In one of the most significant developments in the financial sector in a long time, HDFC Ltd announced its merger into HDFC Bank. It would be a reverse merger of sorts since HDFC Ltd is the holding company that holds a 21% stake in HDFC Bank. Post the merger, HDFC Ltd will cease to exist and shareholders of HDFC Ltd would become shareholders of HDFC Bank Ltd. As much as the merger sounds like a win-win situation for both the parties, there is likely to be many a slip between the cup and the lip. That possibly explains why the price of both the stocks corrected after the initial euphoria.
What you must know about the HDFC Bank – HDFC Ltd merger
Here are some basic contours on which the merger between HDFC Ltd and HDFC Bank is based.
a) The deal will be a complete stock swap deal. As per the exchange ratio approved by the boards of HDFC Bank and HDFC Ltd, shareholders of HDFC Ltd on the record date will get 42 shares of HDFC Bank for every 25 shares of HDFC Ltd held by them. Consequently, post-merger, HDFC Ltd shareholders will own 41% in HDFC Bank. The deal is subject to shareholder approval.
b) After the merger, HDFC Ltd will cease to exist as a separate listed entity and would be subsumed into HDFC Bank via stock swap in the ratio mentioned above. After the deal, there will be no promoter group for HDFC Bank and it will become a 100% public shareholder company. HDFC stake in HDFC Bank would be fully extinguished.
c) The subsidiaries and associates of HDFC will shift to HDFC Bank and these will include the life insurance, the general insurance, the mutual funds and the securities business of HDFC Ltd. There could be issues over a systemically important bank holding two large insurance companies, but we will come back to this point later.
d) All the branches and employees of HDFC Ltd will be absorbed into HDFC Bank, although rationalization at a later date cannot be ruled out. Since the portfolio of HDFC Ltd is predominantly of secured mortgage loans, this merger will help reduce the share of unsecured loans in the books of HDFC Bank.
e) In terms of immediate gains, HDFC Ltd has been, for long, plagued by the holding company discount. Now that will go away and enable better value creation for the group. HDFC Bank customers will be offered mortgages as a core product in a seamless manner. HDFC Bank will also own the customer life cycle in a more comprehensive way.
What triggered this merger at this juncture?
The idea of HDFC merging with HDFC Bank is nothing new. Deepak Parekh had suggested this back in 2015, but the idea had been put off since the regulatory environment for such a deal was not conducive then. A lot has change and now the merger has been triggered by a combination of 3 factors.
The whole idea of HDFC preferring to remain an HFC was driven by a simpler regulatory environment. Post Dewan Housing, RBI has tightened regulations and the incremental advantage in remaining an HFC does not exist any longer. Also, the current regulatory changes facilitate such transactions without too may roadblocks.
The merger of HDFC Ltd and HDFC Bank will be a $40 billion deal and will create a behemoth with a combined market cap of $171 billion. The combined size of the asset book would call for substantial capital raising. With interest rates at all-time lows and about to turn hawkish, the situation was ripe for merger and aggressive fund raising.
It is an open secret that Aditya Puri was never comfortable with the idea of merging HDFC Ltd into HDFC Bank as it would put unnecessary strain on the balance sheet of HDFC Bank. With Aditya Puri having retired, Shashidhar is more amenable to the idea. Also, Deepak Parekh is 77 and it would be a much deserved last hurrah for him.
The idea of the merger was always there. It is just that the timing was ripe now.
Are there downside risks to the merger?
Like in any merger, there is likely to be a clash of capital, methodology and cultures. The good thing is that both are part of the same group, so the cultural gaps should be lesser. However, there are some other distinct risks to the deal.
The first risk is at a regulatory level. RBI has never been comfortable with banks having substantial ownership in insurance companies. With the merger, HDFC Life and HDFC Ergo General will come under HDFC Bank. They can look at alternative structures like a holding company structure, but that would be too expensive in terms of taxes.
While combining cultures may not be a problem, transmuting skills could be a bigger challenge. At some point, HDFC Bank will have to look at rationalizing the branches and the manpower. That will be painful and expensive. Getting home loan personnel attuned to selling banking products will hardly be a cake walk. Skill mutation is the big challenge.
Then there will be huge capital and reserve requirement challenge. With a substantially larger asset base, the combined entity will need huge amount of capital as well as enhancing CRR and SLR requirements. That is going to lead to a lot of dilution of equity for the combined entity which will also be EPS dilutive in the medium term.
Finally, there is a risk that institutional shareholders of HDFC Bank may not be happy with the swap ratio. The swap ratio favours HDFC Ltd, notwithstanding the fact that the market cap of HDFC Bank is nearly double that of HDFC Ltd. Also, HDFC Bank may want to hive off HDB Financial Services prior to the merger, for which it always had IPO plans. The whole story is likely to be fairly complex.
There is no gainsaying the fact that consolidation is the road ahead in the financial sector. However, for a behemoth like HDFC group, this exercise will not be that simple. How the integration is handled over the next 18 months will be the litmus test.