[ad_1]
Revenues of most businesses have cratered because of lockdowns that was imposed on account of Covid-19. Even as such lockdowns are gradually lifted, their effects will persist for months to come.
Except for a few businesses that are structurally insulated, or which have a very strong balance-sheet, virtually every other business will struggle. In many cases, these challenges will be existential.
Limited Capacity of Debt Markets
In a much needed intervention, the RBI enabled banks to give borrowers the benefit of a limited forbearance, and at the same time afforded banks access to additional liquidity on the condition that such funds are invested in commercial paper and bonds (for transmission of liquidity to the economy).
However, it is unrealistic to expect that these measures are sufficient to stem the tide. In addition, many businesses are already over-leveraged or would simply not have access to the market for high-grade bonds commercial paper – it is likely that the bulk of such funding will be received only by very large and known issuers.
The capacity of the debt markets to target good businesses that most require financial assistance is also inherently limited. Instead it is to the equity markets that we must look for sustenance at such times.
The Importance of Equity
For one, there is a great variety of sources for equity financing compared to the debt markets – these include private equity, family offices, corporate groups, multinationals, sovereign and pension funds and foreign portfolio investors.
Secondly, when it comes to equity financing, businesses that are likely to fare better (with the benefit of a capital infusion) would get substantially better terms. Thirdly, equity financing from overseas brings more FDI.
SEBI has brought welcome attention to this issue by means of its consultation paper issued on 22 April 2020, which proposes limited relaxations in securities laws.
Unfortunately, SEBI has only proposed marginal changes, which are well short of what is needed (SEBI’s proposal would only benefit insolvent companies).
READ ALSO: SEBI eases funding norms for stressed companies
At the risk of stating the obvious, in these extraordinary times, minor tweaks or adjustments would not suffice. Therefore, we must look at more fundamental roadblocks imposed by law – for good reason or otherwise. It is arguable that some of these had outlived their utility even in the best of times.
The Prescription
1. Valuation
Two regulatory valuation requirements stand out as the most significant constraints on deal-making.
• Foreign investors are not permitted to acquire shares (even in a primary investment) at less than ‘fair market value’.
• In case of public companies, this is based on historic trading prices (going back as far as 6 months), while in other cases, ‘fair market value’ must be calculated by an independent valuer, based on a DCF analysis or other widely accepted methodology;
While valuation is inherently subject to differing opinions even at the best of times, it presents a particularly thorny issue now. There is no clear benchmark to value a business in the backdrop of the Covid-shock and the resulting uncertainty. Assumptions, in the pre-Covid environment are unlikely to hold good.
The same goes for historic trading prices or multiples, may be prohibitive in the current environment. Except for a negotiated valuation, how does one value a company which is on the verge of insolvency (absent immediate capital infusion)? This point is well made by the debate around the valuation of a business under the Bankruptcy Code, as also the valuation adopted by the RBI and SBI in the rescue of Yes Bank.
It is high time for the government to allow prices negotiated at arms’ length to prevail. In a dynamic and volatile environment, that is the only true measure of a business’s value. In cases that involve investment in a public company by its ‘promoter’, sponsor, parent or management, approval by a majority of public shareholders (majority of the minority) ought to suffice.
2. Mezzanine Financing through Convertibles
Foreign investment through optionally convertible instruments was freely permitted until 2007, when policymakers clamped-down, citing concerns that it could result in an excess of debt-like liabilities owed to overseas investors. Since then, FDI has only been permitted through equity shares and ‘compulsorily convertible’ instruments.
However, our financial markets have changed substantially in the meantime, with FPIs now being substantial holders of corporate bonds and even distressed corporate debt (through securitisation receipts). This begs the question of whether it is time to reconsider this restriction.
Mezzanine financing that employs convertible instruments plays an important role in bringing equity-like financing to companies, which are considered too risky for plain-vanilla equity investments. There are also numerous investors whose risk appetite is incompatible with pure-equity investments absent some form of seniority or down-side protection (even if unsecured), especially in the Covid or post-Covid environment.
This form of financing is particularly valuable in cases where there is uncertainty about the value and prospects of the investee-company. In such cases, the prospect of equity-like returns would encourage investors to provide financing to businesses that do not meet the usual underwriting standards for traditional debt.
Indian companies would be happy to raise financing, which is convertible into equity, but has an option for repayment if their business outperforms investors’ expectations. One could well argue that companies may be forced to accept equity financing on more dilutive terms, at lower valuations, in the absence of mezzanine financing options. Such flexibility is all-the-more important to bridge the gap between the desperate need for financing on one hand and uncertain prospects and valuations on the other.
As it happens, this issue is relevant for domestic investors as well – specifically in the context of investments in listed companies. SEBI’s rules impose severe limitations on the terms on which listed companies may issue optionally convertible instruments. Most significantly, the option to convert such instruments cannot extend beyond 18 months.
In practice, an 18-month period is too short for an option to convert to be commercially relevant in most cases.
3. Calibrated changes in the Takeover Code
The requirement to make an open offer for at least 26% of the outstanding shares of a company imposes a significant burden on a potential investor, which would pose an obstacle for listed Indian companies to raise equity in the current environment. In this context, we propose calibrated changes to the Takeover Regulations:
• Permit shareholders to waive the requirement for an open offer, at least in the context of a primary investment. This could be done by means of an approval of the majority of public shareholders (i.e., ‘majority of the minority’), which may be specified as a condition precedent for the transaction.
• In cases where the price for an acquisition has been negotiated at arms’ length, it should suffice for purposes of the resulting open offer under the Takeover Regulations, as against a ‘floor-price’ under regulations (based on historic trading prices going back as far as 60 days).
Conclusion
The Covid crisis has precipitated an immediate need for equity investments in corporate India on an unprecedented scale. It is therefore time for policy makers to take a relook at regulatory conditions that have long been seen at roadblocks for equity investments (some of these may have already outlived their objective).
ABOUT THE AUTHOR(s): Harsh Pais and Harsh Maggon are Partners at Trilegal.
DISCLAIMER: The views expressed are solely of the author and ETCFO.com does not necessarily subscribe to it. ETCFO.com shall not be responsible for any damage caused to any person/organisation directly or indirectly.
[ad_2]
Source link
