Case for PSU Disinvestment through Exchangeable Debt

Introduction

The hullabaloo surrounding PSU(public sector undertaking) disinvestment has been in the news again lately following the budget announcement of disinvestment targets in 2014-15. Meeting the fiscal deficit target through disinvestment is a key priority for the new government. Although analysts are positive about the resurgence of the primary capital market in the short term and the beginning of a new investment cycle, the government continues to encounter questions with regard to pricing, market timing and offer mechanisms. Readings from popular press indicate how investor confidence fluctuates around the announcement of these piecemeal public offerings and how regulatory provisions have been made to sweeten the deal. In light of such market uncertainty and haphazard regulatory interventions, whether a more structured and phased disinvestment process independent of market timing is possible begs the question.

Historical Trends

Let's look back at disinvestment targets and realized proceeds in previous years.

Figure 1. Disinvestment targets and actual receipts (2010 - 14)

Disinvestment targets have not been met in the past few years and this was expected. It would have been foolhardy to expect the government to sell its equity holding using the traditional methods of equity sale (including IPO/FPO and OFS) in this period of poor market sentiment. A more nuanced approach, however, might help the government solve its optimization problem in the future.

What are the ultimate goals?

The Department of Disinvestment, MoF has the following mission statement:

1. To promote people's ownership in PSUs.
2. To ensure better corporate governance in PSUs.
3. To unlock true value of PSUs for investors, employees, company and government.

Furthermore, the disinvestment policy states that 

"Public sector undertakings are the wealth of the nation and this wealth should rest in the hands of the people."

Are these goals being met?

Vibrant domestic market - 

1. Investment in equities by households remain abysmally small (around 3% during the recent financial crisis) despite a high savings rate. Traditionally, households have invested in fixed income debt instruments although they posted negative absolute returns over the last decade. While stock market scams in the last two decades may have been responsible for the sour experience, some firms in the past - notably Reliance - had large retail shareholding due to compelling incentives which were provided for investors. How did Reliance succeed in creating investor confidence? Can the government take a leaf out of its book and align risk-return incentives to further its goal of distributing gains from public goods for the public?
2. With the view of providing investment protection, capital controls on public finance institutions including pension and insurance funds limit their exposure to equities. Sub-optimal returns hamper the growth of these institutions. What provisions can be made to improve this?

Corporate governance - 

Corporate governance in PSUs remains weak despite regulations in Companies Act, 2013 and SEBI listing requirement.

It seems that the government is more focused on unlocking the true value of its strategic sales at the expense of the other stated goals. 

What can be done?

The requirement of timing the market during periods of economic upheaval leads to only short-term success e.g. meeting fiscal deficit targets. Furthermore, true value remains elusive due to price reactions around the disinvestment period and the government is constantly on its tenterhooks. No wonder it has no foresight to pursue long term goals!

A paradigm shift in moving away for direct equity sale can be the answer. How can this be done?

What are exchangeable bonds?

Exchangeable bond is: 

"a type of hybrid security consisting of a straight bond and an embedded option to exchange the bond for the stock of a company other than the issuer (usually a subsidiary or company in which the issuer owns a stake) at some future date and under prescribed conditions."

For example, the GoI may issue an exchangeable bond of Rs 1,00,000 with the option to buy say, 350 shares of ONGC at a price of say, Rs 286 per share in the future. 

In terms of pricing, exchangeable bonds are similar to convertible bonds. The figure below shows the market value of convertible bonds with respect to the value of the underlying equity share.

Figure 2. Convertible value against underlying equity value

Exchangeable bonds have the advantage of providing investment characteristics of both fixed-income securities and equity. An investor, therefore, can participate when the equity market rises with limited downside exposure and potentially greater return on capital. It has a lower bond yield than a sovereign bond and gives lesser returns than the underlying equity.

Embedded options can be also be added to the exchangeable bond to cater for certain provisions favouring the issuer or the investors e.g. callable options. 

Why exchangeable bonds?

Exchangeable bonds have a number of incentives for different entities:

1. Government -

• The government issues securities worth Rs. 5 trillion every year. By issuing exchangeable bonds instead of some of the sovereign bonds, the government can reduce its debt burden.
• Market timing becomes redundant and the government can disinvest in a phased manner and meet its disinvestment targets.

2. Individuals and public institutions -  

• They have the option of risk free return and capital protection with the potential upside of equity ownership.
• Improves exposure to equity and better returns.

Results

1. Since the government retains control of the PSUs in the interim, it will push them to comply with corporate governance requirements - which most have been evading. Additionally changes in the management of PSUs will improve their performance. 
2. Public finance institutions like pension and insurance funds will have greater exposure to equities in their investments. Potentially large return over the long term will improve their finances. 
3. Potentially large long term returns for individuals after conversion to shares will improve their experience and lead to greater participation in the future.
4. Government can issue exchangeable bonds in a phased manner at predefined intervals of time. This will reduce information asymmetry and lead to better price discovery.

Conclusion

The current disinvestment policy is plagued with short-sighted vision for immediate results instead of long term gains. Introduction of exchangeable bonds with reservations for retail investors and public finance institutions will bring vibrancy in the domestic market without the need for the government to take any additional debt burden. Furthermore, matched incentives will put pressure on PSUs to improve their performance and better growth figures will translate to higher returns for investors. This 'win-win' situation will be achieved without sacrificing on the primary goal of getting fair price for the equity of the PSUs. 

An overhaul of the PSU disinvestment process is an important reform which requires immediate attention from the government if it is committed to improving growth of the macro economy.