FINANCING FOLLY

Akash Saraf, 32, Managing Director of cloud computing company Zenith Infotech, is caught between a rock and a hard place. Reason: the company missed its deadline last September to redeem $27 million (`132.30 crore) in foreign currency convertible bonds (FCCB). The trustees for the bond-holders, Bank of New York Mellon (BNYM), accelerated repayment of $50 million on a second tranche of bonds that was due only in August 2012 and moved the Bombay High Court seeking to wind up Zenith Infotech. That has left Saraf, son of Zenith Computers founder Raj Saraf, with little room for manoeuvre. The Sarafs sold Zenith Infotech’s remote management services business to Boston-based Summit Partners six days after missing the payment deadline. The sale yielded around $54 million and Zenith was ready to redeem the first set of bonds. However, by that time the bondholders were demanding payment for both sets of bonds. Negotiations are on even as BNYM and the Sarafs fight multiple court cases. “We want to pay the holders of the first bond in full right now. We just got delayed. We are not asking for a haircut,”says Saraf. A haircut here refers to a reduction in the value of the financial instrument.

A deal to re-negotiate the FCCBs with a lower conversion price is something that scares the Sarafs and threatens to hand over control of the company, valued at`598-crore by Ernst & Young, to the foreign funds.

The FCCBs have hit where it hurts the most. “It is much easier to deal with Indian banks. One can sit across the table and negotiate a restructuring,” says Saraf, who started Zenith Infotech in his mid-twenties.

FCCBs are foreign currency-linked bonds, with tenures of five years or more, at the end of which subscribers convert their money into equity at a pre-fixed price. Usually, no interest is payable on conversion. However, in case the share price of the company is way below the conversion price, the bond holder can reclaim the money as if it were a loan with a pre-decided interest rate.

For instance, let us assume that company A decides to raise `1,000 through FCCBs in 2012. The FCCBs are subscribed by investors B and C, who each get one bond of `500. Company A’s share price is `40 today. B and C are given the option to convert their bonds into ten shares at `50 per share in 2017. If the market price of the shares is at `50 or more in 2017, B and C will convert their bonds at `50 and make a profit. But if the share price on maturity is `20, then B and C will ask for the return of their money with, say, five per cent interest. So A will have to fork out `1,276.28 instead of issuing fresh shares.

Due to the conversion option, interest rates levied on redemption of FCCBs are half of what a normal loan costs.

With stock prices of many companies below their 2007 levels, this last scenario, repaying money instead of issuing shares, is a threat for some. Subex, Cranes Software, Strides Arcolab, GTL Infrastructure, Indowind Energy and Suzlon Energy are just a few names among the Indian mid-sized companies on the long list of FCCB borrowers facing headwinds.

The case of Wockhardt, where FCCB holders took the company to court after it defaulted in repaying its FCCBs, is certain to be playing on their minds. In 2009, the cashstrapped pharma firm had proposed to buy back its FCCBs at a 65 per cent discount to the conversion price. However, the court ordered that the FCCB investors be repaid in full. Wockhardt had to sell its hospital, nutrition and animal health divisions to generate cash to de-leverage its balance sheet. The company declined comment for this story.

“FCCBs are an accounting problem. The Institute of Chartered Accountants needs to reflect if these should be treated as debt or equity,” says Shailendra Bhandari, Managing Director, ING Vysya Bank.

Currently, as FCCBs are treated as quasi-equity instruments, companies need not provide for their repayment. However, in a bad year, FCCBs are almost like a pure debt product. Avinash Gupta, leader of Deloitte’s Financial Advisory Services in India, sums it up: “FCCBs work in bull markets. There are a number of cases globally where people have not been able to pay up their FCCB liabilities. When the business faces a downturn, it is a double whammy for the promoter.”

In a report this February, Fitch Ratings India said that 59 Indian companies face FCCB redemptions amounting to $7 billion in 2012, of which 20 per cent is likely to see a default (see: In Trouble). “The risk of redemption of the FCCBs was never properly analysed,” says Probir Rao, who heads investment banking in India, at Jefferies, a global dealmaker. Jefferies has helped many Indian companies raise money and restructure themselves.

