Sid Mehta’s view India’s ECM flight to quality

October 5th, 2020

The country is enjoying a record year in equity capital raising, built on rights issues by Reliance Industries and the country’s top banks. Behind the numbers, however, there are signs that the leaders will get stronger, while those behind may struggle.

India has suffered like few other countries under Covid-19. It has the second-highest number of cases, over five million, and the third-highest number of deaths, at least 82,000, in the world. The density of its population and the strain on its health services makes its outlook particularly tough.

The heavy burden of the pandemic had a pronounced effect on equity capital raising in the country: first shutting it down, then driving it to record levels in a matter of months. With $33 billion raised in the equity markets by early September, India has never seen anything to compare with it. “It’s been an exceptionally busy period in terms of capital raisings,” says Arvind Vashistha, head of equity capital markets for India at Citi. “The last time India raised this much capital in a year was in 2007.”

Since then the exchange rate has changed dramatically, from 45 to 50 rupees to the dollar in 2007 to around 75 today.“So in absolute INR [rupee] terms, India has raised record capital already,” Vashistha says. And that’s with several months of the calendar year still to go.

But the high volumes mask a striking underlying trend: almost all the issuance is from established names with strong track records and loyal institutional followings. Few smaller or lower-quality names have access to the market. The result is likely to be an environment in which the strong get stronger and the weak are in trouble.

The listing of Carlyle-backed SBI Cards in March – raising Rs103.5 billion ($1.4 billion) in a 20-times-covered deal for the State Bank of India’s credit card company – proved to be the last deal of its type for quite a while. Shortly afterwards, India went into lockdown and new issuance came to a halt. Things stayed that way until May, by which time two things had happened.

One was that banks, in particular, had realized that they really ought to raise capital. It wasn’t that they were in trouble yet, but, with a moratorium on loan repayments, the precise state of asset quality was unclear; so it was far better to get ahead of potential problems and raise money. Soon, Kotak Mahindra, ICICI, Yes Bank, Axis, HDFC and Punjab National Bank began preparing new raisings, mostly through the qualified institutional placement (QIP) route commonplace in India.

The second thing that happened was Reliance Industries’ decision that this was the right moment to launch the biggest rights issue in Indian history and the biggest by a non-financial anywhere in the world for a decade. Reliance, both as a corporate and in terms of this deal, is an outlier, but it had a considerable impact on the market regardless.

“Reliance Industries was a very unique transaction in many senses,” says V Jayasankar, senior executive director and head of equity capital markets at Kotak Investment Banking, which, with JM Financial, was joint global coordinator and lead manager at the head of a field of 13 book runners.

“It was primarily considered as an oil and chemicals company five to seven years ago,” he says. “Since then it has significantly transformed itself preparing for the digital age.”

This is most visible through subsidiary Jio Platforms, which owns India’s largest mobile network operator, Jio, as well as other digital businesses of Reliance. In the course of 2020, Jio has attracted investment from Facebook, Google, Qualcomm, Silver Lake Partners, KKR, Mudabala, Adia, TPG Capital and Saudi Arabia’s Public Investment Fund.

“It now derives substantial value from telecoms and retail/e-commerce businesses,” says Jayasankar. “The rights issue was carried out after Reliance took significant strides in its transformational journey.”

All told, by the time of its completion in early June, the rights issue had raised Rs531.2 billion, receiving commitments of over Rs840 billion. It was a distinctive deal: executed entirely online through a digital platform, because of the movement restrictions imposed by Covid, and structured as a partly-paid rights issue in which investors only had to pay one quarter of the cost up front, with their entitlements being tradable in their own right.

Existing investors proved loyal, either subscribing or buying up rights entitlements to boost their holdings. “The level of interest was across the board,” says Jayasankar. “There were two or three days when the volume of trading was higher in the rights entitlement segment than that of the underlying shares.”

