Thursday, October 6, 2011

Indian FCCB Hacks

Act in haste, repent at leisure. India’s well-functioning and globally popular capital market almost always manages to take the attention off its debt market. Consequently, a lot of people are completely unaware of the crisis of sorts being faced by Indian companies which have issued Foreign Currency Convertible Bonds (FCCBs) and are scouring the horizon for funds. Some, as we shall see later, are also getting ready to unleash dirty tricks to get out of a tight situation.

FCCBs are bonds issued in foreign currency and sold offshore with an embedded option to convert to equity at pre-determined conversion prices.

FCCBs became the favoured instrument to raise capital for Indian companies during the bull run from 2004-05 to 2007-08. Most companies that issued them were on a high growth trajectory and assumed that increased earnings in future would induce investors to convert their bonds to equity in the future.

The lack of strong bankruptcy laws in India combined with their ineffective implementation doesn’t leave the holders of the FCCBs, which are classified as unsecured debt anyway, with much recourse to get their money back. The corporates use this fact to their advantage.

Different companies are following different tactics based on their financial position, connections and level of corporate governance. Here are the major ones:

1. Internal accruals: This is an ideal case scenario. However most of them don’t have enough cash on the books to redeem their FCCBs in entirety.

2. Company buyback: The Reserve Bank of India (RBI) opened a one-year window in 2009 under the automatic route for Indian firms to raise foreign currency loans to buy back their bonds at a discount to the conversion price from bondholders. This window has now been extended till March 31, 2012. While some companies were successful in repurchasing their FCCBs, many faced stiff resistance from bondholders, especially hedge funds, who were unwilling to exit their position at a haircut – discount to the price mentioned in the FCCB.

3. Promoter buyback: There have been a few cases in which the FCCBs were trading at a discount in the secondary market and have been bought back by the promoter under his personal account and/or in the name of some ‘friendly’ parties. The promoter then does one of two things:

Roll over the bonds: Since the promoter owns a super majority (either directly or indirectly), he alters the terms and conditions of the bonds and extends the date of maturity, sometimes by as much as 10 years. This way the company doesn’t have to service the debt in the short to medium term.

Redeem the bonds: This enables the promoter to take cash out of the company and put it in his pocket as effectively he is just paying himself. Moreover, since the bonds were bought at a discount from the secondary market but redeemed at the redemption premium, the promoter realises a neat profit.

4. Refinancing: This is the preferred way of repaying the bonds by most Indian companies. However, with banks tightening their credit, a lot of companies won’t be able to secure bank loans. A few large companies like Bajaj Hindustan and Bharti Shipyard have managed to raise funds domestically to meet their obligations. At the same time many mid-cap companies have been knocking at the doors of various foreign hedge funds to obtain private debt which won’t come cheap. Bigwigs like Reliance Communications Ltd, which has secured a US$ 1.33 billion loan from China Development Bank, are also looking at foreign banks, especially Chinese ones for refinancing.

5. Issuing new FCCBs: Many companies like Assam Company have tapped/are tapping the international markets to place a new issue of FCCBs. While some of them have chalked out large capital expenditure plans and claim that only a part of the proceeds shall be used to service outstanding FCCBs, others are quite open about their intent regarding the funds raised.

6. Raising equity: Not only is raising equity in this market difficult but it would also lead to substantial dilution of the promoter’s stake in the company. However, many companies don’t have a choice as they are highly leveraged and can’t take on any additional debt. While some of them are issuing global depository receipts, many others are rumoured to be in talks with private equity (PE) players to get funding.

7. Negotiations with bondholders: A few corporates have entered into talks with their bondholders to either roll over the existing bonds with a lower conversion rate or a higher redemption premium. Unfortunately for them, not many hedge funds are willing to take a haircut on their investment and are examining their legal options.

In conclusion, the experience of Indian companies and bondholders alike has not been good with FCCBs and if there are a large number of defaults over the next 12-15 months that might well be the last nail in the coffin for this debt instrument. This would be very bad news for smaller companies which aspire to be a Tata or an Infosys but won’t find an audience next time they come to the international markets to raise funds. Things might start looking up though if one or more of the following happens:

— RBI accelerates the growth of credit default swaps, a form of insurance cover purchased by lenders against the risk of default by borrowers. This shall allow foreign institutional investors (FIIs) to hedge their credit risk in India and shall give them some comfort.

— The Indian equity market improves drastically in the same period and most bond holders convert to equity.

If not then a large crisis looms over this former love of international investors for sure. Watch this space.


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