Upcoming redemptions include Sterling Biotech, which has to repay$183.84 million by May 16; Pyramid Saimira, which has to repay $122.56 million by July 4; and KSL, which has to redeem $111.58 million by May 19. Late in January, Jefferies advised Bangalorebased Strides Arcolab in its $393-million deal to sell its generic pharmaceutical operations in Australia and Southeast Asia to US-based Watson Pharmaceuticals. Arun Kumar, Executive Vice Chairman and Group CEO, Strides Arcolab, says this is in line with its focus on sterile injectibles. However, a part of the proceeds was to be used to pay down$250 million in debt, of which $120 million were to be used for redemption of FCCBs due in June 2012.

Rao says that while Strides Arcolab and Wockhardt had assets to sell and reduce their debt burden, not every company in distress may have that luxury. Take the case of Suzlon. When the wind-energy major acquired German wind power company RePower and Belgian company Hansen Transmission, oil prices were on an upward trend and alternate energy looked to be the way forward.

Suzlon had a debt-to-equity ratio of 2:1 on December 31, 2011. Its net debt on that date totalled `12,072 crore, nearly 19 per cent more than the `10,167 crore figure of a year earlier. Last year, Suzlon restructured its debt after investors forced it to set a new conversion price for its existing FCCBs. However, the company does not feel that the FCCBs landed it in a trap. “FCCBs are only one part of our overall structure. In combination with various other instruments, they have played a useful part in our financial planning and management,” says a spokesperson for Suzlon, in an email response.

“Many Indian promoters who have grown rapidly continue to sign all the payment cheques themselves. They would do it at `100 crore turnover and continue to do it when sales touch`1,000 crore,” says Prashant Agarwal, principal at Boston Consulting Group.“They should be spending more time on key decisions.”

ING Vysya’s Bhandari says that nonperforming asset levels among his middle-rung borrowers crossed the five per cent mark for a while after 2008. These were entities with sales of more than`1,500 crore but below the blue-chip grade. “This segment gets over-banked. These are usually risk-taking entrepreneurs. They are targeted by larger banks as well as smaller banks. A lot of money is thrown at them and they sometimes do risky things like an acquisition or a derivative transaction.”

Often, it is also bad advice that does the entrepreneur in. “Indian entrepreneurs are usually stuck with their first CFO, probably a CA, but one who did not have knowledge of global businesses, fund raising and managing acquisitions,” says the head of corporate finance at a foreign bank that has filed a winding-up petition against a software company in India.

Over the last three years, Suzlon involved global financial advisor Rothschild to restructure its finances and brought in a new CFO, Robin Banerjee, in March 2009. Banerjee quit Suzlon in March. Kirti Vagadia, who for many years was the company’s CFO, came back in his place.“These steps were part of our longterm strategic plan to strengthen our balance sheet and overall business,” says the spokesperson. They helped Suzlon survive, but they have not solved its problems. Suzlon had to sell its holding in Hansen Holdings to bring its debt under control. And now, industry watchers believe it may sell RePower, something that Suzlon denies.

In fact, this has been a theme among some Indian entrepreneurs: overstretching, making an overseas acquisition, borrowing through FCCBs and then selling the acquisition to manage debt. It has largely been a trend among the second-rung of Indian corporations. Large Indian conglomerates have managed their finances and repayments much better.

In 2008, Hyderabad-based GMR Infrastructure bought 50 per cent of Dutch power generation firm InterGen for $1.1 billion. But two years later, when GMR was grappling with higher debt on its books, it divested its stake to China’s Huaneng Group for $1.2 billion. Was this a strategic mistake? “We did not sell our stake in InterGen because we had to bring down our debt,” says A. Subbarao, CFO of GMR Group. He claims that GMR’s interests did not align with those of the other shareholder, Ontario Teachers’ Pension Plan.

One aggrieved investor, a hedge fund with exposure in Zenith Infotech’s FCCBs, says that Suzlon is at least making an effort to find a solution. He points at Chennai-based Indowind Energy, the newest addition to the list of defaulters. The company had raised $30 million through FCCBs in December 2007, which fall due in December this year. However, in December 2009, Indowind defaulted on an interest payment and has missed five more payments since then. “We have filed a windingup petition there as well,” says the hedge fund representative, on condition of anonymity.

