NSE may exclude HDFC from Nifty index before its merger with HDFC Bank

The merger of the parent firm with its subsidiary HDFC Bank– the country’s biggest merger deal so far — is scheduled to be concluded by mid-2023.

The merger proposal of the two entities has already got all the approvals, barring shareholders’ nod (scheduled on November 25) along with the final clearance from the Reserve Bank of India.

HDFC has 5.5 per cent weight in the Nifty. This translates into USD 1.3-1.5 billion outflow from passive funds on its exclusion from the index.

Analysts are expecting heavy fluctuations in the Nifty on the possible fund outflows on merger of the HDFC twins which together command over 13 per cent of the Nifty now.

Given this huge weight of the HDFC twins in the benchmark index, NSE has issued a consultation note on the possible outcomes of the merger on the index and the resultant exclusion of HDFC and inclusion of a replacement stock.

Analysts are expecting that either adhesive maker Pidlite Industries or Adani Enterprises may replace HDFC.

In the note, NSE has proposed exclusion of HDFC from index on merger ex-date, going by its extant practice in such a scenario.

Analysts estimate that according to the extant rules, HDFC may be excluded from the Nifty in December or early January as the over USD 40-billion merger process has been faster than expected.

If NSE’s proposals are accepted, HDFC will be excluded on the ex-date, which will likely happen mid-next year.

NSE Indices, an arm of NSE, has proposed to exclude or include a company from or into the indices closer to the event. If the NSE plan is approved, that may avert sharp swings in shares prices of companies that are in the process of merger/demerger on account of forced selling and purchases by passive funds that track these indices.

NSE Indices has sought market participants’ feedback on the treatment of merger and demerger in the Nifty by November 2.

The Nifty Indices’ methodology book states that in case of a merger, spin-off, capital restructuring or voluntary delisting, shareholder approval is considered the trigger to initiate the replacement of such stock from the index through additional index reconstitution.

The consultation paper further states that currently additional event-based index reconstitution is undertaken in case of the merger/demerger of an index constituent, where shareholder approval is considered as a trigger to initiate the exclusion and replacement. Exclusion of such stock is done much ahead of its ex-date of merger/demerger.

The paper further states that more specifically, in case of event-based reconstitution on account of merger, index reconstitution takes place at the time of exclusion of the transferor company. Subsequently, weight rebalancing of the stocks in the index takes place when the shareholders of the transferor company are allotted shares of the merged entity and they are available for trading on the NSE.

This results in churning of stocks twice in case passive funds like ETFs/index funds are tracking such index.

Further, in case of event-based reconstitution due to demerger, the index reconstitution and weight rebalancing take place at the time of exclusion of the demerged company irrespective of its size in terms of market capitalization or demerged business.

The paper further says, “shareholder approval for the merger is considered as a trigger for making the index reconstitution and weight rebalancing of the index”, which will be effected “soon after the shareholders approval for the merger and the exclusion of the transferor company is initiated from respective indices.” In case the transferor company is a constituent of the indices on which futures and options are traded on the NSE, changes are announced four weeks prior to the index reconstitution date.

Following this, the transferor company is excluded from the index and the same is replaced with another eligible stock, which results into reconstitution and weight rebalancing of the index.

Another extant practice is increasing the number of equity shares of the merged entity after merger.

This has two components: If the equity shares of the merged entity account for more than or equal to 5 per cent of the current equity of the merged entity, these shares are updated for calculation of market capitalisation with effect from the last trading day.

But if the equity shares of merged entity account for less than 5 per cent equity of the merged entity, these shares are updated with effect from the last trading day of the corresponding quarter.

In case a transferor company is a constituent of an index and is merged into another company which is also an index constituent, index reconstitution and weight rebalancing get triggered on two instances: First, on the index reconstitution by the exclusion of the transferor company and the inclusion of the replacement. In this case, funds tracking the index will be required to sell the shares of the transferor company and rebalance the weights of the index constituents.

Weight rebalancing is also done when shareholders of the transferor company are allotted shares of the merged entity and are available for trading. In this case, funds tracking the index will be required to again buy shares of the merged entity, which are allotted to the shareholders of the transferor company.

For funds tracking the index, both the above instances will result into additional buying and selling transactions in relevant companies in a short span of time. The transferor company is excluded from the index much ahead of its ex-date of merger, says the paper.