DARE - Because Entrepreneurs Do

These are interesting times for emerging economies like India. For one, the combined effects of a controlled and cautious fiscal policy and a robust demand-driven domestic market have together ensured that the country has largely been able to ward the global meltdown off and that the growth trajectory,

from a long-term perspective at least, has not been dented. The Indian markets did balk under the twin effects of FII outflows (following the sub-prime havoc unleashed in the US) and fears of a slackening domestic and global demand, but like almost all other markets, they have come back smartly and are trading at levels that have the highs of January 2008 well within sight.

While analysts are divided on whether the markets are overpriced and if a 10-15 percent correction is imminent from the current 16000-17000 BSE levels, there is unanimity on the view that substantial amounts of foreign and domestic money is waiting in the wings looking to get into and tap the market. That said, what cannot be overlooked is the fact that the markets do remain volatile and the upsurge in the market and steps like bonus issues notwithstanding, most companies that have listed in the recent past have been trading at a discount. So, if you are a business looking to raise cash, should you consider tapping the open market through the IPO route? How well do the costs of raising money from, say, an IPO or a follow-on-offer, really match up with the alternatives like strategic partnering, debt financing or reverse mergers? DARE gives you some alternate routes to follow:

Why tap the primary market?
The fundamental premise behind raising cash is that you want to expand your business either in terms of diversifying or enhancing capacities or capabilities. The IPO route is not taken just with these ends in mind. Often, an IPO is also a way to unlock value, particularly for the promoter. That is, the promoter sells a part of his stake in the open market to realize in part the result of his efforts in building up the business. This article looks at alternatives to an IPO, purely from the viewpoint of raising finances to scale the business.

In a stable market, where stocks are valued fairly (or overvalued), it bodes well for a company to sell equity and raise cash by a primary issue of shares in the open market or a follow-on offer or a rights issue to existing shareholders. An IPO comes with its share of regulatory and statutory requirements that require considerable amount of effort and time before you can actually approach the market. In times like these, when markets are volatile, things may not run according to the script you had in mind at the time of deciding an IPO, at actual listing and beyond. Recently, stocks have even been listed on a discounted price and do not regain the allotment price for a sustained period of time after the IPO. This invariably hurts the investor confidence. Other than this, for a closely held private limited company, the IPO route might present some inherent limitations; one of which is that equity dilution into the open market can often become a one-way ticket and it may become difficult for a company to delist at a later date, if it achieves a certain scale and valuation by then.

Alternatives to tapping the open market
Strategic partnerships
This is a circuitous route to raising money, but may be the best option for an unlisted company if it wishes to avoid (unnecessary) public scrutiny. This typically involves partnering with one or more companies who are more than mere investors and have a long term interest in the entity. Such partnering institutions would be expected to infuse more than just cash. Often such institutions have core competencies that complement the core business of the entity they are investing into. Therefore such investors are typically not on the lookout for immediate returns on their investments and stay on with the investee for the long haul. Since this is typically a private arrangement entered into by two or more entities among themselves, there are no specific minimum provisions, such companies need to fulfill.

Qualified Institutional Placement (QIP)
This mechanism, open only to listed companies, was introduced by the market regulator Securities and Exchange Board of India (SEBI) in 2006, primarily as a means of dissuading Indian companies from accessing foreign funds from the American Depository Receipt (ADR) route, as it was seen as an avoidable export of domestic equity. Companies often find it easier to access foreign funds as over-regulation makes accessing the primary market for follow-on issue or rights issue tedious. Listed companies do not need any pre-placement clearances from the SEBI for the QIP; whereas the company is mandated to issue at least ten percent of the securities issued, with mutual funds. If the issue size is up to Rs 250 crores, it is mandatory to have at least two allottees and at least five allottees for issue sizes of over Rs 250 crores respectively. Under the QIP route, securities can be issued only to Qualified Institutional Buyers (QIBs), which are mandated as such by SEBI. Since its introduction, the QIP route has become the most preferred avenue for raising money in India (see table).

Private Placement of Stock and Bonds
This involves selling of securities or bonds to institutional investors like banks, hedge funds, insurance companies, etc. It does not require SEBI clearance as long as the transfer of equity is purely for investment and not for a resale thereafter, something that is usually specified in the investment agreement. The world over, this largely unregulated and faster route has become very popular for diluting equity to raise money without the need for accessing the primary market, which requires lengthy procedures and is much costlier as compared to private placement. Technically, this route is open to small investors as well, but the lack of regulation has largely kept them out. Often, smaller investing institutions and individuals do not have proper procedures in place for carrying out due diligence. This raises the risk of fraud occurring on account of omissions in disclosures and violations of terms of contract, something the small player is wary of. In both these cases, the state can step in to provide due protection by mandating public disclosure of information about private placements and by ensuring that the terms of contract are not violated by either party. Further, defaults on commercial paper issued by companies dent the creditworthiness of the overall corporate bond market.

