Investing strategies for high promoter pledged highly leveraged companies

The case of Arshiya International excellently covered by Punit Jain of Value Notes (http://www.valuenotes.com/Investment-Analysis/Arshiya-International-A-Collapsing-Star/180224/15530028.00/C)  showcases the perils of investing in innovative companies with great businesses, but which somehow are cash deficient and therefore highly leveraged. Arshiya was a pioneer in logistics parks, was even picked by Kotak as a possible multibagger for 2013, yet was hit by the vicious cycle of panic selling of pledged promoter holding. Other companies like Tulip Telecom, GTL Infrastructure/GTL Limited, Suzlon had faced the same cycle as below

1. Company has very good growth/business, becomes the darling of Dalal Street with high valuations
2. In quest to expand, burns cash flow and results in persistently negative free cash flow. However, analyst myopia on just profits ensures that EV/EBITDA type multiples inflate the valuation, without any downward risk adjustment for leverage.
3. Funding gap(negative FCF means that funding gap should be met through fresh financing) usually through debt, since 'pecking order' theory(tax arbitrage, control issues) and reluctance of promoters to give up stake in growing companies, rules out safer path of equity
4. Lenders may request promoters to pledge their shares in the company/and or give guarantee. At the high prevailing share prices, a lesser % of pledge may be required.
5. The bubble bursts through poor market sentiment/poor economic performance. Flight to safety happens with investors going to 'safe' stocks like FMCG/Pharma that actually generate free cash flow. Market Valuations of the leveraged companies dip
6. The Mark to Market(MTM) valuations of pledged collaterals begin to touch levels exceeding the haircut/margin of safety. Lenders ask for 'top-up' in collateral
7. Company tries to refinance the loans-approach suppliers/vendors/NBFCs etc in most cases it is just deferring the problem. Sometimes it works(like RCOM got loans from Chinese banks), or else rights issue opted for(like how Dish TV did in 2009)
8. Promoters try negotiating lower top-up, till then market gets rumours/bear cartel attacks the shares and stock starts hitting lower circuits. Lenders decide to cut their losses and sell the shares at a loss
9. Promoters sue the lenders for breach of trust/selling the family silver and matter goes to courts. Company lands up in CDR(Corporate Debt restructuring)
10. CDR compensates the promoters/lenders by issuing shares almost at par! Everyone is happy except the minority shareholders  who do not get chance to rights issue(since preferential allotment done)

Business Today suggests(http://businesstoday.intoday.in/story/invest-companies-fccbs-due-redemption-caution-returns/1/21869.html) looking at the re-financing ability of the company-reputed companies and/or asset rich companies may still get secured financing and exit CDR/pledge status. Also, robustness of business model matters in case companies exit. Some pointers before investing for speculative gains in these shares

1. Evaluate refinancing options-this may stop the cycle at Step 7 instead of going the whole way
2. Compare with industry parameters, if EV/EBITDA or P/B multiples are dramatically lower, a white knight/takeover offer may arise as happened with Everonn.
3. Be willing to remain for a long time, but then you may get a Wockhardt! 

Corporate Debt Restructuring(CDR)-a primer on how it affects share prices

Kingfisher Airlines, GTL Limited, GTL Infrastructure, Vishal Retail(now renamed V2), Suzlon, India Cements, Jindal Steel-what is common to these disparate stocks? In the recent past, their share prices all shot up after there were rumours of their onerous debt being restructured under the CDR mechanism. Ordinarily, those unable to repay their debt when due are adjudged commercially bankrupt and can be forced into insolvency. But for companies with operating profits and significant intangible assets/reputation capital, such liquidation can destroy a large chunk of the company. Also, India's legal system is not too fast, and although SARFAESI and other acts do exist, they also take their own time.

Hence, lenders may prefer taking control of the company and sacrificing some interest/debt to ensure that they atleast get back something. Although common stock holders are last in line and would realistically earn zero in liquidation, CDR buys them time for the company to turnaround and for the common stock to carry some value. 'Time is money'-this adage is true for equity owners when CDR is enforced on the company. But investors should not impulsively react on the rumours of a CDR, but should note the following points and get extra information before they respond. This presentation by CA Rajesh Chaturvedi given at WIRC in Feb12 is very useful(http://www.wirc-icai.org/material/Final-CDR-presentation-03022012.pdf) and I suggest people read this carefully as well.

