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An ambitious target, but is it possible?

01 Oct 2012

Indian government divestment plans are always a cause of excitement in the ECM world, because they can contribute so much of the market’s overall deal flow. But the government has yet to achieve anything towards this year’s target and ECM volumes have not been encouraging, writes Louisa Burwood-Taylor.

After a disappointing year, the Indian government re-launched its divestment plan in September, sending out new requests for proposals to banks in an effort to raise Rs300bn ($6bn) before the end of the fiscal year in March. But this is a drop of one-third on last year’s target, the government is still sitting on mandates that date back to 2010 and it has yet to issue anything in this fiscal year.

The government has faced challenges: markets have not been welcoming and broader Indian ECM volumes are at some of the worst levels on record. Just $7.66bn has been raised so far this year, 5.7% lower than for the same period last year and more than 50% down on 2010 volumes. Considering these market conditions, ECM bankers are adamant that the government needs to be realistic about what it can achieve, and at what price.

Investors have also been particularly picky this year. Certain sectors, such as power, utilities, infrastructure and commodities, are practically off-limits because of policy indecision and macro concerns about India, say ECM bankers. And those that have done well by comparison, such as financials, are unlikely to provide much in the way of supply for the government.

That’s a problem for the state, because much of its divestment pipeline is in unloved sectors — names like the Steel Authority of India (SAIL), Hindustan Copper, Bharat Heavy Electricals, steel plant Rashtriya Ispat Nigam (RINL) and Hindustan Aeronautics. Already put off by policy issues relating to these sectors, such as subsidies and land acquisition, investors also cannot ignore the more fundamental macro worries hanging over India — namely, its burgeoning fiscal deficit.

The government and ministry of finance are still pursuing different options for issuance, however. And despite earning no fees, banks are working with the government to find alternative and attractive methods of selling stakes in the public sector undertakings (PSUs), as state controlled companies are commonly known. These might include private deals with strategic partners or the creation of a government exchange traded fund linked to a basket of the government assets.

The government will also be able to use the Securities and Exchange Board of India’s newly introduced offer for sale (OFS) process for already listed companies with small free floats, taking advantage of its quick-to-market structure (see Corporate ECM article for more details of the OFS process). While some bankers say this is the perfect structure for the government to use, others, concerned by the country’s macro and sector-specific problems and the government’s avoidance of discount sales, think the method of execution will make no difference.

"The divestment structure is less important than the attractiveness of the underlying security," says Tarun Kataria, chief executive, India at Religare Capital Markets. "I do not believe enough substantial divestments will take place to move the deficit needle. Possibly at the beginning of next year, when foreign institutional investors have fresh allocations, some deals may get done. But until India becomes an attractive investment destination this may be hard to achieve."

Every year the government sets itself a divestment target in the hope that it can raise some capital to fund part of its burgeoning expenditure bill. But this year, plagued by the deficit and a depreciating currency, the country has a potential ratings downgrade hanging over it. That makes it more difficult to attract investors, but it is precisely these macro concerns that make hitting this year’s divestment target even more urgent, say bankers and economists.

"In the current scenario the government’s divestments are turning out to be very important," says Indranil Pan, chief economist, Kotak Mahindra Bank. "Growth is underperforming compared to what was used for the budget calculations and with a great reliance on corporate and excise tax, growth concerns raise obvious questions about how revenue targets could be met."

If the government is not able to raise the funds, there could be considerable slippage in terms of the fiscal deficit and state borrowings, adds Pan. "Interest rates continue to be high and so additional government borrowing at this time would be very negative."

Price it right

As far as bankers are concerned, it is sensible pricing that holds the key to achieving the year’s divestment target. Unfortunately, there is only one obvious case study from this year — the sale of shares in Oil and Natural Gas Corp (ONGC), the government’s most recent divestment and one that is widely regarded as a disaster.

Sold under the Securities and Exchange Board of India’s new OFS structure at the beginning of March, the offering got almost no demand from international investors, despite positive inflows of foreign money into Indian equities at the time. The domestic bid also failed to pick up any momentum and state-controlled insurance company LIC came in at the last minute to take most of the stock.

Teething problems relating to the OFS process were partly to blame, but ECM bankers think the offering’s premium pricing was the main turn-off. It was offered at a 2.3% premium to ONGC’s stock price on the day of the announcement.

The Empowered Group of Ministers (EGOM), headed by the finance minister, decides on the pricing of divestments and is subject to much political and public pressure, making it difficult to sell discounted stock in a public entity, say ECM bankers.

"The government was given standard capital markets advice by its mandated banks but their pricing committee made its own decision on the deal’s floor price and we couldn’t do much about it," says one ECM banker. "We hope the government will be more realistic with pricing in future but it is very difficult to predict what they will do. Ministers make the decision so it is very political."

