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Event update: Financials; LVB merger with IHFL- Unprecedented. Benefits both in the short -term

India Bulls Housing Finance (IHFL:IN), an HFC regulated by NHB,  has decided to buy Lakshmi Vilas Bank (LVB:IN), a loss making bank regulated by RBI, in an all-stock deal. The proposed swap ratio is 0.14 shares of IHFL for every share of LVB. The swap ratio values LVB at a premium of 36% to the CMP / 2.4x unadj.BV 9MFY18. The bank will be merged into the HFC and the amalgamated  entity will retain the banking license. Sameer Gehlaut, the current promoter of IHFL will head the new entity. IHFL management believes that the amalgamated entity complies with all the prevailing licensing requirements.

Unprecedented and crucial for both entities: There has been no precedence of an NBFC/HFC buying a bank, only the reverse has happened. LVB is loss making. In the past there have been instances of stronger banks buying weak banks – OBC – GTB, ICBK – Sangli, ICBK – Bank of Rajashtan. RBI in the past has been very strict about the entry of corporates into banking, even for minority stakes. The India Bulls group is into real estate development which is a non-financial business, so going by past experiences the promoter does not qualify for a banking license.  However given the NBFC liquidity crisis and capital shortage for weak banks, there is a likelihood that RBI would now take a more liberal view of NBFCs (even with non-financial / corporate businesses) taking over banks. As such we could see a change of RBI stance on promoters with other non-banking interests owning banks.  RBI approval is a key monitorable. It will take around a month for shareholder approvals and an additional 6-8 weeks for RBI approval. So RBI approval is 3 months away. If RBI approves this merger, it will open the door for many other eligible corporates/NBFCs getting into banking.

Both benefit in the short term, long term still uncertain: Both IHFL and LVB stand to benefit as the merger offers a solution to both their current problems. For IHFL, business growth has slowed following the NBFC crisis and migrating to a more scalable, sustainable banking model would be of great help. LVB on the other hand would benefit from IHFL’s strong capital adequacy and IHFL’s strong track record of NPL recovery. So the merger is positive for both in the short term. However, the long term success of the merger would depend on how successful the merged entity is in garnering retail liabilities. It is getting incrementally difficult to garner retail liabilities with savers choosing to stick to established deposit-taking brands.

If required both are open to a reverse merger and Sameer Gehlaut assuming a non-executive role:  The current proposal is that Sameer Gehlaut will head the amalgamated entity as Executive Vice Chairman. He is promoter of IHFL. Given that the India Bulls group has interests in non-financial businesses, if RBI insists, Sameer is willing to take up a non-executive role which means that he will have nothing to do with the bank’s management. Both parties are also open to merging the NBFC into the bank if RBI insists. Because IHFL is the larger and more profitable entity, the current plan is to merge LVB into it. They are open to doing the reverse if RBI insists. India Bulls Ventures will not be part of this deal.

Promoter stake to come down to 15% on date of merger: Promoter of IHFL will hold 19.5% in the amalgamated entity against the current stake of 21.5% in standalone IHFL. Promoter will sell stake in the standalone entity before the merger is effective to ensure that promoter stake in the amalgamated entity is 15% on the date of the merger, in compliance with the existing RBI requirement.

Amalgamated financials: IHFL has a track record of being profitable every year with a 7-year CAGR of 26% in earnings. LVB is loss making with high GNPAs of 14%. Due to its weak profitability it has not been able to raise the capital it requires. It could raise only Rs4.6bn recently. Due to losses of LVB, IHFL’s return ratios will get diluted on merger. RoA drops to 2% on amalgamation from 3.2% and RoE to 19% from 28%. It will take 2-3 years to regain pre-merger return ratios. While IHFL will benefit from lower cost of funds through a banking platform, it will take 2-3 years for the impact to show given the smaller base of LVB – LVB’s assets are only 20% of the amalgamated entity. The merged entity will have Tier 1 of 14.4%.

RBI’s current role: Mgmt had briefed RBI on the deal. Now they will approach RBI with a formal plan. RBI has already issued a press release clarifying their stance. At the analyst call, mgmt. alluded to the presence of two nominee directors of the RBI on the Board of LVB who could facilitate RBI approval. RBI has clarified that the merger announcement does not have any approval of RBI at this stage. It has also clarified that presence of Additional Directors nominated by the RBI on the Board of LVB does not imply any approval of the RBI of the merger proposal. RBI will evaluate the merger proposals when they are submitted.