BUYBACKS AND DE-LISTING

• 'Stock repurchase' or 'share repurchase’ commonly known as 'share buy back' refers to the process of a company buying back its own shares from its shareholders.

• In this sense, it is the reverse of an issue of shares and is therefore also one of the ways in which an 'exit' may be provided to a shareholder.

Conceptual Justification for Share Repurchase• Theoretically, it is said that shareholder wealth

maximization has to be the objective of every corporate enterprise.

• Therefore, if a company has a return on equity (ROE) that is better than the opportunity cost for the shareholder, his wealth is maximized by redeploying the-profits back into the business.

• In other words, such a company should follow a no-dividend policy. But if a company is sufficiently mature and quite stable in its business model, there are two things that would happen—(a) its annual growth rate reaches a more sustainable level (b) its investment needs become more modest.

• In such a company. there may not be a scope to redeploy all the internal accruals since the returns may not be as good as the opportunity cost of the shareholder and/or There is simply no requirement for so much extra cash in the business.

• Such companies would therefore need to make significant cash distributions as dividends or resort to stock repurchases to keep the capital employed in the business under control.

• In the US market, significant research was done about corporate share repurchases in the 1980s that led to the conclusion that the market does not value a company for its liquid cash balances or near to cash investments.

• Mature companies should look for maximizing share, value through a build up of book value, earnings, dividends and return of surplus capital through share repurchases.

• Share repurchases tend to keep a company from becoming 'over capitalized' i.e. having too much capital for the level of business being done.

Particulars Company A Company B Company C

Sales 1,00,000 1,00,000 1,00,000

EBITA 24,000 24,000 24,000

EBITA % 24% 24% 24%

PAT 15,000 14,000 12,000

PAT % 15% 14% 12%

Share Capital (Rs 10/Share) 50,000 25,000 20,000

Reserves & Surplus (Including Profit)

1,00,000 10,000 (15,000)

Secured Borrowings 0 25,000 35,000

Capital Employed(Share Cap.+ Res. + LTB)

1,50,000 60,000 40,000

Capital Turnover Ratio .66 1.67 2.50

ROCE (EBITA/Capital Employed)

16% 40% 60%

EPS 3 5.60 6

Debt- Equity Ratio 0 .71 7

• It may be observed from the above data that though all the companies have the same EBITA, the ROCE, EPS and debt-equity ratio vary widely.

• Looking at the ratios, it is possible to deduce that Company A is over-capitalized since it has large accumulated profits and a higher capital employed' for the same level of operations as the other two companies.

• Due to this reason it has the least ROCE. It also has a higher share capital which has depressed its EPS.

• Company B is more optimally capitalized both in terms of total capital and the debt-equity mix, while

• Company C appears to be grossly under:

capitalized and is treading dangerously on a very small net worth.

• Company A has to look at distribution of capital back to its shareholders to improve its ROCE and EPS.

• Company B does not have to do significant

distribution as of now since it has a healthy ROCE of 40% and has growth requirements for the future. The shareholders would be happy to keep the funds with the company as long as it shows a healthy trend of growth that is better than their opportunity cost.

• Company C requires immediate infusion of equity to refinance its losses and substitute debt as well so that bring down its debt-equity ratio and look for nourishment.

• The prolonging of this situation could lead the company into a very difficult situation or eventually lead to bankruptcy.

Implications of Share Repurchase1. Correction of over-capitalization

Well-performing companies that enjoy good margins and high recovery rates from customers are generally left with surplus liquid cash and cash equivalent assets that are in excess of their long-term requirements. The pitfalls of having excess liquidity are many;

• It could be misdirected into ill-conceived ventures and if not profitably employed, it would reduce the return on capital (ROCE) generated by the company.

• The fall in such return has serious repercussions in terms of fall in the return on networth (RONW) and consequent adverse impact on the market price of the share.

• In order to correct a condition of over-capitalizationA company can resort to a repurchase of equity shares (and preference shares too if the terms of issue so permit)" for payment in cash from the shareholders.

• Through this process, the company reduces its capital and excess liquidity in its business. As a result, the shareholders' funds are decreased and the equity capital is trimmed of the excess flab.

