Debt to equity conversion initiative may have limited effect
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While the exact procedural details are awaited, the synchronised efforts of the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (Sebi) to ease the process of conversion of debt in a listed borrower entity is a welcome step.
The ability of banks to convert debt into equity will provide another tool in the hands of lenders to fight non-performing assets (NPAs). But the conversion of debt into equity is unlikely to meaningfully benefit lenders as well as borrower companies as they are already in distress or are close to distress. India Ratings & Research has been tracking the credit metrics of 500 largest such borrowers.
Market capitalization of companies classified as “known stress” and “vulnerable” has eroded by 80-99% over the past 2-4 years. The debt-to-market capitalization (median) for these companies is around 8.0. So, theoretically, even if existing shareholders are wiped out and equivalent debt is converted into equity, it would address only 10-12% of the total debt.
Liquidation a better option: The median price-to-book value ratio for 120 companies is 0.36. Even allowing for those instances where book value may not fully reflect the market value of a lot of assets, it appears that the book value would correspond to around 30% of the debt (again assuming existing shareholders are wiped out). The regulators and government should consider ways to liquidate at least some of these companies to facilitate the recovery prospects of banks struggling with NPA.
Even 51% conversion not enough: Banks, according to RBI guidelines, can invest up to 30% in the equity of a company. As per reports, Sebi is expected to notify banks a process that will allow them to own up to 51% of equity in listed companies, where their debt may be converted into equity.
Most of these 120 companies were in acknowledged or unacknowledged distress for over 2-4 years. So, if the debt is reduced by 30% of their equity value, based on their current market cap, the leverage number will not reduce meaningfully for three-out-of-four companies. This implies that the interest servicing ability will also not improve much. Thus, the problem of impending NPA remains unaddressed for companies which account for around 65% of distressed debt.
Cash flow stress not addressed, equity need cannot be bypassed: One of the key challenges faced by stressed companies is to improve their cash flow and profitability.
This necessitates incremental working capital. Unless the aspect of additional funding is addressed, it looks a tall proposition for these entities to turn around and service the residual debt and provide returns to shareholders.
It is estimated that while known stress companies require Rs.2.4 trillion equity to survive, vulnerable companies would need Rs.89,200 crore to avoid slipping. So, even if debt is converted into equity, the question remains as to where the incremental capital will come from.
Concerns and required clarifications: While details are awaited from both the RBI and Sebi as to the exact procedures to facilitate such moves, the guidelines may consider throwing light on some of the following aspects:
1. Companies will need equity infusions. Mere conversion of debt into equity by a class of lenders will not serve the purpose. Once lending banks become shareholders and such a company goes for a fresh equity infusion, the banks would be in a dilemma as to whether they should subscribe to fresh equity to maintain their stake and, therefore, the bespoke management control.
2. After conversion, the bank would be a significant owner of the equity stake and will also remain a lender. Equity holders prefer to infuse higher volatility to earnings to improve the upside of equity valuation but debt holders would be interested in maximizing certainty to their cash flow.
3. In terms of reducing information asymmetry, minority shareholders more than ever need to know the delinquency status of the companies they own.
Also, after conversion of debt into equity, the bank would be a significant owner of the equity stake and would also remain a privileged‟ lender compared with other lenders that may not be equity owners with access to board meetings. Guidelines must be provided on how other banks should resolve this competitive disadvantage of information.
4. The conversion of debt into equity would necessitate a material change in terms of the existing lenders or debenture holders in relation to the original contractual terms. The debt exchange is necessary to avoid bankruptcy liquidation or a payment default.
Edited excerpts from a report by India Ratings & Research.