On 18th May, ICICI Bank approved its merger with the Bank of Rajasthan through a share swap (25 shares of ICICI Bank for 118 shares for Bank of Rajasthan) for roughly Rs. 3015 Crore. In the term paper we have done study of the events leading to merger of the banks and tried to come-up with our own independent valuations for the Bank of Rajasthan using different valuation techniques. The Bank of Rajasthan seemed to have violated multiple RBI regulations which led to RBI imposing a fine of Rs 25 lakh and the subsequent declaration of SEBI that the promoter holding was 55.1%, had led to the merger of Bank of Rajasthan and ICICI bank. The team first arrived at multiple valuations for Bank of Rajasthan to compare with the value paid for by ICICI Bank. Reformulated balance sheet and income statements were used to work out the valuation from Standard Forecasting method 2 and Standard Forecasting method 3. Even with optimistic SF3 estimate, ICICI Bank overpaid for the merger by a factor of 1.5.
ICICI rationalised the merger that it helps them expand their branch network. Thus, valuation made would have been justified if the cost of similar expansion project would have been comparable. The valuation by the branches approach also values Bank of Rajasthan at approx. Rs. 1900 Crore, well below the amount paid for. Valuation using price to book ratio of the comparable banks resulted in Rs 1573 Crore which is half the amount paid by the ICICI bank. Thus our analysis using different valuation methods shows that the deal was favourable to the shareholders of Bank of Rajasthan.
Next the team also estimated the impact of the merger announcement on the market values and concluded that the combined market capitalization of the two entities was 3% lower than what was estimated for this point in time if the merger announcement was not made. Additionally we went into details of possible benefits ICICI bank can have by this merger and how they are proceeding with seemingly difficult task of integrating very different workforce.
Introduction
On 18th May, ICICI Bank approved its merger with the Bank of Rajasthan through a share swap (25 shares of ICICI Bank for 118 shares for Bank of Rajasthan) for roughly Rs. 3015 Crore. In this term paper we have done a study of the merger of the two banks. Bank of Rajasthan prior to merger was having troubles in meeting RBI guidelines. SEBI had questioned the promoter's claim of only 28% shareholding which according to SEBI was more than 55% through front companies and related holdings. In this study we do an analysis of various regulatory breaches by the Bank of Rajasthan. This helps us understand importance of various regulations by RBI and SEBI which are important for a bank's functioning. In the second part, we have come-up with our own valuation of the Bank of Rajasthan using various methods. We have tried to explain difference in our valuation and the value paid by ICICI bank. We have explored how the merger is shaping up and how the seemingly difficult task of integration of very different work force is happening.
The study has helped us understand the regulations, operations, valuation and merger of private banks in India.
ICICI Bank
The Industrial Credit and Investment Corporation of India (ICICI) was incorporated in India as a development financial institution in the year 1955. ICICI bank came into existence only in the year 1994. However in 2002, ICICI bank was reverse merged into its parent entity ICICI along with ICICI Personal Financial Services Limited and ICICI Capital Services Limited. Today, ICICI bank provides full gamut of banking and financial services to both retail and corporate customers and is the largest private sector bank in the country in terms of market capitalization.
ICICI bank has backed its brand with an efficient work force with one of the best and flexible technological system in place. Its strategy has been to differentiate from other banks especially public sector banks in terms of speed and quality of service in order to increase its portfolio of assets. The bank has impressive fundamentals in terms of profitability, CASA ratio, non-performing assets and capital adequacy. These are listed in the Table 1 below for the quarter ending June 30, 2010.
Table : Financial Performance of ICICI Bank Limited
Financial Parameter
Rs. Crores (as on June 30, 2010)
Rs. Crores (as on June 30, 2009)
Year-on-year growth
PAT
Rs. 1026 crores
878 crores
17%
CASA ratio
42.1%
30.4%
38%
Provision coverage
64.8%
51.1%
27%
During the same period, net performing asset ratio decreased from 2.19% to 1.62%. Strong capital adequacy ratio of 20.2% and Tier-1 capital adequacy of 14.0% are also reflective of bank's strong liquidity position.
