Mumbai: Convertibles are increasingly becoming the preferred investment instrument for private equity (PE) firms. Around two-thirds of the deals in the PE space in recent times were made through compulsory convertible preference shares, say industry trackers. This is to bridge the gap in the “mismatch in valuation expectations” between investors and promoters.
Compulsorily convertible preference shares are those that have to be converted into ordinary shares after a predetermined date. PE investors link the time of conversion to the company’s performance. This essentially means that the shares get converted only after the company achieves the promised growth. If the milestones are not achieved, then the PE firm reserves its right to increase the stake.
PE firms are less inclined nowadays to take equity directly, said Raja Parthasarthy, managing director IDFC Private Equity Co. Ltd. “It (convertibles) is a win-win situation for both PE firms and the promoter.”
Graphic: Yogesh Kumar / Mint
Nainesh Jaisingh, managing director, Standard Chartered Private Equity Advisory (India) Pvt. Ltd, said the percentage of such deals has gone up dramatically—“probably two-thirds of all deals over the last year’.
The $450 million (Rs2,129 crore) investment by a clutch of PE firms including Morgan Stanley Infrastructure Partners, General Atlantic Llc, Goldman Sachs Investment Management and Norwest Venture Partners in Asian Genco Pte Ltd is one such deal.
Temasek Holdings Advisors India Pvt. Ltd’s Rs1,600 crore investment in GMR Energy Ltd, the Rs40 crore investment of Motilal Oswal Private Equity Advisors Pvt. Ltd in Minda Industries Ltd and the Rs300 crore investment by Blackstone Advisors India Pvt. Ltd in GatewayRail Freight Ltd, have all taken place through this route in the past six-eight months.
The instrument is also useful while doing PIPE (private investment in public enterprise) deals, said Vijay Sambamurthi, founder partner, Lexygen, a law firm that structures deals for PE firms.
Under the capital market regulator’s norms, any acquisition of 15% or more in a listed company triggers an open offer. According to Sambamurthi, a PE firm can take 14.9% direct equity and the rest in the form of securities that turn into equity within 18 months. This gives the firm the leeway to exit its investment in parts as typically a PE investment has a one-year lock-in period. In other words, before owning more equity and exceeding the 15% threshold limit, a PE firm can cash out at least a part of its existing stake, and avoid making the mandatory open offer.
“We typically recommend convertible instruments as they give more flexibility to investors,” Sambamurthi said.
Till 2007, it was not mandatory for foreign investors to transform convertibles into equities and they had the freedom to redeem such convertibles. In April 2007, the foreign direct investment laws were amended, making the conversion mandatory.
According to Varun Batra, partner, Baring Private Equity Partners India, domestic promoters tend to take an optimistic view. “Also, valuations are benchmarked to public market valuations, which can sometimes be stretched,” he said. “The PE firms are, therefore, opting for the structured transaction route.”
Another reason why PE firms prefer convertible preference shares is that in case a company is winding up, such shareholders get paid ahead of the equity holders.
“Almost 50% of the deals done today are through convertible preference shares, though a recent amendment relating to the pricing of convertible instruments may be a cause for concern,” said Sambamurthi.
According to an FDI (foreign direct investment) circular issued in April, the pricing of convertible instruments will need to be determined up front, at the time of issue of these instruments, but this may not deter the trend. Till now, pricing has been determined at the time of conversion.
“There are deals in the pipeline being structured using convertibles as the regulation refers to deciding the methodology of pricing and not the actual price,” said Muneesh Chawla, managing director, Blue River Capital India Advisory Services Pvt. Ltd, a Mumbai-based PE firm.