4. raising finance from international markets

Investment Banking

4. Raising Finance from International Markets

[email protected], Phone: 40434399

Course Content - Syllabus

Ch. Title Book Reference

1 Introduction to Investment Banking ICMR Ch. 6, Subra Ch. 6, 8, 9

2 Financial Markets ICMR 3,4, Subra 1,2, Bhole 16,17,19,22

3 Merchant Banking ICMR 6, Subra 4,5,7,10, Gurusamy 1,2,4,5,6

4 Raising Finance from International Markets ICMR 7, Subra 2, 4, 5

5 Corporate Restructuring (Numericals)

6 Corporate Valuation (Numericals)

7 Financial Engineering

8 Financial Bubbles, Scams and Crisis

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Books

1. Investment Banking & Financial Services, ICMR Book

2. Investment Banking: Concepts, Analysis and Cases,

Pratap G Subramanyam

3. Capital Market Management, V. A. Avadhani, Himalaya

Publishing House

4. Merchant Banking and Financial Services, S. Gurusamy

5. Financial Institutions and Markets, L. M. Bhole, Tata

McGraw Hill

6. Manual of SEBI: Guidelines…, Nabhi Publications

7. A Manual of Merchant Banking, J. C. Verma, Bharat Law

House

Syllabus – Merchant Banking

1. Intermediaries

2. Euro-dollar Market

3. Instrument – ADR / GDR

4. FCCB

5. ECB – Regulatory Aspects

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Introduction

Figure below shows various sources of external finance and

various channels for accessing these funds.

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IMFIFCADB

Country FundsGlobal Mutual Funds

Pension FundsCommercial Banks etc.

Money Markets

Surplus Units

International Financial Markets

Capital Markets

Deficit Units

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Introduction

Prefix ‘Euro’ implies that these transactions originated in

Europe, mainly in London, but later on expanding to far

east, to Hong Kong and Singapore. At present, more than

half of the transactions in Euro markets take place outside

Europe.

During 1970s, removal of exchange controls by UK, France

and Japan gave a boost to financial markets. Application of

new technologies to financial services, institutionalization

of savings and deregulation of markets have channelized

funds from surplus units to deficit units across globe. The

markets are classified into Euro markets, American

markets and other foreign markets.

Introduction

Various instruments used to raise funds abroad include

equity, debt or hybrid instruments. Following figure shows

the types of instruments in International markets

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International Capital Markets

International Bond Market

ADRIDREDR

International Equity Market

Foreign Equity Euro Equity

Yankee BondsSamurai BondsBulldog Bonds

GDR

Foreign Bonds

Euro/DollarEuro/YenEuro/Pounds

Euro Bonds

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Introduction

Debt InstrumentsInternational bonds are classified into two categories:1. Foreign Bonds: These are the bonds floated in the domestic market denominated in domestic currency by non-resident entities. Dollar denominated bonds issued in US domestic markets by non-US companies are known as Yankee Bonds, Yen denominated bonds issued in Japanese domestic market by non-Japanese companies are known as Samurai Bonds. Pound denominated bonds issued in UK by non-UK companies are known as Bulldog Bonds.2. Eurobonds: Dollars that used outside US are called as Eurodollars. Here, the term Euro signifies a currency outside its home country.

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Introduction

The term Eurobonds thus refer to bonds issued and sold

outside the home country of the currency. For example, a

dollar denominated bond issued in the UK is a Euro

(dollar) bond. Similarly a Yen denominated bond issued in

the US is a Euro (Yen) bond.

The borrowings in the international capital markets are in

the form of Euro Loans for medium-term and long-term

funds. Syndicated loans, called as Eurocredit have a wide

network of banks participating over the globe. Typically,

syndicated loans are available for three to seven years.

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Introduction

Equity Instruments

Equity issues from developing countries, able to access

international equity markets through the issue of an

intermediate instrument called ‘Depository Receipts.’

Depository Receipt (DR) is a negotiable certificate issued

by a depository bank which represents shares issued by a

company. These shares are deposited with a local

custodian, which issues receipts against the deposit of

shares. DRs are of three types:

Global Depository Receipts (GDRs)

American Depository Receipts (ADRs)

International Depository Receipts (IDRs).