Bank of Rajasthan
Bank of Rajasthan is an old private sector bank headquartered in Jaipur. Founded in 1943, the bank has a customer base of over 2 million. BoR has a network of 463 branches, 29 offsite ATMs and 82 onsite ATMs covering 22 states and 2 Union territories across the country. Most of BoR branches are located in northern and western India and the bank has a strong hold in the state of Rajasthan with a network of 294 branches (~63 % of total branches). Bank has focused on increasing its penetration to Tier II cities especially centers of high economic activity such as areas with high concentration of SMEs where they act as bankers to both the labors as well as the owners.
BoR has an asset base of Rs172.2bn with a loan book size of Rs77.8bn. Retail loans constitute approximately 10.8% of the total loan book. The bank had delivered net profit of Rs1.18 billion in FY09 and booked a loss of Rs. 100 million for 9mFY10. The bank has total deposits base of Rs151.9 billion with a CASA ratio of 27.4%.
Pre-merger Analysis
Pre-merger Strategies
Prior to merger, ICICI Bank has been focusing its attention on positioning its balance sheet for growth and focusing on the 4Cs: CASA, Costs, Credit, Quality and Capital. The overall aim has been to- Defend market leadership through consolidation, Improve presence in Northern India to become a truly pan-Indian bank, Improve top-line through increased customer acquisition, Reduce non-performing assets from the current levels of 5.06%, and Improve Asset-Liability Management. Also, ICICI Bank followed a strategy of 'Product-focus' prior to merger. In terms of composition of advances, ICICI was focused on retail finance, services, petroleum, infrastructure, iron & steel.
Unlike ICICI Bank, that had a balanced mix of internal and external business focus, BoR largely focused on its internal troubles in the year prior to merger and had strategies aligned to the same as well. The strategy of BoR has been to- improve Corporate Governance, Cut down the high credit costs and employee costs to improve the bottom line, Improve the CAR to regulatory minimum, and Improve branch presence. In terms of composition of advances, BoR had a strong focus on infrastructure and metals & mining. BoR also had a strong presence in SMEs by virtue of the location advantage of its branches and strong link-up with RRBs, especially in the sectors of textiles, pharmaceuticals and chemical, and gems & jewellery.
Key violations by Bank of Rajasthan
RBI's directions issued under Section 35A of the Banking Regulation Act, 1949
During the period 2002-2004, Bank of Rajasthan acquired properties in Mumbai through close relatives of the promoter Mr. P K Tayal. As per RBI guideline para VI, landlords of the property who lease/rent their property to the banks can take loans above 2 lakhs from the bank at a minimal interest rate. Since the transaction between BoR and the owners of the properties was not an arm's length transaction the beneficiaries were the members of promoter's family and hence not allowed by RBI. On the same lines the Deputy Managing Director of BoR Mr. Saruparia leased a building from a construction company that was owned by the promoter Mr. P K Tayal. The property at Lower Parel currently houses the headquarters of BoR. These transactions were against the guidelines of RBI and were flagged by other agencies as well. It was only in February 2010, RBI decided to impose a fine and propose further enquiry on BoR
Deletion of records in the bank's IT systems
Key records relating to funds transferred to other companies were deleted from the IT records of BoR allegedly at the behest of the top management. This money was not part of the promoter's equity but taken from the savings deposits of the customers. As per RBI norms, a bank cannot transfer funds to companies related to the promoter unless disclosed and approved by RBI and the board.
Non-adherence to KYC/anti money laundering guidelines
BoR transferred public funds to a few corporate groups who were in fact owned by Mr. Tayal. The funds transferred or loaned were in turn transferred to third parties again owned by MrTayal, which in turn purchased the stocks of BoR and gave their voting rights to Mr. Tayal. No due diligence was done to check the background of the corporate which were borrowing from the bank. Neither there was any collateral to guarantee the loans extended. This favouritism was particularly for the group of companies owned by Mr. Tayal.
Failure to provide certain documents sought by the Reserve Bank of India and misrepresenting that such documents were not available
According to RBI's press release on Feb 25 2010, the Bank of Rajasthan did not provide certain documents that were needed by Reserve Bank of India. Also, the press release noted that Bank of Rajasthan false claimed that such documents were not available.
