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.
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.
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