THE CLASSIC POST-MORTEM

Many management consultants remarked that though Classic emerged as a full-scale financial services company in early 1990s, it never matured from its original status as an asset financing subsidiary. A majority of Classic's problems stemmed from the structural anomalies like cross holdings in other group companies. Although consultants McKinsey & Co and Arthur Andersen (who had been mandated to go into the details of restructuring Classic in the mid 1990s), had emphasized the need for untangling Classic from the corporate maze of cross holdings in the group companies, no action was taken to do so. A Classic source[3] remarked, McKinsey could not even figure out why some of the financial services companies existed and why Classic should hold equity in such companies. McKinsey wanted to form Classic into a single financial services company by merging various group companies involved in financial services such as Classic Infrastructure Development Ltd., International Travel House Summit, Sage, Pinnacle, ITC Agrotech Finance and a host of other small companies. McKinsey further recommended that Classic should reduce its investment banking exposure, concentrate more on asset financing and re-enter niche segments like automobile finance. The Arthur Andersen study talked about the need for a leaner organization with strong management. The consultants identified a complete lack of focus as the most crucial problem faced by Classic. However, ITC sources brushed aside the recommendations stating that, Reorganizing the business is very much on our agenda but our immediate concern is to keep the company liquid. After the Rs 285 crore loss was recorded, Classic sold its heavily eroded investments in Morgan Stanley and Jaiprakash Industries, which helped in covering the losses to a certain extent. However, its portfolio still comprised shares that had seen heavy erosion in their values. Classic had to hold large amounts of shares of other ITC group companies like ITC Bhadrachalam and International Travel House, whose share prices had also taken a beating. The company could not even sell these shares because of their low prices. Though ITC bought back Rs 69 crore worth of Bhadrachalam shares, financial analysts remained skeptical of Classic's portfolio. Some of its investments in group companies like Greenline Construction, Minota Aquatech and ITC Agrotech Finance etc. were illiquid for all practical purposes and only artificially inflated the company's net worth and the asset values. Classic also had a huge asset-liability mismatch. Its asset-financing portfolio was functioning fine till September 1995, when due to a liquidity crunch it had to miss on installment repayments. Eventually, the volume of overdue payments reached as high as Rs 300 crore. A Classic executive said, Most of our assets are wholesale in nature while our liabilities are retail. When the market got gripped by a panic, all wanted their funds, but we cannot make our assets liquid at such short notice.

In 1995, Classic had entered into a lease and buy-back deal of used electricity meters with the Rajasthan State Electricity Board (RSEB). Later, RSEB defaulted on lease rentals worth Rs 40 crore, forcing Classic to make provisions to repossess the meters and settle the losses. Classic's real estate forays also did not prove to be beneficial for the company. Analysts also remarked that the fact that over the years, Classic had become increasingly dependent on public deposits. Public deposits, deemed to be a rather volatile source of fund, had to be resorted to by Classic mainly due to the reluctance of banks to fund NBFC operations during that period. This later resulted in the heavy redemption rush putting a strain on the company's cash reserves. The credit rating agency, Credit Rating Information Serviced Ltd. (CRISIL) downgraded Classic's rating for its fixed deposit scheme and non-convertible debentures from AA to A+ and from FAA+ to FAA-, respectively in June 1996 and further to A- and FA, respectively in December 1996. An internal CRISIL note revealed some other important issues that had led to Classic's demise. The note stated: Although the company's asset portfolio remained fairly welldiversified in terms of the client base/industry spread, the high growth rate, and the inherent risk in corporate plant and machinery financing had an adverse impact on the company's asset quality, resulting in difficulty in timely recovery of dues from a number of clients. The note further criticized Classic's exposure to the corporate asset financing business in general, and to the machinery segment in particular, which was inherently deemed to be risky. Classic was also reported to have made a tactical error by shifting its focus from its primary business of hire purchase and leasing to secondary market operations. The company was blamed to have entered the latter arena to get rich quick'by stock market deals, besides to spread the risk associated with asset financing. In 1995-96, a former Classic director said, Only about 55% of Classic's business was in hire purchase and leasing, while the rest was in stock market operations. THE MERGER ITC soon realized that only one of the country's three mega-financial institutions - Industrial Development Bank of India (IDBI), Industrial Finance Corporation of India (IFCI), or ICICI would be in a position to absorb Classic's losses and bad loans. ITC approached IDBI and ICICI and held extensive discussions with both the FIs. Eventually, a deal was struck with ICICI at a swap ratio of 1 ICICI share for 15 shares of Classic[4] . In January 1998, shareholders of Classic approved the company's amalgamation with ICICI with 99.93% of the votes in favor of the resolution. Justifying the merger from ICICI's perspective, Kamath said, Our goal is to move towards universal banking with a spectrum of financial solutions. Any opportunity to move closer to the goal will be capitalized. However, a section of ICICI shareholders, holding shares of both ICICI and ITC Classic, opposed the merger resolution claiming that the merger ratio was unfair and was leaked'to the market. They said that the price dropped and adjusted to the merger ratio much before the announcement of the ratio by the company. They also alleged that if the market price of the

