Green Shoots

Introduction

The whole world is aware of the improvements seen in the global economic system. 'Green Shoots' seem to have become the favourite term for the financial gurus. But as is with ever theory, this too has its share of critics, with a school of thoughts terming these 'green shoots' nothing but weeds. While the debates continue between the gurus and the critics as does the battle between the bulls and bears, the winners seems to be the stock markets, which are seeing increasing flow of funds.

Just to get the facts right, the Sensex level has more than doubled since March 2009 when the key benchmark index stood at around 8000. The Q1FY10 results of the Indian corporates have been encouraging as the deterioration in the health of financials and business overall seems to have ceased, boosting the investor confidence. The economic indicators have improved and the FII flows have resumed their way into the Indian markets. Economic situation in India has stabilized after arrival of late monsoon and India's GDP is expected to grow at about 7%. The factors playing a spoilsport are the possible threat of rate hikes by the Reserve Bank of India (RBI) and a growing fiscal deficit which is estimated at 6.8 percent of gross domestic product, which is a 16-year high.

However, irrespective of the grey areas as regards India's financial health, there is no denying the fact that the current environment seems lot more promising than that a year before. The past year was a nightmare for the global financial markets. The dramatic turn of events, which were unraveled post the subprime crisis claimed many world renowned and legendary business houses. Cash was king and no amount of pursuing would have led one to part with it for any form of other asset, as such investments were plummeting. Equities markets were collapsing like a pack of cards and the liquidity seemed to have suddenly evaporated out of the financial system across the world.

But, now, after the intervention of the governments and federal banks across the world, the system is coming back to life and the investor optimism is slowly seen returning. The emerging markets are seeing the much needed liquidity return in to the economy. The credit-starved corporates, who were just managing to survive, are suddenly fuelling ambitious dreams. And to realize them, they have entered the primary markets with all their might to again woo the investors.

Optimal Capital Structure

Modern Finance Theory propounds that the capital structure of a firm should be chosen to maximize the value of the firm's assets. It says that a company can select that option from amongst the various financing alternatives which adds maximum value to the firm. This requires some technique of measuring the cost and risks associated with these financing alternatives. The companies should aim at attaining optimal capital structure by selecting more efficient financing alternatives. Optimal capital structure refers to the use of equity, debt and other hybrid financing alternatives in such a proportion that it minimizes the cost of capital and risk while maximizing stock prices.

One of the most important issues in corporate finance is responding to "How do firms choose their capital structure?" Determining the optimal capital structure has for a long time been a focus of attention in many academic and financial institutions.

There are various methods for the firm to raise its required funds; the most basic instruments are stocks or bonds. The mix of the different securities is known as its capital structure, so it can be defined as the combination of debt and equity used to finance a firm. And the target capital structure is the ideal mix of debt, preferred stock and common equity which adds maximum value to the firm.

The Popular Tools of Financing in the Domestic Markets

Initial Public Offering (IPO)

In case the company decided to go to the public and offer equity, the company, which so far was private limited becomes public limited through the mode of IPO, which, on one hand brings huge funds while leaving the controlling position in the hands of the promoters, but on the other hand the company has to comply with the complicates rules laid down by the regulatory authority of the stock markets. The IPO route is also chosen by some large privately owned companies who are looking forward to go public.

The Indian corporates have developed a bad taste for the Initial Public Offerings (IPOs) after the clouds of instability settled over the financial markets, world over since 2008. The cold response generated by the largest of IPOs deterred the new entrants from testing waters in the last year and half.

IPOs have been one of the most popular fund raising routes for Indian companies in the past. A small start-up during its initial days of struggle attracts money from the venture capitalists and private equity players. However, once the scale of operation begins to grow, it reaches a stage where the company, in order to unleash its complete potential and to fulfil its dream ambition requires enormous funds.

To facilitate the transition of the company's future plans into reality, it can either dilute the equity or bring in debt. And very often the extent of funding cannot by satiated by debts, as no financial institution would part with their funds just to appear as a creditor, when they can get a slice of the companies' equity for the huge sum. So the equity dilution comes as a lucrative option, where either general public is offered a stake in the equity of a company or a third party is offered a lump sum stake.

