Mumbai: In what comes as relief for the private equity industry, the foreign direct investment (FDI) policy unveiled by the Department of Industrial Policy and Promotion (DIPP) on Thursday brought out a clear picture on convertible instrument prices.
DIPP said companies would now have the option of prescribing a conversion formula, instead of specifying the price of convertible instruments. Last year’s policy, which said the conversion ratio should be specified upfront, led to a delay in the flow of private equity deals, in which most of the prices of convertible instruments were decided during conversion, not upfront.
Convertible instruments offer an investor the choice of whether or not to convert on a specified future date. The instruments include compulsory convertible preference shares (CCPS) and compulsory convertible debentures (CCDs).
According to the DIPP circular, “Instead of specifying the price of convertible instruments upfront, companies will now have the option of prescribing a conversion formula, subject to the Foreign Exchange Management Act and Securities and Exchange Board of India guidelines on pricing. This would help the recipient companies obtain better valuations, based on their performance.”
In January, Business Standard had reported that private equity/venture capital deals routed through CCPS or CCDs were delayed due to the ambiguity over the new policy introduced last year.
Mayank Rastogi, partner (private equity), Ernst & Young, said, “In a scenario in which the instrument is issued with a determined ‘conversion formula’, the actual conversion price should not be lower than the price worked out according to the relevant guidelines at the time of ‘issuance’ of the instrument.” As a result, a rise in performance would enable Indian companies to issue shares at a higher conversion price, thus benefiting the company and the promoters. On the other hand, if there is a decrease in the valuation, foreign investors will not benefit as much, since the conversion price will be locked on the minimum price determined, based on the discounted cash flow (DCF) at the time of issuing the convertible instrument, Rastogi said.
According to the DIPP and the commerce ministry circular dated March 31, 2010, the pricing of all convertible instruments issued to offshore investors must be carried out at the time of issuance, without leaving any room for adjustment at the time of conversion. This would be applicable even if the pricing complies with the applicable pricing guidelines.
Roshan Thomas, partner, Lexygen, said, “There was an ambiguity regarding the requirement of determining an ‘upfront price’ for convertible instruments and whether it meant a numerical conversion price had to be agreed upon, or whether a conversion formula would suffice. As convertible securities are probably the most efficient method to affect valuation adjustments, this would be a welcome move for the investment community...Thursday, DIPP has clarified that the parties are free to either agree on a numerical price or a conversion formula, as long as the price at which the conversion takes place is not less than the floor price prescribed by RBI’s pricing guidelines,” he added.
“While there have been a few deals over the course of last year that involved convertible securities, the risk that regulators saw in numerical conversion prices being fixed upfront, had led to waning interest in convertible securities. This clarification will now help provide valuation adjustments in an uncomplicated, logical, transparent, and enforceable manner, ” Thomas said.
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