Once in a decade
It showed that there was certainly money ready to invest in the right deals, Covid or no Covid.
But as the banks swiftly followed – Kotak Mahindra raising Rs74.4 billion in May, Yes Bank $2 billion equivalent in July, then Axis Bank, HDFC (Rs140 billion) and ICICI (Rs150 billion) within the space of two weeks in August – something else was becoming clear.

The ICICI, Kota and HDFC deals, for the strongest names in Indian financial services, flew
out of the door. “We saw best-in-class Indian banks – that have always traded at a meaningful
premium to global peers – raising money at historically cheap valuations,” says Vashistha at Citi. “Some large fund managers saw this as a once-in-a-decade buying opportunity.”

But Yes Bank, which was rescued by State Bank of India due to loan defaults earlier in the year, limped to the finish line, closing its share sale undersubscribed and just 0.93 times covered despite being launched at a 51% to 55% discount to the bank’s July 9 close. Bank employees,
for example, took up only one third of their entitlement.

The deal only reached its full amount because SBI Capital – owned by Yes’s now-largest shareholder, State Bank of India – had hard underwritten the deal and bought the
unsubscribed stock.

“There is a clear differentiation between banks,” says Abhinav Bharti, head of ECM at JP Morgan. “Those that are able to tell investors that they repaired their balance sheet pre-Covid and that their capital raising is for growth have received strong take-up, while those banks that have failed to address the quality of their assets are finding capital raising more challenging.”

This is not surprising. Financials have tended to account for 55% to 60% of new issuance over the last few years, so it’s no surprise that leaders in that sector should lead the issuance trend.
“It’s the large-cap, well-researched, liquid names that start the music – and the rest follow,” says Sachin Wagle, head of global capital markets at Morgan Stanley India.

Although this has been a characteristic of the pandemic, it is common of any period of disruption.“If you turn the clock back to demonetization or any of the other episodic events in India in recent years, it’s always the high-quality names who come first,” Wagle adds.

“The polarization-to-quality theme has always played out in India. If you look at the players who have gone out and raised capital, they have strong balance sheets as a starting point, no asset quality issues. They saw panic in the market and the competition in disarray.”

This not only plays out in capital raising but in other ways too – retail customers worrying about the outlook for weaker banks and transferring their deposits to stronger ones, for example. Consequently, the strong get stronger and are well-placed for recovery.

“While credit growth is slow right now,” says Wagle, “the pandemic is not going to stay for ever; as the economy comes out of this, the banks that raised capital will have the wherewithal to boost credit growth on their own terms, with pricing power. Earnings are compounding for these players.”

Yes Bank, although ultimately successful in its raising, gave an impression of how much harder a task issuers will face in this environment if there is any doubt at all about them. It only succeeded because the management and book runners, with Kotak Mahindra Capital at left lead, succeeded in convincing the market that it had turned a corner.

“The bank was undergoing a unique transformational turnaround,” says Jayasankar, “with
the old management being replaced by a new one and the balance sheet being significantly restructured through fund infusion first by banks and financial institutions and then by the follow-on public offer.

“The management positioned the transformation story well and we could pull off one of the largest capital raisings in the banking sector. Now investors believe that Yes Bank is well funded to grow for at least the next two years.” But there is a sense that, as successful as the bank issues have been, anyone any less robust is going to struggle and that the bulk of the easier capital has been raised.

“Probably the companies that could attract capital have already attracted it and few more can do it,” says Ravi Kapoor, head of banking, capital markets and advisory for Citi. “The question is: is Covid going to make the big bigger and the small smaller, the weak weaker and the strong stronger?

“This is what the next round will decide, when companies that really need survival capital will find out if the market is receptive to them.” One thing that is becoming clear is that small is not necessarily the same as weak and big is not necessarily the same as strong either.

“It is a theme towards the stronger, not necessarily the larger,” says Wagle.

His colleague Samarth Jagnani, executive director for India global capital markets at Morgan Stanley, notes that there have been several mid-cap names finding a good reception in recent weeks. “The mid-size names are also quality,” he says. “Are we seeing capital available for everyone? No. People with a good track record are the ones that are receiving broad support.”

It helps that mid-caps tend to be more cautious than some of their bigger peers.