Tayal's failure to deposit Rs. 20 crore in an escrow account to gain the promoter status
In order to gain promoter status Mr Tayal was required depositing at least Rs 20 crore in an Escrow Account (special security deposit to be used only with RBI approval). While doing this, he had to disclose the source of the funds. The RBI also stipulated that the Escrow Account could be withdrawn only with its approval in writing. The other condition laid down by the RBI was as follows: "The shares of the Tayal family and his associates/ group concerns in your Bank (BOR - existing and proposed acquisition) should not be alienated for a period of five year without the approval of RBI to ensure continued commitment of this group in improving the bank."Tayal, accordingly should have kept the RBI informed regarding the compliance with the above requirements. But Tayal ignored the RBI strictures regarding the deposit of Rs 20 crore in BOR. Surprisingly; the RBI did not show any interest in finding out the source of the Rs 20 crore. The source of funds was Krishna Texport Industries Ltd, a Tayal-owned company. This is a blatant violation of the RBI norms. Further, the Escrow Account of Rs 20 crores was utilised for issuance of benami shares in rights issue of the bank. But the Tayal groups of companies say that they have fulfilled all the RBI conditionality. "As per pre condition of RBI, promoters put in Rs 20 croere in the Escrow account so that any shortfall in the Rights issue can be taken care of and the interest was paid with the prior permission of RBI."
Violation of promoter holding guidelines
According to Reserve Bank of India guidelines, to ensure distributed ownership no promoter should have more than 10% of stake in any private bank. Bank of Rajasthan's promoter P K Tayal had close to 28 % shareholding before merger on December 2009. However, as per SEBI, the promoter had tried to hide their shareholding by showing only 28% on paper but it had 55% stake through front entities and companies held by the Tayal Group. SEBI then banned any trading by 100 firms owned by the Tayal group until this got resolved.
After SEBI's declaration about promoter's holding, Bank of Rajasthan fell into trouble. RBI consistently followed with BoR to reduce their share to 10%. Bank of Rajasthan in turn was asking P K Tayal to say in writing how he intended to go about reducing his stake. Then RBI appointed Deloitte Haskins and Sells to audit BoR's lending policy and Deloitte Touche Tohmatsu was hired to audit the information security system.
If it is proved that there are major irregularities in a bank, RBI has powers to change the management and promoters or in some cases it can allow takeover by another banks.
This seems to have happened in this case.
Approvals for the Deal
In February 2010 RBI levied a penalty of Rs. 25 lakhs on BoR for the violations in acquisition of immovable property and anti money laundering guidelines, deletion of bank records from systems and accounting irregularities. In the subsequent month, SEBI restrained the Tayal group, who owned a declared stake of 28.6% and 55.01% in actual, from involving in capital markets. RBI appointed Deloitte Haskins and Sells as a special auditor for accounts inspection. These hassles had to be cleared to enable ICICI to enter into the amalgamation deal.
The deal had to clear a new regulatory hurdle because of the controversies regarding ICICI being considered to be a foreign owned private bank rather than an India Private sector bank. The FII shareholding in ICICI as on 31 March, 2010 was 65.30%. So, Central government asked ICICI to get an approval from Foreign Investment Promotion Board (FIPB) to complete the deal. Also, a minority of shareholders filed a case against the deal in Calcutta High Court; but the court dismissed the petition. ICICI and BoR moved RBI on June 25, 2010 for the final regulatory clearance.
Merger Analysis
Merger
ICICI bank approved merging of Bank of Rajasthan (BoR) with itself on 18 May 2010. The share swap ratio was announced at 25:118 (25 shares of ICICI Bank for 118 shares of BoR). The Reserve Bank of India on 13th August 2010 gave its nod to the merger. Following the sanctioning of the scheme of amalgamation of Bank of Rajasthan with ICICI Bank, all branches of BoR started functioning as branches of ICICI Bank with effect from August13.
Deal Structure
The amalgamation of Bank of Rajasthan by ICICI was a no-cash deal. The deal was valued at Rs.3041 crores. Each share of BoR was valued at Rs.189/- giving a premium of around Rs.90 per share. On price per branch basis, ICICI paid Rs.65.7 million per branch as compared to Rs.238.7 million paid by HDFC for Centurion bank.
