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Sebi to drive ECM supply, but demand still uncertain

01 Oct 2012

India’s ECM market is set for a much-needed boost in supply over the next nine months as companies scramble to increase their free floats ahead of new regulatory rules in June 2013. But although foreign inflows demonstrate interest in the country, successful issuance in the ECM market is no sure thing, writes Louisa Burwood-Taylor.

The year 2012 has been one of the worst years on record for Indian ECM volumes. For India’s corporates, the poor environment could not have come at a more unhelpful time: a new rule on minimum free floats is set to be implemented by the Securities and Exchange Board of India (Sebi) in June 2013, meaning that a flood of companies must get deals away before then.

The absolute level of foreign inflows is not to blame for the low deal volumes so far this year, but ECM bankers reckon that where those funds have been allocated might have contributed to the disappointing picture. The first seven months of 2012 have seen record levels of foreign investment in India’s equity market, with Rs522.7bn ($9.4bn) pouring in, but it has tended to go into exchange traded funds or secondary market flows rather than primary market deals.

"ETFs help secondary volumes and sentiment but not primary offerings where you need active money with fundamental views on specific stocks," says Debasish Purohit, head of ECM India at Bank of America Merrill Lynch.

A poorly-received budget in March has not helped, with the prospect of more stringent tax regulations spooking some foreign investors. Some $7.66bn of ECM deals have priced this year, but more than 75% of that was in the first three months of the year. Bankers also blame policy indecision in some of the sectors where most needs to be done in order for companies to meet the incoming Sebi free float rules.

"India needs to get political dysfunction off the headlines and embark on a process of constructive reforms," says Tarun Kataria, chief executive, India at Religare Capital Markets. "This will go a long way towards making domestic and international investors want to re-invest in India. Many of us have decent pipelines but domestic investors need to renew their faith in the Indian market. Foreign investors too need to move from cautious to compelled."

In light of this, several companies with small free floats have appealed to the regulator for a deadline extension. But Sebi has been very clear that the June 2013 deadline is set in stone and issuers have yet to see any reprieve. Government-owned entities or public sector undertakings (PSUs) will need to have a minimum free float of 10%; private companies will need to have 25%.

This lack of relief has upped the pressure — and will make it more likely that bankers have deals to do. "Issuers were hopeful that the regulator would relax the free float guidelines ahead of the June 2013 deadline but since it became clear they would not, issuers are getting more serious about doing deals," said Sumit Jalan, head of Indian ECM at Credit Suisse.

The good news for listed companies that need to increase free floats is that follow-on offers and block trades have been the only ECM product that has really worked this year.

"The IPO market is shut", says one senior ECM banker. Flotations have contributed just 3.6% of the year’s deal volumes. And while ECM bankers readily admit they do not expect to see any more IPOs until 2013, they do see some opportunity for block trade business in some sectors. Whether or not there will be enough opportunities for all companies to meet Sebi’s requirement remains to be seen.

Although it has so far resisted any relaxation of its rules, the regulator is trying to help in other ways. It has provided new mechanisms to help issuers and promoters achieve the requirements, such as the offer for sale (OFS) process and the institutional placement programme (IPP), which aim to simplify things for issuers. Sebi has also shown itself willing to work with bankers in modifying these systems so that they might realise their potential.

But bankers are still not convinced that all companies will succeed. Some even expect Sebi to backtrack when it becomes clear that its demands cannot be reached.

"The deadline is not realistic for all issuers," says one senior ECM banker. "The regulator is unlikely to change its stance for some time because they are serious about it, but I think they will realise towards the end of the year that the markets are just not there for some sectors and they will be forced to extend the deadline."

The new processes

The OFS was introduced for sellers or promoters of India’s top 10 companies by market capitalisation or for those with a free float of less than 25%. By skipping the need for arduous documentation, it allows deals to go ahead quickly, with a floor price set by the seller the day after the announcement of a deal, followed by an auction the following day.

The IPP is a similar one-day auction process but intended for companies selling primary shares to increase their free float. In these cases, issuers still need to print a prospectus a week beforehand but they are also able to announce a price range the day before the deal.

Both processes are open to the public, unlike other block structures such as the qualified institutional placement (QIP). The IPP method even sets aside a quarter of any deal for mutual funds.

But with retail investing typically comes margin financing. In an effort to prevent investors from pulling out, all accounts participating in the new processes are asked to put up 100% of their bid on the day — and that is a tall order for many, according to bankers, who blame this requirement for the muted demand in Azim Premji Trust’s sale of Wipro shares in March. The deal had to be halved in size.

"The Wipro deal really showed the challenges of the OFS structure," says Bhavna Thakur, head of equity capital markets origination, Citi India. "The feedback from investors, particularly in the US, was that it was a challenging mechanism.

"Sebi is being helpful by providing more avenues for companies to increase their free float ahead of the deadline, and their initial vision was broad and idealistic in trying to include the public. But given the current state of the markets, are retail investors really going to participate and make any sizeable difference to the current set of deals in the marketplace?"

The government’s selldown of Oil and Natural Gas Corp stock in March — the first outing for the OFS structure — was widely considered to be a disaster, getting just one international order and muted domestic demand. The deal only got across the line when LIC, the state controlled insurance company, came in at the last minute for the majority of stock.

But this dearth of demand was more down to the deal’s premium pricing than to the process, according to bankers. "In the tough markets that we have had so far, the OFS structure has become an excuse for investors not to participate," says Citi’s Thakur. "Instead they said they would just buy in the secondary market." In ONGC’s case, the secondary market price was cheaper.

Sebi has not ignored the difficulties, making some changes after consultation with bankers, including requiring just 25% margin financing. Investors cannot increase or decrease their bid if they choose to put in just 25%, however.