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Introduction

Quasi Instruments or Hybrid Instruments

These instruments are debt instruments for a time-frame

and are converted into equity at a option of investor or

company, after a expiry. These are warrants, Foreign

Currency Convertible Bonds (FCCBs) etc. Warrants are

issued with debt instruments as a sweeteners.

FCCBs have a fixed coupon rate with a legal payment

obligation. They have greater flexibility with the

conversion option to equity at the option of an investor.

Euro Convertible Bond is issued for investment in Europe,

which provides an option to convert to equity.

1. Intermediaries

Intermediaries in international Capital Markets include:1. Lead and co-managers: Responsibilities of a lead manager

include undertaking due diligence and preparing the offer circular, marketing the issues including arranging the road-shows. Lead manager sometimes in consultation with the issuer, can choose to invite a syndicate of investment banks to buy some of the Bonds/DRs and help sell the reminder to other investors. Co-managers are thus invited to join the deal to sell to their investor clients. Quite often there will be more than one lead managers. One of the lead manager will ‘run the books’ for the issue, involves arranging the whole issue, sending out invitation letters, allotting Bonds/DRs etc. 12 / 55

1. Intermediaries

2. Underwriters: Lead manager(s) and co-managers act as

underwriters for the issue, taking on the risk of interest

rates/markets moving against them before they have

placed Bonds/DRs. Lead manager(s) may also invite

additional investment banks to act as sub-underwriters.

Third group of investment banks may also be invited to

join the issue as members of selling group and they receive

a commission in respect of any Bonds/DRs sold. The co-

managers and the underwriters are also members of the

selling group.13 / 55

1. Intermediaries

3. Agents and Trustees: These intermediaries are involved in

the issue of bonds/convertibles. The issuer of

bonds/convertibles, in association with the lead manager,

must appoint ‘paying agents’ in different financial centers,

who will arrange for the payment of interest and principal

due to investors under the terms of the issue. These paying

agents will be banks.

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1. Intermediaries

4. Lawyers and Auditors: Lead manager will appoint a prominent firm of solicitors to draw up documentations for Bonds/DRs issue. Various draft documents will be scrutinized by lawyers, each needs to be reviewed carefully to ensure that all parties are satisfied with the wording. The issuer will also appoint legal advisors to seek advice on matters pertaining to Indian/English/American law and to comment on necessary legal documentation. Auditors or reporting accountants will become involved, supplying financial information, summaries and an audit report which will be incorporated into the offering circular. The auditors provide comfort letters to the lead manager on the financial health of the issuer. They also provide a statement of difference between the US/UK and the Indian GAAP in case of GDR issue. 15 / 55

1. Intermediaries

5. Listing Agents and Stock Exchanges: Listing agents helps

facilitating the documentation and listing process for

listing on stock exchanges and keeps on file information

regarding the issuer such as Annual Reports, Articles of

Association, the Depository Agreements etc.

Stock Exchange (Luxembourg/London/AMEX/NYSE as

the case may be) reviews the issuers’ application for listing

of the Bonds/DRs and provides comments on offering

circular prior to accepting the securities for listing.16 / 55

1. Intermediaries

6. Depository Bank: is involved only in the issue of DRs. It is responsible for issuing the actual DRs, disseminating information from the issuer to the DR-holders, paying any dividends or other distributions and facilitating the exchange of DRs into underlying shares when presented for redemption.

7. Custodian: The custodian holds the shares underlying DRs on behalf of the Depository and is responsible for collecting rupee dividends on the underlying shares and repatriation of the same to the Depository in US dollars/foreign currency.

8. Printers: are responsible for printing and delivery of the preliminary and final offering circulars as well as the DRs/Bond certificates. 17 / 55


Eurodollars are bank deposit liabilities denominated in US

dollars but not subject to US banking regulations. Banks

that offered Eurodollar deposits are located outside US,

mostly in Europe (hence the name Eurodollars) and Far

East Asia. However since 1980s, non-US residents have

been able to conduct business, free of US banking

regulations at International Banking Facilities (IBFs) in

the US.

