Unlocking value via SDR: PEs, others can check in

By Iqbal Khan

On the July 27, 2015, the Joint Lenders Forum (JLF) for Electrosteel Steels (ESL) threw the company a much-needed lifeline. Saddled by over Rs 9,500 crore of debt, the Kolkata-based firm had few viable options left after it failed to successfully implement the CDR (corporate debt restructuring) package earlier this year. A well-timed regulation from the Reserve Bank of India (RBI) allowed the JLF to invoke Strategic Debt Restructuring (SDR). This landmark piece of regulation allows lenders to ultimately take shareholding control of a “sick” company by converting its outstanding debt (principal as well as unpaid interest) into 51% or more of the company’s equity.

SDR was introduced by the RBI based on the general principle of restructuring, i.e., that shareholders should bear the first loss rather than debt holders. As companies in certain sectors, such as power and metals, continue to struggle, SDR presents a viable alternative for lenders to safeguard their interests and prevent further erosion of company’s value.

In principle, SDR allows the consortium of lenders (known as the JLF) to take control of a stressed/distressed asset, which has failed to achieve the prescribed milestones under the JLF restructuring mechanism or the CDR scheme. The JLF can invoke SDR pursuant to the approval of the majority of the JLF members (minimum of 75% of creditors by value and 60% of creditors by number). The conversion of outstanding debt (principal as well as unpaid interest) into equity should be at “Fair Value”, and cannot be lower than the “Face Value” for the shares.

The conversion at Fair Value is an important one, since as per the RBI guidelines, the fair value cannot exceed the lowest of the market value (average of the closing prices during the 10 trading days preceding the date of the JLF’s decision to invoke SDR) and the break-up value (book value per share as per the latest audited balance sheet, without considering any revaluation of resources, and if the latest balance sheet is not available, this break-up value shall be Rs 1). While SDR ultimately vests 51% or more of the equity of the stressed/distressed asset with the JLF, this consortium of lenders is required to divest this stake as soon as possible. This exit requirement presents a remarkable opportunity for financial and strategic investors.

Investors with an appetite for special situations investing should consider evaluating opportunities in asset rich, undervalued companies, where the JLF is looking to exit its stake. Given the size and scale of potential SDR situations, the market is ripe for strategic and financial investors such as private equity funds to acquire such stakes from JLFs at relatively low valuations to benefit from higher valuations and other synergies in the future.

PE funds can consider a number of creative commercial transaction structures for the acquisition of the stressed/distressed targets, such as forming a consortium with other financial players and a management team for acquisition of such targets, investing in a strategic company (for example, through a PIPE if the strategic company is a listed entity), which then uses the funds to acquire such targets, or coming in as a lender and becoming part of the entire SDR process itself.

Each such structure has its own challenges and adoption would depend upon the risk appetite of the transferee investor. For example, although the Fair Value pricing formula has been exempted from the Securities and Exchange Board of India (Sebi) (Issue of Capital and Disclosure Requirements) Regulations 2009, such exemption is only available to the members of the JLF and not to any transferee investor.

Additionally, in case of listed companies, the acquiring lenders on account of conversion of debt into equity under SDR will also be exempted from making an open offer under Regulation 3 and 4 of the provisions of the Sebi (Substantial Acquisition of Shares and Takeovers) Regulations 2011; however, a transferee investor is not exempted from such open offer requirement.

Investors, especially financial investors, should also keep additional considerations in mind, such as lock-in of the equity shares for a period of one year from the date of conversion (such lock-in continues for the remaining period with the transferee even after the lenders transfer their shareholding to the transferee) and all investments must comply with additional applicable regulatory requirements, such as investment caps under the Foreign Exchange Management Act, 1999 and filing requirements under the merger control regime.

Finally, investors must also take into consideration the potential impact of the soon to be introduced — the new bankruptcy code, as such risky investments may end up seeking bankruptcy protection all over again.

The jury is still out on whether investors can actually turnaround or benefit from a company acquired under SDR. But with corporates struggling under a burden of debt and with the macro economic recovery still not on the horizon, the market is ripe for this kind of disruption. It remains to be seen which set of investors — strategics or financials, will make the first move.

(The author is partner, Shardul Amarchand Mangaldas & Co. The views expressed are his own)