1. Does it involve writeoff/deferment of interest or debt? These are equivalent in NPV terms, but often come with added riders like lookback options if company recovers etc. 
2. Is debt converted into equity-if so at what price? Usually, SEBI ICDR norms mandate pricing of such conversion as if it was a preferential allotment(so last 6months/last 2 week pricing etc). Hence, it usually being at a premium to the market price by force, market should not interpret as lender's faith in the company, but rather that they had no choice to fix the equity price..
3. Does the promoter infuse more funds besides sharing sacrifice? Especially in case of promoters with large personal wealth like say Vijay Mallaya, investors may want to see whether they walk the talk by infusing equity as well into the company, or whether they just want others to take a loss without themselves contributing. This is a powerful signal/information source for the market. 
4. History of the firm with earlier CDR/restructuring:-While this data should have been seen earlier, investors who invest purely based on past 2-3yrs annual reports may have missed out on earlier near-death experiences. Hence, looking back into history with Google News would add that layer of judgement on whether past performance can back the future recovery. Firms like Suzlon/Kingfisher Airlines/Essar group companies with repeated distress may fail this test
5. Are lenders holding=>75% willing to go for CDR? The balance sheet would usually indicate lender wise breakdown. If some lenders(especially foreign banks) have other exposure to CDS/equity/FCCBs, they may have conflicting interests which may delay CDR. 
6. RBI Guidelines affect the potential upside of the shareholders due to following norms
1. Unit should be viable within 7yrs/10yrs(in case of infra) quite obvious else not worth it..
2. Promoter’s sacrifice and additional funds brought by them should be minimum of 15% of the banks’ sacrifice(but what if the debt equity ratio is more..)
3. Personal Guarantee is offered by the promoter except when the unit is affected by the external factors pertaining to the economy and industry(isn't this always the case!!)

The above points will hopefully help investors evaluate the realism of the CDR proposals, and the chances of their upside. Usually, a CDR with only bank sacrifice/ without any added infusion by promoter, is not aligning the incentives of both parties. Also, do not go by rumours till the formal proposal is put up to the board. But ceteris paribus, CDR would cause the share prices to shoot up, but investors should still do their own fundamental analysis and downside analysis before investing

GTL debt restructuring analysis-investors still at risk

When the GTL debt restructuring was announced, the GTL stocks had rose around 20%-40% in anticipation of a sweetheart deal and some opportunity for equity holders to salvage something. But the debt restructuring details contained in the postal ballots(http://www.moneycontrol.com/livefeed_pdf/Feb2012/GTL_Ltd_160212.pdf and http://www.moneycontrol.com/livefeed_pdf/Feb2012/GTL_Infrastructure_Ltd_160212.pdf) do not inspire much confidence for equity investors to accumulate their position. My reasons for stating this are given below.

1. GTL Infra has outstanding FCCBs of $228MM, redeemable @40% premium in Nov,2012. Though the company is in talks with the holders to restructure those FCCBs, the outcome would merely mean significant dilution given that the conversion price is far above the existing market price. Of course, since the banks have agreed to convert 25% of their debt into equity, the FCCB holders may follow suit but I would not bet on it. 
2. The banks have a conversion option on their debt in case GTL Infra/GTL Limited default on the repayment as per CDR LoA. This increases dilution risk, and it is not very clear whether SEBI will allow favourable pricing to the banks in future. This would lower the potential upside for the stockholders, as banks would prefer conversion later on. We need more clarity on this.
3. Dilution is significant under the CDR. I applied the pricing as per the SEBI ICDR Regulations 2009, and my estimate came to Rs 11.8 for GTL Infra, and Rs 53 for GTL Ltd taking the stated record date. I assumed that the conversion price would be same for the next two tranches BUT since that is taken on trailing six months basis as per SEBI norms, it may be higher(thus reducing dilution later). But banks seem to have wanted maximum conversion upfront under the existing lower prices. Interestingly, even the market seems to have converged to that price, but the shares increase alone will be around 70%-100% for both companies, diluting existing shareholders.
4. 
5. GTL/GTL Infra have, in anticipation of the CDR, reversed certain interest expense and charges, thus making credit analysis tougher and complicated. 
6. As if the holding structure was not tough already, the GTL promoter got back his shares from ICICI in return for some debt returning to CNIL's books. This really complicates further analysis till a balance sheet is available, which would take till June at the bare minimum. If only proforma balance sheets were mandated by SEBI!

Hence, due to the complexity of the whole deal and the limited upside(read my earlier posts on GTL group companies where I felt it was fairly valued), investors can seek better opportunities.