Eurodollar deposits may be owned by individuals,

corporations or governments from anywhere in the world,

with the exception that only non-US residents can hold

deposits at IBFs. 18 / 55


Originally, dollar-denominated deposits, not subject to US banking regulations were held almost exclusively in Europe, hence named as Eurodollars. Most of these deposits are still held in Europe and in such places as the Bahamas, Bahrain, Canada, Cayman Islands, Hong Kong, Japan, Netherlands, Panamas and Singapore. Regardless of where they are held, such deposits are referred as Eurodollar deposits.

Bank I the Eurodollar market, including US IBFs, compete with banks in the US to attract dollar-denominated funds. Since the Eurodollar market is relatively free of regulation, banks in the Eurodollar market are able to operate on narrower margins or spreads between dollar borrowing and lending rates than those in the US. 19 / 55


This gives Eurodollar deposits an advantage relative to

deposits issued by banks operating under US regulation.

The Eurodollar market has grown largely as a means of

avoiding the regulatory costs involved in dollar-

denominated financial intermediation.

Size of the Eurodollar Market: Eurodollar volume is

measured as the dollar-denominated deposit liabilities of

banks located outside the US. Sum of all dollar-

denominated liabilities of banks outside US measures the

gross size of the Eurodollar market. To construct the net

size measure, deposits owned by banks in the Eurodollar

market are netted out. 20 / 55


Incentives for Development of the Eurodollar Market

Banks may avoid some US banking regulations by

accepting dollar-denominated deposits and making loans

outside the US and at US IBFs. For example, banks

located outside US do not have to hold reserves against

their dollar-denominated deposits.

Regulatory initiatives such as stricter capital standards,

higher deposit insurance premiums and more intense

supervisory scrutiny have raised the cost of depository

intermediation in the US.

Eurodollar banks hold balances with the banks in US for

clearing purpose only and avoid reserve requirements. 21 / 55


There is no deposit insurance assessment on Eurodollars. Although stricter capital standards have been imposed internationally, regulatory cost of depository in US remains higher than in the Eurodollar market. Entry into Eurodollar banking is virtually free of regulatory impediments/requirements and banks set-up in locations where tax rates are low. Foreign monetary authorities are reluctant to regulate Eurodollar business, because by doing so, business would be driven away, denying the host country income, tax revenues and jobs. Competition for Eurodollar business has been fierce, so even if US wish to regulate Eurodollar business, it would be extremely difficult to impose regulations on the entire Eurodollar market. 22 / 55


Financial Instruments in the Eurodollar Market

Majority of the money in the Eurodollar market is held in

fixed-rate Time Deposits (TDs). The maturities range from

overnight to several years. Bulk of Eurodollar TDs are

inter-bank liabilities.

Eurodollar Certificate of Deposit (CD) is an important

Eurodollar instrument. An active secondary market allows

investors to sell Eurodollar CDs before the deposits

mature.

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Advent of GDRs in India has been mainly due to the balance

of payment crisis in year 1991. At that time, India did not

have enough foreign exchange to meet the requirements of

a fortnight’s imports. International institutions were not

willing to lend because of non-investment credit rating of

India. Out of compulsions, accepting the World Bank

suggestions, the government gave the permission to allow

private corporates to raise funds in international capital

markets through equity or equity related instruments. The

companies were asked to get their own foreign currencies

which led to the advent of the GDRs. 24 / 55


The instrumentGDRs are essentially those instruments which possess a certain number of underlying shares in the custodial domestic bank of the company. GDR is a negotiable instrument which represents publicly traded local-currency-equity share.By the law, a GDR is any instrument in the form of a depository receipt or certificate created by the Overseas Depository Bank outside India and issued to non-resident investors against the issue of ordinary shares or foreign currency convertible bonds of the issuing company. Usually, GDR is denominated in US dollars whereas underlying shares are in local currency of the issuer. 25 / 55


GDRs may be, at the request of an investor, converted into

equity shares by cancellation of them. GDRs are

considered as common equity of the issuing company and

are entitled to dividends and voting rights. The company

transacts with only one entity – the Overseas Depository.

Issuance of GDR

Following activities are involved during issuance of GDRs.

