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Arjun Patwardhan was in a quandary. All of the work he had put in for the past months, indeed his entire career, was boiling down to this single moment.

Six months ago, Arjun had been asked by the finance ministry to identify, prepare and privatise a government owned financial institution. Working with a small team of analysts, Arjun had come up with a shortlist of three banks. Each represented the best in its class: the first was one of the largest, most diversified banks in the country, albeit with considerable financial problems; the second was a mid-sized national bank among the most profitable in its category; and the third was a small regional bank with a limited demographic footprint and considerable potential for improved profitability.

Arjun had joined the Indian Administrative Service 11 years ago against the advice of his parents and peers. After his MBA, he chose IAS over other lucrative job offers because he was motivated by the dual ideals of serving his country and shaping a rapidly evolving economy in which the very role of the government was undergoing a transformation. Certainly, there would always be a role for the government as legislator and regulator across industries, but it seemed clear to Arjun that the time had finally come when India would begin to reform and privatise many of its public sector companies, thereby reducing the direct participation of the government in economic activity.

It had taken 10 years for this vision to begin to play out. Now, Arjun stood on the cusp of what could be the most far-reaching piece of financial and economic reform undertaken by an Indian government in the last two decades.

The background

There was a general consensus that the pace of reform of India's regulatory regime and privatisation of state owned companies had been painfully slow to date. Foreign investment into India had been steadily increasing, but at a much slower rate than many of India's emerging market competitors. Further, the fact that China had, over the last 10 years, pulled substantially ahead of India as an emerging economic power had put the fire in a great many pants.

Simultaneously, pressure from the domestic private sector and the international investor community for India to speed its pace of structural reform had brought about, for the very first time, a consideration of how to reform the largely state run Indian financial services sector. The need for reform of the country's banking sector was clear: the challenge lay in garnering widespread support for privatising state owned financial institutions. Arjun believed a transparent privatisation process that accounted for the concerns of all stakeholders would avoid the pitfalls that had plagued earlier projects and serve as a model for the future.

The constraints within which Arjun would lead the privatisation team had been clearly spelled by the finance ministry.

First, the bank Arjun and his team would recommend for privatisation could be any of the banks controlled by the central or state government.

Second, Arjun needed to select a bank that could serve as a prototype for future privatisations in the sector. As a result, the institution needed to attract the interest of a diverse set of bidders who could meet the price and other expectations of the government.

Third, Arjun's choice of bank to be privatised and the parameters of the privatisation process needed to be clearly articulated to and approved by the ministry before it could commence.

Fourth, the bidding process needed to be fair and transparent to encourage participation by both domestic and international investors.

Finally, the finance minister personally took Arjun aside to stress to him the need for utmost care in determining the best bidder. No one consideration -- such as price -- could be allowed to be paramount. Arjun's recommendation to the ministry had to be such that the ministry could gain Parliamentary approval for the privatisation quickly and without controversy.

Picking the right apple

Arjun was confronted with a difficult choice in determining which bank to pick for privatisation.

Picking the large, diversified bank would send the most positive and decisive signal to the domestic and international capital markets about India's determination to reform its banks, and would attract substantial media attention. However, the size of the institution implied there would be many interested parties who would engage in strong political lobbying and a vocal media campaign to exert control over the process at every stage. As a result, it would be hard to maintain the integrity of the privatisation process and Parliamentary approval for privatising a financial institution of that size and scope would be the most uncertain.

The second option -- a profitable, medium-sized national bank -- would generate less noise in the media and in political circles but would still be an attractive acquisition candidate for both domestic and international bidders. The bank was profitable relative to its Indian peers but had significant improvements to make to be competitive by global standards. Its strengths included a strong retail presence in large and medium-sized cities across the country, as well as a highly profitable lending business to small and medium-sized enterprises.

While all of India's banks competed intensely to provide banking services to large corporate clients, SMEs had traditionally been an under-banked segment. Information on companies of this size was harder to come by and often needed to be painstakingly gathered on a case-by-case basis. Credit risk assessments were therefore harder to make but, consequently, margins tended to be higher. The downside was, since this would be the first privatisation of its kind, there was some doubt as to whether the government would be able to maximize the sale proceeds from of one of its more profitable banks.

The last bank under consideration -- a small regional bank with room for improvement -- was based in one of India's most prosperous states and served several of the state's urban centres, in addition to wealthy farmers and landowners in the rural areas. Few other banks were active in its areas of operation and the bank had the potential, with some investment in its infrastructure and personnel, to significantly raise its profitability by a combination of streamlining costs, increasing product cross sell and deeper market penetration.