Table 2: Value of deal
Particulars
ICICI
BOR
Swap Ratio
25
118
Outstanding shares(crore)
111
16
Price before announcement
889.35
99.5
Market Cap
99221
1597
Deal Value(crore)
3042
The deal was done through stock swap. Initially it was supposed to be 1:3, but later the swap ratio was fixed at 25:118 as mentioned in Table 1; means 25 shares of ICICI for 118 shares of BoR. The swap ratio was around 90% premium over the market pricing of BoR. Since the deal was a no-cash one, ICICI just had to dilute its 3% equity for this deal. The net worth of BoR at the time of merger was estimated at around Rs 760 crore and that of ICICI Bank Rs 5,17,000 crore. Also, in the quarter ending Dec 2009, BoR reported a loss of Rs 44 crore on an income of Rs 373 crore. So, ICICI had to take in these losses too.
Valuation
Residual earning Method (with and without growth)
Cost of capital calculation
The Beta for the bank is taken from capital line. Having taken Rf and Rm, we have come-up with WACC rate. The calculation has been shown in the table 3 below. The WACC rate thus calculated has been used for Standard Forecasting (SF) method 2 and Standard Forecasting (SF) method 3 valuations. The debt, equity and required rates have been taken from the Bank of Rajasthan balance sheet.
Table 3: Calculation of WACC for Bank of Rajasthan
WACC Calculation for Bank of Rajasthan
Rf
7.22%
Rm
11%
Required rate of return
0.1701
Beta
0.89
Rate
Debt
Deposits
0.0655
Unsecured non-convertible redeemable sub-ordinated with different maturity
Bond Series III Option I redeemable at par 0n 15-11-2011
0.075
Bond Series III Option II redeemable at par 0n 15-7-2014
0.0755
Bond Series IV Option I redeemable at par 0n 28-4-2015
0.087
Bond Series V redeemable at par 0n 15-1-2017
0.095
Tier II bonds redeemable at par 22-9-2021
0.105
Tier II bonds series VI redeemable at par 5-1-2019
0.115
Tier II Bonds series VII redeemable at par on 8-4-2016
0.1025
Equity
0.1701
Weighted cost of capital
0.07585
Valuation using SF2 Method
The valuation of Bank of Rajasthan using the SF2 method is shown below. The value calculated is at the start of 2009. This should not change at the announcement date either because growth in Retained Earnings is assumed to be zero. The valuation thus is Rs 1655.34 Cr, which is well below the amount paid by ICICI bank.
Table 4: Valuation of BOR using SF2 Method
SF2
2008
2009
2010
2011
NOA
945.34
1048.79
Change in NOA
103.45
Current Income
117.7147
125.56137
125.5614
Cost of equity
1.07585
1.0758499
1.07585
Normal Earning
71.70391
79.550576
Residual Earning
46.01079
46.010793
Discount Rate 7.585%
Value
1655.394
Valuation using SF3
For SF3 we have assumed the rate of growth as deposit growth rate (4.66%) in the last year. The valuation of the Bank of Rajasthan comes out to be Rs 2356.266 Cr, which is also lower than the price paid by ICICI bank. Thus even with the optimistic growth rate of 4.66% rate for perpetuity the valuation is lower than the amount paid by ICICI.
Table 5: Valuation of Bank of Rajasthan using SF3 method
SF3
2008
2009
NOA
945.34
1048.79
0
0
Current Income
106.1036
117.7147
117.7147
0
RNOA
0.112239
Normal Earning
71.70391
79.550576
Residual Earning
34.39971
38.164124
Value
2356.266
Multiples Method
Value based on comparable P/B
The following table gives P/B ratio of some private banks which can be compared with the BOR( We have excluded high profile private banks like HDFC, ICICI, Axis Bank etc)
Table 6: Value of Deal-A Comparables approach
Bank
P/B Ratio
Dhanalakshmi Bank Ltd
2.2
Karur Vysya Bank Ltd
2.0
City Union Bank Ltd
1.9
ING Vysya Bank Ltd
1.7
Development Credit Bank Ltd
1.6
United Western Bank Ltd
1.4
Jammu and Kashmir Bank Ltd
1.2
South Indian Bank Ltd
1.2
Federal Bank Ltd
1.1
Karnataka Bank Ltd
1.1
Lakshmi Vilas Bank Ltd
1.1
Average
1.5
The average price to book ratio comes to be around 1.5. Using this ratio and calculated book value of 1048.8 crore we have value of BOR = 1.5 x 1048.8 = 1573 crore. The deal value of more than 3000 crore is quite expensive in this regard which values BOR at almost twice the current value.