1. Shareholder approval needed

2. Appointment of Lead Manager

3. Finalization of Issue Structure

The company should obtain the final approval from the

government. 26 / 55


Company should furnish the information about the entities

involved in the GDR issue and the following parameters to

the government. Lead Manager and Co-lead Manager Currency Issue Price (approximate range in case of GDR) Form and Denomination Negative pledge provisions Taxation Commissions Reimbursable expenses Governing Laws 27 / 55


Overseas Depository Institution Indian Custodian Issue Structure and denomination of underlying shares Issue amount Green Shoe option (right to sell more shares) Warrants attached, if any Listing modalities Selling commission and Underwriting commission Legal expenses, printing expenses, depository fees etc. Taxation procedure

The government will give a final approval for the issue, if

satisfied. 28 / 55


The Documentation

Documentation for Euro equities is a complex and

elaborate process of GDR issue. A typical Euro-issue

requires following main documents Prospectus Depository agreement Custodian agreement Subscription agreement Trust deed Paying and conversion agency agreement Underwriting agreement and Listing agreement 29 / 55


The Launch

Two approaches for launching are Euro-equity

Syndication and Segmented Syndication. Euro-equity

syndication attempts to group together the placement

strengths of the intermediaries. Segmented syndication

forms a geographically targeted syndicate structure to

achieve broader distribution of paper.

Marketing

A judicious mix of financials and marketing help better.

Most of the marketing activities are handled by the lead

manager in consonance with the advertising agencies.

Road show form a predominant facet of the launch of any

GDR.30 / 55


These are face to face presentations with fund managers

and analysts. These are normally conducted at the

financial centers like London, New York, Boston, Los

Angeles, Paris, Geneva, Hong Kong etc. The price that is

preferred is noted by the book-runner during

presentations / road shows and the eventual price, in favor

of the fund manager is finalized.

Pricing and Closing: The price is determined after the

underwriters’ response and the response may be drawn.

The final price is determined after the book runner closes

the books after the road shows. A tombstone

advertisement will be issued and GDRs will be listed. 31 / 55


Costs

The cost incurred by the company is proportional to the

issue size. The lead manager takes the lion’s share in the

issue expenses. Cost incurred on marketing is fast

increasing. Other expenses include printing costs,

accounting fees, listing fees, road show expenses etc.

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ADRs

ADR is a dollar denominated negotiable certificate, it

represents a non-US company’s publicly traded equity. It

was devised in late 1920s to help American investors to

invest in overseas securities and to assist non-US

companies to have their stock traded in the American

market. ADRs are divided into 3 levels based on the

regulation and privilege of each company’s issue.

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1. ADR Level-I: It is often the first step for an issuer into the US public equity market. Issuer can enlarge the market for existing shares and thus diversify the investor base. In this instrument only minimum disclosure is required to the SEC and the issuer need not comply with the US GAAP. This type of instrument is traded in the US OTC market. The issuer is not allowed to raise fresh capital or list on any one of the national stock exchanges.

2. ADR Level-II: Through this level, company can enlarge the investor base for existing shares to a greater extent. However, significant disclosures have to be made to SEC. The company is allowed to list in the American Stock Exchange (AMEX) or New York Stock Exchange (NYSE).

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1. ADR Level-III: This level of ADR is used for raising fresh

capital through public offering in the US Capital Markets.

The company has to be registered with the SEC and

comply with the listing requirements of AMEX/NYSE

while following the US GAAP.

Intermediaries for ADR issue perform the same work as like

GDR issue. Additionally, the intermediaries involved will

liaison with the QIBs for investing in ADRs. Some of the

well known intermediaries for ADRs/GDRs are Merrill

Lynch, Goldman Sachs, JP Morgan etc. The regulatory

framework for the ADRs is provided by SEC.

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4. FCCB

A Foreign Currency Convertible Bond (FCCB) is a convertible bond issued in a foreign currency i.e. different than the domestic currency. In other words, it is used to raise the finance in foreign currency. FCCB is a hybrid instrument between bond and equity. It acts like a bond by making regular coupon and principal payments and also give the option to convert into the stock.

