciated c.9% since Jan 2008) which does not bode well again does it? Let us not forget that we also need to fund the rising food costs and an upcoming election which will eat into the exchequer’s reserves. These are difficult times. Times which call for prudence and perseverance. Times which call for collective measures to be taken. It is high time for India to wake up and smell the coffee!

It is about Capital

The first three posts of this blog have dealt with Foreign Currency Convertible Bonds as these instruments have created quite a stir with respect to India of late. From 2004 – 2007 this frenzy was an upbeat one, however, now it is one of some concern. Till about July 2007 Indian issuers were keeping global investors busy with their sea of FCCB issuance. Then before the credit crisis could hit India, came the RBI crunch, hitting Indian corporates with its overnight change in guidelines prohibiting raising overseas debt. All this in a bid to stop currency appreciation! A well thought out decision or pulling the last trick out of the hat? There are arguments to be made on either side. Anyway the end result was that issuance of FCCB from India dried and the corporates were left grappling with trying to find newer mechanisms to raise cost efficient financing.

Soon after the new RBI guidelines were issued on August 7, 2008, the credit crisis started to deepen. Global credit spreads which had had been at five year lows began to increase. Within a span of few months, the high yield spreads had almost doubled. Coupled with this increase came a downturn in the equity markets. In the first half of 2008, this southward journey of global equity markets has caused significant losses. What this has meant for FCCBs is that they have lost value in the interim. With underlying equity trading at lower levels the expected appreciation to reach conversion thresholds is now higher than before. Also, most FCCB issuance from India is in the form of zero coupon convertible bonds implying that the rate of accretion is the highest (please see the previous post for an explanation) and hence the requirement for share appreciation still higher. This has brought about a huge interest from media speculating on corporate profit erosion due to FCCB issuance etc. While it is absolutely incorrect to suggest that FCCB redemption will result in corporate profit erosion (see the first post of the blog for my views) there is some concern that needs to be expressed on how some of these bonds have been structured and whether the issuers did take into consideration the worst case scenarios before signing the dotted line.

One of the main issues here is the amount of money that was raised by a singe corporate using the FCCB product. Traditionally a corporate should refrain from raising more than 25% of its free float (shareholding held outside of the core and strategic investor circle) via a convertible bond. This is to ensure that at the time of conversion there is minimum impact on share price and in case of redemption the repayment is not disproportionate to the company’s market capitalization. The issue size to free float ratio is where a lot of mid cap Indian issuers were aggressive (or shall I say in some cases very aggressive). Today with some of these stocks down 50% - 60% and with the redemptions being at 30% - 40% premium to the issue price, a handful (thankfully!!) of issuers are looking at repaying over a 100% of their market cap in a couple of years. This is a situation that could have been averted successfully had the issuers, bankers and investors all worked in tandem. May I even add the regulator to this list?

Let me elaborate on my standpoint here. Corporate issuers in bull and bear markets have believed that their stocks are grossly undervalued. This belief becomes stronger in the bull market scenario where access to capital is easy and buyers abound. Thus the long term view remains for the share price to increase. Premiums demanded on the convertible bond thus are sometimes beyond the reasonable. At the same time the desire to grow is tremendous resulting in a natural attraction toward the premium redemption or zero coupon structure. Both these situations combined imply that an instrument which should be used as a hybrid is being structured more akin to debt. In addition to these two points, there is also a want to raise as much cheap money as possible. Thus issuers desire the maximum issue size to be availed via one single issuance. All these point to a non optimal issue for the balance sheet.

While the corporate client has expectations, bankers have the expertise and foresight. While advising clients, sufficient education needs to be imparted to explain the impact on the balance sheet in the best and the worst case scenario. The corporate should be provided sufficient data to make an informed decision about the suitability of FCCB for the capital structure. Structuring and pricing needs to result in an optimal product minimizing distress situations in markets such as current. Post issuance after market support is critical for the issuer in terms of regular follow ups and trading updates. Regular meetings between investors and issuers ensure that full transparency is maintained at all times.

This brings me to the point of investors. There are investors who do not read offer documents at the time of issuance. Could there be clauses not favorable for investors leading to disputes alter on? Could there be unanswered questions or unread risks? While questions about financial health and business strategy of the issuers are given fair importance, liquidity of underlying shares and market cap of issuer also needs to be considered carefully.

Where does the regulator fit in though? Well Indian regulators have given substantial thought to capping the yield to maturity (at issuance) of FCCB at issuance with the aim of preventing marginal credits coming to market. What about hard underwriting provided by lead managers? Many a time this can only aid marginal issuers achieve their motives. What happens when all equity gets concentrated in one hand? The issuer risks imparting excessive control to one entity and in case of a sale such as that undertaken by Bear Stearns earlier in 2008, the share price comes under pressure. With non converted issues, the FCCB comes under pressure and distress sale could result which could also impact the stock price. With the Indian banking landscape still not being deep enough, hard underwriting could lead India Inc indebted to a few financial institutions. Over reliance on a select group of institutions for financing cannot be the best way forward for a growing economy or is it? Hard underwriting prevents the company from achieving the best possible pricing, which does not serve the best interests of shareholders. While the promoters, the major shareholders hold big chunks of the stock, the regulator needs to protect the interests of the retail investors. The other factor for the regulator to consider is the following - with some of the debt trading at a discount and balance sheets being under pressure, should they not allow early refinancing (currently repayment of debt prior to the minimum maturity of 5 years is not permissible)? It could potentially provide some companies room to breathe.

