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All you wanted to know about reverse merger

Keerthi Sanagasetti | Updated on July 19, 2021

Earlier this month, the stocks of Equitas Small Finance Bank, Ujjivan Small Finance Bank and their holding companies skyrocketed following a new development.

The market’s positive reaction was based on the RBI’s permission to these small finance banks to apply for a reverse merger with their holding companies. But why is this reverse merger so important for these banks?

What is it?

A merger is a corporate action where two companies decide to bring together their assets and liabilities to create a single entity that is bigger and better than either of them. While a merger is usually proposed between equals, a reverse merger is a combination where a smaller company merges into a larger one, or a loss-making company merges into a profitable one.

In the case of small finance banks, the holding company is expected to be merged into the subsidiary bank. This type of a reverse merger is also referred to as a downstream merger.

Why is it important?

When NBFCs were originally allowed by the RBI to bag small finance bank licences to offer credit to unbanked segments of the population, the RBI required them to set up their banks under the non-operating financial holding company (NOFHCs) structure.

This was so that the NBFC would separate its new banking operations from its other businesses. Later when small finance banks were mandated to be listed, Equitas and Ujjivan opted to list their holding companies first, instead of the bank. This did not satisfy RBI.

They subsequently listed their respective SFBs as well. As there is no point in both the parent company and the bank trading on the bourses essentially playing on the same business, the RBI has now cleared the decks for a reverse merger of these banks with their holding companies.

The other requirement of the RBI with respect to SFBs was that their promoter holding be brought down to 40 per cent within five years of commencement, and to 30 per cent and 26 per cent within 10 and 15 years, respectively.

Currently, the holding companies hold slightly more than a 80 per cent stake in the SFBs. This impending stake sale has been a negative overhang on small finance bank stocks. For Equitas the initial five-year period ends by September 2021, for Ujjivan SFB it ends in January 2022. The downstream mergers could help dilute promoter stakes in these banks.

Why should I care?

While reverse mergers usually create uncertainty for the merging companies, especially when loss-making entities are involved, small finance banks look set to benefit from this reverse merger.

A RBI working group recently recommended that the regulator do away with the sub-targets of promoter holding within five to 10 years. It had also suggested that banks that are currently under the NOFHCs structure be allowed to exit from it, if they do not have other group entities in their fold. The RBI’s permission to the SFBs to apply for a reverse merger is a step in that direction.

This could help investors unlock value in two ways. It eliminates dual listing of both the small finance banks and their holding companies. It may ward off equity dilution on account of the mandated reduction in promoter holding.

The holding companies of Equitas and Ujjivan were trading at a 40-50 per cent discount to the value of their equity stakes in their banks, prior to the announcement. After RBI’s permission to apply for a downstream merger, their discounts fell to 35-45 per cent and analysts expect it to further fall to sub 20 per cent levels.

The bottomline

The reverse merger proposal has made small finance banks a better bet for investors.

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Published on July 19, 2021

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