Markets| SEBI’s proposed buyback rule change no cure-all

Shishir Asthana

In a move to clarify rules for buying back shares, market regulator Securities and Exchange Board of India (SEBI) is tweaking buyback norms to make the process more transparent, say media reports.

According to these reports, SEBI has proposed to consider consolidated numbers instead of standalone financials to see if a company is eligible to go ahead with buying back of its shares.

The entire exercise had to be taken up because of Larsen & Toubro’s buyback, which was rejected on the ground that its consolidated debt to equity ratio was high – more than two times the norm set by SEBI.

When a buyback is on the table, the cash level of the parent company assumes significance. The firm does not use the cash of its subsidiary to buy back the shares.

So, it is logical to say a company with a high level of debt should not be allowed to buy back equities from the market. Lenders always have the first right to a company’s asset, including cash which is used to buy back shares.

One may, however, argue that 2:1 debt-equity ratio is too rigid and in some sectors, the norm should be relaxed. In all earlier buybacks in India, subsidiaries were more or less in the same line of business, but in L&T, it was not.

In the case of L&T, the company has a subsidiary which is a non-banking finance company (NBFC). Now for an NBFC, the debt-equity ratio cannot have the same guidelines as those of manufacturing or an engineering entity.

L&T’s financial arm had a debt-equity ratio of 6:1 which was well above the 2:1 norm set by Sebi. But this is like comparing apples with oranges.

Realising this, the Sebi-appointed Primary Market Advisory Committee (PMAC), which was looking into the matter post L&T’s buyback, has recommended that the ratio should be 9:1.

Banks and finance companies generally do not announce buybacks in order to maintain their capital adequacy ratio. Hence, by that logic, they should not be included in the calculation of consolidated debt equity. Reports say the PMAC has suggested that consolidated numbers should be considered, but NBFCs should not be part of it.

In the case of L&T, the presence of an NBFC subsidiary added a new twist. At the consolidated level, the balance sheet would look skewed because of the extremely high level of leverage. In the profit and loss account, all interest transactions of the NBFC will be at the operational level. This would skew the calculation of debt:equity at the consolidated level.

While the PMAC may be right in suggesting that the NBFCs be taken out of the equation to calculate debt-equity ratio, another point needs to be considered here. One has to look at the parent company from the risk level.

Running an NBFC is a risky business in India, especially over the last decade. A highly-leveraged NBFC can transfer the risk to its parent firm.

Coming back to L&T’s case, there is a case for not taking the NBFC’s 6:1 debt-equity ratio. But what if there is a liquidity crisis and slowdown, and the NBFC arm starts bleeding. The heavily-leveraged arm would need the parent’s support. There has to be a way to account for the risk of an NBFC subsidiary. The PMAC’s current formula wishes away this risk. If that is the case, there is nothing stopping L&T from announcing a buyback.

While the present suggestion of not considering the NBFC in its calculation is logical, the premise will be tested in case the NBFC’s health deteriorates. All that the PMAC has done is kick the can down the road.