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Buying Back Our Deficit

Atlas Invested

The government has not been able to divest public sector company shares in the market, due to depressed investor sentiment as markets have fallen over 20% in the year. The lack of this "extra" revenue means that total government receipts — or "income" — have fallen 18% compared to last year (as of October 2011). With expenditure growing at 10%, the fiscal deficit is at Rs. 3  lakh crore, which is already about 4% of GDP. It is only expected to grow.

Last year, a significant amount of revenue came from non-tax income. A Rs 100,000 cr windfall was made from the spectrum auctions to telecom companies, and another Rs 22,000 cr came from divestments in government owned enterprises like Coal India, SAIL, and MOIL. The divestment target for FY 2011-12 was Rs 40,000 cr, of which the government has only managed a little more than Rs 1,100 cr through a follow on offer of PFC.

Recently the government has been asking public sector companies to buy back their shares to help plug the fiscal deficit. This is an interesting move — it wants government-owned companies which have surplus cash reserves, to use that money to buy back their shares. In India, buyback procedures have strict rules, to prevent rogue promoters from siphoning cash into their own pockets.

Companies can buy back shares in two ways.

Market buybacks are where the company decides to buy its own shares back from the market. They first take shareholder approval for how many shares they intend to buy, at what maximum price, and for how long they will do it. A merchant banker is then appointed, and the company reveals to the exchanges how many shares it bought back every day, until the goal is met or time runs out.

While many companies have taken this route, it is largely a method used to pull wool over investors' eyes. The announcement of a market buyback is largely intended to keep the share price high in anticipation; the reality is that it does nothing because companies, for the most part, don't really intend to buy a lot of shares back. What they do is try to rig the share price upwards, going by the public disclosure of shares bought or sold each day; if the share price goes up, the buyback on that day is furious, but if the share price falls, the purchases go down to a trickle. Having learnt this over the years, investors do not pay much heed to market buyback announcements.

The government can't use a market buyback approach —it's not actively trying to sell shares in the market, for one. For another, the anonymous trading exchanges don't allow you to selectively buy from one participant — the best price will always win. That means the government can't ask a merchant banker to buy government owned shares first; the shares purchased will be those with the lowest "offer" prices in the market.

The other form is the "tender offer" buyback. Companies can use spare cash to buy shares back from all investors who tender their shares, in a proportionate manner. Piramal Healthcare did this recently, when it sold part of itself to Abbott for over Rs 16,000 cr. The buyback at Rs. 600 was way more generous than the existing stock price (Rs. 460). Since only 20% of the company would be bought back, if all shareholders tendered their shares, only 1/5th of any investor's shares would be bought back (the rest returned). Piramal Healthcare ensured a "proportionate" buyback — that is, where a portion of every investor's tendered shares would be bought back, not favouring anyone in particular.

Proportionate buybacks mean that the buyback must be offered equally to all investors, and where the government owns only 50% of shares, it cannot hope to get more than 50% of the money used in such a buy back. The government will have to use this route, and it holds around 90% in many profitable PSUs. Yet, they can't be asked to pay their entire cash hoards to buy back shares (they will need capital to survive or grow, and they are likely to have debt on which interest must be paid).

The subject of buybacks is also important for unlisted companies or startups. In some cases, a co-founder or an early investor intends to leave, and the company has the money to buy his shares back. But the buyback rules stipulate that all investors must get to participate; so to get one investor out, startups will need to convince all other investors to stay in (and thus, not tender their shares). Subsequently, for six months, the company can no longer issue new shares, which means the exit of one investor will delay any fund raising rounds.

Using buybacks to fund the deficit might solve the immediate problem for the government but it really should consider divesting stake even at depressed prices. There is no reason for keeping 90% of a Coal India or 84% of an NTPC. There is demand at low prices; prices that are still high enough for the government to cover a deficit. But it seems that the government has gotten enormously greedy when it comes to IPOs, as nearly every of their recent IPOs is off substantially. An example: NHPC — a nice hydro power utility company — was priced at a ridiculously high price of Rs 36. More than a year of disappointment followed, and even with much improved performance, the share languishes at Rs 23, and IPO investors have lost a third of their money. The MOIL share is also down 30%, in what seems like another overpriced IPO. To regain investor interest, IPOs must be priced much lower.

If the cash is available in their companies as a real surplus, then the government could use dividends as a better way to pay themselves; at one level the government will get a dividend, and at another, the dividend tax of 15% comes straight to them as revenue. It also avoids the associated costs of a tender-offer in the form of SEBI approval and banker fees.

Yet, the amount of money the government gains from the exercise will take money out of the corporate and into the hands of an entity that is likely to fritter it away in useless bailouts such as Air India, which has requested Rs 43,000 cr till 2021.  The idea of taking from performing enterprises and putting it into non-productive areas has only political benefits, not economic ones. Tomorrow, don't be surprised when conservative taxpayers will be asked, through higher taxes, to pay for an increasingly profligate public sector. I wonder what it will take for us to buyback governance.