Deval Pandya[1]
Amitabh Sharma[2]
This Article, broadly, aims to cover the concept of Leveraged Buyouts (LBOs), the Indian situation and regulators’ take on LBOs in India.
Introduction
Imagine buying a company but not having enough liquidity for the same. What do you do? Option 1 – Drop the idea and move on, or Option 2 – Borrow the required amount and buyout the shareholders of target company. The second option is known as a Leveraged Buyout (literally means leveraging the buyout). According to an early definition, an LBO is “a transaction in which a group of private investors uses debt to purchase a corporation or a corporate division”[i].
The acquisition of another company through an LBO involves employing a significant sum of borrowed funds either by issuing bonds (junk bonds in most cases) or through loans to cover the acquisition costs, “buyout is typically financed with anywhere from 60 to 90 percent debt”[ii]. Along with the assets of the acquiring company, the assets of the target company are also used as collateral for debt. The borrowed funds are repaid using the cash flow generated by the target company.
While the phrase “leveraged buyout” only became popular in the 1980s in the United States, the notion of a debt-financed transaction in which a public company becomes private has existed for much longer. Notably, in 1919, Henry Ford and his son Edsel, purchased the whole outstanding shares of his Ford Motor Company from the public shareholders making Ford Motor Company a private company. It was one of the first significant management buyouts. Approximately 71% of the total consideration was borrowed from a consortium of East Coast institutions that included Old Colony Trust, Bond & Goodwin, and Chase Securities of New York.[iii]
[i] (Palepu, 1990, p. 247)
Consequences of Leveraged Buyouts. Journal of Financial Economics.
[ii] (Stromberg, 2009, p. 124)
Leveraged Buyouts and Private Equity. Journal of Economic Perspectives.
[iii] (Gaughan, p. 306)
Mergers, Acquisitions, and Corporate Restructurings (Seventh ed.). New Jersey: John Wiley & Sons, Inc.
[1] Pandya (LinkedIn), author of this Article, is a Qualified Company Secretary and a Paralegal with the Firm’s Corporate-Commercial Practice. He keenly follows fintech, start-ups, securities markets space with a focus on investments (M&A and Private Equity) in those sectors. He tweets on these topics on twitter under the handle @pandya_sahab.
[2] Sharma (LinkedIn), co-author of this Article, is a Partner with the Firm, specializing in mergers & acquisitions, private equity, corporate-commercial and projects. He regularly tweets on paradoxes of law, policy, and geo-political affairs on twitter under the handle @Amitabh_AMS.
Junk bonds
Conceived and created by investment banker, Michael Milken in 1980s, High-yield bonds (commonly known as junk bonds) are non-investment grade bonds used as a financing mechanism in mergers and acquisitions. Junk bonds, as the name suggests, come with a higher chance of default, although they often offer high rates of return to entice investors.
Unlike most bank debt or investment grade bonds, high-yield bonds lack ‘maintenance’ covenants whereby default occurs if financial health of the borrower deteriorates beyond a set point. Instead, they feature ‘incurrence’ covenants whereby default only occurs if the borrower undertakes a prohibited transaction, like borrowing more money when it lacks sufficient cash flow coverage to pay the interest.[iv]
[iv] (Chokshi, 2007, p. 13)
Challenges Faced In Executing Leveraged Buyouts in India The Evolution of the Growth Buyout. The Leonard N. Stern School of Business, Glucksman Institute for Research in Securities Markets.
Ideal LBO targets
Companies with following operating and financial characteristics are considered ideal LBO targets[v]:
| Operating characteristics | Financial Characteristics |
| Leading market position – proven demand for product | Significant debt capacity |
| Strong management team | Steady cash flow |
| Portfolio of strong brand names | Availability of attractive price |
| Strong relationships with key customers and suppliers | Low capital intensity |
| Favourable industry characteristics | Potential operating improvement |
| Fragmented industry | Ideally low operating leverage |
| Steady growth | Management’s success in implementing substantial cost reduction programmes |
[v] (Chokshi, 2007, p. 5)
Challenges Faced In Executing Leveraged Buyouts in India The Evolution of the Growth Buyout. The Leonard N. Stern School of Business, Glucksman Institute for Research in Securities Markets.
Hinderance from Indian point of view
- Investors’ desire for rated paper
The desire for high rated bonds/paper in the Indian corporate debt market is an interesting aspect. This desire for investment in rated bonds makes it difficult to find investors for bonds with lower ratings. The usage of junk bonds as a financing strategy in mergers and acquisitions in other countries is a stark contrast to this Indian practice.
- Federal Bank – Reserve Bank of India’s (RBI) restraint
The RBI forbids banks and financial institutions from making loans to any entity for the purchase of shares in any Indian company. However, subject to the limits that the RBI may impose, domestic banks are permitted to extend loans to Indian corporations for the purchase of shares in foreign joint ventures and wholly owned subsidiaries.
- Restriction in the Companies Act, 2013 and Indian jurisprudence
Section 67(2) of the Companies Act, 2013, prohibits public companies from providing any financial aid to a person in connection with the purchase/acquisition of such company’s shares. Furthermore, companies are prohibited from directly or indirectly offering any guarantee, loan, or security of any kind to an investor. Such prohibited financial aid includes using of target company’s assets as collateral. This prohibition on financial aid does not permit the investor to leverage the assets of Indian target companies for availing loans for the buyout.
