
In March 2007, Subash Menon, Chairman, Managing Director & CEOof the Rs 485-crore Bangalore-based telecom solutions providerSubex, needed money to finance the acquisition of Canadian companySyndesis. That same month, his company issued foreign currencyconvertible bonds (FCCBs) worth $180 million (Rs 792 crore then) andcompleted the acquisition.
The conversion price was set at Rs 656 per bond. The company'sshare was then trading at over Rs 600, and the BSE Sensex was at13,000 levels. Since then, the Sensex rose to 21,600 before fallingback to 14,355 on July 31, 2008. Subex's shares, meanwhile, havecrashed; it closed at Rs 76.30 on BSE on July 31. Obviously, nobondholder will want to convert his bonds into equity in such ascenario. The bad news: Subex will have to pay back the entire debtplus interest and premium if its stock continues to trade below theconversion price.
The good news: it faces no immediate threat; the redemption willbecome due only in March 2012. Subex is not the only Indian companyfacing this predicament. India Inc. has issued FCCBs worth about $21billion. Of this, bonds worth an estimated $19 billion (Rs 76,000crore then) were issued between January 2004 and December 2007, whenthe stock markets were on fire and almost every share worth its namewas ruling at, or near, its all-time high.
Companies set conversion prices high on the assumption that thestock market would continue to move only in one direction up. Andforeign investors, keen to cash in on India's growth, bought thestory. Emerging markets were where we had wanted to invest andIndia looked good,'' says a senior executive of a UK-based financialinstitution, which has invested in Indian FCCBs.
FCCBs, as the name suggests, are foreign currency-denominatedbonds, akin to convertible debentures, with maturity periods ofbetween three and five years. The investor has the option ofconverting the bonds into equity. If the stock is trading at morethan above the conversion price, he can sell it and book profits.Alternatively, he can hold them till maturity and opt for redemptionat an agreed price. Either way, the investment is protected.
But the conversion option is what makes FCCBs attractive, both tothe investor if the stock appreciates, he can earn a windfall profitas well as to the issuing company as it does not have to shell outlarge sums of money to redeem the debt.The lure of equity
American, European and Far Eastern investors bought FCCBs not asinstruments of debt but for the lure of the equity they promised. They are least interested in the 7 or 8 per cent rate of interestthat they carry,'' notes a foreign banker.
Not everyone, however, is equally pessimistic. A top executive ofa US-based institution, which is sitting on piles of Indian FCCBs,says: Investors who have invested in good quality companies and arewilling to sit through these volatile times are, at least, assuredof getting their capital back with interest, regardless of whetherthe stock markets rise or fall.
Raj Bhatt(Elara Capital), Deepak Srinath(Viedea Capital), VishalGoyal(Edelweiss Securities)
FCCBs were win-win instrument as long as the bulls had a free runof the stock markets. But with the bears now crowding the bulls out,India Inc. or at least a large percentage of the companies that hadissued FCCBs may be sitting on a time bomb that is ticking away ontheir balance sheets. The fear: many of the companies concerned maynot have sufficient funds to redeem their obligations.
They will have to refinance these borrowings from the localmarket at high interest rates. This will certainly impact their cashflows adversely and may even cause project delays,'' says AshokJainani, Research Head, Khandwala Securities Limited, Mumbai.
But raising fresh debt to retire an existing one is easier saidthan done. Besides, external commercial borrowing rules clearlyforbid refinancing. We have options. Besides, our company will haverevenues and profits much higher than they are today by the time thebonds mature,'' says Menon of Subex.
K. Ramakrishnan, Executive Director and Head, Investment Banking,Spark Capital Advisors, adds: I'm concerned about the fact thatFCCBs worth $7.7 billion (Rs 30,800 crore) were raised in calendar2007. A lot of it remains unconverted, and I don't see a greatchance of conversion taking place given where the markets are. IfFCCBs were raised when the rupee was at 38/39 against the dollar,and if it has to be redeemed when it is 42/43, that poses anotherchallenge as debt need to be repaid in dollars.
Double-edged sword
They (FCCBs) are like a doubleedged sword, says T.V. MohandasPai, Director (Human Resources), Infosys Technologies, who is aformer Chief Financial Officer (CFO) of the company, adding that thedownside risk increases when markets fall.
There is a possibility that many companies will default unlessthey have tied up liquidity support, he says. Ramakrishnanelaborates on that. FCCBs are hanging as a sword of Damocles overIndian companies because of the interplay of currency risk,redemption risk, interest rate risk and the need for greatertransparency in reporting.
Raj Bhatt, Chairman & CEO of the Londonbased Elara Capital,agrees with some of these views, but points out that a number ofIndian companies that had issued FCCBs have strong balance sheets,and so, have the ability to redeem their bonds. The situation isnot grim yet.
Not many bonds are due for conversion now. Then, Aarti Drugs(which had issued FCCBs worth $12.75 million, or Rs 58 crore inApril 2005) redeemed them last month,'' he points out.
But many investors have already burnt their fingers with Indianbonds. Several investors want to exit their bonds but there are nobuyers, says a senior executive at a European investment bank. Theyhave two options: they can hold on to their investments or sell outat a loss and many are, in fact, exercising the second option. Abanker says wryly: Indian companies are enjoying cheap credit whileinvestors are suffering.
The accounting conundrum
Then, there is also the question of how Indian companies treatFCCBs in their books of accounts. There is a justified complaintthat by treating them as contingent liabilities, several companiesare guilty of overstating their health and understating theirliabilities. Vishal Goyal, an analyst with Edelweiss Securities,notes in an 18-page report on the subject: Currently, mostcompanies either reduce redemption premium from their net worth ortreat it as a contingent liability. Thus, their profit & lossaccounts do not reflect the actual cost of FCCBs. This issue isparticularly relevant for companies whose current share price issignificantly lower than their conversion price.'' Infosys's Paiagrees on the need for greater transparency in disclosures.
Rating agencies will, obviously, look at these very issuescarefully.'' Adds Raman Uberoi, Senior Director, Crisil Ratings: Wetreated FCCBs as debt in our analysis and assigned it theappropriate risks in case conversion did not happen.''
Lingering hopesBut the investment banking fraternity has not losthope. Deepak Srinath, Founder-Director of Bangalore-based I-bankViedea Capital Advisors, dubs the alarm over FCCBs as a bit toopremature .
He reasons that a majority of the FCCBs were issued between 2005and 2007, and most of them have 60-month maturity periods. I expectthe markets to bounce back within two years,'' he adds. Meanwhile,he suggests, companies that have the reset clauses should negotiatewith investors for a lower conversion price. They must also startfiguring out ways to refinance the debt in case their stock pricesremain at present levels.
Subex seems to be doing that, though its management expects itsshare price to rebound before its bonds mature. We have not yetlost hope. In case we can't use the conversion option, we willrefinance the debt or raise equity to redeem the bonds,'' saysMenon.
The companies will raise rupee debts in the domestic market andclear dollar debts after conversion in local markets, according toanalysts. Meanwhile, the time bomb continues to tick away.