IDFC Bank and its hunger for growth: Story of merger with Capital First

IDFC Bank would issue 139 shares for every 10 shares of Capital First; m-cap of combined entity would be Rs 313 bn

IDFC Bank is the newest universal bank to start operations, and most certainly one that has been written about a lot in the two years of its existence. The term-lending institution that partly became the bank is much older and has its share of problems, which the lender had to bear.

Nevertheless, the standalone bank, under IDFC Financial Holding Co Ltd, has been unique for showing a voracious acquisition appetite, despite being around for such a short period. And with good reason. The share of legacy corporate loan was more than 90 per cent on the bank’s books. Gross non-performing assets (GNPAs) were as high as 6 per cent of advances at the end of the second quarter of FY17. At the end of September 2017, GNPA ratio was 3.9 per cent.

Private banks depend on retail lending. And at a time when the economy was slowing down and big firms were defaulting, IDFC Bank started life with a significant handicap. 

Like its peers, the bank should have aggressively opened branches. But its cost structure didn’t allow that. The bank’s legacy burden created a drag on its profit and loss accounts for two reasons: There was a legacy bad asset stock of Rs 37 billion, costing it Rs 1.75 billion a year. Then, Rs 360 billion of bonds were contracted for a coupon of 8.9 per cent. This had a net negative drag (netted for the amount the bank would have paid if the bonds were contracted at the present rate) of around Rs 4 billion a year. This pre-tax Rs 5.75-billion drag translates into a 0.35 per cent hit on the return on assets.

Compiled by BS Research Bureau

“I should open up 200-250 branches a year for realisation of accounts. But with this kind of a drag, how can I?” said Rajiv Lall, CEO and MD of IDFC Bank, in an interview with Business Standard in October last year. The bank could not add about 100 branches in the past two years because of this skewed cost structure, he said. 

However, shareholders, including the government of India, wanted value. The bank had a good capital base, and free cash. The only option, then, was inorganic growth in retail. The idea was to expand the balance sheet through retail loan aggressively and grow out of the problem. 

In July 2016, the bank acquired south-based microfinance company Grama Vidiyal Microfinance, expanding the balance sheet by Rs 15 billion in assets and acquiring 1.2 million customers in the process. Then Lall got even more ambitious and wanted to merge with the Shriram Group, which had a larger book than the IDFC Group. While the Shiram Group’s loan book was about Rs 800 billion in June, IDFC Ltd and IDFC Bank’s total loan book was about Rs 600 billion. The exclusive merger talks started in July last year but collapsed by October 30 as Shriram shareholders did not reciprocate.

The deal structure was complex, to start with. Analysts and shareholders of both the companies were dismissive about the plan from Day One. The Reserve Bank of India was not very comfortable with the proposed structure, said sources in the central bank. When the deal was called off, it came as a natural outcome to most observers.

However, Lall had then said the bank would start scouting for merger candidates immediately. Within three months, IDFC Bank landed Capital First Ltd, floated by former ICICI Bank retail head V Vaidyanathan, in a management buyout of a non-banking finance company.

IDFC Bank would issue 139 shares for every 10 shares of Capital First. The market capitalisation of the combined entity would be Rs 313 billion, based on the closing stock price of January 12. The new entity would have assets under management of Rs 880 billion and would serve more than 5 million customers. Profit after tax would have been Rs 12.7 billion at the end of FY17. The entity would have a distribution network of 194 branches (December 2017 numbers), 353 dedicated business correspondent outlets, and 9,100 micro-ATM points.

As part of the deal, Vaidyanathan would become the managing director and chief executive officer of the merged bank. Lall would become non-executive chairman. 

Analysts have not been enthusiastic about the merger, considering the question of garnering retail deposits does not get addressed by the merger. But the deal would get through this time, they said, simply because Capital First’s primary shareholder, Warburg Pincus, seemed to be interested in capitalising its investment.

Vishal Mahadevia, head of Warburg Pincus India, said a merger with IDFC Bank would create a powerful combination. “We are excited about the opportunity to be part of something special here, and look forward to supporting Vaidya and the teams at Capital First and IDFC Bank as they grow the platform into a leading banking institution.”

In May last year, Cloverdell Investment Ltd (an arm of Warburg Pincus) sold 25 per cent of its shareholding in Capital First, bringing down its shareholding to 34.32 per cent. 

As for the shareholders of IDFC Bank, it makes sense to accept the merger proposal, said Lall on Saturday. “It accelerates the growth of the bank to gain at least three years. In the absence of this deal, we would have depressed earnings because we would be invested in building our branch network and Casa (current and savings account) franchise. So this actually gives us again the best of both worlds.”

Vaidyanathan was excited about the prospects of heading the bank. “We have built a very good capability to originate and manage retail loans. But we didn’t have a banking licence. They have a banking licence, and they have a terrific infrastructure and wholesale financing book. So, two of them put together is entirely complementary,” he had said after the announcement of the deal.