Indian companies have been using FCCBs as a major source of finance-raising tool for meeting its capex requirement at competitive rates. The quality of Indian paper has also gained widespread International acceptability. FCCB are also referred as FCCN (Foreign Currency Convertible Notes) by some issuers. 36 / 55

4. FCCB

The investors receive the guaranteed payments on the bond

and are also able to take advantage of any large price

appreciation in the company's stock. Bondholders take

advantage of this appreciation by means warrants

attached to the bonds, which are activated when the price

of the stock reaches a certain point. Due to the equity side

of the bond, which adds value, the coupon payments on

the bond are lower for the company, thereby reducing its

debt-financing costs. So these bonds are beneficial to both,

the issuer and the investors. The issuers of FCCBs are

companies, banks, governments and other sovereign

entities may issue bonds in foreign currencies. 37 / 55

4. FCCB

Features of FCCBs FCCB is issued as interest bearing or zero coupon bonds

and are convertible during their tenure into equity. FCCB issues have call and put option to suit the structure

of the Bond. A call option entitles the issuer to call the loan

and make an early redemption. On the other hand, a put

option entitles the lender to exercise the option to convert

the FCCB into equity. FCCB are generally issued by companies, which have high

promoter shareholding and hence do not perceive any risk

of losing management control even after exercise of

conversion option. 38 / 55

4. FCCB

For FCCB issue, automatic route is available to real sector

i.e. industrial sector, specially infrastructure sector in

India, while all other sectors have to take RBI approval. In India, FCCB are treated as Foreign Direct Investment

(FDI) and FCCB guidelines are liberalized from time to

time to give impetus to infrastructure development and

expansion plans of corporate India. In India, FCCB are issued in accordance with guidelines

and regulations framed under FEMA Act by the RBI and

schemes notified by the Ministry of Finance and must be

meeting the requirements of the ECB guidelines.39 / 55

4. FCCB

Yield to Maturity (YTM) in case of FCCBs normally

ranges from 2 % to 7 %. The foreign holders of FCCBs can trade the FCCB in part

or in full i.e. the holder can sell the debt part while holding

the option; or vice versa. While a credit rating of FCCB is not mandatory, since

they are mostly issued by top corporate having excellent

track record. However, rating definitely helps to price the

coupons competitively. FCCB carries fewer covenants (agreements) as compared

to a syndicated loans or debentures, hence these are more

convenient to raise funds. 40 / 55

4. FCCB

FCCB can be unsecured or secured, but in practice most

of the FCCB issued in India are unsecured (since they are

issued by top companies having excellent track record.) FCCBs shall be denominated in any freely convertible

foreign currency and the ordinary shares of issuing

company shall be in Indian rupees. FCCB issue proceeds need to confirm to ECB end use

requirements. In addition, 25% of the FCCB proceeds can

be used for general corporate restructuring. FCCB are generally listed to improve liquidity. Indian

issuer have listed FCCBs at Luxembourg Stock Exchange

and Singapore Stock Exchange. 41 / 55

4. FCCB

Advantages to issuers

It is a source of low-cost debt as coupon rates on the bond

are lower than the average lending rates, since it has a

convertible option

It may appear to be more stable and predictable than their

domestic currency

It gives issuers the ability to access investment capital

available in foreign markets

Companies can use the process to break into foreign

markets42 / 55

4. FCCB

The bond acts like both a debt and equity instrument.

Like bonds it makes regular coupon and principal

payments, but these bonds also give the bondholder the

option to convert the bond into stock It is a low cost debt as the interest rates given to FCC

Bonds are normally 30-50 percent lower than the market

rate because of its equity component Conversion of bonds into stocks takes place at a premium

price to market price. Conversion price is fixed when the bond is issued. So,

lower dilution of the company stocks43 / 55

4. FCCB

Benefits to investors

FCCBs bring the advantage of capital protection, by the

guaranteed payments on the bond, like any other debt

instrument and the chance on an appreciation in the price

of the company’s shares through conversion.

Redeemable at maturity if not converted

Easily marketable as investors enjoys option of conversion

in to equity if resulting to capital appreciation

44 / 55

4. FCCB

Disadvantages of FCCBs to the investors and companies Exchange risk is more in FCCBs as interest on bond

would be payable in foreign currency. Thus companies with low debt equity ratios, large Forex earnings potential only opted for FCCBs

FCCB means creation of more debt and a Forex outgo in terms of interest which is in foreign exchange

In case of FCCB, the interest rate is low (around 3 to 4%) but there is exchange risk on interest as well as principal if the bonds are not converted in to equity

If the stock price drops, investors will not go for conversion but redemption. So, companies have to refinance to fulfill the redemption promise which can hit earnings

It will remain as debt in the balance sheet until conversion.