After much soul-searching, Arjun and his team made their recommendation to the finance ministry, outlining the reasons for their choice. The team was unanimously of the opinion that the mid-sized bank -- India National Bank -- be put up for sale by the government.

Table 01 contains the summary of the financial information on INB.

Table 1

INB's sale would be perceived as a sign of the government's determination to allow greater competition and foreign participation in the Indian financial sector. It would attract the attention of a diverse set of bidders who had signalled interest in Indian banks in the past, and media and political attention, without hopefully attracting the ire of the country's trade and labour unions.

Arjun assured the minister the bidding process would require that prospective buyers recognise and address the needs of all of INB's stakeholders. After spending a few days deliberating internally on Arjun's recommendation, the finance ministry gave Arjun a mandate to proceed with the privatisation.

Bidding parameters

Arjun's immediate task was to determine the parameters of the bidding process whereby buyers would submit bids for the bank. He decided to create a task force drawn from his staff to study and evaluate other bank privatisation precedents.

There seemed to be generally two types of drivers for privatisations and two types of outcomes.

The two drivers were: distressed sales of banks during periods immediately following economic collapse; and second, the sale of banks during periods of economic optimism often accompanying political evolution when governments had a strong enough mandate to undertake reform of the domestic financial sector.

Banks privatised in the latter situation were often considered 'healthy'. On the other hand, sales of distressed banks had generally resulted in transitional ownership, which then gave way to a more stable long-term shareholder structure.

It was hard to gauge if the short term or transitional owners had actually created much value for the institutions and the banking sector more broadly. Recent examples of this included Korea First Bank and Koram Bank in South Korea, and Long Term Credit Bank in Japan.

In other situations, governments had sought or had been able to avoid such an outcome by mandating that the purchaser of a bank be a long term shareholder such as another financial institution or a buyer with strong long term local interests.

Unfortunately, these precedents had also highlighted several potential pitfalls.

In those cases where control of institutions had been sold to strategic buyers in the financial sector, host countries found these new owners tended to pursue a strategy targeting those customers who represented the least credit risk. Typically, these were large corporates and high net worth individuals. As such, these two customer groups were already being banked by local institutions. So arguably, these new strategic players in the market did not deepen penetration of banking services in the local market particularly in the SME and higher risk individual segments.

In cases where control was acquired by strong local groups with no presence in the financial sector, the value added was even harder to ascertain.

Arjun knew the auction rules had to be formulated such that the bank would attract the attention of an established foreign or domestic bank or financial institution with a long term interest in the Indian market. The buyer needed to have the strategic expertise to position INB to compete effectively against the larger domestic banks and increase INB's profitability to make it competitive with its global peers.

Arjun then formulated a list of rules based on which interested parties would be invited to submit bids for INB. The auction rules were approved by the finance ministry before they were put out in the form of a press release made available to the financial community in India and abroad.

The rules

Buyers would be required to demonstrate the financial wherewithal to ensure smooth completion of the transaction and provide a plan for the development of INB, including capital, technology, human and other resources that would be contributed. In addition, most state owned enterprises including the domestic public sector banks would be prohibited from bidding.

The auction process would take place in two phases.

In Phase I, buyers would be invited to submit preliminary indications of interest to the ministry of finance. The indications of interest would need to contain a basic financial profile of the bidding institution along with a description of its key businesses and geographic areas of operation, and an estimated range for the bid price per share.

The lower end of the price range indicated would be considered a binding minimum in order to establish a price floor for the transaction. Any price above the minimum would be considered non-binding and subject to re-evaluation based on due diligence.

Interested bidders were given two weeks to put together their indications of interest. Arjun and his team would assess bidders and determine which would proceed to the second and final phase of the auction.

Phase II would give each bidder three weeks to conduct their due diligence of INB and submit sealed final binding bids. Due diligence would comprise bidder access to data rooms containing a comprehensive set of INB's historical financial information and meetings with members of the INB management team.

Final bids would need to contain a bid price per share, and a detailed restructuring plan outlining a business plan for the first five years after the transaction close. The restructuring plan needed to outline the specific steps the buyer in question would seek to undertake to diversify INB's product profile, and deepen its penetration in select local markets. Each bid also needed to explicitly spell out any guarantees, indemnities or carve-outs the bids were subject to.

Arjun and his team would evaluate bidders based on a number of criteria to determine which would to go through to the second and final round of the auction.