share was one of the considerations, then the fall in the price of the share just before the merger was a clear indication that the swap ratio was already in the market before the announcement. Voices were also raised against ICICI's decision to retain only those Classic employees whom it found capable after internal evaluations. However, since the dissenting shareholders were in minority, the resolution was successfully tabled. ITC and its affiliate companies subscribed to a preferential share issue of Rs 350 crore of ICICI as part of the merger proposal. The preferential share capital carried a nominal interest of Re 1 for every Rs 1 crore of share capital issued for a period of 20 years. The infusion of funds in ICICI by ITC was to take care of any future liabilities arising out of the merger. One-fourth of Classic's asset base of Rs 1,000 crore accounted for investments in subsidiaries that operated in the stockbroking and mutual funds business. As ICICI was not interested in them, ITC provided Rs 272 crore to repay secured creditors, and to make up for the losses due to the decline in the investments made by these subsidiaries. It was decided to prepay Classic's creditors to reduce its interest burden. ITC also assumed the liabilities and obligations in relation to all guarantees and indemnities issued by Classic. ICICI accepted to absorb the Classic personnel as per its requirements and the rest were redeployed by the ITC group. The swap ratio was based on four factors - net asset value (NAV), market value of the shares, earning potential and credit for intangible assets. Independent auditors C.C. Chokshi and Company and Bansi S. Mehta and Company carried out the valuation exercise. The NAV of Classic was negative; the market value of the shares did not reflect the true value (the scrip was then trading at Rs 20); and the earnings potential for the next three years was deemed to be zero. Only the intangibles of the company were found to be of some value. The worth of the firm, calculated after deducting the net present value of its assets from that of its liabilities, was found to be negative. This led to the swap ratio being heavily biased in favor of ICICI. Classic loyalists who had seen the scrip quoting as high as Rs 375 in September 1994 were quick to point out that this was an extremely poor valuation. However, the valuation was justified on the basis that it took into account the high level of non-performing assets of Classic. THE MERGER POST-MORTEM Media reports claimed that pressure from FIs coupled with desperation drove ITC to hand Classic on a platter to ICICI. K.V. Kamat, managing director, ICICI had maintained right from the beginning that he would consider the deal as long as it did not involve any cash outgo. The issues of ITC bringing in substantial funds, providing cushion against bad debts and loans and accepting an unfair'swap ratio kept surfacing in the media. The only silver lining for the unhappy Classic shareholders'seemed to be the fact that they could hope for a better future with ICICI. TABLE GAINERS AND LOSERS I

ICICI

Classic

Investors

The Upsides

Selling off a Risk-free takeover of Acquiring, for every business it was not a retail network 15 shares in a sick keen on, which since ITC would pay company, 1 ICICI share enabled BAT to Rs 622 crore for ITC whose value was enter financial Classic's NPA. bound to rise. services on its own.

A fall in profits in ITC Classic's NPAs An ICICI share would 1997-98, since it might be larger than have to rise by 400% if would also have to The projected, and its the pre-merger ITC cope with the Rs Downsides depositors might Classic share price was 800 crore excise cash out. to be realized. duty claims.

Source: Business Today, December 22, 1997. As far as ICICI was concerned, it seemed to be a clear win'proposition. The biggest benefit for ICICI was Classic's retail network comprising eight offices, 26 outlets, 700 brokers and a depositor-base of 7 lakh investors. ICICI planned to use this to strengthen the operations of ICICI Credit (I-Credit), a consumer finance subsidiary that ICICI had floated in April 1997. Kamath said, The retail network will help us save two to three years. Our estimate of opening 15-20 branches to reach a million people at the retail level required at least 2-3 years. This offer came our way, which had the retail network already in place. An additional benefit for ICICI was in the form of the Rs 110 crore tax-break because of Classic's losses and the provisions for bad loans. This was something ICICI badly needed since its net profits of Rs 572 crore during the first half of 1997-98 had increased by 71.77% per cent. While ICICI was happy over getting a large deposit base of about seven lakh, it seemed to have ignored the fact that the base was built on high interest rates offered by Classic - about 16%. ICICI was forced to give this promised interest while the going rates were much lower. Also, deposits aggregating Rs 550 crore were to mature by 1999, threatening to be a cash outflow burden on ICICI. However, ICICI tried to average out the interest outgo by asking the depositor coming in for renewals to switch over to ICICI books. This was easy to do as the depositors got the security of an AAA-rated institution. ICICI soon began the clean-up operation'of Classic's balance sheet by substituting high-interest liabilities. As 75% of Classic's clients were ICICI clients as well, ICICI was confident of recovering 8-16% of the outstanding amounts from various parties. ICICI sources claimed that the Classic merger would not affect the dividend or the non-

performing assets of ICICI. This was supported by his justification that Classic was a company with an asset base of just Rs 1000 crore, while ICICI's asset base was as large as Rs 41,000 crore.

QUESTIONS FOR DISCUSSION: 1. Analyze the reasons behind Classic's failure. Do you agree that the company's demise was largely due to ITC's poor handling of the company? Support your answer with reasons. 2. Explain the reasons behind ICICI agreeing to merge with the loss-making Classic. Was the merger truly a win-win situation for both the parties involved? 3. Classic should have stuck to its leasing and asset financing business rather than entering secondary market operations.'Critically comment on the above statement