The FCCB Trap

by Niranjan Rajadhyaksha/ BW

On 16 February 2006, Ranbaxy Laboratories raised $440 million from global investors through an issue of foreign currency convertible bonds (FCCBs). A little more than a month later, it used part of this money to acquire a 96.7 per cent stake in Terapia, the largest generics company in Romania. Other Indian companies, too, have been aggressive in the FCCB market. They have raised a total of $4.17 billion through FCCBs in the first 11 months of the previous financial year, making India the largest issuer of such convertible bonds in Asia.

FCCBs are bonds that give holders the option to convert them into equity at some future date, usually at a premium to the price of the company’s share at the time of the issue. IVRCL Infrastructures & Projects, for example, mopped up $65 million in December through an FCCB issue. Investors who have bought the bonds can convert them into equity at Rs 1,170 a share over the next five years, which was a 55 per cent premium on the quoted price that day (Rs 754.95).

The drop in stock prices has hit companies like IVRCL very hard. Its share was trading at Rs 248 when this article was being written. The conversion premium has jumped to an astonishing 371 per cent. In other words, the IVRCL share will have to go up by more than 4.5 times over the next five years before the FCCB investors can exercise their conversion option.

And what if the share does not reach these heights? The bonds will remain as pure debt on the IVRCL balance sheet. The last audited balance sheet of the company shows that the company’s net worth was Rs 257.64 crore and the total debt was Rs 247.17 crore. The leverage was a modest 1.08. Now, if the FCCBs are not converted into equity over the next five years, debt and leverage will double.

A senior official at a credit rating agency says that he is uncomfortable with the sort of debt that is being piled up by FCCB issuers: issuers are raising debts and pretending it is equity. Take a worst-case scenario and assume that Ranbaxy is unable to convert its debt into equity. Its balance sheet will not exactly be in tatters. The fact that Ranbaxy has used its foreign currency borrowing to buy a foreign asset also provides it with a natural hedge against currency movements. But the acquisition of Terapia could end up as a leveraged buyout if the share price does not rise beyond the conversion price of Rs 716.32 a share.

For those who think of this as just a pessimistic view, a reminder: IPCL was forced to redeem $176 million (Rs 860 crore at the exchange rate prevailing then) in March 2002 because they were never converted into shares. FCCBs were issued in February 1997, few months before commodity shares went into deep declines because of the Asian crisis. Companies who jumped onto the FCCB wagon in a hurry should pay heed to this.

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