• The reduction in capital has a positive impact on the ROCE and RONW and the pruning down of equity share capital has a positive effect on the earnings per share (EPS).

• This would lead to improved perception in the stock market and a consequent increase in market capitalisation.

• However, buyback of equity is not advised for companies that have high growth rates and market capitalisation.

• In such companies it would be advisable to retain the capital in business and reduce borrowings so as to bring down the current cost of capital and improve profitability and liquidity.

• Similarly, in companies that have high debt-equity ratios, excess capital should be used initially to repay existing borrowings rather than to buy back equity.

• Lastly, share buyback is also not recommended for companies with reasonable debt-equity ratios but with a long cash cycle or with unpredictable cash flow patterns.

• Such companies would do well to retain

excess capital in liquid assets to meet contingencies or to retire debts and reduce financial leverage.

2. Shoring up management stakes• Equity buy back can also be used as an effective

measure for increase of promoter stakes in a company.

• Company managements normally look out for such opportunities during times of depressed market conditions during which, buy back of shares from the public shareholders could be made at attractive price by the promoters. This would be a cost effective way of consolidation of promoter interest in a company.

3. Exit mechanism Equity buy back is an investor-friendly

measure in times of depressed markets wherein the retail investor is locked in the share due to its low market price.

If the company can support a buyback with enough liquidity, the investor gets a respectable exit from the share during such times.

4. Shareholder value management• Equity buyback would be required in times when

the company is not able to generate enough return on the surplus capital in its businesses to offset the opportunity cost to shareholders.

• If it continues to keep such funds in the business, it would destroy shareholder value.

• Therefore, a buyback at such times helps in unlocking the excess capital and the shareholders would be free to deploy such funds elsewhere.

EQUITY REPURCHASE IN INDIA• Exit offer is a new concept in the Indian context.

Till 1998, Indian companies were not allowed to buyback equity shares from their shareholders or from the secondary market.

• So the only exit option for the common investor was to sell through the secondary market.

With the amendments to the Companies Act, companies were allowed to buyback their shares subject to a lot of statutory restrictions.

• The basic framework of a share repurchase mechanism in India is to allow it as a step to be implemented from timeto time by companies.

• Buy backs are being discussed in the context of investment banking since statutory regulations are also provided.

• It says that appointment of a merchant banker as a manager to the offer is mandatory for listed companies intending to make a buyback offer to their shareholders.

• In such offers, the merchant banker plays a very significant role not only in pricing the issue but in ensuring compliance with law and in advising the company at every stage.

REGULATORY FRAMEWORK FOR EQUITY REPURCHASE

• Equity repurchase by a company was not allowed under the Indian law until the Companies Act was amended to provide for limited repurchase of its shares incompliance with section 77 A that was newly-introduced with effect from October 1998.

• This section applies to all types of companies intending to all types of companies and all types of shares and other securities that may be bought back as specified from time to time by the government.

• In addition to section 11 A, which has universal application across companies, unlisted companies have to comply with the regulations issued by the Ministry of Company Affairs.

• Similarly, listed companies intending a buy back of shares need to comply with the SEBI guidelines on the subject.

• General Conditions• The general conditions applicable to all types of

companies for buy-back of securities in terms of the provisions of sections 11A and 77B of the Companies Act are listed below:

1. The buy-back by the company has to be financed out of free reserves or securities premium account or from proceeds of earlier issue of dissimilar shares or other securities.

2. The maximum time allowed for the completion of the buy-back process is 12 months from the date of the relevant resolution.

3. Buy-back can be made from existing security holders on proportionate basis, or from employees and directors out of the ESOP shares or sweat equity shares or through open market purchases.

4. A declaration of solvency has to be filed with the ROC and the SEBI (where applicable) with a verification through an affidavit by the Board of Directors of the company that they believe that the company would remain solvent for a period of 12 months from the date of such declaration.

5. All securities that are bought back have to be destroyed within seven days from the date of conclusion of the buy-back programme.