The Supreme Court of India in Ramesh B. Desai and Ors. Vs. Bipin Vadilal Mehta and Ors. said: “It is, therefore, well settled legal principle that any valuable consideration paid out of the company’s assets will make a transaction amounting to a purchase and, therefore, invalid.”[vi]
Further, there were suggestions from the public on the draft Companies Bill, 2011 to exclude ‘leveraged buyouts’ from the restrictions of Section 67, the Standing Committee on Finance, in its 57th Report on Companies Bill, 2011 observed “Leveraged buy outs take place either contractually or through approvals of scheme of compromise/ arrangements by Courts (Tribunal once new Bill comes) and need not be referred to in statute specifically”.
[vi] Ramesh B. Desai and Ors. Vs. Bipin Vadilal Mehta and Ors., Civil Appeal No. 4766 of 2001 (The Supreme Court of India July 11, 2006).
Structuring an LBO deal – Working around the regulatory hurdles
Owing to the regulatory hurdles completing an LBO in India, a way out needs to be looked at. In that regard, to overcome the regulatory hurdles, following common structures are generally adopted for executing LBOs:
- Foreign holding company structure
Investor raises debt in foreign holding company (Foreign Co.) and uses the debt proceeds to acquire shares of Indian target company (Target). The repayment of debt of Foreign Co. is done by up streaming the cash flow generated by Target to Foreign Co.
- Indian holding company structure
Investor incorporates a domestic holding company (Domestic Hold Co.), which raises debt in foreign country and down-streams it to its domestic subsidiary (Domestic Co.) by way of Non-convertible Debentures (NCDs) issued by Domestic Co. to Domestic Hold Co. Proceeds of NCDs are used by Domestic Co. to acquire shares of Indian target company (Target). The repayment of NCDs is done by up streaming the cash flow generated by Target to the Domestic Co. Further, Domestic Co. up streams such proceeds to Domestic Hold Co. for paying off the foreign debt.
- Asset buyout structure
Investor incorporates a domestic holding company (Domestic Hold Co.) which raises debt to acquire operating assets of the Indian target company (Target) (the debt is secured against such operating assets). The repayment of debt is done by up streaming the cash flow generated by the acquired operating assets of the Target in the hands of Domestic Hold Co.
Way ahead for India
The LBO model has been popular in the United States for some time, but its viability in the Indian economy has yet to be become robust. The robust corporate debt market in the United States is favourable to debt financing, which is the foundation of the LBO concept. The high level of debt generated by the corporations imposes strict discipline on the target company’s management in order to create cash flows to service the debt and achieve a return on capital invested.
When investing outside of India, the business and financial sectors in India have used the LBO model of investment by obtaining loans from foreign financial institutions. Following are some major LBOs abroad by Indian companies:[vii]
| Target Company | Target Country | Indian Acquirer | Value |
| Tetley | United Kingdom | Tata Tea | ₤271 million |
| Whyte & Mackay | United Kingdom | UB Group | ₤550 million |
| Corus | United Kingdom | Tata Steel | $11.3 billion |
| Hansen Transmissions | Netherlands | Suzlon Energy | €465 million |
LBOs are subject to regulatory limits; nevertheless, changing the framework would make it more investor friendly and encourage funds to invest through LBOs, making them more cost efficient and appealing. LBOs have shown to be beneficial in the United States; how effective they will be in India remains to be seen.
[vii] (Chokshi, 2007, p. 6)
Challenges Faced In Executing Leveraged Buyouts in India The Evolution of the Growth Buyout. The Leonard N. Stern School of Business, Glucksman Institute for Research in Securities Markets.
[i] (Palepu, 1990, p. 247)
Consequences of Leveraged Buyouts. Journal of Financial Economics.
[ii] (Stromberg, 2009, p. 124)
Leveraged Buyouts and Private Equity. Journal of Economic Perspectives.
[iii] (Gaughan, p. 306)
Mergers, Acquisitions, and Corporate Restructurings (Seventh ed.). New Jersey: John Wiley & Sons, Inc.
[iv] (Chokshi, 2007, p. 13)
Challenges Faced In Executing Leveraged Buyouts in India The Evolution of the Growth Buyout. The Leonard N. Stern School of Business, Glucksman Institute for Research in Securities Markets.
[v] (Chokshi, 2007, p. 5)
Challenges Faced In Executing Leveraged Buyouts in India The Evolution of the Growth Buyout. The Leonard N. Stern School of Business, Glucksman Institute for Research in Securities Markets.
[vi] Ramesh B. Desai and Ors. Vs. Bipin Vadilal Mehta and Ors., Civil Appeal No. 4766 of 2001 (The Supreme Court of India July 11, 2006).
[vii] (Chokshi, 2007, p. 6)
Challenges Faced In Executing Leveraged Buyouts in India The Evolution of the Growth Buyout. The Leonard N. Stern School of Business, Glucksman Institute for Research in Securities Markets.