Evil Designs: RNRL, Reliance Power merger

Reliance Power, RNRL merger ratio fixed at 1:4, Swap ratio in line with Market rate of the stocks.

This headline from Economic times, July 5th , is interesting because it shows the extent of ignorance(or worse connivance with rogue promoters) of Indian financial newspapers. The content of the news item had conflicting points. It mentioned that "The merger swap ratio is in line with the two companies' market capitalization, or the value of the total shares at ruling market price. At Friday's close, RNRL's market capitalization stood at Rs 10,394 crore, nearly one-fourth of that of R-Power's Rs 41,979 crore " and yet, the article had a comment from an analyst that the RNRL stock may open 25% down from its closing price.

Indeed, the stock opened 20% down and crashed further to 28% below its closing price on Friday. If the "Swap ratio in line with Market rate of the stocks", why did this happen?

Before we delve into this, let me forewarn you that I consider the Reliance promoters are the pinnacle of evolution of corporate fraudsters. Since their last scandal in 2004, I consider them untouchables for investment purposes. This news item is of relevance solely due to its educational value.

There is an error of simple arithmetic. On Friday, RNRL's total outstanding shares of 163 crs were valued at 63.65 Rs. Per share, giving it a market capitalization of 10394.9 crs. Anil Ambani gave the RNRL shareholder, 1 Reliance Power share for every 4 shares they held in RNRL. This means, RNRL's total outstanding shares of 163 crs, were valued as equivalent to 40.8 cr shares of Rel Power which had a value of 7171 crs on Friday. (Assuming the deal is fair, Reliance Power shouldn't gain from this)

So over the weekend, RNRL shareholders lost 3243 crores or 31% of the market value. The loss of RNRL is the gain of Reliance Power because it got 10394.9 crs worth of shares by paying out only 7171 crs.

But doesn't Anil Ambani lose the money as RNRL shareholder? Yes he does but he can more than make up for that loss by virtue of his stake in Reliance Power. He owns 84.8% of Reliance Power but only 54.8% of RNRL. He makes a cool 971 crs overnight by this if we take the closing prices of RNRL and Reliance Power as fair value. You shouldn't have been surprised at this. Anil Ambani has majority stake in both companies and he can pass any resolution in the board. His self interest, myopic vision and confidance on short memory of public make this a rational decision. Remember what Aumman said "Rationality is orthogonal to the idea of good and bad"

But my grudge is against the media who is reporting this incorrectly. The swap ratio is NOT in line with the market rate of the stocks. A company with n1 outstanding stocks of price p1 is merged with another company of n2 outstanding stocks with p2 price. If the swap ratio is in line with the market rate of the stocks it should be p1/p2

First company shareholders give a value equivalent to p1 * n1.
Number of stocks of second company they should get is p1*n1/p2
For every share they hold, they must get (p1*n1/p2) / n1 => p1/p2 of second company.

The second company pays out (n1* p1/p2) * p2 which is p1 * n1, exactly same as the value of the business they are getting, assuming the market price is fair.

When RNRL is merged with Rel power, they should have got 63.65/ 175.15 shares for every shares they held in RNRL.That translates to about 3 shares for every 8 shares in RNRL.
Compare thus to 3 shares for every 12 shares in RNRL they are getting now.

I'm not saying that the prices of Rel Power and RNRL were in line with their intrinsic value. For me, RNRL had no reason to exist and even if it did, no sane investor had any reason to invest in it. The second clause is true even for Reliance Power. All I'm saying is that the swap ratio IS NOT in line with market rate of the stocks. You SHOULD NOT take the ratio of market capitalization to find out the swap ratio. It's simple math. Considering this, the excerpt from ET quoted above is highly misleading.

The only saving grace for ET is the adage known as Hanlon's razor. "Never attribute to malice that which can be adequately explained by stupidity"


Anonymous said...

Very good analysis, it is amazing how our media and broker houses etc can be kept silent or be asked to give a postive spin by money power

Anonymous said...

Replying to the previous comment, I have to say, in all honesty, that I don't find it "amazing" or even surprising that our media can be bought.

Its been happening for so long now, that all that it evokes from me is a yaaaaawwn.

Good article, Kamlesh. Caveat Emptor !

abrar said...

good article kamlesh keep it up

cooldude said...

Dear Mr. Kamlesh,
It is indeed good to see you back. Most of your articles are extremely enlightening. It is nice to see you settling down with a life partner. I only hope that domestic bliss does not result in one more long disappearance from this blog.

I would like to bring some of your blogs (particulary the one on delisting and the RNRL and Rel Power merger) to the attention of more investors on other websites. The state of our country seems to be more like that of a banana republic than that of a vibrant, vigilant democracy. That is why guys like Ambanis, Madhu Kodas, Shibu Soren etc. seem to go from strength to strength.

Ravi said...

Hi Kamlesh,

Good to see you back after a long break. Wish you and Seema a very happy married life.
Now coming to the article, While I dont have any comments on reliance's ways of managing shareholders and business, I am confused with the math you had explained. Let me depict the scenario you mentioned into a simple one and explain. Please let me know where I am wrong. This is purely to understand your explanation better and in noway to challenge your analysis. Let us assume you are the sole shareholder of your business worth 41,979 cr and I am the only shareholder of another business worth 10,394 cr. Now we both thought its good if we merge our business and come together. Also, let us assume that the IV of the business is the same. So we are assuming that we are bringing in the capital that our business is worth. So our combined entity is now worth 52,373 cr. Now you shareholding in this combined entity is circa 80% (52k crore/41.9k cr) and mine is 20% (52k cr/10.3 k cr). In another way you own 4 times the share for every share I hold in the combined entity. This translates to to 3:12 ratio that the deal was struck at. I do not understand the math of n1*p1/p2. Please let me know if I am missing something here.


Kamlesh Pandey said...

Hi Ravi, thx for your best wishes.

You are wrong in taking a special case where n1=n2=1 and generalizing it.

If company1 is merged into company2, company2 should own mcap2/(mcap2+ mcap1) of the combined entity. You are right till here.

Suppose the swap ratio is x shares of company2 for each share of company1.

new shares issued = n1*x
total shares of merged company = n1*x + n2

For swap ratio to be in line with market valuation
mcap2/(mcap2+ mcap1) = n2/(n1*x+n2)

1 + (mcap1/mcap2) = 1 + (n1*x/n2)

mcap1/mcap2 = n1*x/n2

x = (mcap1/n1)/ (mcap2/n2)
= p1 / p2

In the special case you have taken where both company have only 1 share n1=n2=1

x = mcap1/mcap2

I hope you get it..if not, try taking the same scenario but assume that first company has 1 cr shares and other has only 1

Anonymous said...

I am doing research for my college thesis, thanks for your brilliant points, now I am acting on a sudden impulse.

- Kris

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