6. No company shall make a public issue of the same kind of securities that have been bought back within a period of six months from the conclusion of the buy-back programme

7. Only except through issue of bonus shares or through conversion of outstanding convertible instruments.

8. Two buy-back programmes shall be separated by a period 'of 365 days even if they are for dissimilar securities.

9. The buy-back should be a direct purchase by the company and not an indirect purchase through its subsidiaries or group investment companies.

BUYBACK BY UNLISTED PUBLIC COMPANIES AND PRIVATE COMPANIES

• Unlisted companies that are either private or public companies are governed (apart from the provisions of the Companies Act 1956,) By the Private Limited Companies and Unlisted Public Companies' (Buy-back of Securities) Rules 1999.- A company may buy-back its shares by either of the following methods:

1. From the existing shareholders on a proportionate basis through private offers.

2. By purchasing the securities issued to employees of the company pursuant to a scheme of stock option or sweat equity.

• There are no specified pricing guidelines and the Board or the company is free to fix the price as found appropriate.

• The Letter of Offer (L of O) sent to shareholders for the buyback offer shall contain specifically the following details:

The information on the proposed offer with elaborate details on capital structure, shareholding pattern and the basis of arriving at the quantum and price of the proposed buy-back.

All material facts relevant to the buy-back offer.

Audited financial information for the previous three years together with specified financial ratios pre and post buy-back.

Management discussion and analysis on the likely impact of buy back on the company's earnings, shareholding pattern and any change in management structure.

The Declaration of SolvencyAuditors' Report addressed to the Board.

The buy-back offer has to be kept open for members not less than 15 days and not more than 30 days from the date of dispatch of the L of O.

The buy-back offer has to be accepted on proportionate basis

in case of over-subscription by the shareholders. The company shall complete the verifications of the offers received within 15 days from the date of closure of the offer.

The Company shall immediately after the date of closure of

the offer, open a special bank account and deposit therein, such sum as would make up the entire sum due and payable as consideration for the buy-back in terms of the Rules.

The company shall within seven days of the specified time, make payment of consideration in cash or bank draft/pay order to those shareholders whose offer has been accepted or return the share certificates to the shareholders forthwith.

The company shall extinguish and physically destroy the share certificates so bought back within seven days from the date of acceptance.

BUYBACK BY LISTED COMPANIES• Listed companies are governed in addition, to

the provisions of the Companies Act, by the SEBI (Buy-back of Securities) Regulations, 1998 and the provisions of the Listing Agreement with the stock exchange.

• Under the SEBI buyback Regulations, it is mandatory to engage a merchant banker to prepare the L of O and manage the buy-back offer.

• The Regulations also do not fix any pricing mechanism, which has been left free to the Board or the company

Under the Regulations, a company can buy-back securities under the methods described below:

Fixed Price Tender Offer• Under this method, the shareholders on record of the

company as of a record date are invited to tender their shares for re-purchase by the company at a fixed price arrived at by the company and disclosed in the notice, public announcement and the L of O.

• This method is simpler to understand but may not realize the best price for the shareholders.

Book-Building Method• This method prescribes a reverse book building to

be applied for purchases from the open market whereby shareholders are invited to put in bids for re-purchase of their shares.

• The board resolution or the special resolution as the case may be, shall specify the maximum price at which the securities shall be bought back by the company.

• The company would make a public announcement based which shall specify the method by which shareholders can put in bids for their securities to be bought back by the company.

• The company fixes the buy-back price based on the highest price bid received from the shareholders. The bidders who bid at lower prices would also be eligible to receive the highest price.

• Therefore,- this method is beneficial to the shareholder since it allows the highest bid price to be received by them instead of a price fixed by the company as in the Tender Offer method.

• However, as far as the company is concerned, it

helps in making a more efficient pricing as compared to the Tender Offer since this method allows for price discovery.

Open Market Purchase• In this method, the company buys back the shares

directly from the secondary market using the electronic trading system and placing buy orders in its own name.

• Therefore, within a specified period, the company buys the shares from the market at varying prices based on the prevailing market price but subject to the maximum price and quantity already approved.

• This method is transparent and the company may actually end up buying the shares at an average price, which could be lesser than the maximum price approved.

• This method is suitable when promoters wish to consolidate their stakes by letting the company to mop up shares for buy-back from the secondary market.