“Most mid-cap Indian companies have an aversion to debt leverage,” says Jagnani. “I’m not seeing issuance driven by people who need capital, because otherwise they’re going to go down. It’s growth capital, people who raise proactive capital without them really needing it today.”

Foreign buyers
One interesting element of the volumes raised in India is the question of who is buying them.
Jagnani at Morgan Stanley says that around 60% of the deal flow this year has been bought by foreign institutions.

Behind this number are some interesting patterns. Foreign investors have typically led big Indian deals: up until a few years ago, the foreign proportion of buying in important capital raisings was as much as 75% to 80%. “But since 2016, we have seen domestic flows grow to the point where deals have been 50% foreign, 50% domestic,” Jagnani says.

Indeed, the growth of the domestic bid is one of the biggest shifts since the financial crisis.
“The local pool of money, which was almost absent in 2007, has grown meaningfully as Indians have moved away from real estate and gold and put their money into mutual funds
and insurance companies,” says Citi’s Vashistha.

The trade war between the US and China definitely plays into India’s hands a bit says Siddharth Metha, Bay Capital Partners

Bharti at JPMorgan dates this trend back to 2014 when the Reserve Bank of India signalled an intention to move real rates into positive territory as an incentive to put money into financial assets. That in turn led to big inflows into mutual funds and created a large domestic support base for capital raisings that had not existed in such scale before.

“Since then, domestic investors have become extremely important,” Bharti says. “Investing in mutual funds has become a core part of the savings that individuals and families have.”

Jagnani agrees: “As interest rates have moved down in India over the last couple of years, money has moved towards alternatives to fixed deposits.”

Today, he notes, the government bond yield is higher than a typical fixed deposit rate: “I don’t think we’ve had that dynamic on this scale for a long time.” Mutual funds are benefiting from this thirst for alternative sources of returns. “There is a healthy pattern building up in the Indian asset management industry,” Jagnani says.

That being the case, why are foreign funds back representing the majority of the funds in recent deals?It is not that the domestic appetite has faded. “The domestics will remain relevant,” Jagnani at Morgan Stanley says. “I don’t see the domestic bid going away.” It is just that the foreign bid has been so strong that, relatively speaking, domestics have got a lower proportion of the available paper.

In fact, after much foreign capital exited India in March and April (foreign portfolio investors withdrew about $8 billion, which fortunately was roughly matched by domestic inflows, keeping liquidity and demand intact), it came back with a vengeance.

In the three months from May 26, there were more than $10 billion of foreign institutional investor flows into Indian equity markets – portfolio flows, distinct from foreign direct investment. Part of the reason for this has been that capital raising has been dominated by established high-quality names that already have a large proportion of foreign shareholders. Of the $32 billion of capital raised between May and the start of September, only about $2 billion of
it was from IPOs; the vast majority was paper from already listed and well-covered stocks.

One interesting subplot is whether the geopolitical tension between the US and China – and in particular, president Donald Trump’s increasing efforts to encourage US endowments not
to invest in Chinese companies – helps India.

“I think the trade war between the US and China definitely plays into India’s hands a little bit,” says Siddharth Mehta at Bay Capital Partners.

Trump is not the first president to try to build a pro-India policy at the expense of both China and Pakistan – former president Barack Obama did it too – and it may be that capital flows from the US to India will increase alongside it. Even if it doesn’t, Mehta has sufficient confidence in the country’s top corporates to be optimistic about the outlook for India.

“As a bottom-up investor, there are great franchises to invest in here,” he says. “And we will continue to hold them through the trials and tribulations they go through.”

Mission impossible? Tough deals that made it over the line
Some of the recent mid-cap deals in India are eye-catching because they have come in troubled sectors. Of these two stand out.

One is the IPO – one of very few new listings, as opposed to qualified institutional placements (QIPs) and other follow-on deals – of the Mindspace real estate investment trust, which owns office space in Chennai, Hyderabad, Mumbai and Pune. Office space has been hit by the fact that there’s nobody in it, which hardly helps renewal figures or the ability of tenants to pay rent.