Another example of a need for all stakeholders to work together is the on-going derivatives saga in India. Admittedly that has nothing to do with the investor community. The corporates would like to claim that the bankers who sold them derivative contracts did not explain the working of these instruments completely. I would beg to ask whose responsibility was to ensure that all impact on the balance sheet was understood completely. If the derivative transaction was entered into to hedge a USD exposure for a company with costs and revenues in INR and to some extent in USD, then why was the contract a USD/JPY swap? Where does the JPY figure? If the bank did indeed sell a USD/JPY swap were they really advising the client in the client’s best interests? Should the regulator not consider allowing open market derivative transactions?

Today mid sized corporates are ready to sue the banks throwing good money after bad money in long drawn legal battles. Only if the CEO, CFO and the board would take informed decisions in the best interests of the company. Only if bankers were to act with caution and prudence. Only if investors asked all the questions they should. Only if the regulator looked at all aspects of a market. Only if……I could continue, however, I guess it is about capital in capital markets and efficiently working efficient markets remain a hypothesis.

Foreign Currency Convertible Bonds - Structural Variances and Conversion Decisions

The origin of convertible bonds can be traced back to the days of railroad development in the US. Since then the size of the convertible bond market in the US has grown making US the largest convertible bond market (both in terms of number of issues and investors) globally. As the market has grown (in and outside of the US) the convertible bond structure has also adopted several variations. Amongst the most straightforward variations is what is known as an FCCB in India, where the currency in which the debt is issued (a hard foreign currency e.g. USD) is different from the currency of the underlying shares (INR). Since the bond is issued in a foreign currency it is called a foreign currency convertible bond.

In its simplest form, a convertible bond (or an FCCB) can be issued as a fixed maturity debt issued at 100% of its face value, converting into the underlying shares at a fixed price (provided the shares trade above the conversion price), paying an annual cash coupon and if not converted then redeeming at a 100% of the face value at maturity. In this case, the issuer has a considerable cash outflow annually through the life of the bonds and the return for investors (assuming redemption) is the cash coupon on the bonds. This structure is most commonly known as par in-par out (or simply par-par) structure.

A slight variation to the above most straightforward structure is to defer a part of the annual interest payment to maturity. The investor receives part of the interest as an annual coupon while holding on to the bonds and the remaining interest is paid at maturity in addition to the face value. This implies that while the bonds are issued at a 100% of face value, at maturity they redeem at a premium to the issue price (the premium being equal to the deferred interest). Annually the bond accretes at a fixed rate such that at maturity the redemption amount is equal to the face value plus the deferred interest payment. The return for investors (once again assuming redemption) is the cash coupon and the premium redemption amount. The advantage for the issuer is that through the life of the bonds there is reduced cash outflow burden on the balance sheet. This structure is typically known as a premium redemption structure.

In both of the above cases if the bonds were to convert into the underlying shares, the return for investors would be greater. So let us focus on how investors take the decision to convert or not to convert. In order to understand the same let us take an example:

Illustrative Examples

Assumptions:

Issue Amount: USD 25m

Reference price (closing price of shares): USD 100
Denomination of bonds: USD 100,000

Premium: 25%
Years to Maturity: 5

Conversion Price: USD 125
Conversion Ratio: 800

1. Par – Par Structure

Annual Cash Coupon: 5.00%

Annual cash paid by the issuer: USD 1.25m
Total cash paid through 5 years: USD 6.25m

In this case there is no accretion of the bonds. The value of the bonds remains at the issue amount of USD 25m. The conversion decision thus rests on if the share price increases above USD 125 (the conversion price) to a level where converting the bonds would generate more income for the investor than holding on to the bonds and receiving coupon payments.

An example is below (to keep it simple, the example ignores PV calculations)

2. Premium Redemption Structure

Annual Cash Coupon: 2.00%
Rate of Accretion 4.95%

Annual cash paid by the issuer: USD 0.50m
Total cash paid through 5 years: USD 2.50m

In this case investors receive 2% cash coupon through the five years. To ensure that at maturity the bonds redeem at a value which compensates investors for the face value and the deferred interest, the bond accretes annually at 4.95%. The value of the bonds increases annually. The conversion decision thus rests on if the share price increases above USD 125 (the conversion price) to a level which generates more income than the annual coupon payments and the accreted value of the bond. Hence, the expected increase in the share price is more than that in case of a par-par structure.

An example is below (to keep it simple, the example ignores PV calculations)

The above examples highlight that a par-par structure while maximising the cash outflow also maximises the chances of conversion. Hence while issuing a FCCB; issuers should weigh the cash conservation attraction vs. the redemption risk very carefully.

An extreme case of premium redemption bonds is a zero-coupon FCCB where the entire interest obligation is deferred to maturity. This implies that the rate at which the bond needs to accrete is higher than that of a premium redemption bond further implying that the probability of conversion is lower than that of a premium redemption FCCB. The issuer in this case, however, conserves significant cash through the life of the bonds in order to invest in the business. With this idea, most Indian issuers have used the zero coupon structure while issuing FCCBs. Whether this has been the best decision in all cases is yet another discussion.