CAPITAL MARKETS
THE VALUATION LANDSCAPE
Dushani Corea notes that policy consistency is critical to attracting FDI to Sri Lanka
Q: How do you view global economic trends impacting corporate finance strategies here in Sri Lanka?
A: As a relatively small frontier market, Sri Lanka is affected by global trends including interest rates, growth in developed countries and stock market behaviour in those nations.
With higher interest rates in developed markets, which carry much lower risk profiles than Sri Lanka, we face challenges and must work harder to attract investments into capital markets.
For example, while most developed countries and some frontier markets trade at high double digit multiples, Sri Lanka’s market trades at a high single digit price to earnings ratio. This should make the market attractive while adjustments must be made for the country’s higher risk profile.
Q: What are the key challenges in structuring capital in today’s economic environment?
A: Given the inflation and interest rate environment over the past few years, there was little incentive for investors to consider equity investments.
Similarly for banks, it was more attractive and prudent to invest in government securities than lend to companies. The high level of nonperforming loans driven by multiple factors also dissuaded banks from lending to certain sectors.
However, with lower and stable interest rates, and a better performing stock market, both debt and equity options are now available to corporates looking to expand.
The tax and regulatory environment should be conducive and consistent, allowing corporates to structure their capital effectively. Currently, the tax environment is favourable for listed equities and debt instruments.
Q: How can companies leverage mergers and acquisitions (M&A), for growth and sustainability?
A: In some sectors, inorganic growth through M&As is the only means to expand as the market becomes saturated and competition intensifies.
With political stability, lower interest rates and an active stock market in recent months, both large and small companies should consider mergers and acquisitions as a strategy for growth and expansion.
This model could also be used to expand a business beyond Sri Lanka by acquiring overseas companies, thereby gaining a foothold in international markets.
Currently, Sri Lanka is more a sellers’ market with fewer opportunities for buy-side interest. There’s a lack of good investment opportunities, as promoters often overlook M&A for growth at a time when they are growing organically.
Q: What are the most critical factors in determining a company’s valuation?
A: The risk-free rate – which reflects the rate at which the government borrows – is one of the most critical factors for business valuation in Sri Lanka. High risk-free rates lead to investors requiring higher rates of return when valuing a business.
And a robust and achievable business plan is essential for building a strong case for investment and valuation.
Similarly, an active and in-depth stock market is crucial to identify proxy companies to assist with the valuation of private businesses. Historically, the price to earnings multiple has been quite low, which tends to depress the valuation of private companies.
Certain sectors such as technology, apparel and infrastructure are underrepresented on the Colombo Stock Exchange (CSE), making it challenging to accurately value businesses in these segments.
Q: How do Sri Lanka’s regulatory and tax policies influence corporate financial structuring?
A: Tax rates and policies impact the choice of debt or equity capital.
For example, interest payments are currently tax deductible for companies. The exemption of capital gains tax on the sale of listed shares is a major advantage for raising equity capital.
The capital gains tax rate also varies depending on whether the investor is an individual or a company. It’s important to remember that policy consistency is more critical than any particular policy. For instance, businesses can plan and work with taxes as long as there is certainty and consistency in their application, which is critical to attracting foreign direct investments (FDI).
Q: What are the best practices to raise capital through debt or equity financing?
A: It is important to have financial systems and processes in place, to help expedite and secure the best possible financing package. Equally important is having a governance structure, as both investors and banks place great emphasis on this.
Timing is also critical in securing the best rates or valuations, and leveraging market sentiment is crucial to raising equity successfully.
Q: How do private equity and venture capital play a role in Sri Lanka’s corporate finance landscape?
A: Private equity and venture capital investors are an important part of the corporate landscape in any country, especially to develop sectors such as IT. Unfortunately, Sri Lanka has inadequate representation of such investors and the funding available through them is limited.
Corporates and high-net worth individuals (HNIs) fulfil this role to some extent but they’re not fully geared to replace them. There is a dearth of funding for startups and growth stage companies, creating ample opportunities for PEs and VCs to establish a presence in the market.
