Pragmatic Pricing On Convertibles To Boost FDI.

The existing foreign direct investment (FDI) policy mandates foreign investors to determine the conversion price of convertible instruments upfront at the time of issue. However, the norm does not factor in commercial considerations of foreign investors using the FDI route to enter India.

This adversely impacts various private equity players because a significant number of deals in the private equity space are through convertible preference shares. It has also impacted the real estate sector where investments are through compulsorily convertible debentures. In cases where there was no consensus on valuation, foreign investors often invested in convertible instruments issued by Indian companies.

This option worked better since the price of conversion into equity of the investee company was then linked to the performance of the company. Convertibles provide immediate funding to the company and flexibility to the investor to convert or not to convert depending on the future performance of the company. In June 2007, the investments in optionally convertible instruments were taken off the FDI window and treated as external commercial borrowings. Despite the strengthening of FDI norms, foreign investors continued to invest in compulsorily convertible instruments as they could have the benefit of performancelinked pricing formula.

As with any foreign investment, investment in convertibles was also to be made at least at the floor price prescribed by Sebi/RBI. Till April 2010, different views prevailed on the cutoff date for the floor price - i.e., the date of issue or date of conversion or both. Since pricing was performance-based , the floor price on the date of conversion was most logical.

However, the FDI policy unveiled by the department of industrial policy and promotion ( DIPP )) in 2010 made it clear that the conversion ratio should be specified upfront. This means that the terms of issue of a convertible instrument should specify the number of equity shares the holder of the convertible instrument will get upon conversion. Simply put, foreign investors can no longer have the benefit of determining the price at which the instrument should be converted into equity based on the milestones achieved by the investee company.

Perhaps, the rationale behind the policy was that if the pricing is open-ended at the stage of issue, the investor need not take the risks of any upside or downside till the conversion. This means if the investee does not perform well once the convertible instrument is acquired by the foreign investor, the investor will get shares at a discounted rate and hence, would be protected from any downside risk.

While this could swing the other way too, the RBI did not consider this as the amendment was intended to bring the risk borne by the foreign investor on par with the risk borne by an ordinary shareholder. Such a move has, however, made convertible instruments far less attractive than equity shares. Further, the RBI was of the view that in case such formulabased pricing mechanism was preferred, then the investment should comply with the ECB policy as the instrument is akin to a debt instrument.

However, such aview is incorrect as the instrument issued is fully and mandatorily convertible into equity shares and no redemption is permissible unlike in case of ECB where the borrower, on maturity, has to repay the loan. The conversion price ideally ought to reflect the value of the investee company. When companies are at a nascent stage, it is often not possible to predict their true growth potential. The value hinges on the dynamics of the economy and the sector in which the company operates. Given the current policy, many private equity investors are reluctant to commit to a higher valuation sought by promoters.

Imposing the requirement to fix the conversion ratio upfront works as a double-edged sword. While in some cases, foreign investors may stand to loose and in some other, the promoters may also stand to loose as they may have to agree to a lower valuation upfront. In most such cases, the investee companies are at nascent stage and hence, have lower current value. So, the chances of the Indian promoters losing out are far more.

The government should, therefore, review the pricing of such convertible instruments as it has deterred many foreign investors from investing in India . Official estimates for 2011 show that FDI in India has dipped by approximately 23% from the previous year. At $16 billion (till December 2010), India definitely needs more foreign investment. A pragmatic approach towards pricing of convertible instruments could benefit the investee companies as well as the foreign investors and reignite the flow of FDI into the country.


Source : economictimes.indiatimes.com