Master Study Notes: Other Merchant Banking Activities — Disinvestment & PSU Performance Evaluation (Chapter VIII - Part 1)
Overview of Disinvestment in India
Disinvestment refers to the dilution or sale of the government's stake in public sector enterprises. Specifically, disinvestment means the direct or indirect sale by the Central Government, any State Government, or a government company, of shares, voting rights, or control over a target company that is a Public Sector Undertaking (PSU).
When a merchant banker is appointed to handle transactions related to government entities, the mandate typically falls under two broad categories:
- Disinvestment Transactions: Directly selling the government's stake to public or private entities.
- Advisory Transactions: Providing strategic advice on capital restructuring, such as bonus issues, buybacks, or other financial advisories.
Types of Disinvestment Transactions
Disinvestment transactions are structurally executed through two primary routes:
1. Offer for Sale (OFS) through Prospectus
This traditional route involves offering the government’s existing shareholding to the public. It can be executed as:
- A pure Offer for Sale (OFS) by the selling shareholder (the Government) through a formal prospectus.
- A combination transaction, which merges a fresh issue of shares by the PSU itself with an offer for sale by the government.
2. Offer for Sale (OFS) through the Stock Exchange Mechanism
This is a faster, more transparent market-driven route where promoters (in this case, the government) offload/dilute their holding in listed companies via a separate, dedicated trading window provided by the stock exchange. It ensures wider public and institutional participation in a highly streamlined manner.
Role of the Merchant Banker in Government Transactions
A merchant banker's responsibilities vary depending on the nature of the government mandate:
Disinvestment & Capital Restructuring Advisory
When advising a government entity, the merchant banker must operate within the strict boundaries of the Department of Public Enterprises (DPE) guidelines.
For example, if a merchant banker recommends a bonus issue, they must thoroughly evaluate and advise the government on the long-term capital implications:
- Expanded Equity Base: A bonus issue increases the total number of outstanding equity shares.
- EPS Dilution: With more shares outstanding, the company's Earnings Per Share (EPS) will likely decrease, calculated as: EPS = Net Profit / Total Outstanding Shares.
- Impact on Credit Rating: A lower EPS and a significantly expanded equity base might impact the PSU's financial ratings, which the merchant banker must forecast and mitigate.
PSU Performance Evaluation & DPE Guidelines
To evaluate the overall performance of a Public Sector Undertaking (PSU) over a sustained period, a composite score is calculated based on its financial and operational performance over the last three years.
The DPE framework utilizes six performance indicators that are universally applicable, ensuring a balanced evaluation regardless of whether the PSU belongs to the manufacturing or services sector.
Table 8.1: Six Identified Performance Indicators under DPE Guidelines
| Parameter No. | Performance Indicator / Parameter | Weightage (%) | Formula (Simple Line Format) |
|---|---|---|---|
| 1 | Net Profit to Net Worth | 25 | Net Profit to Net Worth Ratio = Net Profit / Net Worth |
| 2 | Manpower Cost to Total Cost of Production (or Cost of Services) | 15 | Manpower Cost Ratio = Manpower Cost / Total Cost of Production (or Cost of Services) |
| 3 | PBDIT to Capital Employed | 15 | PBDIT to Capital Employed Ratio = PBDIT / Capital Employed |
| 4 | PBIT to Turnover | 15 | PBIT to Turnover Ratio = PBIT / Turnover |
| 5 | Earnings Per Share (EPS) | 10 | EPS = Net Profit / Total Number of Outstanding Shares |
| 6 | Inter Sectoral Performance | 20 | Comparative benchmark score against sector peers |
| TOTAL WEIGHTAGE | 100 |
Note: PBDIT refers to Profit Before Depreciation, Interest, and Taxes; PBIT refers to Profit Before Interest and Taxes.
Detailed Scoring Scale for Earnings Per Share (EPS)
Under the DPE guidelines, the Earnings Per Share (EPS) parameter (which holds a weightage of 10%) is evaluated using a standardized scoring scale. This scale assumes a standard share Face Value (FV) of Rs. 10.
Negative values represent net losses and carry zero or negative scores, penalizing deteriorating performance.
Table 8.2: Scoring Scale at Different Levels of EPS (FV Rs. 10)
| Earnings Per Share (EPS) Range (Rs.) | Score Awarded | Performance Interpretation |
|---|---|---|
| >= 30 | 10 | Exceptional financial performance |
| >= 20 and < 30 | 8 | Very strong performance |
| >= 10 and < 20 | 6 | Good/Moderate performance |
| >= 5 and < 10 | 4 | Average performance |
| >= 0 and < 5 | 2 | Below-average but profitable performance |
| >= -5 and < 0 | 0 | Net loss; poor performance |
| >= -10 and < -5 | -2 | Severe net loss; highly penalized performance |
Important Terms to Remember
- Disinvestment: The process of diluting or selling government-held equity shares or voting rights in a Public Sector Undertaking.
- Public Sector Undertaking (PSU): A government-owned enterprise where the Central Government, State Government, or a government company holds control or substantial equity.
- Composite Score: A consolidated performance rating calculated over three years to assess a PSU's financial and operational health.
- Offer for Sale (OFS): A mechanism that allows promoters (including the government) to sell their shareholdings directly to investors via a prospectus or a dedicated stock exchange window.
- DPE Guidelines: The official regulations issued by the Department of Public Enterprises governing the financial and advisory transactions of PSUs.
Key Takeaways
- Dual Mandate of Merchant Bankers: In PSU transactions, merchant bankers act as transaction managers for direct disinvestment (via OFS or prospectus) and as financial advisers for strategic restructuring (such as bonus shares and buybacks).
- Restructuring Caution: Merchant bankers must evaluate the capital dilution effects of a bonus issue, particularly the risk of lowering the PSU’s Earnings Per Share (EPS) and damaging its credit/performance ratings.
- Structured PSU Benchmarking: PSU performance evaluation relies on a 100-point composite score computed over three years, where profitability (Net Profit to Net Worth) holds the maximum individual financial weightage of 25%, and EPS levels below Rs. 0 are heavily penalized with zero or negative scores.