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TATA Steel and Corus Deal - Looking at Debt instruments

Posted in Finance Articles, Total Reads: 3057 , Published on 19 March 2014
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We do understand that there are certain occasions wherein rms cannot go for standard instruments/products to
raise funds. For example there may be situations where existing shareholders of the rm may not be willing to dilute
their ownership in the rm; hence the rm cannot issue more shares. Also existing lenders might not be willing to lend
more money. In such situations, if the rm is short of cash, it generally goes for raising money through dierent
nancial instruments. Financial instruments these days are more than just raising funds for the rm. They are also a
way for the rm to share their business risks with the lenders/buyers of the instrument.
Two very interesting cases come to my mind when I write this article:-

Macroni strategy: - There have been instances wherein several rms try to protect themselves from unwanted Mergers
and Acquisitions. These rms create a lot of debt instruments with the clause that if an outside rm tries to acquire it,
it would be required by the acquirer to give a high premium to the rms lender or redeem the lenders of the rm
before acquiring or may be take the advice and consensus of the lenders before acquiring the rm. These clauses
trigger during M&As and making the rm unattractive for acquisitions.

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Another very interesting case comes from the oil sector. Firms like ONGC rely a lot on the price of crude oil. Wealth of
the rm depends heavily on it. When the prices of crude oil go up, the wealth of the rm goes up and vice versa. Now
there are other rms which process this crude oil to make petrochemical products. If the price of crude goes up, it
seriously impacts the cash ows of the rm and brings down the value of the rm. If ONGC creates a crude oil index
bond wherein they create a clause that when the prices of crude go up, they would be paying more coupon on the
bond and vice versa. They will nd buyers of this instrument in the rms which use this crude oil easily as when the
prices go up these rms would be getting a high coupon which would mitigate their loss to some extent. In this way
risk starts to evaporate from the system.

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With this introduction about nancial instruments, we shall now go into the acquisition of Corus by Tata Steel but
before that I shall give a brief introduction of the two rms.

Tata Steel was originally incorporated as The Tata Iron and Steel company Limited, as a public limited company under
the provisions of the Indian Companies Act 1882. The company manufactured a diversied portfolio of steel products,
including at and long products, as well as non-steel products like ferro alloys and minerals, tubes and bearings. The
main markets included Indian construction and automotive industry.

Corus was formed by the merger of British Steel plc and Koninklijke Hoogovens N.V. The company prior to its
acquisition was listed on the London Stock Exchange, New York Stock exchange. It had four operating systems; strip
products, long products, distribution and building systems and aluminium. It had good distribution network in North
America and Europe. It was the second largest steel producer in Europe and the ninth largest steel company in the
world. The steel division of the company accounted for 91 percent of the total turnover of the company.

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The UK panel on mergers announced the winning bid of Tata Steel of 608 pence per share of Corus. The total
consideration for the acquisition worked out to around 6000 million Euros. Following the auction, Corus board
unanimously recommended the oer of Tata Steel to the shareholders who gave their approval.

Convertible Alternative Reference Security (CARS)

The issue of US$ 725,000,000 in aggregate principal amount of one percent letter of credit backed Convertible
Alternative Reference Security (CARS), due 2012, which would include any CARS issued pursuant to an option to
increase the principal amount of the CARS up to an additional US$150,000,000 was authorised by a resolution passed
by the BoD of Tata Steel. CARS was a variant of a standard International Convertible bond; among the typical features
missing (from an Indian FCCB) was the call option to the issuer linked to the market price performance of the convert
(the issuer did not have the right to call the bond under dened circumstances and eectively force conversion). The
CARS issue was backed by an irrevocable letter of credit under a credit agreement entered between Standard

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Chartered and Tata Steel. It was issued in favour of the trustees for the benet of the holders of the CARS.

CARS was required by Tata Steel to defer cash ows and also the fact that the rating agencies did not consider this
instrument as a plain debt as these were convertible to shares at a later stage. It was therefore considered to be an
Quassi equity instrument and the ratings of the company didnt fall because of this.

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Some of the features of CARS were:1) Provided coupon rate of 1%

2) The bond would be redeemed at 23% premium
3) Eective Yield was 5.15%
4) The provision of convertibility came into picture after 4 years and was open for only one year. This was dierent
from the normal FCCB wherein call option was there with the rm (it could call back the instrument and convert it into
shares and issue them or pay back cash to the investor). In this case one needed to wait for 4 years and only if the
share prices were high and rising at that time would convert the bond into shares. At the time of purchasing CARs the
market was bullish and people thought prices would continue to rise even after 4 years hence they purchased the
bond.
5) The instrument was supported by Letter Credit and this attracted foreign lenders easily as backing an instrument
by LC grades the instrument at A or AA.
6) Tata Steel being a Capex heavy company had a lot of operating leverage. When market goes into recession it
becomes dicult to manage the operating leverage. With this instrument the company had the lenders also to partner
with them and share the risk.
7) On conversion, voting rights were not given to the shareholders.

Valuation of the instrument:Convertible bonds have two parts in value:-

Value of plain bond+ value of convertible part

Value of plain bond comes out to be Rs 97,425

Convertibility gets estimated assuming call option. Convertible price quoted was Rs 876 i.e when the stock price
increase beyond Rs 876 the lender will exercise conversion.
Value of underlying

21

Strike price

22

Option price per CAR

4,591

Option value (derived using Black Scholes model)

10

Option value of CARs

43,898

Value of plain bond

97,425

Value of CARs

1,41,323

Since it is a case of deferred conversion, option value will not vary linearly with the underlying price.
The above calculations show that CARs was trading at a discount then and with a few more incentives interested the
buyers to purchase the bond.

Post Acquisition
Then, the 2008 subprime crisis happened. With the collapse of marquee names such as Bear Stearns and Lehman
Brothers, the Western world went into a tailspin. Automobile companies and construction companies, the main
sectors aected in the nancial crisis, were key customers of Corus. The company recorded a 23 per cent decline in
Ebitda for 2008-09, followed by a $303 mn (Rs 1,361 crore) operating loss in 2009-10.

Tata steel thought Corus would do well and stock prices would go and they would not have to redeem debt. The
investors would convert the bond into shares. Exactly the opposite happened and Tata Steel was asked for redemption
of debt. The company already in a lot of cash crunch decided to postpone the date of payment of principal amount.
This made the investors ask for more interest that previously decided.

Conclusion
Theindentureprovisions on a convertible bond are generally much more stringent than they are either in a short-term
credit agreement or for common or preferred stock. Hence, the company may be subject to much more disturbing
restrictions under a long-term debt arrangement than would be the case if it had borrowed on a short-term basis, or if
it had issued common or preferred stock. Firms issue such nancially engineered instruments keeping a rosy picture
of the future economy in mind or considering that a period of recession will not arise soon. As we have seen in this
case, such plans generally go for a toss leaving the rm with a lot of liquidity crunch and also bringing bad name to it.

Moreover sometimes the complexity of the instrument (or in other words when the buyers are not able to understand
the clauses of the instrument completely) either he will refrain from buying the instrument or buy it at a higher coupon
rate.

This article has been authored by Rahul Gupta from XLRI

References:
http://www.thehindubusinessline.com/companies/article2436532.ece

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http://www.thehindubusinessline.com/companies/article2436532.ece
http://en.wikipedia.org/wiki/Tata_Steel
http://en.wikipedia.org/wiki/Tata_Corus_acquisition
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