Future is for sale

The value of a firm’s equity can be thought of as the difference between the value of its assets and the value of its debt. There is no rocket science in this definition - this is an accounting identity.

However, when the value of the firm’s debt exceeds the value of its assets, the value of the equity doesn’t go negative. Limited liability implies that the value of the firm’s equity is floored at zero. Once the value of the assets is equal to the value of the debt, any further losses are taken by the owners of the debt.

Thus, standard corporate finance views equity as a “call option on the value of the firm”, with the value of the firm’s debt representing the strike price.

When the firm is debt-free (or nearly debt-free, as Reliance Industries aims to be), the option is “far in the money”, and there isn’t much “leverage”. A dollar gained or lost by the firm is a dollar gained or lost by the equity holders. The more debt a firm takes on, the greater the leverage (OK we seem to be uttering a lot of tautologies today) for the equity holders - every dollar gained by the firm represents far more than a dollar gained by the equity holder.

For some Indian promoters (they can be thought of as founders or owners who own large stakes (often majority stakes) in their firms), the leverage offered by taking on high levels of debt in their firms is not enough. They add further leverage to their portfolio by borrowing against their own equity.

How this works is simple - they take a loan from the bank by offering the shares in the company they own as security. In case they default on the loan, the bank can sell these shares and make good its money. Also, in case the value of the shares drops, the bank can demand additional collateral. In case the promoters cannot furnish further collateral, the bank can sell some of the pledged shares.

This is standard lending practice. Usually, banks protect themselves by offering a loan of only a fraction of the present value of the shares being pledged. Also, banks demand that promoters only pledge a part of their holdings in the firm, so that they retain some skin in the game.

That, however, isn’t how it usually works in India. It is rather common for promoters here to pledge a large portion of equity in the firm. When the value of the shares falls, banks threaten to seize the collateral, and then a legal battle ensues. For a long time, the lengthy legal battles have allowed Indian promoters to get away with excessive leverage. The recent Insolvency and Bankruptcy Code (IBC) has proved to be a fly in the ointment.

Reinventing the (big) Bazaar

In March this year, The Economic Times wrote that the recent carnage in the Indian stock markets had taken several loans against promoter shares underwater, and that some promoters could risk losing their companies. The piece contained this rather helpful graphic.

Source: The Economic Times, 20th March 2020

Shares of Kishore Biyani’s Future Group companies have been badly affected by the recent selloff. Stocks such as Future Supply Chain, Future Consumer and Future Enterprises have plunged by 48%, 37% and 30%, respectively, since February 19. Promoters have pledged more than 90% in the three companies. 

In May, it was rumoured that Kishore Biyani, promoter of Future Group, would “sell a significant stake to Amazon” in order to reduce his own debt burden. With Amazon being a foreign company, and India’s laws on what foreign companies (especially in retail) can sell being stringent, this would have required significant financial engineering and corporate restructuring for the deal to go through.

Again quoting The Economic Times:

If the deal goes through, this would be Biyani's second deal with Amazon. Last year, Amazon had purchased a 49% stake in Biyani's Future Coupons, which owns 7.3% of Future Retail, with an option to buy the entire holding at a later stage. That deal gave Amazon roughly 3.6% in India's largest listed retail entity Future Retail.

In late May, the pledged shares “stuff” (this is a family newsletter) started hitting the fan.

Lenders have invoked promoter shares in companies such as JustDial, Asian Hotels (North), Reliance Capital, Eveready Industries, Reliance Home Finance and Mandhana Retail in the past month. The more deep-pocketed promoters of over 50 firms managed to bring in fresh shares to make up for the decline in collateral. 

This wasn’t the first time pledged shares had proved the undoing of Indian corporate promoters. This story in Mint (from December 2019) gives a good history of share pledging among promoters in India.

The suicide of Cafe Coffee Day’s V.G. Siddhartha in July this year; the roller-coaster ride that Yes Bank Ltd’s stock went through when its former promoter Rana Kapoor dealt with lenders; and even the unfolding financial scandal at Karvy Stock Broking Ltd have one thing in common—the use, or rather, overuse of a humble instrument called LAS (loan against shares).

It’s a long, but brilliant article, and we urge you to read the whole thing to get the context of pledged shares in India.

Back to our story, in mid-May, Business Insider reported that Future Group’s Kishore Biyani was in trouble. His family’s “net worth has fallen from $1.8 billion to $400 million, according to Forbes”. Covid-19 had hit Future Group’s retail businesses really hard, with some stores being forced to close on account of being located inside malls, with March and April sales being down 75% from normal. Future Group’s debt had been downgraded.

What possibly saved Biyani was the government’s covid-19 related stimulus package. Monthly repayments on debt were halted until August, and the Insolvency and Bankruptcy Code was put on hold for a year, giving Biyani time to arrange for a deal.

In mid-June, Bloomberg (syndicated by Mint) reported that Mukesh Ambani’s Reliance Retail was in talks to buy Future Group’s retail operations.

A successful deal may draw the battle lines between Amazon and Ambani, 63, who just secured almost $14 billion for his e-commerce venture Jio Platforms Ltd. from investors including Facebook Inc. Amazon has made the nascent Indian market, with its 1.3 billion consumers, a key focus of its global expansion. Investment from Reliance, India’s most valuable company, would help Future’s founder Kishore Biyani pare debt, even if it risks the tie-up with the U.S. online shopping giant announced by the Mumbai-based company a few months ago.

[…]

In August, Seattle-based Amazon agreed to purchase 49% of one of Future Group’s unlisted firms, allowing it to buy into Future Retail after a period of between three and 10 years. The two deepened that partnership in January, with Amazon becoming the authorized online sales channel for Future Retail’s stores that sell everything from groceries to cosmetics and apparel.

Earlier this week, the deal got (“nearly”) confirmed.

According to the deal, Biyani will give up control over all businesses under the Future Retail basket, including Big Bazaar, FBB, Food Hall and Central. Future Supply Chain Solutions and Future Lifestyle Fashion Ltd will also be sold to Reliance Industries. Biyani will be left with only Future Group’s FMCG business and some of the other smaller group entities. He had earlier sold the Pantaloons retail chain to Aditya Birla group in 2012.

Reliance Retail is much larger than Future Retail. Compared to Future Retail’s total turnover of ₹200 billion in the 2019-20 financial year, Reliance Retail had a turnover of ₹1.6 trillion. Compared to Future Group’s 1400 stores, Reliance has nearly 12000.

It seems likely that three companies “controlled” by Biyani, Future Retail, Future Lifestyle Solutions, and Future Supply Chain Solutions will be going in for a merger before the sale. The Times of India also reports that Amazon may get a stake in RIL as part of what might be an all-stock deal (RIL’s desire to remain debt-free might mean it uses equity for acquisition).

The deal is unlikely to close quickly given Future Group’s rather complicated holding structure. This graphic from a Bank of America Merrill Lynch report gives a good picture.

Source: Bank of America Merrill Lynch

We won’t even attempt to describe the holding structure in words.

This is not the first time that Kishore Biyani has had to sell assets thanks to excess debt. In 2012, he had sold Pantaloons Retail to the Aditya Birla Group. Interestingly, the Aditya Birla Group sold its other retail operation More to Amazon and private equity investor Samara Capital in 2018 (Amazon and Samara together were suitors for Future Group as well).

Future Group Brands. Image taken from their website https://www.futuregroup.in