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Monday, April 25, 2011

Will IFRS kill pre-IPO convertible bond financing in India?

If there was ever the case of the 'tail wagging the dog', this is it. Take the example of pre IPO financing by a strategic investor. Typical covenants include:-
  1. Debt security with nominal interest(or even zero interest)
  2. Call option-to convert the debt to equity at the IPO price/other reference price. This may even be adjusted with the performance of the company.
  3. Put option-promoters/company to buyback the debt at a fixed IRR
Earlier, Indian companies were permitted to account for these securities as debt. But now IAS-39 mandates that the embedded derivatives(call option/put option)should be separately valued-even if not accounted for separately on balance sheet. And given the typical deal sweeteners, the option value by any model is likely to be high. And as the IPO approaches, the increase in option value will need to be expensed out by the company('issuer'). This may render it ineligible for listing/fetch low price on listing, due to the MTM losses on the derivatives issued by it.

Of course, the company could argue that investors should consider a proforma picture ignoring this adjustment, analogous to ignoring 'credit value adjustments' on own debt. But if this loss leads to an enhanced call option for investors/exercise of put option due to triggering earnings based covenants, then the company has a problem. This calls for top notch investor relations and legal experts to help cover all such bases during financing. But despite that, such transactions would need to be structured much more carefully because more the protective covenants, likelier is it that more embedded options exist.

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