The revival of investor interest in IPO market during the second half of 2009 is more likely to get a boost this year. As many as 50 companies have already filed the draft prospectus with the Securities and Exchange Board of India (SEBI).

Indian Inc. raised about Rs 20,000 crore through the IPO route in the year of 2009. With the government planning to dilute its stake in a host of profit making public sector companies by way of IPOs and follow-on public offers (FPOs) fund raising is expected to go up to Rs 50,000 crore in 2010.

Qualified Institutional Placement (QIP)

The year 2008-09 was not a really exciting year for the IPO markets in India. Similar dry spell was also seen in case of the relatively new tool of Qualified Institutional Placement (QIP), which saw lack of activity until recently.

Qualified Institutional Placement (QIP) is a fund raising tool, wherein a company that is already listed on a stock exchange can issue equity shares or convertible debentures, or any other security (except warrants) which can later be converted into equity shares, to a Qualified Institutional Buyer (QIB). Other than preferential allotment, QIP is the only other speedy fund raising route for private placement by any company. It's better than other methods, since it does not involve many of the common procedural 'overheads', such as the submission of pre-issue filings which need to be made with the market regulator SEBI.

Before the introduction of QIPs, the Indian listed companies, in a bid to make raising capital in the domestic markets simpler, resorted to raising funds from the overseas market by issuing Foreign Currency Convertible Bonds (FCCBs), American Depository Receipts (ADRs) and Global Depository Receipts (GDRs).

In order to prevent the over dependence of the Indian corporates on the foreign capital, the market regulator SEBI had introduced QIPs in 2006, which enabled listed companies to raise money from domestic markets in a short span of time. Since their introduction, QIPs have proved to be attractive for companies as the issue cost is lower, the process is simpler and faster (no prior filing of draft offer document with SEBI), and compliance requirements are lighter as compared with ADRs/GDRs.

Although QIPs were first introduced in May 2006, they actually gained momentum only in 2007. The QIP route stagnated in 2008 when the markets went into a bear grip. Ending the long gap in the QIP issues was the Unitech QIP. The issue saw as many as five large foreign institutions pick up about 15% in the company's shareholding for $325 million in mid-April of 2009. Unitech's QIP was followed by similar issues coming from IndiaBulls Real Estate which was worth Rs 2,657 crore and PTC India worth Rs 500 crore.

As per the information provided by Prime Database, Indian companies had successfully raised a total sum of Rs 32,543.34 crore through 66 QIPs since its inception in May 2006. In 2006, there were 16 QIPs by Indian companies, followed by 41 in 2007. The appetite for QIPs diminished in 2008, and the markets witnessed only 8 placements, as fund raising became challenging in the wake of the global financial turmoil. In 2009, Indian companies had raised close to Rs 33,000 crore by way of 45 QIP issuances.

Majority of share prices have seen significant correction since January 2008, when the markets were trading near their life-time highs. As a result of lower prices and improved liquidity in the system, recent times have seen has seen more buying interest from institutional investors. As many as 73 companies have expressed their intentions to raise funds through QIPs of approximately Rs 100,000 crore. Companies interested in QIP issues include Tech Mahindra, Sterlite Industries, Hindalco, JSW Steel, Reliance Comm. and Essar Oil

Why a sudden rush of IPOs/QIPs?

The Indian markets saw large selling of over Rs. 50,000 crore by FIIs in the year 2008. These outflows were a result of the global economic slowdown, where the entire financial systems had collapsed and stock markets across the globe were crashing to new lows in long time. It was the worst financial crisis witnessed in decades since the Great Depression of the 1930s.

It is important to understand that this crisis basically stemmed from the realty market of US, where sub-prime markets saw big numbers of failures and foreclosures in servicing the loans. This led to a vicious cycle of cash crunch, which impacted the Mortgage Backed Securities (MBSs) built upon these defaulting homeowners loans.