Pledging of stock
Often, to raise funds for the company or for personal needs, promoters pledge a part of the company's stock held by them as collateral against loans from banks or non-banking financial institutions. This can be a risky proposition, especially in a bear market situation, when the price of the pledged stock goes below that at which it was pledged, which will provoke lenders to cover margins in cash or stock. If the promoter is unable to do so, the lender may resort to selling the stock in the open market, which will further depress its market value, thus aggravating the pain for an already beleaguered company and its shareholders. Hence, in the shareholder interest, the promoters should refrain from pledging stock.

Debt financing
a) Corporate Bonds
These are long-term debt instruments and can be secured (collateralized) or unsecured, with maturity periods usually over a year. Bonds of shorter duration are called 'commercial paper' in business parlance. These bonds are mostly traded over the counter in dealer-based markets. Often, corporate bonds come with a call option which allows early maturity at a reduced yield or are convertible into equity, upon maturity. Further innovative offerings like floating rate instruments, convertible bonds and step-redemption bonds have made the corporate bond market vibrant. Traditionally, in a developing market, the equity segment grows much faster than the debt segment. Whereas nearly half the global corporate bond market is US-based; in India, the corporate bond market is less than one percent of the total GDP.

b) Convertible and Non-Convertible Debentures
Debentures are debt instruments that obligate the borrowing company to pay back a certain maturity amount and are freely transferable. Debentures are often issued by well capitalized public limited companies that need to raise funds and can be converted to equity upon maturity. Such convertible debentures are often issued by companies to existing shareholders, while the non-convertible ones can be issued to non-shareholders as well.

c) Corporate Fixed Deposits
To meet short term requirement of funds, corporate houses can issue unsecured fixed deposits, which offer rates of higher returns than bank fixed deposits, for companies with lower creditworthiness offering higher rates. Usually, interest rates offered do not change during the period of deposit.

d) Loans
Loans are still the most preferred methods of raising funds. The rates of interest for secured loans are usually lower as compared to the unsecured sort. The rates however depend on the prevailing market situation and the interest rate regime in vogue at any given point of time.

Reverse Mergers
Also called a "reverse IPO," it is the acquisition of a publicly listed company by a privately held company, in a bid to avoid the hassles of launching an IPO. This is done by reorganizing the capitalization of the privately held company. In other words, the privately held company invests into the publicly held company (which, in most cases is just a shell company), to such an extent, that the former effectively becomes the owner of the latter. The private company incorporates itself within or under the shell company and therefore, by default, becomes a listed entity, saving on the cost and procedural hassles of going public. A company can thus go public without raising additional capital and also hope to command a good price for a follow-on-offer in future. Moreover, market conditions per se have a minimal effect on the resulting entities, unlike in the case of IPOs. Also, since no underwriting institution is involved in the process, there is no risk of an underwriter pulling out of the process citing bad market conditions. One downside of this process can be that some shell companies might come with some 'historical baggage' in the form of disgruntled shareholders, who would however be in a minuscule minority. Their power will be further dumped down by the fact that consequent to a reverse stock split, their shareholding would be reduced.

Private Equity
In this, a private equity (PE) firm buys out a majority stake in an existing privately held company. What differentiates 'private equity investments' from 'venture capital' is that while in the former, a PE firm typically invests in a mature company, in the latter, the PE firm invests in a new or emerging business and does not usually take a majority stake. Typically, when a company does not desire a change in its ownership, a private equity fund steps in to help it with funds enough to facilitate its expansion plans by taking a minority stake in the company. Growth capital is also used to reduce the leverage (or debt) a company has on its balance sheets. A private equity firm could also invest in a company facing financial difficulty with a view to eventually buy it out or turn it around.

Private equity investments are done either through the leveraged buyout (LBO) route or through mezzanine capital. Other strategies include growth capital infusion and infusion of funds during distressed situations.

a) Leveraged Buyout (LBO)
In this, a financial leverage is used to buy out a business. Typically a private equity fund (which acts as a financial sponsor) raises a non-recourse debt (i.e. a debt collateralized against the physical assets of the company in which a controlling stake is being acquired) from a financial institution such as an investment bank and thereby hedges its risk. Only mature companies that generate operating profits are usually bought out using the LBO route. The amount used as a percentage of the total buyout price is a function of several factors that include the financial health of the buyout target, market conditions, interest costs and the ability of the company to cover the same and of course the willingness of the lenders to extend credit.

b) Mezzanine capital
It is often used to reduce the amount of equity capital needed to finance a leveraged buyout (LBO). This is high risk money typically given to smaller companies that cannot access the high-yield market.

Sale of surplus capital assets
Often companies have excess physical assets (especially real estate) that they can part ways with without affecting their operations. In this way, liquidating real estate becomes an excellent way to unlock value and generate working capital.

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