After a salubrious initial period for foreign currency convertible bonds (FCCBs) as a way of financing, Indian companies could now be facing some harsh reality. This is because, most of the bonds are up for redemption in the next year and a half and with the markets taking a beating, many calculations could go wrong, and this could have a telling impact on your portfolio.
Thanks to the lull period of the markets, the difference between the conversion price and the current market price of most companies has almost become a chasm.
Investors must therefore get some answers before investing in companies with an FCCB exposure or in companies wanting to make issues. These, important questions emerge from key dynamics. They are: Where are these companies, which issued FCCBs ? Would FCCBs susceptible to the all-pervaded market lull bring about a black phase in India Inc? And, what you should do if you have been invested in these companies?
The FE Investor takes a hard look at some crucial pointers that you must know after a company raises funds through FCCBs. Here, the risks and advantages involved in an FCCB way of funding with cases, which would give you an idea of how leveraged or resilient your company is.
Why it comes in vogue
With inorganic options in the overseas markets and capital expansion plans in the domestic market beckoning, Indian corporations are putting their best foot forward when it comes to arranging finances. While there are a plethora of options available for the same today including ADR/GDR issues, qualified institutional placements, private equity placement, public issue and the plain vanilla bank funding, the option that seems to have been the cynosure of India Inc is foreign currency convertible bond better known as FCCB.
The relatively attractive return on investments offered by emerging markets like India, increased international recognition of strong economic fundamentals of the Indian economy and demand for funds from Indian companies to finance the ambitious capex plans fuelled the spurt in FCCB issues over the last couple of years. It is also worth noting that while most of the issues carried zero coupon rates, conversion price of FCCBs issued by Indian companies were fairly attractive (at a considerable premium to the market price as on the date of issuance).
And, being a hybrid instrument, the coupon rates on FCCBs are typically lower than pure debt or zero, thereby reducing the debt-financing costs. It saves the risk of immediate equity dilution as in the case of public issues. Investors get guaranteed returns on the bond in the form of coupon rates and opportunity to take advantage of the price appreciation in the stock, which are activated when the price of the stock reaches a certain point. Not to mention the substantial yield-to-maturity (YTM), which is guaranteed at maturity.
The other side
Despite the all the positives linked to the instrument, what gets ostensibly ignored are some of the risks that are attached to it. For example, FCCBs do not portray the real extent of leveraging and do not divulge the exact date of conversion, as there is a reasonable time period available for investors to exercise the option.
Usually, the company?s ability to meet the repayment obligations if the issue does not get converted into equity – is not looked into. Also, the zero coupon FCCBs fail to factor in the cost of servicing the debt (the promised yield to maturity) in case of non-conversion.
While India Inc?s ambitious capex plans surely make a good reading and project the economy with a superlative bias against its peers, the fact that the same may build up palpable risks for the future is a concern that needs to be looked into with disdain.
One aim, different games
Explains S Ramesh, COO, Kotak Investement Banking, ?Companies issuing FCCBs don?t project the real extent of leveraging and its ability to meet the repayment obligations if the issue does not get converted into equity is not looked into. And, if the FCCBs are not converted into equity over the next five years, debt and leverage will increase noticeably.? And, of such cases you need to be vigilant of. Because greater the extent of leveraging on an already weak turf results in a higher debt/equity, which is an indication of the company efficiency in handling at-hand cash.
One of the factors that have worked in favour of companies, which are leveraging high through FCCBs, is the Indian GAAP. A research report by CLSA Asia Pacific cites the Firstsource Solutions?s FCCB example.
The company financed its acquisition strategy through $275m FCCB, which has zero cost attached on its profit & loss account according to Indian GAAP. However, if one considers the US GAAP accounting, it would have eroded a chunk of Firstsource?s reported profits. Hence, due to this, many companies have leveraged more than they could have. And, the result of this leveraging is seen in the high debt/equity ratio, the report adds.
The study also reveals that Subex, Aurobindo Pharma, Hotel Leela Venure, HCC and Bajaj Hindustan all have FY09 debt /EBITDA of over four times, with Subex topping the list at 11.25(x) debt/equity. It remains to be seen in 2009, which would be the first year when large FCCBs start coming up for redemption if they do not convert and the trend accelerates in 2010 and 2011.
The study adds that Subex, Aurobindo Pharma, Orchid Chemicals, HCC, Hotel LeelaVenure and Bajaj Hindusthan are some companies with deeply out of money FCCBs and these companies face high liquidity risks once FCCBs come up for redemption (unless there is a significant rally in stock prices).
While corporations like Ranbaxy, Tata Motors, M&M, Bharat Forge should not have liquidity problems when FCCBs come up for redemption, reported earnings are likely to be hit 5-10% as FCCBs are replaced by debt, the study states.
However, all is not lost for Indian companies gone for FCCBs. There have been companies, which are fundamentally good, whose current market price have neared and also crossed the conversion price level.
And these are the companies, which need to be monitored closely because they have stood the worst period of the markets.
How to cull
Says Pankaj Jaju, senior VP, Investment banking, Enam Securities, ?A tight and expensive debt market, lacklustre equity markets performance and low investors? appetite, would be the impact-making factors in the equity conversion.? He adds, ?It is how strong a company is and what price the market is offering that differentiates the winner from the loser.?
It is believed that in most cases, before going to the international market, promoters pep up the stock prices in the domestic market to get a good price abroad. Not only this, when companies raise money from the international market, most of the time promoters plough that back in the domestic market to make quick bucks. Sometimes, they get back the fund through participatory notes (P-Notes) with FII?s.
As FII?s were not bound to reveal name of the P-Note holders, the regulator couldn?t find the source of money being invested in the market.
In fact, main instrument of rigging the market in 2000 was P-Notes. As the economy started performing well during this phase, promoters gained heavily.
But as the market crashed, they sold out, which hit the small investors. Points out Abhijit Das, vice president, Kotak investment banking, ?As an investor you need to assess whether the company is genuinely in need of raising funds or not. And, irrespective of the debt phase, equity markets, it is the fundamentals and what the company is going to do with funds raised is important.?