These MBSs were sold to the investment banker, who further repackaged these securities into unregulated asset backed security called collateralized debt obligations (CDOs), which is essentially repacking the MBS into categorized by the rating agencies into different tranches based on their assessed value by these agencies - senior tranches (rated AAA), mezzanine tranches (AA to BB), and equity tranches (unrated). A huge chunk of these CDOs was brought about by the commercial bank in greed of huge incomes as a reward for higher risk associated with these securities. But this was not meant to be as these securities turned out to be toxic for the banks as the payoff coming from the homeowners stopped. This led to a severe credit crunch, which spread throughout the monetary system thanks to the greedy bankers.

Now, this rot of the US home markets quickly spread to other markets world over as directly or indirectly, all the nations in the world had some interest in this leveraged asset class. It follows that Indian markets also reacted to this development in the expected negative way as the FIIs secured their positions by booking profits, which caused massive spells of corrections in the Indian benchmark indices. The FDI investment dried as a result of the liquidity crisis. As a result of this, those sectors, which needed heavy CAPEX to survive, were groping desperately for some sort of help from the government.

The companies in the real estate and infrastructure sectors saw severe downturn, and many realty companies, who were starving for money, found it difficult to stay afloat, as the projects came to a screeching halt, the banks were reluctant in providing credit and home prices and sales kept falling.

After much intervention from the government and the Reserve Bank the Indian markets started showing signs of recovery much before their European and American counterparts. Limited exposure of the India markets to derivatives like the CDOs and other MBSs was a major reason for India to emerge as a relatively insulated economy, safe from the dangers of the western markets. The domestic demand in the country has been strong, giving the markets a strong support. Also the election of a stable UPA government added to improving market sentiments amongst domestic investors. The comparatively swift recovery of India made it an interesting destination for FIIs who were looking for safer shores to invest.

The revival in market sentiments came as a big relief to these ailing companies, who were rushing to raise money, majorly to retire expensive debt and restructure their balance sheets. The revival brought in a fresh wave of opportunities for these companies to consider the IPO/QIP routes to raise funds. Companies in the real estate and infrastructure sectors were especially looking at QIPs as a means to either retire debt or to fund ongoing projects. The major reason for increasing interest in the QIP route for fund raising is its time-effectiveness. While an IPO issue can take anything from 4 months to as long as a year, QIP issues on the other hand can be wrapped up within a span of 4-5 days.

The 45 QIP issuances done during the year 2009 have resulted in a mark-to-market (MTM) profit of around 21.60 per cent, which is equivalent to about Rs 7,050 crore for the QIBs. The year 2009 can easily be labeled the year of the QIPs. And moving forward in 2010, till the time we see some serious appetite in overseas markets for instruments like converts/ADRs/GDRs, QIPs shall continue to dominate the fundraising space.

Foreign Currency Convertible Bonds (FCCBs)

FCCBs are a popular mode of raising money from the foreign soils, which is as much a benefit to the issuer as it is to the investor. It has the features of both equity as well as debt. FCCBs are typically issued as interest bearing or zero coupon bonds and are convertible during their tenure into equity.

FCCBs are a popular source of raising money as they have considerable benefits for both the investors and issuers of the bonds. Similar to any other debt instrument FCCB brings the benefit of capital protection along with the chance to capitalize on any appreciation in the company's stock prices by means of conversion. This is very beneficial to an investor who will invest in such bonds. As for the issuing company, FCCBs are a source of low-cost debt as the coupon rates on such bonds are lower than the average lending rates prevailing in the markets.

But in recent times of liquidity crunch and the market meltdown FCCBs have turned out to be a double-edged sword. Firstly, FCCBs were a concern due to the swelling foreign exchange losses of the Indian companies. Along with the MTM losses on derivatives, companies also had to make provisions for interest expenses on the issued FCCBs, following the severe decline of the Indian rupee. Later, the problem of high conversion prices for outstanding FCCBs made its presence felt in the midst of falling stock prices, underscoring the possibility of their non-conversion. In fact, the conversion price of their foreign currency convertible bonds in most cases is several times higher than their current market prices (refer to the table given below).

