Monday, June 2, 2014

Financing Domestic M&A

A Times of India report indicates that the Finance Ministry is considering a proposal to allow banks to finance domestic M&A, i.e. acquisitions of local targets by local acquirers. If this proposal goes through (although significant doubts have been raised regarding that), it will mark a sea-change in the funding of domestic M&A that is currently deprived of bank funding.

At present, there is some level of discrimination between the financing of foreign and domestic acquirers. While foreign acquirers are generally entitled to obtain flexible forms of financing to make acquisitions of Indian companies, domestic acquirers are hamstrung when it comes to bank financing, which is not available. Historically, it appears that the policy of the Reserve Bank of India (RBI) shunned bank financing of share acquisitions on the ground that it could lead to lending towards speculative activity resulting in undue risks posed to banks. This inability of acquirers (particularly domestic) to raise bank financing has been recognized even in the report of the Takeover Regulations Advisory Committee (at pages 19 and 20). Any change to this policy permitting bank financing of domestic acquirers would not only propel greater domestic M&A but could also reduce the disparity among foreign and domestic acquirers.

At the same time, it must be noted that bank financing by itself may not be sufficient to create a vibrant market for acquisition financing. Such financing is usually structured in the form of leveraged buyouts (LBOs) that require the target to provide some support in the form of guarantees or securities in favour of lenders so as to enable them to lend to the acquirers. In other words, the acquirer leverages the assets of the target while obtaining financing from the lenders for the acquisition. Such leveraged financing in the customary form is not permissible in India due to the rules against financial assistance that are contained in section 67(2) of the Companies Act, 2013 (which compares with section 77(2) of the 1956 Act). Although other jurisdictions carry whitewash provisions that enable shareholders to approve the financial assistance so long as the company continues to be solvent thereafter, such a facility is not available to Indian companies. The only exception available is in the case of private companies, but this is not altogether attractive as targets in large leveraged buyouts are likely to be public companies. Moreover, since the definition of a public company is considerably wide to include a private company that is a subsidiary of a public company, the possibility of the exemption being invoked is rather minimal.

Although most countries are progressively relaxing the rule against financial assistance but at the same time incorporating protections to creditors and minority shareholders, the rule in India continues to be rigid and inflexible. It is not clear as why such a relaxation effort was not undertaken when Indian company law was recently reformed with the enactment of the Companies Act, 2013. Unless statutory amendments are introduced, acquisition financing by way of leveraged buyouts would be a non-starter in the Indian context.


Anonymous said...

But isn't 67(2) only concerned with loans, advances or securities being forwarded by a company for the purpose of buying shares in the same company or its holding company?

Aren't leveraged buyouts, buyouts made from borrowed money generally. And wouldn't the funds(loans) raised for such buyout usually come from an external source (like a bank, FIs, public funding, third part lender etc) usually??

Umakanth Varottil said...

@Anonymous. Section 67(2) would also cover any guarantee or security provided by the target company in favor of a lender who had advanced loans to the acquirer. Such a guarantee or security by the target company is common in a leveraged buyout although the actual funds may come from a third party such a bank. Hence, the restriction would apply.

Anonymous said...

Wasn't Heromotocorp's buyout of Honda similar to this?

Neelasha Nemani said...

Sir, request you to clarify the following.

Assume an LBO structure involving three parties - Acquirer, Target and an SPV. The Acquirer would infuse funds into the SPV for it to buyout the Target. The remaining funds for this buyout would be sourced from an AIF which would infuse funds (primarily debt but also a certain about of equity to gain a small amount of controlling stake) in the SPV to facilitate this LBO transaction. Isn't this allowed in India?