The Game Changer: Time For Some Hybrid Instruments

A hybrid security is a single financial security that combines two or more different financial instruments. Hybrid securities, often referred to as "hybrids," generally combine both debt and equity characteristics. The most common type of hybrid security is a convertible bond that has features of an ordinary bond but is heavily influenced by the price movements of the stock into which it is convertible.

Hybrid instruments have the characteristics of debt and equity and come with differential voting rights. In a number of IT companies overseas, promoters hold less than 15% equity but exercise full control.

The issuance of non-traditional hybrid securities has increased significantly in recent years. In part this development is the result of a more favourable treatment of hybrid securities by regulators and rating agencies. Consequently, these instruments can bring a number of advantages compared to traditional debt or equity instruments due to a combination of debt and equity-like characteristics.

Newer forms of hybrid securities are structured somewhat differently and do not necessarily involve the option of converting a bond into equity.

These types of hybrid securities are designed to fulfil the requirements of issuers, investors, regulators and rating agencies and as a result can become quite complex. This type of instrument is very flexible with different options on every feature.

India will soon unveil a wide array of hybrid instruments on the lines of those available in developed markets that will allow promoters to retain control of an entity even with a minority stake, a move that will make fundraising easier, particularly for startups.

A new policy framework may be put in place as there is a growing view within the government that these instruments need a fresh look and should not be clubbed with debt or equity. The government has been keen to attract foreign investment to spur job generation and economic growth, taking various steps to liberalise the framework, including the fungibility of all forms of overseas capital within sectoral caps.

Our Take

Any instrument that is not mandatorily converted is considered debt and governed by external commercial borrowing rules. The proposed policy is expected to go beyond this categorisation with built-in pricing freedom. Need for such instruments seems inevitable for growth but critical changes will be required in various laws and regulations. However the window is not available if economic interest to foreign investors goes beyond 49%, Company law provisions make it further complex and limit the ability to decide and negotiate commercial returns, priority distribution, optionality etc. on investment, which is important for high-risk capital. But the road ahead seems promising.