To deal with the situation, the companies were left with two options. One was to redeem the bonds, which could raise the company's debt obligations that were already significant in some cases. The other was to reset the price to current market price, which could result in dilution of the promoter holdings, as it would mean issuing more equity shares in the market.

Realizing the 'no-win' situation that some of the Indian companies were in because of large outstanding FCCBs; the RBI had permitted the buyback of FCCBs in November 2008 (subject to fulfillment of specified conditions) through new ECBs (External commercial borrowings). A few months later the RBI allowed buyback through rupee resources as well.

Private Equity

Private Equity (PE) is the security of companies that are not listed on a public exchange. And as such these securities are not traded in the secondary markets. PE comprises of funds and investors who directly invest into private companies or buyout public companies that causes delisting of public equity. PE is an attractive financing option for small and emerging companies, who are planning to expand their operations and need capital for the same. PE makes more sense to Small and Medium Enterprise (SMEs) as compared to other options such as QIPs because of two major reasons. First is the added advantage of the financial and operational acumen that a PE investor brings to the company. SMEs can greatly benefit from the expertise of the PE investor. Secondly, since most of these SMEs are not listed on any stock exchanges, raising capital becomes a difficult task for them. PE provides them with the opportunity to raise funds without the need to be registered with a stock exchange.

Private equity has witnessed phenomenal growth over the last few decades as institutional investors, seeking higher returns, embraced this alternative to traditional asset classes. The last few years leading into the current financial crisis was a boom period for private equity in terms of the size and number of deals, driven primarily by buoyant credit markets that have since squandered.

In the year shrouded by an aura of uncertainty, India witnessed 287 deals in 2009 at a disclosed value of $4.43 billion compared to 502 deals with a total disclosed value of $11.98 billion in the year 2008 and 488 deals with an announced value of $15.61 billion in 2007.

Some of the large private equity deals in 2009 included KKR and CPP Investment Board's $255 Mn investment in Aricent Inc., Siva Ventures Ltd. acquisition of 51% stake in S Tel Ltd. for $230 Mn and TPG Capital's $200 Mn investment in Mumbai based Indiabulls Real Estate. With respect to high value deals there were 14 and 9 deals over $50 Mn and $100 Mn respectively in 2009 as compared to 30 and 25 deals of over $50 Mn and $100 Mn respectively in 2008.

Treasury Stocks & Stake sales

Both, the Sensex and the Nifty are today trading at levels near their 30-month highs. And many corporates are rushing to make the most of the current market rally. Consequently, promoter stakes sale and treasury stock sale has witnessed a significant rise. The highly leveraged firms, who are unable to raise further capital from other conventional sources, resort to this route, where in a bid to raise funds, these cash strapped companies' promoters decided to sell a part of their stake or sell of the shares accumulated in the company trust and use the proceeds for financing their business activities. The trust structure or treasury stock gives the flexibility to a company to sell its shares at an appropriate time without undergoing the expansion of capital.

Just a couple of days back on the 5th January 2010 Reliance Industries Ltd. (RIL) sold a part of its treasury stock for Rs 2,675 crore second such transaction in less than four months. The amount raised by this sale of shares, which were originally held by a trust, would be utilized for the proposed acquisition of LyondellBasell, the Netherlands-based petrochemicals company. In the process RIL sold 258.50 lakh treasury stocks at an average price of Rs 1,035 apiece, which was a 5% discount to RIL stock's December 31 closing price of Rs. 1089.40. Just a couple of months back, Reliance Industries (RIL) raised another Rs 3188 Cr from treasury stock sale held under Petroleum Trust. The company plans to utilize the raised capital to acquire some oil blocks overseas, following the dip in their valuations. The trust, which is a part of RIL, sold around 1% of its stake or 1.5 crore RIL shares at an average Rs 2,125 apiece.