Valuation by Branch method
The whole idea of acquisition was to increase the reach and branches of ICICI. ICICI even used Market cap per branch (MCAP/branch) as one of the parameter for their valuation. Other option for them would have been to expand organically i.e. build their own branches and operate. Thus, the valuation of Bank of Rajasthan should not be more than value of the project which ICICI would have undertaken to build 463 branches. Thus the whole valuation problem simplifies to project valuation of building 463 branches.
An average bank branch construction is a 2 year project involving 4 crore of capital investment upfront. This Construction is considered at risk free rate as there is no risk of revenue involved in construction. Further Bank of Rajasthan has deposits of 15187 crore and CDR of 74.20% . CDR is credit deposit ratio which indicates how much credit bank has been able to make out of the deposit. Higher the CDR for bank, better it is. The spread which bank of Rajasthan bank has been able to make on the loans is 3.5%. The remaining 25.80% of deposits can be kept with RBI through reverse repo window at 4.5% .Since the cost of deposits is around 6.55%, so this 25.8% will have negative spread of 2.05%. Thus the total income from the same deposit which bank of Rajasthan has currently will be 0.678 crore .Capitalising it and finding the value of each branch, we get the valuation per branch as 4.12 crore and value of total deal as 1911 crores.
Table 7: Valuation using the Brand approach
Year
2010
2011
2012
2013
Cash Flows
-2
-2
0.678364
Factor(1.0722)^t
1.0722
1.149613
Present Value
-1.86532363
-1.73972
Total Present Value
-3.605039763
Continuing Value
8.949388
Present Value Of CV
7.732684
Value per Branch
4.127644237
Value of 463 branches
1911.099184
The Continuing Value Calculation
CV=
Table below indicates the calculation of income per branch with same kind of deposit as Rajasthan.
Table 8: Income per branch
CALCUATION OF INCOME PER BRANCH
Total deposits(in crores)
15187
CDR
74.20%
spread on money they can lent
3.50%
Spread on money they can't lent
-2.05%
Money which they can lent
(15187*CDR)
11268.75
Money which they can't lent
(15187*(1-CDR))
3918.246
Number of branches
463
Income on money they can lent
0.85185
Income on money they can't lent
-0.17348
Total Income
Income on money they can lent = = 0.85185
Income on money they can't lent == (-0.173486)
Total Income =0.85185+ (-0.173486) = 0.678364
Thus even if they would have gone organic growth and built all the branches, it would have cost them 1911 crore which is way below the valuation that they paid to acquire bank of Rajasthan. Thus the deal is definitely overpriced and would have resulted in value destruction for ICICI shareholders.
Merger benefits for ICICI
ICICI bank expanded its network of branches through acquisition. Addition of 463 branches increased the number of banks by 25%. ICICI bank's position in North and West India is strengthened.
ICICI Bank would strengthen its rural marketing drive through 98 branches of BoR which are in rural area.
Increase in deposits: deposits of ICICI bank increased due to amalgamation of BoR. It could have taken 3 to 4 years to increase the deposits to this level. This saved time and cost of ICICI bank also gave them advantage in terms of time to market.
New customers: ICICI bank got new customers through BoR's customer base which is close to 3 million. This would improve revenue of ICICI bank.
Improvement in services of BoR: ICICI banks internet and telephone banking services are being implemented for BoR and expected to complete by third quarter of 2011.
Cross selling: ICICI bank can do cross selling of products and services to customer base of BoR. This would be new source of revenue for ICICI bank.
Efficiency improvement: ICICI bank can improve the efficiency of BoR branches thus improve profitability.
Post Merger Analysis
Estimate of impact of merger announcement of market capitalization
The 90-day return on stock for ICICI Bank and Bank of Rajasthan was calculated for the 6 month period from November-2009 to May-2010. These returns were regressed against the corresponding 90-day returns on the BSE-Sensex. The result of this regression was used to estimate the market capitalization (from stock price) of both ICICI bank and Bank of Rajasthan on the day of the announcement and 90 days after the announcement.