• The drawbacks of this system are that the promoters cannot sell their own shares since the system is transparent. Secondly, if the company does not enjoy a good free float, the company may not be able to get sufficient quantities for buy-back.

De-listing

Introduction to De-listing• De-listing is a process by which a company whose

shares are listed on a stock exchange is taken private once again by getting its publicly held shares bought over by private shareholders and terminating the listing agreement with the stock exchange.

• As a result, there can be no public shareholding after de listing and the shares cannot be traded on a stock exchange. Therefore, de-listing is a process also known as 'going private'.

• The subject of de-listing in the Indian context, can either be compulsory or voluntary.

1. Compulsory de-listing happens when, the stock exchange penalizes a company through de-listing its shares for non-payment of listing fee, violation of the listing 'agreement or for other statutory violations such as non-filing of accounts etc.

2. Voluntary de-listing is a process initialed by a promoter or an acquirer or any other person other than the stock exchange.

• Capital market depth is in danger if well-performing companies opted to de-list.

• There is no provision in the Companies Act or the SCRA that provides for de-listing by companies.

The Dr. K.R. Chandratre Committee set up in 1997 prescribed criteria for de-listing of loss-making companies and other provisions.

• Later on, further examination was made of this issue, which led to the framing of the SEBI (De-listing of Securities) Guidelines 2003.

• The current thinking is to allow de-listing as a natural process since the listing agreement is primarily a contractual relationship between the issuer and the stock exchange.

• Therefore, it should have an exit option subject to the interests of the investors being protected.

• De-listing also offers a right balance for companies to look at the capital market as a source of capital as and when necessary and not as an obligation that becomes counter-productive in times of depressed market conditions.

• Secondly, companies need to protect themselves from time to time from unwanted intrusions through the secondary market route, especially when their market capitalization is unduly depressed. In such times, voluntary de-listing offers a strategic alternative.

• De-listings in India• De-listing has become a common occurrence

in India. Most multinational companies, which prefer 100% subsidiaries to listed companies, have been active in de-listing their Indian subsidiaries.

• Till recently, government policies prevented this route but with the opening up of 100% FDI in many sectors, they are now preferring this route.

• Examples are Carrier Aircon, Otis India, Philips India, Castrol India, ITW Signode, and Wartsila India which have all been delisted in 2000-01. In the USA, 66 companies went private in 2002 as compared to 35 in 1999 according to Thomson Financial.

• There, have been many delisting in recent years despite strong market conditions.

• The validity of the concept of de-listing has to be examined on the same grounds on which the company went for listing.

• If the cost of remaining listed outweighs the benefits sought to be received, it would not make sense to the company to remain listed.

• According to a study conducted by Scott Larson, a professor at National-Louis University in Chicago (as reported in the 'Economist'), there are two components of cost for a company to stay listed(a) the cost of regulatory compliance, (b) the cost of equity which is higher than the cost of risk-free debt.

• Together, these two elements constitute the cost of public equity. In order to decide on de-listing, this cost of public equity should be compared to the return demanded by private equity investors.

• In good market conditions, private equity investors have to shell out more to acquire stakes in companies which constrains spread of their portfolio for a given size of the fund.

• Since the same fund has to be allocated to less number of portfolio companies, their risk concentration is higher. This in turn increases their return expectation. Secondly, private equity is illiquid which also increases return expectations.

• However, the return expected by public equity investors would be lower since it entails liquidity.

To-sum up, in a good market, cost of private equity is higher than that of public equity and therefore, the company should remain listed.

• However, in a weak market, the argument is reversed.

• The return expectations of public equity increase due to the absence of an exit route in the secondary market.

• In addition, if the cost of regulatory compliance increases, it adds to the increased cost of servicing public equity.

• On the other hand, the return expectations of private equity investors get moderated since they can acquire good stakes in larger number of portfolio companies at attractive valuations.

• Secondly they would also be privy to inside information and decision making which can guide them on their investments.

• For example, if the company has been approached for a strategic merger or a stake, the private equity investors by virtue of being on the board, would participate in the decision making.

• Therefore, in a weak and highly regulated market, the cost of public equity overtakes that of private equity.

