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NCDs: The New Favorite!

Published on Mon, Apr 28,2014 | 16:17, Updated at Mon, Apr 28 at 16:17Source : 

By: Raj Ramachandran, Partner, JSA

Funding transactions assume various structures, which are driven primarily by commercial terms and structured in accordance with applicable regulations. Traditionally, debentures and deposits have been key instruments for companies to raise funds when the nature of funding sought is debt and not equity. Debentures continue to remain relevant, despite the occasional hiccups, for the simple reason that they meet the requirement of both the financer as well as the borrower. Traditional financer mindset favours debentures being a simple debt (in some cases also secured), and the traditional borrower prefers it for the reason that there is no share in the capital or equity, which is considered precious.

While in the not so recent past, equity and equity linked instruments were generously given to one and all, what appears to have remained unchanged was the mindset. Equity was available to a third party only where risk capital was required.

The trend recently seems to have shifted to debentures again. There are a variety of reasons for this which comprise of a unique mix of favourable debt regulations, complex regulations governing equity and equity instruments and an unclear economic and policy framework.

Not linked to performance or valuation: Any debt availed is payable irrespective of the business condition and where debt is secured, the lender can even proceed to enforce the security. NCDs are allowed to be secured. Equity investments are unsecured, often linked to business performance and subject to valuation and other regulatory compliances, and hence lag behind as a choice of instrument.

Ease of payment: Parties are free to negotiate on the rate of interest payable on the NCD. This is typically also based on what the alternate funding option (perhaps equity) would entail vis a vis the borrower. The interest and other amounts payable can be from out of the cash flows or from other borrowings, and there is no requirement of profitability. Equity instruments/ convertibles however are typically subject to certain ceiling on dividend and interest, where the investor is a non-resident entity. Further, dividend on equity shares is payable subject to profits.

Transferability: NCDs have no lock in stipulated and are freely transferable. Typically, there is also a trustee in whose favour the security is created by the issuer and therefore irrespective of the holder, the security remains for the benefit of the debenture holders collectively. Equity instruments on the contrary suffer a lock in based on the sector of investment. Even where there is no sector specific lock in, as it currently stands, a put option exercisable in respect of an equity instrument is required to be held for minimum period of 1 year.

Liquidity: NCDs are typically listed and hence there is a market available to the holder. The debenture holder may therefore choose to liquidate a portion of or the entire holding. Equity instruments or convertibles are rarely in listed form and therefore not marketable. Typically there are also conditions on transfer, i.e. a right of first offer, right of first refusal, etc.

Ease of settlement: NCDs can be settled by redemption and the process can be completed with ease. Where payment is to be made to a holder of equity shares or convertibles, the modes are limited and the processes quite complex. While dividend can be paid on equity/ compulsorily convertible preference shares and interest on compulsorily convertible debentures, the principal amount of the contribution itself is difficult to be paid out. A buy back is a complex process and can take a few months. Where buy back is not possible, the promoter has to purchase the instruments to facilitate the exit.

Some conditions: Although for a foreign investor to be able to take the route of an NCD investment, a key requirement is to hold a registration as a foreign institutional investor (FII) or a sub-account FII, this route is still attractive. For the issuer, such registration also acts as a KYC on the quality of funds coming in. While previously, there was a lacuna in the debt regulations that required an FII to subscribe only to listed NCDs, the regulations have since been amended permitting an FII to subscribe to unlisted NCDs provided the NCDs are committed to be listed within 15 days of the investment. This perhaps is one of those rare instances where foreign funding can be secured by way of both immovable and movable assets. This becomes particularly relevant where funding is sought in sectors that are otherwise considered sensitive.

In fact, being an investment regulated under a separate schedule of the FEMA regulations governing inbound investments, even the conditionalities and other restrictions stipulated in the FDI policy for certain sectors are not considered applicable. 

In conclusion, it would appear that NCD is the instrument of choice. The equity/ risk capital is therefore being substituted with debt. In the larger interest of the economy, it is time that the regulations governing equity and equity instruments are simplified. Perhaps the announcement under the monetary policy is taking that step, but it needs to be encouraging enough considering the benefits that debt regulations already provide.


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