Based on the calculation, the combined expected market of ICICI bank and Bank of Rajasthan was found to exceed the actual market capitalization, albeit by a mere factor of 3%. This is well within the margin of error (of calculation), and hence we can conclude that, while there was no dramatic creation of value (as estimated by market), there was no significant value-erosion either.
Evaluation of performance
Results of third quarter for ICICI bank include the BoR. But it had been merged in ICICI bank only for 49 days so any financial results are not conclusive of any performance improvement.
ICICI bank got network of branches and new customers in its portfolio. Based on this it achieved its branch based and customer focused growth through this acquisition. The increase in deposit base of ICICI bank has given huge time-to-market advantage of anywhere between three to four years.
All the BoR branches are connected through internet. Internet banking facility is to be made available to all BoR customers by the end of third quarter of 2011. Anywhere banking enabled and ATM connectivity established for all BoR customers. This would improve the quality of service for BoR customers.
The main result of this amalgamation is the geographical expansion in ICICI branch network in the north-western region of the country, by just diluting 3% of its equity stake. To start new branches would have been tough for ICICI and for BoR it was a chance to merge itself with India's biggest private sector bank. So, from ICICI's point to view, it's an expansive strategy and for BoR it results in improving operations and service quality. So, this merger has been fruitful to both the acquirer and the target.
Integration Process
The final approval for the amalgamation of BoR by ICICI happened on August 12, 2010. The integration process started after this date. The main part of the amalgamation was the integration of IT systems and the employees. ICICI agreed to implement the systems the bank uses in already existing branches to the BoR branches so as to extend the similar services to the customers. The IT and the ATMs connectivity are established as of now. Deposit mobilization from retail customers and advances processing is currently being done, while maintaining continuity in products and charges.
The main apprehensions were about taking the BoR employees as part of ICICI. But, around 4000 employees of BoR were ready to join the ICICI, although they raised some concerns when the deal was initially announced in May 2010. Also, the average age of employees at BoR was around 53, whereas in ICICI it was very much lower. So, the BoR employees were also apprehensive about their future amidst the merger. But as per the amalgamation agreement, ICICI promised to absorb all the BoR employees, although the individuals had the option to leave, if they wanted to leave. But this integration is also smoothly done and these employees are now officially ICICI bank employees.
Update on what happened & happening
Although United Forum of Bank of Rajasthan Unions had opposed the merger of Bank of Rajasthan (BoR) with ICICI Bank, citing cultural compatibility issues before the execution of the merger the employee migration after merger was very smooth. Four days after the RBI approval for the merger around 4000 employees (out of 4200) has shown interest in joining the new company. "Please give us your heart and hard work. We will take care of your family for life" is the first official communication to the BoR employees after the merger. There were also apprehensions on whether BoR employees, with an average age of 53, will be absorbed by ICICI Bank, where the average of employees is much lower. All 463 branches of BoR have started functioning as ICICI Bank's as per the directive of the Reserve Bank of India.
Reserve Bank has fixed Rs 154.50 per share as price for dissenting shareholders of Bank of Rajasthan, BoR informed the Bombay Stock Exchange (BSE). Meanwhile the erstwhile BoR promoter Pravin Kumar Tayal's had moved to Supreme Court questioning the SEBI order to freeze his holding in ICICI bank. SC has given a notice of 2 months to SEBI to decide on the issue.
ICICI Bank, has announced its results for the quarter ended September 2010; which was the first one after merger which includes the impact of the merger for a period of 49 days. Deposits grew 11% QoQ to Rs 2.2 trillion (adjusted for the merger, growth was 4% QoQ). CASA (current and savings accounts) grew 34.5% YoY to Rs 981 bn (adjusted growth of 33.9% YoY). While SA deposits grew 28% YoY (12% QoQ), CA deposits grew 48% YoY (24% QoQ).
Post-merger strategy
Post merger, ICICI-BoR ("the merged entity") intends to leverage the strong SME presence and RRB network of BoR to improve its Wholesale banking presence in mid-corporate and SME segments, and also in Infrastructure and other project finance. In retail banking, the merged entity intends to leverage its increased branch network to reorganize the retail business around geographies and customer segments. The merged entity plans to improve its sales and service orientation through enhanced decision making ability at its branches.
