Friday, September 12

FCCD


A convertible bond (CB) is debt at issuance and through its life, until converted into shares. Conversion into shares happens if the share price is above a certain share price (“conversion price”) either at maturity or through the life of the bonds. Typically on the day the convertible bond is priced, the volume weighted average price of the shares or the closing price of the shares is taken as a base price (“reference price”).
Conversion price is then calculated as (reference price x (1 + conversion premium)), where the conversion premium is typically between 10% and 30%. The number of shares per bond is fixed by dividing the denomination of the bond with the conversion price. This defines the maximum number of new shares that can be issued at any time, limiting maximum dilution for existing shareholders.

In order to see how this works, let us take a simple example:

  • Assumptions
  • Issue Amount: USD 25m
  • Reference price (closing price of shares): USD 100
  • Denomination of bonds: USD 100,000
  • Premium: 25%
  • Outputs:
  • Conversion price: USD 100 x (1+0.25) = USD 125
  • Number of shares per bond: USD 100,000 / USD 125 = 800
  • Maximum number of new shares: (USD 25m / USD 100,000) x 800 = 200,000

Premium attained over the prevailing share price can be quite an attraction for issuers as it means using the same number of shares, a convertible bond can raise more money for an issuer compared to straight sale of the shares at the market price.

Illustration of maximizing funds raised via CB using the example above:

  • Sale of shares at market price raises: USD 100 x 200,000 = USD 20m
  • Extra funds raised via a CB: USD 25m – USD 20m = USD 5m

With CBs, issuers have the flexibility not to pay the dividends on the underlying shares (the shares into which the bonds convert) until conversion happens. This has an impact as dividend is paid from profits after tax while any coupon on the convertible debt gets a tax shield. For small and mid cap growth companies, prudently structured and priced convertible bonds can be quite an advantage. At early stages of growth it can be useful to raise cheaper debt (vis-à-vis conventional unsecured capital markets debt) and simultaneously defer any potential equity dilution (actual dilution occurs only upon conversion) that too at a premium to the current price.

One word of caution here pertains to the size of the CB relative to free float of a company and liquidity of its shares. Upon conversion, new shares of the company come into existence. This increases free float and affects liquidity. Some investors might want to sell the shares they receive upon conversion to realize gains. If the issue size is large relative to the free float and liquidity then sale of these shares is difficult. A downward impact on the share price can be a likely outcome if discounted selling begins. Some Indian corporates have raised money via FCCBs such that the issue size is over 50% of free float and represents over hundreds of days of trading volumes. Such high issue volumes also put an immense pressure on the balance sheet. As the share price underperforms, the issue size ratio to market cap only increases (issue size remains constant while market cap keeps reducing), implying a huge redemption obligation for the issuer. Going forward, in my humble opinion, Indian issuers must pay heed to the issue size and not get carried away.While we discussed benefits of CBs for issuers, for investors, the option to participate in the upside of the company’s shares via a CB is also an appealing proposition. To begin with, in convertible bond participation, principal investment is protected unlike investment into equity capital of a company (in the worst case scenario shares under perform and bonds are redeemed for cash). If the shares perform well, beyond the premium level, investors can have 100% participation in the share price performance. For companies that have transparent and stable credit, this equity option is quite cheap and hence can prove to be lucrative for the investor community.

Taking the same example as above, let us see how the share price at maturity impacts an investor’s decision to convert into the underlying shares or redeem the bonds for cash.

  • Share price at maturity: USD 120
  • Worth of the 800 shares per bond: USD 120 x 800 = USD 96,000
  • Value of each bond: USD 100,000

Hence the investor opts to redeem the bonds in cash as economically he is better of and gets his principal back (ignoring any interest for the time being).

However, consider the following scenario:

  • Share price at maturity: USD 130
  • Worth of the 800 shares per bond: USD 130 x 800 = USD 104,000
  • Value of each bond: USD 100,000

In this case, the investor will want to convert into shares. If he sells the shares in the market then he gains USD 4,000 over the value of the bonds (ignoring any transaction costs and assuming share price remains constant). Thus we can see that as the share price increases, the incentive for investors to convert also increases.

Investors, whose mandates do not allow them to invest directly in equity, use convertible bonds as a proxy to get equity exposure. Equity investors like to invest in the riskier companies via convertible bonds to protect their principal. Fixed income investors look at convertibles as a yield advantage product while dedicated convertible bond investors use both the equity and debt characteristics of the product to make returns. Hence, convertible bonds are appealing to a wide ranging investor base.Most Indian FCCBs have a high bond floor (please refer to the previous post for an explanation) and hence are more debt like. Thus, for India in particular, in the absence of sovereign international capital markets debt, FCCBs provide global investors an alternate means to get exposure to India credit.There is large merit in the product, however, it needs to be structured and priced prudently.

Let us now look at the regulatory aspects of issuing a FCCD (also GDRs) for Indian Companies
Eligibility of issuer: An Indian Company, which is not eligible to raise funds from the Indian Capital Market including a company which has been restrained from accessing the securities market by the Securities and Exchange Board of India (SEBI) will not be eligible to issue (i) FCCBs and (ii) Ordinary Shares through GDRs under the FCCBs and Ordinary Shares (Through Depositary Receipt Mechanism) Scheme, 1993 of RBI.

Eligibility of subscriber: Erstwhile Overseas Corporate Bodies (OCBs) who are not eligible to invest in India through the portfolio route and entities prohibited to buy, sell or deal in securities by SEBI will not be eligible to subscribe to (i) FCCBs and (ii) Ordinary Shares through GDRs under the FCCBs and Ordinary Shares (Through Depositary Receipt Mechanism) Scheme, 1993.

Pricing: The pricing of GDR and FCCB issues should be made at a price not less than the higher of the following two averages:
(i) The average of the weekly high and low of the closing prices of the related shares quoted on the stock exchange during the six months preceding the relevant date;
(ii) The average of the weekly high and low of the closing prices of the related shares quoted on a stock exchange during the two weeks preceding the relevant date.
The "relevant date" means the date thirty days prior to the date on which the meeting of the general body of shareholders is held, in terms of section 81 (IA) of the Companies Act, 1956, to consider the proposed issue.

For unlisted companies:

Unlisted companies, which have not yet accessed the GDR/ FCCB route for raising capital in the international market would require prior or simultaneous listing in the domestic market, while seeking to issue (i) FCCBs and (ii) Ordinary Shares through GDRs under the FCCBs and Ordinary Shares (Through Depositary Receipt Mechanism) Scheme, 1993.

It is clarified that unlisted companies, which have already issued GDRs / FCCBs in the international market, would now require to list in the domestic market on making profit beginning financial year 2005-06 or within three years of such issue of GDRs / FCCBs, whichever is earlier.

Answering to a question asked by a reader, there are no sectoral restrictions/reservations on Indian companies to issue FCCB (at least as far as I know and could find out).

http://www.rbi.org.in/scripts/NotificationUser.aspx?Mode=0&Id=2498
http://tanushree-bagrodia.blogspot.com/2008/06/fccb-it-is-equity-upon-conversion.html

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