First, they would look for the bidders to have demonstrated expertise in running a retail banking operation in a meaningful emerging market. Second, while the selection of bidders would not explicitly be subject to this, Arjun had to consider the finance ministry's minimum price requirement of Rs 360 per share which represented a multiple of 7.1 x to INB's 2004 earnings and 2.0 x to INB's 2004 book value. Third, Arjun and his team would investigate past transactions conducted by the bidders in their home or other countries to assess their record.

The cast

Two weeks later, Arjun and his team had five indications of interest to evaluate. Two of them came from predominantly domestic Indian bidding groups while the other three were from foreign entities.

The first of the Indian bidders was a local Indian conglomerate with a diversified set of business interests in several industries, none of which included financial services. Arjun and his team disqualified this bidder on the basis that it had no industry expertise with which to take over and run INB.

The second Indian bidder was a joint bidding consortium of a mid-sized, family owned Indian bank and a US based private equity fund -- Financial Services Capital Partners -- specialised in investing in financial services companies globally.

Arjun had at first been skeptical of the ability of two such institutions to partner in running INB, particularly given their disparate investment horizons. Upon researching the two institutions, he had found the idea of such a partnership between an Indian and an international entity intriguing.

The Indian bank, Union First Bank, had been successful at both extending its footprint across the country and offering new, innovative products to its customers over the last two decades. In addition, UFB's shareholding family also ran a small but profitable and rapidly growing consumer finance business they had purchased a few years ago. This business was still technically separate from UFB but had recently been rebranded UFB.

FSCP had made investments in several different types of financial services companies, including banks, across the world. They were reputed to be patient turnaround experts with a demonstrated ability to work collaboratively with public and private shareholders, as many of their investments had been made through similar consortiums and in some cases privatising governments had remained shareholders of the target companies for a several years after MIP's initial investment. Arjun and his team decided to allow the consortium through to the final round.

Three other indications of interest came from entirely foreign entities.

The first was from a consortium of generalist US private equity funds. These funds had extensive experience in buying and turning around businesses -- mostly in developed markets -- and had indicated the ability to pay a significant premium for INB. Moreover two of the funds comprising the consortium were leveraged buyout funds with a reputation for breaking up the companies they purchased, resulting in significant layoffs. On balance, Arjun determined to reject this bidder.

An indication of interest came from the Singapore Investment Authority, an arm of the Singaporean government. In recent years, SIA had made several investments in India and was reputed to be a prudent, long-term investor with the deep pockets of the Singaporean government implicitly backing it. The Indian government's familiarity with SIA from its investments in other Indian companies, SIA's attractive bid price, and India's increasingly closer economic ties with Singapore, made SIA an attractive candidate to send through to the final round.

A final indication of interest had been submitted by UK's Charter First Bank. CFB had been active in a variety of emerging markets across Asia, the Middle East, and Africa for many years and operated in India through a wholly owned subsidiary.

To date, CFB's operations in India had been limited to lending to large corporations and providing retail banking services to high net worth individuals. However, Arjun knew that over the last few years, CFB had been considering various growth options to expand its retail business and begin lending to SMEs. In keeping with this strategy, it had recently acquired banks in both Thailand and South Korea with a strong presence in the SME segment. CFB's long history of operating in India and deep industry knowledge made it an attractive candidate to send through to the final round.

Arjun's recommendation to the ministry was that three bidders -- the UFB-MIP consortium, SIA and CFB -- be allowed to conduct due diligence and asked to submit final round bids. With the sign off from the ministry on these three bidders, Arjun's team informed each bidder of their eligibility to proceed to the final phase. The three-week due diligence process and bid formulation process began shortly thereafter and each bidder submitted their bid at the end of the period.

Table 02 contains the key terms of each of the three final bids.

Table 2

While the UFB/ FSCP consortium bid the lowest price -- Rs 375 per share -- Arjun felt the combination of a domestic Indian bank and an international private equity fund was acceptable from a political standpoint.

SIA had bid in between the Consortium and CFB, but it was unclear how politically saleable transferring ownership of a government owned bank to the Singaporean government would be. However, in SIA's favour, this would be its first investment in an Indian bank, making it likely that it would retain most employees and not shut down the bank's unprofitable businesses.

CFB had bid the highest price and had an excellent reputation in the Indian market. But CFB's activities had historically been limited to wealthy individual and corporate clients, making it unlikely that it would retain INB's extensive branch network.

Your question

Which bid should Arjun and his team pick as the winning bid and why?

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