Why does Prospero Tree recommend you to read this article?

"The worst of the decisions are made during the best of the times" - this legendary truth applies to a host of investors and corporates alike. Foreign Currency Convertible Bonds (FCCBs) are a cheap source of fund raising, which if not managed prudently, can become a time-bomb on company balance sheet. Many companies, despite having strong brands and better than average business models like Gati, Suzlon, Tulip Telecom, Educomp, Everest Kanto and hundred others have been pounded by the FCCB time-bomb. At Prospero Tree, our intention is to ensure that investors are aware of the risks that are hidden in the balance sheet and can consciously avoid investments in such companies. We will explain below the reasons why FCCB are not as cheap a source of funding as it seems.

What are the various modes of financing available with the corporates?

An operating company/going concern may require funds for expansion, day-to-day operations, investments or merger-acquisitions. Apart from the internal accruals, the external modes of financing can broadly be classified in three categories:

What is an FCCB? What are its advantages over other forms of financing?

FCCBs are debt instruments raised in foreign currency that can be converted into shares at the end of a pre-determined period. Just like any other convertible instrument, FCCB initially behaves like a typical bond – interest has to be paid on it. At the end of the tenure, the investor has an option of converting the bond to a fixed number of shares at a pre-determined price.

Interest rate advantage: Since FCCBs provide the subscriber an option to buy stake in the company at a future date, interest cost of FCCB is lower than domestic borrowings. Interest cost of a typical FCCB stands at 4%-8% vs. 8-12% for domestic bank borrowing.

Principal re-payment advantage: If the share price of the issuer is higher than the agreed conversion price, the subscriber can covert the FCCBs into shares of the issuing company. This will absolve the company from the need to repay the principal amount.

Accounting benefit: Most FCCBs that have been issued by Indian Companies are zero coupon FCCBs i.e. the interest amount is to be paid only on maturity. Thus, the interest cost of these companies is under-stated every year to that extent. Also, the interest redemption reserve is created below the profit line, so there is no impact on the P&L.

Who are the players involved in raising an FCCB?

The issuer is an Indian company who wishes to borrow money. Subscribers to these FCCBs are generally investors in the Euro Bond market and the US Bond market while arrangers to these issues are banks like ICICI Bank, JP Morgan, etc. Almost all of the FCCBs are listed on the Singapore Stock exchange and can be traded like any other debt instrument.

What are the risks for issuers of FCCB?

Dilution risk: If the stock price of the company is higher than the agreed conversion price, the investors can exercise their conversion option and covert the bonds into equity shares. Although the company need not return the principal amount in this case, the stake of existing shareholders gets diluted.

Bullet re-payment risk: In case the market price at the time of maturity is below the strike price, the issuing company may need to return the principal along with pre-determined interest. If the company has not created redemption reserves for the repayment in expectation that the share price will reach the strike price, the repayment may cause strain on the financials of the issuer.

Currency risk: A host of Indian companies raised FCCBs in 2006 to 2008, when the exchange rate hovered between Rs. 40/US$ to Rs. 45/US$. A lot of them are due for re-payment in 2012-13 and the current exchange rate stands at Rs. 54/US$. Thus, a company that borrowed US$100 or Rs. 4500 in 2007 has to shell out Rs. 5400 just to repay the US$100 principal amount.

Why did FCCBs become the bane of Indian Corporates?

Most Indian corporates raised FCCBs in FY06-08 when India economic outlook as well as global outlook looked benevolent and currency was at Rs. 40-45 to US$. The money raised through FCCBs were used to fund foreign acquisitions at sky high valuations Suzlon purchased RE Power, 3i Infotech purchased three small firms, Everest Kanto Cylinders purchased a company in Middle East. The promoters assumed these acquisitions would do well and push their stock price and FCCBs would never have to be re-paid as they would be converted into equity.

Meanwhile, credit crisis unfolded in 2008 and global outlook deteriorated significantly. Most of these acquisitions started delivering heavy losses. After a brief recovery in 2010, India macro outlook deteriorated again in 2011-12 and our currency depreciated to Rs. 55/US$. The FCCB issuers faced triple whammy  declining revenues, weak balance sheet and 30% depreciation in the currency. Their stock prices have collapsed anywhere between 50%-90% and they are staring at a default. In short, all possible risks played out at the same time!

What are the survival options for these companies?

Borrow more to redeem FCCBs: Since these companies are already in a financial mess, most banks and investors would shy away from any additional lending to these companies

Liquidate the company and repay the lenders: This is the least preferred option as it involves a series of litigations and counter-litigations. Also, asset sale is not easy to execute either.

Restructure the FCCBs: This is the most probable solution to an FCCB default. The terms of conversion and repayment are re-negotiated with the investors taking into account the current earnings outlook of the company. While this is the only solution for most companies, it may bring in the possibility of additional dilution for an existing shareholder in case the conversion price is revised lower. As an illustration, Gatis conversion price was reduced by 60% as a part of the restructuring exercise. Thus the dilution for an existing shareholder would be 2.5x of the original envisaged dilution.

Prospero Tree view

At Prospero Tree, we are of the opinion that a general approach of avoiding companies that have high debt to equity will do more good to your portfolio than otherwise. One must

note that not all companies who have used the FCCB are bad - Tata Motors, Tata Steel, Strides, etc have strong businesses and high management pedigree. However for an average investor who has little time to go through balance sheets and understand the business outlook, it is difficult to identify the good eggs. Our stock research process will certainly eliminate companies where balance sheet risks are high and ensure our investors don’t get a nasty shock on their investments.

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