The Hindu Business Line : Morbid fascination for convolution

The American fascination for complex financial products is quite well known. Till recently, the world looked at awe and marvelled starry-eyed at the American financial market for what was perceived to be its uncanny ability to raise funds using these seemingly exotic products.

But the recent sub-prime crisis has exposed the system for what it is - chronic tinkering with the sole motive of leveraging through securitisation to the extent that poor quality loans euphemistically called sub-prime loans were passed on to thousands of investors by the financial institution that gave the loans in the first place.

And when the cookie crumbled, it brought down the entire American financial edifice and its contagion wrought havoc in other countries, including our own as well.

FINANCIAL LEVERAGE

American financial literature is replete with easy-going euphemisms. Securitisation which is described as the process of unlocking illiquid funds is in the final analysis nothing but a species of financial leveraging.

Financial leverage, which consists in raising a loan that is several times more than one's own resources, to be sure, started with corporates but with passage of time its irresistible appeal caught the fancy of individual as well so much so that today youngsters on the fast track take housing loans sometimes in the region of ten times their own contributions.

It is leverage that is once again at the back of the convoluted corporate structures one is a witness to. Chain holdings are a common sight in the corporate world. Company A is promoted with a modest capital of Rs 200 crore by an intrepid promoter who pitches in Rs 102 crore and prevails upon a private equity firm typically from the US to pick up the rest.

Their stakes are 51:49. Company A now promotes company B whose capital is going to be Rs 500 crore out of which loan is a modest Rs 100 crore.

Company A picks up two-thirds stake for Rs 200 crore at par and ropes in another private equity firm that is persuaded to pick up the remaining one-third at a 100 per cent premium. The PE thus brings in Rs 200 crore - Rs 100 crore towards share capital and Rs 100 crore towards share premium.

Having woven a careful web, now they float a public company, C, which would execute a project, may be telecom. Its capital would be Rs 2,000 crore out of which the debt component would be Rs 1,000 crore. Company B naturally would have the lion's share of the stakes -twothirds - but at the lowest possible price, i.e., by paying Rs 500 crore sans premium.

The public picks up the remaining onethird but at a 100 per cent premium, thus acquiring half the voting rights and half the dividend entitlement even after contributing the same amount as the promoter.

Premium for hard work

The premium is obviously for the hard work done by the promoter, though admittedly it cannot be en-cashed by him in the manner of goodwill.

The Finance Minister, Mr P. Chidambaram, while brushing aside the demands for all the companies down the chain from the purview of Dividend Distribution Tax (DDT) thus sticking to his original Budget proposal contained in Finance Bill, 2008 to confer the exemption only to the domestic holding company that itself is not a subsidiary of another company, wondered about the utility of such convoluted chain holdings.

To wit, in the example on hand, Company A would be spared from paying DDT on the dividend received from C through the conduit of B. The conduit company B will continue to pay DDT as hitherto.

Financial engineers however aver that such a complex web does serve a purpose - leveraging - and even intermediate holding companies should be exempt from DDT in order to spur investments. The operational company C, they point out, has succeeded in mobilising Rs 2,000 crore with a modest initial investment of just Rs 51 crore by the promoter in company A without taking undue risks - the debt equity ratio is 1:1.

Had the promoter stuck to the straight and narrow but desire the same two-thirds control on an investment of Rs 51 crore with the same debt-equity ratio, he would have at best mobilised Rs 600 crore from both debt and equity assuming the remaining one-third of equity is palmed off to the public at a 100 per cent premium bringing in Rs 100 crore, they aver.

More the number of conduits the better is their basic premise and mantra because each successive company leverages the financial strength of its predecessor. Ingenious as the game plan appears, the truth is successive conduits are made possible only by inducting private equity firms to whom naturally part of the control is ceded by the promoter.

In other words, the private equity players themselves come to don the robes of a promoter, thus leaving the original promoter with the inferior status of a joint promoter with so much lesser hold on the ultimate operating company. Thus each successive leveraging exacts a price - the pound of flesh demanded by the private equity firm. In company C, therefore, the promoter actually does not enjoy a two-third voting power. The truth is this he shares with the private equity firms.

Arriving at the share

What exactly is their share? Let us lay this bare to prove the point that all of them could have well been directly accommodated in company C transparently without the services of the conduits. A bit of simple mathematics reveals that in company C, the Indian promoter after all has got only 22.66 per cent stake, the first private equity firm that pitched in 49 per cent in company A has 21.77 per cent stake and the second equity firm that pitched in one-third of equity in company B has 22.23 per cent stake all adding up to 66.66 per cent.

In other words, Rs 500 crore pitched in by company B in company C accounting for roughly a two-third stake could very well have been contributed by all these parties in the above ratio directly upfront in a transparent manner.

The convoluted process of roping in intermediaries is of a piece with the practice of securitisation indulged in by mortgage companies given the fact that the receivables swept off the balance sheet by them to SPVs (special purpose vehicles) could have been offered as security to the bondholders had they retained them in their balance sheets.

In other words, instead of dropping the receivables like a hot potato to garner more funds, the mortgage company could very well have raised the same funds on the strength of its receivables. In the securitisation arrangement the mortgage company naturally becomes slack in appraising the home loan applications secure in the knowledge that it would in any case pass on the buck successfully sooner than later.

Besides, the bondholders would derive greater sense of security and satisfaction from being stakeholders in a reputed mortgage company that has to comply with the capital adequacy norms.

Mr P. Chidambaram who rightly wondered about the utility of the chain holding system that characterises investment in this country would do well to pass and think about the utility of securitisation that has nothing to commend for itself but has the potential to trigger an American style crisis.

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