TATA Steel and Corus Deal - Looking at Debt instruments
Posted in Finance Articles, Total Reads: 3298
, Published on 19 March 2014
We do understand that there are certain occasions wherein firms cannot go for standard instruments/products to raise funds. For example there may be situations where existing shareholders of the firm may not be willing to dilute their ownership in the firm; hence the firm cannot issue more shares. Also existing lenders might not be willing to lend more money. In such situations, if the firm is short of cash, it generally goes for raising money through different financial instruments. Financial instruments these days are more than just raising funds for the firm. They are also a way for the firm to share their business risks with the lenders/buyers of the instrument.
Two very interesting cases come to my mind when I write this article:-
Macroni strategy: - There have been instances wherein several firms try to protect themselves from unwanted Mergers and Acquisitions. These firms create a lot of debt instruments with the clause that if an outside firm tries to acquire it, it would be required by the acquirer to give a high premium to the firm’s lender or redeem the lenders of the firm before acquiring or may be take the advice and consensus of the lenders before acquiring the firm. These clauses trigger during M&As and making the firm unattractive for acquisitions.
Another very interesting case comes from the oil sector. Firms like ONGC rely a lot on the price of crude oil. Wealth of the firm depends heavily on it. When the prices of crude oil go up, the wealth of the firm goes up and vice versa. Now there are other firms which process this crude oil to make petrochemical products. If the price of crude goes up, it seriously impacts the cash flows of the firm and brings down the value of the firm. If ONGC creates a crude oil index bond wherein they create a clause that when the prices of crude go up, they would be paying more coupon on the bond and vice versa. They will find buyers of this instrument in the firms which use this crude oil easily as when the prices go up these firms would be getting a high coupon which would mitigate their loss to some extent. In this way risk starts to evaporate from the system.
With this introduction about financial instruments, we shall now go into the acquisition of Corus by Tata Steel but before that I shall give a brief introduction of the two firms.
Tata Steel was originally incorporated as “The Tata Iron and Steel company Limited”, as a public limited company under the provisions of the Indian Companies Act 1882. The company manufactured a diversified portfolio of steel products, including flat and long products, as well as non-steel products like ferro alloys and minerals, tubes and bearings. The main markets included Indian construction and automotive industry.
Corus was formed by the merger of British Steel plc and Koninklijke Hoogovens N.V. The company prior to its acquisition was listed on the London Stock Exchange, New York Stock exchange. It had four operating systems; strip products, long products, distribution and building systems and aluminium. It had good distribution network in North America and Europe. It was the second largest steel producer in Europe and the ninth largest steel company in the world. The steel division of the company accounted for 91 percent of the total turnover of the company.
The UK panel on mergers announced the winning bid of Tata Steel of 608 pence per share of Corus. The total consideration for the acquisition worked out to around 6000 million Euros. Following the auction, Corus board unanimously recommended the offer of Tata Steel to the shareholders who gave their approval.
Convertible Alternative Reference Security (CARS)
The issue of US$ 725,000,000 in aggregate principal amount of one percent letter of credit backed Convertible Alternative Reference Security (CARS), due 2012, which would include any CARS issued pursuant to an option to increase the principal amount of the CARS up to an additional US$150,000,000 was authorised by a resolution passed by the BoD of Tata Steel. CARS was a variant of a standard International Convertible bond; among the typical features missing (from an Indian FCCB) was the call option to the issuer linked to the market price performance of the convert (the issuer did not have the right to call the bond under defined circumstances and effectively force conversion). The CARS issue was backed by an irrevocable letter of credit under a credit agreement entered between Standard Chartered and Tata Steel. It was issued in favour of the trustees for the benefit of the holders of the CARS.
CARS was required by Tata Steel to defer cash flows and also the fact that the rating agencies did not consider this instrument as a plain debt as these were convertible to shares at a later stage. It was therefore considered to be an Quassi equity instrument and the ratings of the company didn’t fall because of this.
Some of the features of CARS were:-
1) Provided coupon rate of 1%
2) The bond would be redeemed at 23% premium
3) Effective Yield was 5.15%
4) The provision of convertibility came into picture after 4 years and was open for only one year. This was different from the normal FCCB wherein call option was there with the firm (it could call back the instrument and convert it into shares and issue them or pay back cash to the investor). In this case one needed to wait for 4 years and only if the share prices were high and rising at that time would convert the bond into shares. At the time of purchasing CARs the market was bullish and people thought prices would continue to rise even after 4 years hence they purchased the bond.
5) The instrument was supported by Letter Credit and this attracted foreign lenders easily as backing an instrument by LC grades the instrument at A or AA.
6) Tata Steel being a Capex heavy company had a lot of operating leverage. When market goes into recession it becomes difficult to manage the operating leverage. With this instrument the company had the lenders also to partner with them and share the risk.
7) On conversion, voting rights were not given to the shareholders.
Valuation of the instrument:-
Convertible bonds have two parts in value:-
Value of plain bond+ value of convertible part
Value of plain bond comes out to be Rs 97,425
Convertibility gets estimated assuming call option. Convertible price quoted was Rs 876 i.e when the stock price increase beyond Rs 876 the lender will exercise conversion.
Value of underlying
Option price per CAR
Option value (derived using Black Scholes model)
Option value of CARs
Value of plain bond
Value of CARs
Since it is a case of deferred conversion, option value will not vary linearly with the underlying price.
The above calculations show that CARs was trading at a discount then and with a few more incentives interested the buyers to purchase the bond.
Then, the 2008 subprime crisis happened. With the collapse of marquee names such as Bear Stearns and Lehman Brothers, the Western world went into a tailspin. Automobile companies and construction companies, the main sectors affected in the financial crisis, were key customers of Corus. The company recorded a 23 per cent decline in Ebitda for 2008-09, followed by a $303 mn (Rs 1,361 crore) operating loss in 2009-10.
Tata steel thought Corus would do well and stock prices would go and they would not have to redeem debt. The investors would convert the bond into shares. Exactly the opposite happened and Tata Steel was asked for redemption of debt. The company already in a lot of cash crunch decided to postpone the date of payment of principal amount. This made the investors ask for more interest that previously decided.
The indenture provisions on a convertible bond are generally much more stringent than they are either in a short-term credit agreement or for common or preferred stock. Hence, the company may be subject to much more disturbing restrictions under a long-term debt arrangement than would be the case if it had borrowed on a short-term basis, or if it had issued common or preferred stock. Firms issue such financially engineered instruments keeping a rosy picture of the future economy in mind or considering that a period of recession will not arise soon. As we have seen in this case, such plans generally go for a toss leaving the firm with a lot of liquidity crunch and also bringing bad name to it.
Moreover sometimes the complexity of the instrument (or in other words when the buyers are not able to understand the clauses of the instrument completely) either he will refrain from buying the instrument or buy it at a higher coupon rate.
This article has been authored by Rahul Gupta from XLRI