• The company should also consider the fact that due to the weak market conditions, it may not be able to raise further funds through issues in the near future.

• Due to the prevailing low market cap, the company may even find it difficult to raise private equity on reasonable terms.

• In such situations, de-listing could be the way out. There is always an option for the company to come back to the market when conditions improve.

The regulatory framework for de-listing is now prescribed under the SEBI (De listing of Securities) Guidelines 2003.

The main change that has been brought about is that hereafter companies cannot de-list using the fixed price buy-back route. Instead, they need to go through a process of price discovery.

• Regulatory Requirements for De-listing1. Voluntary de-listing must be sought by the

promoters of a company.2. Any scheme of arrangement consequent to

which the public shareholding falls below the minimum limit required for the company to stay listed.

3. Promoters seeking to de-list a company from some of the stock exchanges.

4. Compulsory de-listing of companies must be by the stock exchange.

CAN’T GO FOR DE-LISTING BY THIS METHOD1. In a buy-back of shares if public shareholding falls below

the minimum limit required for the company to stay listed.2. An open offer made by an acquirer pursuant to the

Takeover Code due to which the public shareholding falls below the minimum limit required for/the company to stay listed.

• In both the above cases, the company would not be allowed to use these routes in order to de-list the company.

• Similarly, a fixed price open offer under the Takeover Code cannot also be used to de-list a company because the objective of the de-listing guidelines is to provide the shareholders a fair exit opportunity.

VOLUNTARY DE-LISTING• A company would be allowed to de-list

voluntarily provided it has been listed for at least 3 years prior to that date on any stock exchange.

• Such de-listing would be permitted by obtaining approval of the shareholders in general meeting and making a public announcement of a de-listing offer.

• Before making the public announcement, a merchant banker who is unrelated to the promoter shall be appointed to administer the buy-back of shares from the public for the purpose of de-listing through a public offer.

• The purpose is to maintain transparency and fair dealing in Delisting transaction.

Pricing a Voluntary De-listing

• De-listing could also be an expensive affair since the retail investors would want to make the best of an exit opportunity that comes their way after a long time.

• According to Prof. Larson's study, US companies that de-listed in 2003 had to pay on an average about 40% to 80% premium on the prevailing market prices of their shares to buy them back.

• In another empirical study by Lowenstein (1985) of all the 28 MBO proposals that happened during 1979 to 1984 revealed an average premium to prevailing market price of 56%.

• However, on a larger scale it has been found in various studies that companies taken private pursuant to a buy out deal in the US markets prior to 1990 paid on an average a premium of around 35% to the prevailing market price.

• Unlike in the US market, in India de-listing is more of a voluntary mechanism. Hence, the price can neither be too aggressive nor too low since it has to elicit investor response.

• Moreover, the retail investor needs to be a part

of the price determination for an exit. Therefore, the de-listing guidelines provide for the mechanism of 'reverse book building' in case of de-listing offers.

• For the purpose of the reverse book building, the public announcement made for the de-listing offer has to specify a ‘floor price'.

• The 'floor price" of the offer has to be determined as the average of 26 weeks traded price quoted on the stock exchange where the shares of the company are most frequently traded during such period.

• There would be no maximum price or 'cap' for the offer. In the case of infrequently traded shares, the floor price shall be arrived at as provided in the Takeover Code and this may require independent certification by a merchant banker if SEBI requires so.

• The final price of the offer would be discovered through a reverse book building process as the price at which the maximum number of shares have been offered by the shareholders for sale.

• The promoters or acquirers shall have the option to accept the price or not. If the final price is accepted, the promoter or acquirer shall be bound to accept all the offers up to and including the final price but may not accept the higher priced offers if so desired.

• If the final price is not accepted, no de-listing application should be made.

Other Process Requirements for Voluntary Delisting• The public announcement for de-listing shall contain

information as follows: on the floor price, the trading centers and trading members for the purpose of putting in

the bids, the time table of the bidding process, the stock exchanges from where de-listing is

sought, complete details of all material facts and other necessary details as prescribed.

• The promoter or acquirer should also open an escrow account and deposit therein 100% of the amount required to purchase the full quantity of shares required under the de-listing offer calculated at the floor price.