Without discounted pricing, most ECM bankers are pessimistic about the government’s chances of achieving its targets. The Sensex 30 fell 25% last year, leaving many investors disenchanted. They need to see an obvious upside to any deal if they are going to participate, says bankers. Even financial deals, which have provided the majority of the year’s ECM volumes, have been issued at a discount. Housing Development Finance Corp was sold at a 6.5% discount but managed to complete a $2bn deal on the back of what bankers described as a blow-out book of investors.

"Conventional wisdom says that if you are going to put a sufficiently large amount of liquidity in the market of a particular stock, you need to discount it appropriately, to attract a diverse set of quality long term investors, says Bhavna Thakur, head of equity capital markets origination, Citi India.

"When you look at large blocks across the world, data will prove that large blocks need to be discounted. The quanta of such discounts are based on the fundamentals and scarcity premium the company enjoys in the market."

Bankers admit that there are some companies, whether government-owned or not, that would struggle to find demand at any discount. Issuers have increasingly been looking at selling to private investors instead of tapping the public markets. Just Dial, for example, put off its IPO plans earlier this year after receiving a capital injection from Sequoia Capital and SAP Ventures. The telephone directory company still intends to come to the market, but now it has the flexibility to wait until the IPO market opens up again — which most bankers think will be the beginning of 2013.

Strategic solutions?

The government is considering something similar. It has started a bidding process for the outright sale of Tyre Corporation, while Hindustan Copper is also understood to be the target of a potential private strategic investment. These deals could be the key to reaching the government’s $6bn aim, said bankers.

"The divestment target is realistic but it might not be through capital market offerings only," says Vinay Menon, head of ECM India at JP Morgan. "There could be other ways they could monetise their assets."

The government is also looking into the possibility of offering stakes through an exchange traded fund. The ETF would consist of a basket of stocks in companies such as ONGC or SAIL, and the aim would be to offer investors diverse exposure to India’s PSUs.

ECM bankers say they are in constant dialogue with the government about the effectiveness of this structure. Some think it could work, given the generally cautious approach of foreign investors towards India.

"Several large funds in the US that find the Indian market attractive but are lacking conviction, find the best way to play is through an ETF," says V Jayasankar, head of ECM, Kotak Investment Banking. "The need for active portfolio management is limited so the product has recently become a fairly important mode of investment into India and that may continue."

Other bankers have suggested alternative approaches, such as a series of blocks in individual companies at the same time or a few blocks in the same company throughout the year. Carlyle has sold two blocks in HDFC this year, reducing its stake in what one banker called a "sensible block strategy". This has consisted of taking advantage of small windows of opportunity to place the right name in amounts that can be absorbed by the market at that time. ECM bankers told EuroWeek Asia that they preferred the sale of individual stocks one-by-one in general over other methods such as an ETF.

"Our view is that there will be far greater demand and liquidity investing directly into individual stocks than a government ETF," said a senior ECM banker. "Many of the government’s divestment companies are very liquid so can be exited easily. But an ETF is quite rigid and investors will not have a say on its weighting between companies."

The government may find it tough to go down the IPO route for divestments, say ECM bankers. RINL has long been considered to be the most obvious next candidate, but after just 14 IPOs have completed this year — and only one those for more than $40m — bankers do not expect a meaningful flotation market to return until early next year, at the earliest.

Issuers are put off by the poor performance or cancellation of deals — and the risky two weeks they have to wait before the stock lists after bookbuilding. "The IPO market is more challenging than at any time in the past," says Debasish Purohit, head of ECM India at Bank of America Merrill Lynch. "I think it will take one top-notch name with a decently large-sized well-priced offering to crack the IPO code and open up the market."

But whatever structure is chosen, bankers are still concerned that India’s macro fundamentals will present obstacles to getting deals away, particularly considering the government’s infrastructure and power-centric pipeline. Some resolution of the subsidy debate could help investors predict companies’ earnings in the oil and gas sector more easily, say investors.

If the government does succeed in raising $6bn before the end of March, much of the revenue will go into paying for its growing expenses in subsidies and elsewhere. But Kotak’s Pan thinks the government could prove its commitment to these sectors — building investor and global confidence in India at the same time — by using the funds in another way.

"Expenditures like subsidies are wasteful and do not add to the production, or tax generation capacity of the country," he says. "So instead of just entering the proceeds of these divestments into the current expenditure stream, the government should lead investment in key areas such as the power sector or other infrastructure. This would promote production and growth in the country and also provide a new tax stream."

However the funds are used, bankers are vehement that the government needs to be pragmatic about how to raise them. The strength of demand for some primary market deals in India this year proves there is demand at the right price and for the right name. If the government resolves some sector grievances and offers sensible pricing, the ECM market could pick up again and help the finance ministry on its way to Rs300bn.

"Both the secondary and primary equity markets are waiting for the investment cycle to pick up again and if the government introduces new measures during a parliament session or immediately after one, this could definitely happen," says Sumit Jalan, head of India ECM at Credit Suisse. "I think we will see a much more fertile patch of issuance from now until the end of the year."
01 Oct 2012