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 about the crisis of sorts being faced by Indian companies that have issued Foreign Currency Convertible Bonds (FCCBs).
FCCBs are bonds issued in foreign currency and sold offshore with an embedded option to convert to equity at pre-determined conversion price. They became the favored instrument to raise capital for Indian companies during the Bull Run from FY 2004-05 to FY 2007-08. Most companies that issued them were on a high-growth trajectory and assumed that the increased earnings in future would induce investors to convert their bonds to equity in the future. Investors, which mainly consisted of hedge funds, were more than happy to be able to access the superior returns promised by an exponentially growing Indian equity market, while continuing to benefit from the cash flows of the bond. It was a match made in heaven.
However, now there is trouble in paradise. The Indian equity market is nowhere near the level it was during 2007. It tanked by almost 17 percent between November 2010 and February 2011. As a result, the conversion price for most of the outstanding FCCBs is way below the current stock price of many Indian companies. Consequently majority of the outstanding bonds haven’t been converted to equity. In investment parlance these convertible bonds are known as ‘busted converts.’ The redemption premium for most of these FCCBs is also quite high and companies are bracing themselves to give the money back to the bondholders.
According to some estimates, about 80 companies have their FCCBs maturing over the next 12-15 months with a combined pay-out of US$ 8 billion. Most of them are out of payout money.
How Are Indian Companies Addressing This Challenge?
Different companies are following different tactics based on their financial position, connections and level of corporate governance. Some of these strategies are:
1. Internal accruals: This is an ideal case scenario. However, most Indian companies don’t have enough cash on the books to redeem their FCCBs in entirety.
2. Company buyback: The Reserve Bank of India (RBI) in fiscal 2009 opened a one-year window 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 the bond holders. That window under the automatic route is now closed. While some companies were successful in repurchasing their FCCBs during that time, many faced stiff resistance from bondholders, especially hedge funds, who were unwilling to exit their position at a loss.
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 supermajority (either directly or indirectly), he alters the terms and conditions of the bonds and extends the date of maturity, sometimes by as much as ten 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 — 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 realizes 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 caps have managed to raise funds domestically to meet their obligations. At the same time, many midcap firms 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 for refinancing.
5. Issuing new FCCBs: Many companies, such as Videocon & Assam Oil, are believed to have tapped (or are currently 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 the 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 firms 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 (GDRs) to raise capital, others like Hotel Leelaventure are reportedly in talks with private equity players to get funding.
7. Negotiations with bondholders: A few Indian corporations have entered in 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.
8. Default: As alarming as it might sound, there are some companies out there who have already defaulted or plan to intentionally default on the FCCBs. Their rationale is simple – they don’t expect to tap the offshore market ever again and hence don’t care about the company’s international reputation. The lack of strong bankruptcy laws in India, combined with their ineffective implementation, doesn’t leave the holders of the FCCBs, which classify as unsecured debt anyways, with much recourse to get their money back. The companies use this fact to their advantage.
Finally, the experience of Indian companies and bondholders alike has not been good with FCCBs. If there are a large number of defaults over the next 12 to 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 that aspire to be like Tata Group or 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:
• The Reserve Bank of India (RBI) relaxes buyback guidelines again.
• 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.
Tanuj Khosla is currently working as a Research Analyst at 3 Degrees Asset Management, a fund management firm in Singapore. He can be followed on Twitter @Tanuj_Khosla. Alternatively he can be reached at khosla.tanuj@gmail.com . Views expressed are personal.
