HDFC: The rare merger that makes perfect sense

The Invesco Developing Markets team generally takes a dim view of mergers — particularly in the financial services industry — given complex integration challenges and potential balance sheet uncertainties. However, the pending merger of India’s largest private sector mortgage lender HDFC Limited with its subsidiary HDFC Bank¹ is a rare exception. In our view, it is a nearly perfect and long overdue marriage with incredibly intuitive synergies.

Below are the top three potential benefits we anticipate from this merger:

1. Higher growth

HDFC Bank, which has emerged as India’s largest private sector bank², has an unparalleled distribution network that will embellish HDFC Limited’s mortgage origination. HDFC Bank has pioneered unsecured consumer credit in India during its 25-year history, which coupled with consumer durable lending and small and mid-sized enterprise banking form the core of its credit book.

At present, just 8% of HDFC Bank’s 70 million-plus customers hold a mortgage, and only 2% of these customers hold an HDFC Limited mortgage.³ The runway for mortgage origination growth for the combined HDFC Bank Group is considerable.

2. Higher margins

We believe HDFC Limited’s core mortgage business will be able to increase profitability considerably post-merger as the mortgage business will be able to access the low-cost, granular retail deposits of HDFC Bank.

Currently, HDFC Limited cannot fund itself with bank deposits, and for over 40 years has had to rely upon more expensive wholesale funding. The cost of funding for HDFC Limited has averaged 7.8% for the mortgage lender over the last decade versus 5.3%⁴ for HDFC Bank. Despite this, HDFC Limited has consistently maintained Return on Average Assets in excess of 2.5%⁵ for the past decade. We expect returns on assets in the mortgage business to increase over time as its funding mix shifts.

3. Better capital efficiency

We expect the merger to also increase capital efficiency across the group, further lifting HDFC Bank’s industry-leading Return on Average Equity of 19% versus the average of 12% for India’s private sector banks.⁶

With a Common Equity Tier 1 capital ratio⁷ in excess of 22%⁸, HDFC Limited has significant surplus capital that cannot easily be digested by the already considerable growth of its core mortgage business. We believe the merger will enable excess capital trapped in the holding company to fund over 20% medium-term credit growth of HDFC Bank.

Room for growth in India’s financial services sector

Our longstanding relationship with HDFC Limited⁹ has been largely premised on the underlying attractiveness of the core mortgage business and, more recently, on the significant value shareholders have realized as the holding company has birthed some of India’s largest and most profitable private sector financial service subsidiaries. Most notable among those is HDFC Bank, but that also includes HDFC Life Insurance and HDFC Asset Management, among others.

India remains, in our minds, one of the most attractive growth markets for financial services. Mortgage penetration remains embryonic by most standards at 11% of gross domestic product¹⁰, one of the lowest globally. We believe mortgage and broader consumer finance credit growth can grow in excess of 15% compound for many, many years in India.

Although not the key premise of our investment case in HDFC Limited, we have actively pressed management and boards of both HDFC Limited and HDFC Bank of the compelling logic of this pending merger. And we see even greater upside potential to our investment in this almost perfect marriage.