Newsletter: Buyback of FCCBs

Buyback of FCCBs
Of late there have news reports on various developments relating to Foreign Currency Convertible Bonds (FCCBs). It was only in the late 1990s various corporations started leveraging FCCBs to fund their growth plans.
It is an efficient method of funding, as an FCCB enjoys the general advantage of any convertible instrument. It has the right smoothing effect on the EPS when used for funding a new project or an expansion. Generally the conversion to equity takes p lace after completion of the project for which the funds are raised through the FCCB route. The servicing cost of an FCCB till its conversion is capitalised and hence does not affect the EPS. Post conversion, the earning from the project should more than offset the dilution in EPS due to the expansion of the equity base. Also FCCBs, till they are converted to equity, have the advantage of lower servicing cost applicable for foreign currency loan.
Equilibrium upset
At the same time it also provides an opportunity to leverage the higher PE multiple in the overseas market, which we had seen till the recent meltdown of the global economy. Hence FCCB was a very attractive method of financing.
But the steep fall in share prices together with tight liquidity in the global market has upset the equilibrium, placing both investors and companies in difficulty. The conversion prices for most of the FCCBs were agreed upon years back when the market was experiencing a bull-run. As a result of the steep fall in share prices, the rates are not attractive enough for investors to exercise the conversion. Hence the issuing companies have to find ways to finance the repayment of these bonds.
In this scenario, it makes economic sense for companies to buy back the FCCBs. Such action will not only benefit the companies but also their shareholders. Realising the need and the advantage, the RBI has relaxed its guidelines to enable an issuing company to buy back FCCBs from the market.
RBI eases norms
The earlier relaxation permitted buyback only when the issuing company funded this requirement through new ECBs. This has very little benefit as in today’s global financial market it is almost impossible for companies to raise fresh ECBs to fund the buyback of FCCB.
The new set of guidelines issued by the RBI on December 6, 2008, addresses this difficulty to a certain extent. Now the requirement can be funded using rupees. The foreign currency required to purchase the FCCB can be obtained from the RBI. However this facility is available only when the company is able to buy the FCCB at a discount equal to or more than 25 per cent. One could argue that though the threshold level of 25 per cent discount is arbitrary it is a right step in terms of effective use of the forex reserves.
Internal accruals
However the RBI should seriously reconsider the other condition, namely, that the buyback has to be funded from internal accruals only. This is a stringent condition to meet, as internal accrual will not include share capital or premium on issue of shares. Thus to meet this condition, the total borrowings, including the money required for buyback, should be less than the retained earnings of the company.
This effectively means a debt-equity ratio of less than one. By any standard such a low gearing as a precondition is not justified. Even under the Companies Act, for permitting the buyback of shares the maximum debt-equity ratio allowed is 2:1.
The RBI should reconsider this requirement and bring this precondition in line with Companies Act regulation for buyback of shares. Else, many companies will not be able utilise this opportunity.