Beginning of a Hybrid Era?
In March, Tata Steel attempted to raise Rs 1500 crore via a perpetual bond – the first time a non- banking, non-financial entity has attempted to do so. As an unlimited tenure bond issue it found favor only among insurance companies – LIC & ICICI Pru being the two investors and part of the issue had to be absorbed by the underwriters.
So, next month, when Tata Power decided to raise money, it gave the Perp a twist – and the resulting hybrid was oversubscribed more than 7 times. So is this the beginning of the hybrid era? Sajeet Manghat finds out
Banks have often raised Tier 1 capital via perpetual bonds – bonds of unlimited maturity, hence treated as equity, yet cheaper than equity and non-dilutive. But now, perps have made it from bank street to the heart of India Inc - Bombay House – and when Tata Steel’s perpetual experiment didn’t work so well, Tata Power gave the perp a twist. Tata Power’s wholly-owned foreign subsidiary- Bhira Investments- launched a hybrid-bond offering of 60 years in tenure and an 8.5% coupon rate, the $300 million book received a demand of $3.5 billion, prompting the company to raise the issue size by 50%.
Ravneet Gill, MD, Global Capital Markets, Deutsche Bank says, “As we saw in the case of Tata Power, the book was 8 times of what the issue size was and you know coming from almost 200 investors that there is a lot of investment appetite for an instrument of this nature. Also, I think, given the fact the yield on the hybrid is little higher than pure debt, there are high networth individuals, asset managers and other institutions which typically don’t subscribe to debt- who actually come in as investors-so it also I think expands the investor universe.”
A hybrid lies somewhere between a perp and a vanilla debt issue. Let’s take maturity for instance. While the tenure of domestic debt ranges from 5-7 years, External Commercial Borrowings or ECBs can go up to 10 years. On the other hand a perpetual bond- whether to Indian or foreign investors- doesn’t have defined maturity. With a more than 10-year tenure, the hybrid takes the middle path.
Ravneet Gill says, “Perp really deals with the maturity of the security while hybrid really deals with the nature of the securities. Perp, by definition, goes into perpetuity while hybrid is an instrument which has features of debt and equity rather than debt or equity.”
The other big advantage is that hybrids are treated as equity – yet are cheaper than equity. What that means is under Company Law, the hybrid will be accounted for as debt but because of some of its equity like features – such as long tenure- credit rating agencies would treat at least half the issue as equity.
Ganeshan Murugaiyan, MD & Head of Investment Banking India, UBS says, “We have done three hybrids in the region. In the case of two, the accounting treatment is that of equity. In the case of Tata Power, the accounting treatment is debt. It really depends upon the issuer on what their requirements are."
Ravneet Gill says, “Depending in terms of what the covenants are, what the period of security is, at what time it may get redeemed- so there are multiple factors that may go into providing equity credit by the rating agency.”
So the benefits of equity but nowhere as expensive; though pricier than debt! On an average, the cost of equity would range from 18-20%. A 5-year ECB is priced at approximately LIBOR + 300 basis points. A hybrid instrument would cost about 200 basis points more than that.
Ravneet Gill says “It reflects risk perception on an instrument like this- relative secured pure debt- given the fact that you are getting the equity like credit is reflective of the fact that you are getting equity like feature. The good thing is that you don’t end up paying equity like return for equity like features; it’s still lower than that."
An overseas hybrid is a tax efficient animal. For instance under Mauritius’ general tax laws, there is no withholding tax on principal, premium or interest paid to the bond holder. Add to that the tax deductibility on interest payments upon consolidation back home.
Ganeshan Murugaiyan says “Its really depends on the jurisdiction where the issuer entity is located and in most of the cases the hybrid is structured in a way you could get the full tax credit on the coupon payments.”
But this requires raising the money offshore and keeping it there. Repatriation would cost 20% withholding taxes. Plus there are end use restrictions.
Ravneet Gill says, "If you look at the large borrowing that has happened of this nature, it is either for funding offshore acquisition or refinancing offshore debt where the money does not come back and to that extent does not attract withholding tax. So, I think, that is the basic motivation."
Back to the Bhira Investments hybrid issue and its unique features
Though Tata power is rated, Bhira’s hybrid was not. But with Tata power offering a 200% guarantee subject to maximum $900 million, the issue found more takers than it needed.
And like most long tenure issues, this one too has step-up pricing i.e. 8.5% for the first 5 years, then a floating rate for 10% and a 100 basis point hike for the next 10 years.
The issuer has the option to buyback prematurely, at a predetermined time and rate
And in the case of financial trouble, there is some built in flexibility! The issuer can defer the interest payment, though it adds to the outstanding and a deferral invokes a dividend stopper clause i.e. no dividends to equity shareholders because after all hybrid holders rank higher than shareholders.
Ganeshan Murugaiyan says, “The coupon payment can be deferred; there are obviously some conditions that come along with the deferral of the coupons. The other feature is how you can redeem these bonds; there will be pre-defined criteria as to what kind of instruments you can use in order to redeem these bonds.”
Globally, hybrids are commonly used instruments and undergo continuous innovation. Issuers are usually companies with a degree of stability in cash flow – such as infrastructure, power & utility, roads and highways and the likes. The question is will hybrids become a rage in India? Tata Power has gotten off to a good start but the cap on pricing, repatriation issues mean it might just a be an instrument limited to finance global ambitions of Indian companies.