• The shareholders who wish to put in their bids should do so through the trading members for placing the offers on the screen based on-line electronic system.

• The bidding period should last for at least three days and the bidders have the option to revise their bids before the bidding period closes.

• After the de-listing offer is closed, a second public announcement has to be made within two days of the final price being discovered by the book building process and whether or not, the promoter or acquirer has accepted the price and the same should be communicated to the stock exchange.

• If the final price is accepted, the promoter or acquirer has to then make a de-listing application to the concerned stock exchange(s) along with all the necessary details and seek the approval of such exchange(s) for de listing subject to terms and conditions that are imposed by such exchange(s).

• If the quantity eligible for acquiring shares at the final price does not result in public shareholding falling below the required level for continuous listing, the company shall continue to remain listed.

• Therefore, under these guidelines, there can be two instances when the offer can fail and the company remains listed(a) if the promoter or acquirer does not accept the final price and (b) if the required minimum quantity of bids are not put in by the public.

• The guidelines provide that wherein the second situation is fulfilled, the promoter or acquirer shall not acquire any shares and the offer should be cancelled.

• In case the de-listing offer is cancelled as above or the promoters or acquirers opt out of it as the case may be, the public shareholding has to be brought up to the required minimum within six months.

• The consideration shall be settled in cash for all the bids accepted and the offer formalities should be completed.

• However, the acquirer shall allow a further period of 6 months for any of the remaining shareholder to tender the securities at the same price.

• Where a company has any convertibles outstanding, de-listing shall not be permitted unless the conversion process is completed or the exercise period of the conversion option has lapsed.

`Case on Voluntary De-listing• In the first ever case of voluntary de-listing under

the reverse book building guidelines. Digital Global Soft India was de-listed using the reverse book building under the de-listing guidelines.

• Digital India, which began in 1988 as a joint venture between Digital Equipment Corporation of USA (DEC) and Hinditron, later became a subsidiary of Compaq when the latter acquired DEC in a global acquisition.

• After Hewlett Packard (HP) took over Compaq, Digital India (renamed Digital Global Soft) became the subsidiary of HP.

• HP announced a voluntary de-listing so that Digital India could become a 100% subsidiary of the parent company.

• The de-listing offer was made at a price of Rs 750 per share, which nearly worked out to a 50% premium on the 26-week average price formula.

• The reverse book-building offer opened in the month of January 2004.

• The response from the investors was good but the most number of offers were received at Rs 850 a share which amounted to almost 21% of the total shareholding in the company.

• This meant that HP had to increase its offer price to Rs 850 thereby incurring an additional cost.

COMPULSORY DE-LISTING• Stock exchanges may de-list companies which

have been suspended for a minimum period of six months for non-compliance with the listing agreement.

• At the same time, the stock exchanges may assess the need for compulsory de-listing based on the stipulated norms, which are listed in annexure III of the de listing guidelines.

• The stock exchange shall serve a show cause notice on the company with a fifteen-day period for filing replies.

• The de-listing decision shall be taken by a specially constituted panel of the stock exchange and notice of the termination of the listing agreement needs to be given to the company. The de-listing should also be publicized and displayed on the trading systems.

• Where a company has been compulsorily de-listed, the promoters of such company shall buy back the shares from the public at their option, at the fair price.

• The consideration for the shares should be settled in cash.

DE-LISTING PURSUANT TO A RIGHT ISSUE• In the case of a rights issue, promoters or persons in

control of management are allowed to subscribe to the unsubscribed part of the rights issueor to the rights renunciation even if such a step results in the public shareholding falling below the required minimum, if such an intention was disclosed in the letter of offer.

• In such an event, such promoters have to buy out the balance shareholders also at the rights price and apply for de-listing.

• If de-listing is not contemplated, such promoters have to make an offer for sale to the public to bring the public shareholding up to the required minimum.

RE-LISTING• Re-listing of securities can be permitted by a

stock exchange after a cooling period of two years.

• However, re-listing shall be as per the terms and conditions applicable at the time of re-listing and further subject to the clearance from the relevant stock exchange.

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