4. FCCB

Taxation on FCCBs Until the conversion option is exercised, all the interest

payments on the FCCB is subject to deduction of tax at

source at the rate of 10% Tax exercised on dividend on the converted portion of the

FCCB is subject to tax deduction at source at the rate of

10% If FCCB is converted into shares it will not give rise to any

capital gains liable to income-tax in India If FCCB is transferred by a non-resident investor to

another non-resident investor it shall not give rise to any

capital gains liable to tax in India. 46 / 55

4. FCCB

Some of the Indian companies that raised FCCBs included Tata Motors Tata Chemicals Tata Power Tata Teleservices Jaiprakash Associates Bharat Forge Ballarpur Industries Reliance Energy Indian Hotels Bharti Tele Ashok Leyland and so on... 47 / 55

4. FCCB

Conclusion

FCCB is a good source of raising funds with minimum cost.

The procedural aspect is comparatively simple. The

company can raise loan without creating security on

assets. That is why most of the companies are opting to go

for FCCB, though the exchange risk is there.

48 / 55


External Commercial Borrowings (ECB) from the lenders and investors outside India, are permitted by the GOI as a source of finance for Indian companies for expansion of existing capacities and for fresh investments. ECBs occupy very important position as a source of funds for the companies. ECBs are defined to include commercial bank loans, buyers’ credit, suppliers’ credit, securitized instruments such as Floating Rate Notes and Fixed Rate Bonds etc., credit from official export credit agencies, foreign collaborators, foreign-equity holders, international capital markets and commercial borrowings from the private sector window of Multilateral Financial Institutions. However, offers from unrecognized sources will not be entertained. 49 / 55


Main objective of ECB guidelines is to

Keep borrowing maturities long

Keep borrowing costs low

Encourage infrastructure and

Export sector financing.

50 / 55


ECB Cap

With a view to manage the country’s external debt

prudently, the Finance Ministry sets an annual cap on the

total ECBs that Indian companies can access in a year.

ECB cap would be only in years of excess demand.

Government also puts restrictions on the maturity of the

borrowings to discourages very short term borrowings.

51 / 55


ECB Definition of Average Maturity

According to the Finance Ministry, ‘average maturity of

ECB is the weighted average of all disbursements taking

each disbursement individually and its period of retention.

52 / 55


ECB Guidelines Removal of the end-use restriction for corporate

investments in industrial sector especially infrastructure.

Money has to be parked abroad unless actually required.

Usual restrictions on ECB for investment in capital

market or in the real estate will, however continue. Eligibility: All corporates except banks, NBFCs and

financial institutions shall be eligible ECB borrowers.

However banks and financial institutions will be permitted

to the extent of their investments in the textile and steel

sector restructuring.53 / 55


Interest Rate Spreads: All ECBs shall be subject to the

following maximum spreads over six months LIBOR, for

the respective currency as:

◦ Average maturity of 3-5 years: 200 basis points

◦ More than 5 years of average maturity: 350 basis points Guarantee: Banks, FIs, NBFCs will not be able to provide

guarantee / letter of comfort etc. Procedure: All ECBs satisfying above criteria will be

under the auto route up to $20 million for ECBs between

3-5 years maturity and up to $500 million for ECBs

having maturity of more than 5 years. Other cases will be

decided by an Empowered Committee of the RBI. 54 / 55


End-uses of ECB for working capital, general corporate

purpose and repayment of existing Rupee loans are not

permitted. Maximum amount of ECB which can be raised by an

eligible borrower under the automatic route is $500

million or equivalent during a financial year. Compliance with ECB Guidelines: Primary responsibility

of a concerned borrower is to ensure that ECB raised /

utilized is as per RBI instructions and ECB Guidelines.

Any contradictions will be viewed seriously and may invite

penal action.

***** 55 / 55

4. raising finance from international markets

Documents