But Mindspace is at the top end of its field, illustrated both by its tenants (172, including affiliates of Amazon, Facebook, Qualcomm, Barclays, JPMorgan and UBS) and its strategic investors (including Fidelity, Temasek-owned Fullerton Asset Management and the Monetary Authority of Singapore). Mindspace is owned by Blackstone and leading local developer K Raheja. The deal, led by Morgan Stanley as left lead, raised Rs45 billion ($612 million). Its three-day
book build started slowly but ended up almost 13 times subscribed.

The other stand out is Phoenix Mills, a retail mall developer and operator. Seven of its
nine malls were closed during lockdown, although most have since reopened. Despite the
continuing plight of retail, investors trusted Phoenix as having the best malls in the country, with a noted leader in Atul Ruia; it raised Rs11 billion in a QIP in August.

The Mindspace Reit was interesting in that it showed “investors believe that the top-notch office space story is intact, despite the pandemic, and that the distributions they expect from a Reit are also intact,” says V Jayasankar, senior executive director and head of equity capital markets at Kotak Investment Banking.

On Phoenix Mills, he says: “What investors really appreciated was the current footfall and the fact that when there is a recovery in the economy, this retail mall chain will recover amongst the fastest.” There are exceptions, but the trend suggests that from here on in, it’s going to be difficult for smaller issuers.

“As we go down the food chain, the mid to small companies will bear the brunt – and they already are,” says Ravi Kapoor, head of banking, capital markets and advisory for Citi. “Companies become weaker, recovery may be delayed and liquidity becomes thin.
Everything is under pressure.”

Abhinav Bharti, head of ECM at JPMorgan, adds: “All in all, the capital raisings have been led by leading players in their respective sectors. It’s still not clear whether there will be enough capital in the market to support players in non-leadership positions. “Those companies that investors believe have challenges in their business model will need to find a way to address those problems first [before attempting to raise capital].”

Perhaps the proof will be found in the success or otherwise of airline IndiGo in its attempt to raise Rs40 billion through a QIP announced in August. There is no tougher sector right now than aviation. In mid September, speaking at the company’s AGM, president Ronojoy Dutta said the deal “has a 50/50 chance.”

Who’s buying?
An example of the sort of fund that is looking at the market with great interest is Bay Capital Partners, an India-focused independent investment manager founded in 2006 by Siddharth Mehta, a former Kotak Mahindra asset manager.

Bay takes a disciplined approach to public market investment, focusing only on companies that have achieved returns on capital employed of over 20% in each of the last 10 years, a filter that immediately cuts the Indian public equity universe to 270 names (in practice the fund generally holds only about 20 names at any one time). Most of its underlying investors are US endowments and pension funds.

“We always realized that India is a high cost-of-capital environment, and businesses that have mastered the art of efficient capital allocation are able to translate that into strong market positions,” Mehta says.

Applying his filter means that “most of the businesses we own tend to be market leaders or a strong number two contender.” It also means that, by and large, infrastructure, real estate and utilities companies are counted out.

“Ask any investor where they’ve lost money in India and they will say infrastructure and real estate rank high on that list,” Mehta says.

Bay’s methodology is interesting because it speaks to exactly the theme the equity capital markets bankers have noted: that, rather than going bargain-hunting at the distressed end of the market, international capital is going to be most interested in committing more capital to the best names.

“I think definitely this year has distinguished the bad actors from the great ones,” says Mehta. “Look at HDFC raising 15,000 crores [Rs150 billion ($2 billion)] in eight hours through the pandemic, Kotak raising $1 billion in less than a week. Those were all done on Zoom calls, because nobody would question the integrity of the numbers that are published by names like that.” That wouldn’t have been the case with weaker names, which, correspondingly, have been unable to raise funds.

In practice, Bay finds some of the best opportunities in consumer staples, which today account for about half the portfolio.

The article has appeared in Euromoney dated September 30th, 2020 :-

Posted by Siddharth Mehta, Founder & CIO