The fundamental aspect of any investment is valuation. While an investor would want to make an investment at the “right price”, the promoter would prefer the investment to be made at a “fair price having regard to the efforts that have already gone into the business and will go into the business”, i.e. at a premium.
Therefore, during negotiations on valuation, each party tends to push its case. While the investor believes that although the promoter and business have the potential, it is the investment that really takes the business to the next “orbit”. The promoter, on the other hand, perceives that his business is headed only one way up and the investor is only placing his bet after being sure of the upside that the promoter will toil for and generate. This contrast has continually driven not only the contracting parties in multiple directions, but also the regulator.
The accepted valuation methodology for a fairly long time for unlisted stocks was the net asset value or the profit earning capacity value or the earnings per share method. For listed stocks, the prevailing market price has been followed. While the latter category has not undergone much change, the former has undergone significant changes from time to time.
At one point, discounted cash flow (DCF) was considered a fairly rational valuation methodology for unlisted stocks.
However, even the DCF methodology came with its share of contrary perceptions—while some would argue that an investment is made not based on past track record but with the expectation of future profits, certain others would argue that projections are merely projections and hence there is no guarantee or assurance that the same will be achieved.
RBI, believing that DCF would perhaps be the fair norm and could benefit the Indian party, allowed that for a while. But RBI has since adopted a bolder approach by allowing parties to follow globally-accepted pricing methodologies.
The only caveat, i.e. the guiding principle, stipulated by RBI being that the non-resident investor should not be guaranteed any assured exit price at the time of making such investment or agreement and shall exit at a fair price computed at the time of exit.
In a subsequent encouraging development as part of the Sixth Bi-Monthly Monetary Policy Statement, 2014-15, by Raghuram Rajan, RBI Governor, it was announced that, “with a view to meeting the emerging needs of foreign direct investment in various sectors with different financing needs and varying risk perceptions as also to offer the investor some protection against downside risks, it has been decided in consultation with the government of India to introduce greater flexibility in the pricing of instruments/securities, including an assured return at an appropriate discount over the sovereign yield curve through an embedded optionality clause or in any other manner. Guidelines in this regard will be issued separately.” This announcement, once formalised, is expected to be a game-changer of sorts, but proceeding on this basis until it becomes law would be like putting the cart before the horse.
One glaring example will justify this. The Tata Docomo matter is a publicised one, with Docomo intending to exit its investment in accordance with the terms of the contracts executed between the parties. Apparently, the understanding between the parties was that, in certain situations, Docomo would be provided an exit either at a specified percentage of the investment amount or fair value, whichever is higher.
The current foreign exchange norms stipulate that any transfer of shares by a non-resident party to a resident party can only be at a price not exceeding the fair value. Given this background, since Docomo could not be provided an exit by Tata under the automatic route, parties approached RBI, seeking approval for the exit at the contractually agreed terms. The application was required to be made seeking approval since the fair value was apparently lower than the specified percentage of the investment amount. Although there were certain encouraging rumours that RBI was considering the application favourably and was inclined to provide its approval, one took that to be too liberal of RBI, given the current regulatory framework. Then, with the announcement in February 2015 in the Sixth Bi-Monthly Monetary Policy Statement, it was felt that perhaps the RBI approval for the matter would be forthcoming. However, RBI rejected the application and stipulated that the transfer of shares has to be at fair value.
Perhaps the application was mistimed—although the matter was one-of-a-kind—or perhaps it fell foul of the one restriction that non-resident investor should not be guaranteed any assured exit price at the time of making such investment. It appears that the true intention of the regulator will be reflected while notifying and formalising the policy intent in furtherance of the announcement in February 2015.
Therefore, as it currently stands, valuation is still a closed game with checks and balances, and the regulator does not see the economy in a position strong or mature enough to allow the parties the freedom to permit market forces and commercial considerations drive the market price.
With the government perceived to be taking all steps to leave no stone unturned and project India as a favourable investment destination, including the Make-in-India campaign, the hope of the industry refuses to die down despite the occasional hiccups, which gets one thinking if change is imminent, and it is not “whether” but only “when” the change is to occur.
The author is partner, J Sagar Associates