The merger of RIL and RPL has surprised many investors. The timing of the announcement has kept analysts wondering why the deal is being pushed through at a rapid fire pace.

To understand the logic behind the deal, one needs to look at the equity history of Reliance. Reliance always raised substantial capital in new entities at a high premium and funded its very large expansion projects. The goodwill of Reliance was always monetised in its subsidiaries or sister firms. The investing public gave fancy premiums without a murmur and trusted the Reliance group to deliver returns on their investment. But, the share premium paid to a start up from the Reliance group has never stood up to scrutiny as a standalone entity. Invariably, a merger with RIL would be done just before commercial production commenced. The expansion of the equity-base of RIL was only marginal in each instance. Therefore, the incremental earnings would reflect positively in the valuation of RIL.

Raise investor expectations…

This pattern is not difficult to make sense. When Reliance raises capital, it will inevitably raise investor expecta-tions about the new venture. The new venture will be in focus and would be heavily traded. The parent company, RIL, always enjoyed a higher valuation when a new issue was floated and traded at close to its historic peaks in valuation. The market optimism on Reliance always rose after it raised capital and reflected in the valuations of both the parent company and the sister concern or subsidiary as the case maybe.

This resulted in over-valuation of stocks of both Reliance Industries and the other companies floated. The next move of the promoter would be to either monetise or recapitalise.

It is observed that the promoters always used the situation to either raise money through secondary sale of shares or raise their stake in the new entity through secondary purchase of shares at lower prices.

The promoters pursued alternative strategies depending on the overall market scenario. They bought more shares on listing at lower valuations and held them till the merger happened at much higher valuations. This was the story of ILU - PILU, the two companies floated by Reliance to make polyethylene and polypropylene. Alternately, they sold their promoter shareholding in the newly floated entity at close to the peak valuations through the secondary market. This sale of shares would have freed up promoter capital and also cooled down the valuations of the new company. This trend seems to be the case with the two RPLs.

The promoter group has unfailingly taken advantage of its goodwill by either buying more shares in the new companies through the secondary route or by selling their own shares to the public. No new offering from Reliance has passed without corporate action from the promoter group.

Management privy to vital data…

The management is the only player privy to the future of these entities and is hence ideally placed to exploit the excessive investor frenzy for the shares of a new Reliance company. They unfailingly exploit this opportunity and complete their corporate actions before the plants come into production. Around the time the companies have completed the projects and the cash flows are about to start, the Reliance management swiftly merges the new company itself.

Reliance gives its own shares in exchange for the shares of the new company. This results in moderate dilution in RIL's equity. But, the incremental earnings to Reliance help it to sustain and raise its market capitalisation.

Merger is an instrument to add substantial profits to RIL with smaller incremental rise in own capital. Over the next few years, one sees cash flows from the new company getting the higher valuations which RIL always enjoys. That ensures shareholder rarely complained and possibly explains the `Dhirubhai Magic' which has worked with investors. It also explains how Reliance has grown its market capitalisation during bull markets and protected it during the bear phases.