Coming full circle: Novel financing structures needed

By H Jayesh and Anahita Irani, Juris Corp
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Historically there have been restrictions on financing by banks. Presently, the Reserve Bank of India (RBI) has capped banks’ credit exposure limits at 15% of their capital funds, in the case of a single borrower (additional 5% permitted only on account of credit to infrastructure projects); and 40% of their capital funds in the case of a borrower group (additional 10% permitted only on account of credit to infrastructure projects). Capital funds refers to the aggregate of Tier I and Tier II capital of the lending bank.

The RBI expects banks to internally regulate their exposure limits to various sectors. The exposure of banks to the capital markets is permitted up to a limited extent. Statutorily, a bank can hold shares in any company, whether as a pledgee, mortgagee or absolute owner, but only up to 30% of the paid-up share capital of that company, and 30% of the paid-up share capital and reserves of the lending bank itself.

H Jayesh Partner Juris Corp
H Jayesh
Partner
Juris Corp

The aggregate exposure of a bank to capital markets in all forms is capped at 40% of its net worth, within which overall ceiling, the bank’s direct investment in shares, convertible bonds/debentures, units of equity-oriented mutual funds and all exposures to venture capital funds, is capped at 20% of its net worth. This is an effective reduction in limits as it was previously 5% of outstanding advances of the bank. In addition, the RBI also stipulates the end purpose for which banks can extend finance. As a result, banks in India are unable to provide acquisition financing or sponsor financing in any meaningful manner.

While capital market exposure limits are not prescribed for non-banking financial companies (NBFCs) such companies are subject to limitations as regards lending to a single borrower/single group of borrowers as well as lending and investing exceeding the stipulated percentage of their owned funds. Because acquisition finance is unavailable from banks onshore, corporates approach NBFCs, albeit to a limited extent since finance from an NBFC is more costly. Also, NBFCs which are part of a banking group have to ensure compliance with RBI stipulations that the exposure of a banking group to the capital markets cannot exceed 40% of the consolidated net worth.

Onshore restrictions prompted promoters and corporates to evaluate options for borrowings from offshore sources. Restrictions have been imposed by the RBI on offshore borrowings depending on whether it views the end use of the borrowing as productive or otherwise. Acquisitions of companies in India, by Indian corporates, are not viewed by the RBI as a productive purpose and hence foreign currency borrowings cannot be obtained for such activity.

However, a few years ago, the RBI permitted Indian corporates to obtain foreign currency borrowings for the purposes of funding offshore acquisitions.

Prior to June 2007, foreign direct investment (FDI) could be raised through convertible preference shares and debentures, besides equity. Since the “convertible” element did not specify that it had to be compulsorily convertible, companies resorted to obtaining FDI through instruments such as optionally partially convertible debentures and/or optionally partially convertible preference shares.

Anahita Irani Senior associate Juris Corp
Anahita Irani
Senior associate
Juris Corp

The “optional” element enabled Indian companies to repay the FDI as per their convenience, thereby obviating the need to allot equity shares to investors. The RBI conveyed that investments through optionally partially convertible preference shares/debentures are “hybrid instruments which are essentially debt-like instruments” and stipulated that the “routing of debt flows through the FDI route circumvents the framework in place for regulating debt flows into the country”.

It is now necessary that instruments used for routing FDI into Indian companies are in the nature of fully and compulsorily convertible instruments, with a specific time-frame set out for their conversion. Optionally and/or partially convertible instruments are now treated as foreign currency borrowings.

Borrowing through the FDI route is commonly classified as the “synthetic equity” route and there are a lot of variants to it, including the manner in which the synthetic equity is collaterized, and control over the Indian company is to be achieved on occurrence of pre-specified circumstances. This is directly relative to the negotiating room for investors, the quantum of leverage as well as the comfort with the promoter group/corporate group. The rate of return payable on convertible debentures to foreign investors being deemed as capped makes it a relatively affordable and popular means of raising finance.

The current capital markets meltdown has made it highly difficult for corporate refinancing initiatives with rights issues requiring a mandatory subscription to the extent of 90%. While this would normally have been ensured by hard underwriting, this has now become difficult to execute.

This has inevitably resulted in market participants going back to the drawing board to deliberate on more innovative structures to address the current dynamics. We forsee promoters/corporates engineering disputes to pre-empt or stymie enforcement actions as most promoters will try anything to prevent their “crown jewels” (or for that matter, any jewels), slipping from their grasp.

H Jayesh is the founder partner and Anahita Irani is a senior associate at Juris Corp. The firm is a full-service law firm based in Mumbai and specializes in financial transactions including capital markets and securities, banking, corporate restructuring and derivatives.

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