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September 15, 2008

FCCBs: Are they a Time Bomb or a Blown Up Issue?

An article in Business Today examines the debate around one of corporate India's favorite funding instruments - foreign currency convertible bonds (FCCBs) - at a time when the stock prices of most issuers are trading well below their conversion prices.
India Inc. has issued FCCBs worth about $21 billion. Of this, bonds worth an estimated $19 billion (Rs 76,000 crore then) were issued between January 2004 and December 2007, when the stock markets were on fire and almost every share worth its name was ruling at, or near, its all-time high. Companies set conversion prices high on the assumption that the stock market would continue to move only in one direction—up. And foreign investors, keen to cash in on India’s growth, bought the story. “Emerging markets were where we had wanted to invest and India looked good,’’ says a senior executive of a UK-based financial institution, which has invested in Indian FCCBs.

...FCCBs were win-win instrument as long as the bulls had a free run of the stock markets. But with the bears now crowding the bulls out, India Inc.—or at least a large percentage of the companies that had issued FCCBs—may be sitting on a time bomb that is ticking away on their balance sheets. The fear: many of the companies concerned may not have sufficient funds to redeem their obligations. “They will have to refinance these borrowings from the local market at high interest rates. This will certainly impact their cash flows adversely and may even cause project delays,’’ says Ashok Jainani, Research Head, Khandwala Securities Limited, Mumbai.

...Then, there is also the question of how Indian companies treat FCCBs in their books of accounts. There is a justified complaint that by treating them as contingent liabilities, several companies are guilty of overstating their health and understating their liabilities. Vishal Goyal, an analyst with Edelweiss Securities, notes in an 18-page report on the subject: “Currently, most companies either reduce redemption premium from their net worth or treat it as a contingent liability. Thus, their profit & loss accounts do not reflect the actual cost of FCCBs. This issue is particularly relevant for companies whose current share price is significantly lower than their conversion price.’’ Infosys’s Pai agrees on the need for greater transparency in disclosures. “Rating agencies will, obviously, look at these very issues carefully.’’ Adds Raman Uberoi, Senior Director, Crisil Ratings: “We treated FCCBs as debt in our analysis and assigned it the appropriate risks in case conversion did not happen.’’

Arun Natarajan is the Founder & CEO of Venture Intelligence, the leading provider of information and networking services to the private equity and venture capital ecosystem in India. View free samples of Venture Intelligence newsletters and reports.