"Not all of the attendant issues of OFS have been solved but there has been a substantial improvement in the process and hopefully the OFS should yield better results from here on," said Vikas Khattar, head of capital markets, India, at Morgan Stanley. "In addition, with more experience of this structure we might see further relaxation in the future. It is always an evolving process."

Sebi also announced in August that it would allow companies to use rights issues and bonus share offerings to increase their free float in time. It will also consider other methods of issuance, such as overnight blocks, on a case-by-case basis, it said.

Demand-side challenge

The low issuance levels so far this year remain a formidable challenge, however. Finding active money (instead of passive fund money) in today’s market is difficult, particularly after the March budget. Investors had hoped that, ahead of next year’s elections, the budget would bring solid measures to resolve specific issues such as the government’s out-of-control subsidy bill and ever-widening fiscal deficit, says Jalan at Credit Suisse.

Instead, the budget ushered in new concerns driven by the introduction of retrospective tax on overseas M&A involving Indian assets and General Anti-Avoidance Rules (GAAR) aimed at targeting foreign investors’ avoidance of capital gains tax on Indian investments.

That news, combined with concerns over the country’s deficit and falling growth, did not go down well with foreign investors. Some Rs11.1bn of foreign money was taken out of India in April, according to Sebi figures.

"Investors were particularly taken aback by the rhetoric surrounding GAAR and the lack of clarity over which jurisdictions would be involved," says V Jayasankar, head of ECM at Kotak Investment Banking. "So they became nervous and started looking more favourably at other emerging
markets."

The moves created an image of India as an aggressive tax administration and were of particular concern to funds registered in Mauritus, since the proposals were designed to override a double taxation treaty with the island.

One primary ECM deal in the market at the time suffered the consequences. Samvardhana Motherson Finance (SMFL) was forced to scrap its Rs16.6bn IPO in May after uncertainty surrounding the Mauritius issue was a key factor behind the muted response from investors, according to bankers. The issuer was the only one to attempt a deal of more than $100m from the middle of March until June, according to Dealogic data.

An expert committee formed by the government to examine GAAR has started to allay investor concerns somewhat. The Shome Committee Report, released at the beginning of September, recommended that that the new tax regime should be deferred for three years.

That has been received well by the ECM market. "The good news is the new finance minister [P Chidambaram] is squarely focused on these issues and that makes me more optimistic than I was a couple of months ago," says Religare’s Kataria.

Chidambaram is also understood to be a driving force in the reinvigoration of a domestic mutual fund industry that has suffered a substantial amount of outflows, according to Kataria. The government and Sebi are now trying to create an enabling environment for the sale of mutual funds such as reintroducing front-end loads, commission or sales charges at initial purchase, to encourage sales. This will also apply to insurance policy investing.

"Mutual fund distribution is key to buoyancy in the equity markets," says Kataria.

With moves such as these, the finance ministry appears to be making steps in the right direction to improve India’s reputation among the investing community. Bankers say that this needs to continue from the whole government if ECM issuance is going to pick up to the extent needed for companies to get their free floats across the line.

Macro malaise

Sector-specific and macro concerns are proving more difficult to resolve, however, and are putting investors off sectors like infrastructure, power and utilities. Uncertainty over subsidies in the power sector is one problem.

"If you look at the country’s macroeconomics outlook alone, there is not much of an investment case," says Mayank Khemka, director of portfolio management at Credit Suisse Asset Management, India. "For upstream companies in particular, there is a lack of clarity on the government’s subsidy policy. Investors don’t know how much of the subsidy bill these companies may have to burden down the line."

A lack of investment in the sector could also see production come down in later years, meaning investors have very little visibility on the future earnings profile of these companies, says Khemka. This could also affect the growth profile of industrial companies linked to the power sector.

Government indecision on land acquisitions and coal allocations is also affecting the performance and future prospects of industrial companies, say bankers. This needs to be dealt with if the sector is going to see any investment, they argue.

"Some infrastructure companies and other companies whose revenues are most dependent on infrastructure companies will find the going tough in the short term, especially if their revenues are highly linked to areas where there is policy uncertainty," says A Rajagopal, head of ECM at Standard Chartered.

Some of the companies that most need to raise equity ahead of the Sebi deadline are in industrial and power sectors, making the requirement unrealistic for many. But there is some hope in other areas. FIG deals have accounted for 45% of the year’s ECM deal flow: strip out ONGC’s $2.58bn deal, and they account for nearly 70%. Offerings in stocks such as Axis Bank, Yes Bank and Housing Development Finance Corp met with strong demand from investors, according to ECM bankers close to those deals.

"One can still cherry-pick companies with great fundamentals and decent growth worthy of investment," says Khemka at Credit Suisse Asset Management. "Private sector banks are doing well because they kept their asset quality at a very good level and maintained discipline."

Even the less loved real estate sector got a boost after Godrej Properties managed to price a well oversubscribed IPP. Some ECM bankers think the demand for these deals is a positive sign for the ECM market at large.

"The large quantum of financial blocks that have been absorbed this year and the quality of investors involved tells you that Indian financial services still retain a huge amount of interest from global investors," says Samarth Jagnani, head of international listings for Indian corporates at Morgan Stanley. "The equity transactions in 2012 demonstrate that money is there for quality companies."

Valuations are important, but some issuers will be unable to get investors to bite, however big a discount they offer, according to Credit Suisse’s Jalan. But convincing investors that their investment will perform ought to yield good results.

"Fundamentally, valuations have to be attractive and so it really depends where the stock trades in the market," he says. "But there is a lot of money for India at the right price. Demand or the deal size is absolutely not a problem if investors can see there is money to be made."
01 Oct 2012