After the first RIL treasury sale episode, we saw an outbreak of activities in this space. The RIL treasury sale was immediately followed by a spell of promoter stake sales from various corporates in the open market. Taking advantage of the bull run in the stock market, the promoters of Construction firm Jaiprakash Associates, wind turbine maker Suzlon Energy and pharmaceutical giant Cipla sold off a portion of their treasury stake in the open market to cumulatively raise Rs 2,540 crore. The Tulsi Tanti family who are the promoters of Suzlon Energy sold off approximately 70 million shares out of their holdings (roughly 4.5 % of their total stake in the company) for nearly Rs 678 crore at Rs 96.85 per share. Procceds of this transaction will be used to support the operational expenses of Suzlon, which is sitting on a debt in excess Rs 12,000 crore. Jaiprakash Associates raised Rs 1,190 crore by selling around 45.4 million shares. Similarly, Cipla raised around Rs 672 crore by selling off shares to FIIs and Domestic institutional investors at Rs 263.75 apiece.

Conclusion

The green shoots seems to be the new buzz word as the monthly and quarterly indicators of the global economic health give away better numbers indicating the bottoming out of the recessionary phase or even early signs of recovery. But at same time one must forget that markets are not always a perfect indicator of the economy. It has often been observed that bull runs in the markets come much before actual economic recovery takes place. Certain aspects of the Indian economy are still not very convincing. Declining exports, inflationary pressures, declining kharif output are all indicatives of a 'fragile' recovery.

But what can be said is the fact that a bullish market is always bustling with fund raising activities. Be it IPOs, QIPs, PE or FCCBs. These activities come to a halt as soon as the economy enters a recessionary phase and the cash supply gets tight. A bull run is perhaps the best opportunity for a corporate to raise funds, with surplus cash being available with investors and when market sentiments are strong. So as we are on the edge of a fresh beginning of a bull run, the corporates have smelled the winds of change. To make the best of this opportunity, India Inc is shoring up its resources to enter the arena and win this round.

PE funds in India have accumulated large cash surplus, which was raised in anticipation of a long bull run. Since the meltdown reduced investment opportunities, we can expect the utilization of these idle funds in the near future. IPOs and QIPs have already made the entry, the promoters are out there planning their moves - indulging in open market activities of encashing this opportunistic rally and we can be sure that the FCCBs would soon follows once the consolidation happens, the financial markets gain traction and the markets resume the smooth upward journey.

References

1. Agence France-Presse (AFP): Bernanke sees 'green shoots' of US recovery (Mar 15, 2009).
2. Business Standard: Nomura revises India's GDP forecast to 7% (Jan 03,2010).
3. The Economic Times: Need to balance growth, fiscal deficit: FM (Dec 30, 2009).
4. Determining the optimal capital structure by agricultural enterprises by Adrienn Herczeg.
5. The Economic Times: IPO arena hots up (Jan 03,2010)
6. Business Standard: Cos plan to raise Rs 50K cr in 2010 (Jan 03,2010).
7. The Economic Times: What is QIP? (Jun 05, 2009)
8. The Economic Times: India Inc lines up Rs 30K cr QIPs (May 30, 2009).
9. The Economic Times: India Inc may take QIP route again for funds in 2010 (Jan 2, 2010)
10. Business Standard: Recent QIPs give 39% returns (Oct 14, 2009).
11. The Economic Times: FII inflows hit record Rs 80,000 cr-mark in 2009 (Dec 24, 2009).
12. CNBC TV-18 : Why is India Inc taking the QIP route (Jun 10, 2009)
13. Nimesh Shah, MD Fortune Capital
14. Business Line: FCCB - Double-edged sword (Dec 28, 2008)
15. Business Standard : FCCB redemptions put India Inc in a Catch 22 situation (Oct 3,2008)
16. ANNUAL DEAL ROUNDUP '09 : VCCEdge
17. Reuters: KKR, CPP investment buy Flextronics' pie in Aricent for $255 Mn (Sep 22, 2009)
18. VCCircle : Siva Redials Telecom With 51% Stake In S Tel ( June 20 2009)
19. The Times of India : RIL raises Rs 2675 crore via treasury stock sale (Jan 5,2010)
20. Business Standard: Rally prompts promoters to sell treasury stock (September 24, 2009)
21. The Hindustan Times : India's recovery fragile, says RBI governor (Nov 27, 2009)

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