ISEC / ICICI Bank: Boards and proxy agencies support a Rs 18 bn heist

The proposed merger ratio and rationale of the proposed merger between ICICI Bank and its listed subsidiary, ISEC (a wealth management and broking firm) deserves scrutiny on a few counts:

1. How management thinking of business opportunities changes over time,

2. Do managements and investment bankers rip off investors in IPOs?

3. The role of valuation firms in deciding merger ratios, and

4. Whether proxy agencies who guide institutional and retail investors on how to vote are faultless in their judgements.

Need for cash and value creation:

About eight years ago, under pressure from increasing non-performing loans in a deteriorating macro-economic environment, ICICI Bank decided to list key subsidiaries to shore up its own capital base and to negate any potential capital infusion requirement in its subsidiaries from the parent. Listing of its subsidiaries was always planned but the deterioration in ICICI Banks balance sheet accelerated this decision. The Life and General insurance arms were listed first in September 2016 and September 2017, respectively. Its Online Broking and Wealth management arm - ICICI securities (ISEC) - followed next and was listed in April 2018. ICICI Bank today is well placed it terms of its capital requirements and has had a rethink on the listing of ISEC and wants to merge it back with ICICI Bank, offering investors 0.67 shares of ICICI Bank for every one share in ISEC.

ISEC did not have a great debut listing at a 17% discount to its issue price of Rs 520. Despite its poor debut on listing, it had a reverse merger swap ratio set at the closing price of Rs 445 on the day of its listing on 4th April 2018, the ratio would have been set at 1.65 ICICI Bank shares for every 1 share of ICICI securities (146% premium to the current offer) based on the closing price for both the companies on that date. Had the ISEC IPO price of Rs 520 been used as a benchmark then the share swap ratio would have been 1.9 shares of ICICI Bank for every 1 share of ICICI securities (183 % premium to the current offer) on the day of its listing.

Liar, liar, lipstick?

We can think of the past IPO valuation of Rs 520 per share and the set price of Rs 628 per share (for the proposed merger ratio of 1 share of ISEC equivalent to 0.67 shares of ICICI Bank) as an example of:

1. Greedy investment banks and managements who overpriced the IPO of ISEC and ripped off investors?

2. Clueless and dependent valuation firms who are paid a fee to potentially rubber stamp a management supported merger ratio that is favourable to the parent company?

3. Proxy firms who are meant to be impartial in their judgement have shown their weakness by ignoring publicly available crucial data points while making a judgement.

To be clear, ICICI Bank claims it has followed "due process", appointed two independent valuation experts to arrive at the swap ratio, and based on these expert valuation reports on the date of announcement of the swap ratio valued ICICI securities at RS 628/share.

In its defence of this absurd ratio, the management of the company has stated that ISEC has rarely traded above the proposed merger set price in its history. Hence, the management claims that the valuation is appropriate given the cyclical nature of the business. Data shows that ISEC consistently traded above the proposed merger price of Rs 628 from 29th June 2021 to 3rd March 2022 (source NSE). Another way to interpret this low-balled ratio is that the management and its investment bankers ignored the fundamental 'cyclicality' nature of the ISEC business and overpriced its IPO!

This means that Investors in the ISEC IPO have been whacked twice: investors were sold the ISEC dud packaged as a gem; then the gem trades like a dud; the management of the ISEC dud takes steps to build a gem of a business and the parent ICICI Bank is now making us believe that the potential ISEC gem is a dud - and they are rescuing the idiots who invested in the ISEC dud. To legitimise this googly of a claim, ICICI Bank has the support of valuation experts and proxy agents to brainwash us into believing the potential ISEC gem is a dud and shareholders of ISEC dud are being rescued by this gallant act of the ICICI Bank.

The reasons cited by the management to delist the company was the fact that the market never valued the company correctly and they are using this same low price as a benchmark to gauge the fairness of the swap ratio. To be fair, the competitive nature of the industry has changed dramatically. Since its listing, from April 2018 to April 2023, ISEC barely compounded at 3.2% CAGR as it battled rising competition from PE funded discount brokers willing to absorb large losses while acquiring customers in an era of cheap money. This put pressure on broking margins. To their credit, the management of ISEC has focused on building a diversified business to reduce the share of broking revenues to less than 40% and moved to an open architecture model to reduce the share of 'captive' customers from ICICI Banks in its overall customer base, thereby significantly reducing cyclicality.

Furthermore, the competitive scenario has changed rapidly in favour of ISEC. Rising global interest rates have meant the era of cheap money was over and competition from these new age brokers is likely to ease. Techie-funded platforms across the business landscape from payments to education to micro finance are now facing scrutiny of cash flow and governance. ISEC stands to gain significantly in this new, rational business environment. Since the fourth quarter of the fiscal year ending March 2023, ISEC started expanding its retail cash market volume share of the broking business. Despite a spectacular 66% growth in net profits for the quarter ended Dec 2023, the share price has barely moved because of a cap now placed by the share swap ratio. Existing shareholders already have lost significant upside because of the announced merger ratio from ICICI Bank's ratio that values ISEC as a dud.

The scale of undervaluation of ICICI securities in the swap ratio is even more apparent based on the valuations for listed peers. The merger ratio is valuing ICICI securities at a 30% -77% discount to its other listed peers based on consensus earnings forecast for fiscal year ending March 2024. I guess the valuation experts and the proxy agencies forgot to use publicly available information to make their judgements.

Even if the company was to be valued at the lowest PE multiple reflected in its peer set (20.4x for Angel One) the merger offer would have been at least 30% higher. The proposed merger ratio transfers Rs 17.8 billion to ICICI Bank shareholders from ISEC minority shareholders.

But there is a sign of hope that the actions of the management of ICICI Bank, the valuation experts, and the proxy agencies will be under scrutiny. The independent Board members of the Bank and of ISEC and the shareholders of ISEC need to put on the pressure and challenge the illogical merger ratio. The market price for ISEC has already strayed from the suggested price of the swap ratio and is now trading at a 7% premium. Instead of surrendering the share in the merger It would make sense for any ISEC shareholder to sell the share in the open market, buy ICICI bank shares equivalent in the swap ratio and still have a 7% surplus left over.

In summary, despite following "due process" of law, ICICI Bank, its valuation experts, and the proxy agencies have potentially suspended all logic and significantly undervalued ISEC in the merger process. The independent directors of ISEC have a fiduciary duty to minority shareholders to ensure their interests are not compromised in the merger. Should Independent Directors be asking ICICI Bank scrap the current merger ratio and start afresh to ensure minority shareholders get a fair deal while existing shareholders may consider rejecting the merger offer when it comes to vote?

As the founder of companies Quantum Advisors and Quantum Mutual Fund whose investment arms own shares of ICICI Bank and ISEC, I am an 'interested party.' As an observer and commentator of ensuring that governance prevails in India's wild west capital markets, I have a vested interest in ensuring that Boards and external agencies don't surrender their integrity and sense of fairness to opportunistic managements who potentially misled IPO investors while divesting a stake in ISEC and now wish to again mislead shareholders of ISEC when buying back the shares (dumped on the market with at an overpriced IPO) at a discount to ISEC's fair value.

Ajit Dayal is the Founder of the Quantum Group which includes Quantum Mutual Fund and PersonalFn. Ajit has over 35 years of research and investment experience. An avid writer and speaker, Ajit has been profiled and interviewed by many international and local newspapers, magazines, TV channels and radio shows and is never shy of speaking The Honest Truth. Sign up here to get The Honest Truth delivered every week into your mailbox. It will change the way you think about your investments.