For Indian promoters, domestic banks are the nice guys. “The leeway to look at another person’s point of view is more in the case of public sector banks,” admits Diwakar Gupta, MD and CFO, State Bank of India (SBI).

“Companies in India are often able to better manage their financing with Indian public sector banks,” says Deloitte’s Gupta. He cites a particular case. A company was in trouble with its debt and the banks advised it to go public. An initial public offering (IPO) followed and the same banks that were lenders subscribed to the equity issue. There were not many other takers for the shares. The money raised through the IPO amounted to almost 70 per cent of the loans and the IPO proceeds were used to pay back the loans to the banks. It was an effective conversion of debt into equity, without the stigma of default.

“In case a company has a foreign loan or foreign acquisition, consultants are called in. Otherwise banks often try and restructure loans themselves,” adds the Deloitte consultant. A prime example of this is Kingfisher Airlines.

Indian banks are often ready to go through a corporate debt restructuring(CDR) exercise before seeking legal redress. “Compromises are one-offs and not on a template. There’s always some subjectivity,” says SBI’S Gupta.

Corporate debt restructuring is a voluntary process. The assumption that CDR is a cover-up is not correct. The idea is to make the company stronger,” says ING Vysya’s Bhandari. He points out that 90 per cent of cases that went through the CDR route are alive.

“Any recovery is timeconsuming. On average, a bank can take between one to three years to crystallise recovery,” says Shanti Ekambaram, President of Wholesale Banking at Kotak Mahindra Bank.

The law permits banks to take legal recourse for recovery through debt recovery tribunals (DRT) and enforcing the SARFAESI (Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest) Act.“But these are situational calls and to choose them or not is upon respective banks,” says Ekambaram. SBI’s Gupta feels a better legal system would be a big help.

The CDR mechanism aims to lower the debt burden on the borrowing company either by reducing the interest rate at which its pays or by extending the repayment period of loans or both. This helps the company improve its ability to meet its obligations and avoid becoming a defaulter. Interestingly, in Wockhardt’s case, the term loan lenders’ and bondholders’ interests were in conflict. Led by ICICI Bank, domestic banks SBI, HDFC and Punjab National Bank had approved the CDR scheme without keeping FCCB holders in the loop. The FCCB holders moved court. ICICI Bank declined comment.

The common link between Wockhardt and Zenith Infotech is FCCB investor QVT. It is known for adopting activist positions in lesser known companies worldwide.

Unlike the period between 2006 and 2008, when hedge funds were bullish on equity, FCCB investors are far more circumspect today. Premiums are muted and investors are very keen on yields, says Rao of Jefferies. “The current pricing is more in sync with credit risk and India’s sovereign rating,” he says.

“The good old days are gone,” says another FCCB investor who did not want to be identified. “The biggest change is that for an unsecured instrument we are asking for security wherever possible.” Today, investors not only look at FCCB issuers’ fundamentals but also at the credit risk. “In terms of new covenants, FCCB instruments now carry reset clauses for downward revision of conversion prices,” adds Rao. They are beginning to look more like debt instruments. So, in the illustrative example earlier, the conversion price of Company A’s FCCBs might be reset to `15 in a bad market, from `50.

Take the case of New Delhi-headquartered Amtek India. The company is a leading provider of cast iron automotive components and part of the $1.3-billion Amtek Group, which raised $130 million through FCCBs on March 19. These FCCBs carry a coupon of six per cent payable on a semi-annual basis. (Coupon, in financial parlance, is the interest rate stated on a bond when it is issued.) Upon maturity in 2017, after five years and a day, the bonds are convertible at the initial conversion price of`103.005 per equity share. Given that the weighted average stock price of Amtek India on March 19 was `98.9 per share, the conversion premium works out to a mere 4.15 per cent. Compared to the norm of almost a 40 per cent premium five years ago, this is very low, signifying how the instrument is changing.

And here’s the tailpiece. SBI , the sweetheart for Indian companies, has filed a winding-up petition against Zenith Computers in the Bombay High Court for defaulting on FCCBs it had acquired from Credit Suisse. Clearly, SBI has learnt some survival tricks. For Indian companies in general, and the Sarafs in particular, that is equivalent to the financing world turning upside down.

WITH INPUTS FROM G. SEETHARAMAN