In this article, Shashwat Sarin discusses leveraged buyouts of distressed Indian companies.

A leveraged buyout, which is commonly referred to as an LBO, is a transaction in which companies acquire other businesses. The buyout involves a combination of equity from the buyer, along with debt that is secured by the target company’s assets or financial institutions like a bank or investment banks or private equity funds. LBO can be initiated and executed in cases of acquisition for restructuring and elimination of variable additional cost to grow the output of the company while making it a profitable venture or if a public company is to be taken private. In other cases, if the target company is to be segregated and sold to existing businesses in separate portions

The amount of debt that a bank is willing to provide to support an LBO varies & depends on

1. The financial strength and cash flows of the target company
2. The quality and resale value of assets meant to be acquired from the target company.
3. The opportunity and growth prospects of the target company.
4. History of financial supporters and creditors
5. Lastly the overall economic background, the regulatory framework, administrative structure, policy initiatives and concessions by the government and other variable factors.

Incentives to invest in or purchase a company or its subsidiary via means of an LBO

• A Stable Cash Flow/ valuation on return on equity – The company being acquired in a leveraged buyout must have sufficiently stable cash flows to pay its interest expense and repay debt principal over time. Such structures are commonly acquired in LBOs.
• Low fixed costs – Fixed costs create substantial amount of risk because companies have no option to delay the payment of fixed cost even in economic hardships.
• Low existing debt – If a company already has a high debt balance then an additional debt to acquire the company would only weaken the financial structure and accounts of the company while further depreciating the economic value of its assets.
• Moderate Valuation – Companies that are moderately valued or under valued are preferred in acquisition compared to over valued and high valuation companies. This also increases the risk and debt of the acquirer. Furthermore, if the equity of the target company Is sold at a very high value compared to its balance sheets and assets then it has a depreciating affect on its assets and further raises the risk on debt.
• Variable factors– Policy changes and regulatory framework of company in target jurisdiction. A strong management team coupled with a detailed ground network are also essential value adding credentials.

Private equity regulation has raised some growing concerns in recent times. For example, the activities that private equity firms indulge in, mainly activities like leveraged buyouts may not be compatible with the corporate laws of the state. For instance the European corporate law views leverage buyouts as fraudulent activities and are banned by Article 23 of Directive 77/91/EEC which states that a company may not provide financial assistance for the purchase of its own shares. In February 2000, the Supreme Court of Italy declared LBOs to be illegal (Bottazzi; 2008). In 2001, the Italian parliament filed a petition to reconsider the buyout regulation and finally in January 2004, a new legislation was issued wherein LBOs were legalized under the purview of stringent regulations and disclosure requirements. The American corporate law, on the other hand, understands the crucial rol of distressing debts and emphasizes on the utility of LBOs. [1]

From Indian Perspective

The regulations prohibit Indian banks to lend money to such an acquisition company for the purchase of shares of the target company. However recently the RBI has permitted banks to auction off the distressed debts to financial institutions, non- banking financial corporations and individual buyers.
Even though the corporate debt market in India is evolving dynamically there still persist some hurdles

1. From the point of view of an acquirer, the assets of the target Indian company cannot be taken as collateral for financing the debt of the acquiring company situated abroad.
2. As the debt and operating asset are a part of two separate entities there is no deduction of interest from operating income.
3. The dividend distribution tax has increased.
4. There is a constant risk of Foreign currency fluctuation since the debt that will raised to buy out the target company will be in foreign currency.
5. The asset buy out structure has higher tax liability for seller. Purchasing shares of a company attracts Securities Transaction Tax (0.125%) for listed shares and Long Term Capital Gains Tax (10-20%). However, sale of assets by the seller is treated as revenue by the Income Tax Act, 1956 and such gain is assessed as business income on which the tax rate is 30% to be increased by a 10% surcharge and an education cess of 3% (34% effective tax rate).
6. In an asset buy out structure where the foreign company incorporates a company for acquisition purpose, the additional VAT charges raise significant challenges.
7. An emerging issue with regards to the regulations is whether there should be a uniform code of regulation for financial institutions, banks and private equity funds on buyouts. Since all these institutions have different work structure, capacity of risk and different financial objectives, a uniform regulation makes it a difficult scenario as it reduces the market liquidity and imposes further restrictions.

Are venture lenders in cases of venture debt able to circumvent the legal restrictions on LBOs?

Venture lenders ease the debt on a corporation in exchange of equity. The loans extended by venture lenders is secured through the below mentioned mechanisms combined with a structured monthly payment system with interest. A company can use the debt equity to raise new equity or complete earlier existing outstanding issuing of equity and leverage it for a higher valuation. Venture debt can finance the fixed costs or purchase assets for the corporation in exchange for their equity in the company. Besides the common practice of extending services in exchange or percentage of equity, venture lenders may contract for more collateral in exchange for securing the loan extended by them. These scenarios obviously depend on the severity of the non-performing assets and debt structure. Venture lenders can collateral the corporation’s patent to secure debt. So technically in case the corporation fails to recover the additional debt owed to the venture lenders, the venture lenders get unrestricted and unique access to the patent for their use. In this scenario the buying value of the venture lenders by extending the loan would be at an unfair disadvantage as compared to the lower valuation of the non-performing corporation.

According to the recent regulations by the reserve bank of India, a SEBI registered Foreign Venture Capital Investor may purchase securities, issued by an Indian company and startups engaged in any sector. These securities can be purchased from the issuer or any person holding it. Foreign venture capital institutions can acquire, by purchase or otherwise, from, or transfer, by sale or otherwise, too, any person resident in or outside India, any security.[2] According to the SEBI regulations, foreign venture capital investor shall make investment in debt or debt instrument of a venture capital undertaking in which the foreign venture capital investor has already made an investment by way of equity.[3]

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The lack of regulatory measures for venture debt lenders circumvents the stringent legal framework and restrictions around leverage buyouts. The regulations which prohibit Indian banks to lend money to such acquisition company for the purchase of shares of the target company in case of leverage buyouts are not equivocal and consistent in case of venture debt lenders whereas the role of venture debt lenders is similar to acquisitions by leverage buyouts as far as leveraging equity for a sum is concerned.

[1] https://www.rbi.org.in/Scripts/bs_viewcontent.aspx?Id=2109

[2] https://www.rbi.org.in/scripts/FAQView.aspx?Id=26#Q28

[3]https://www.sebi.gov.in/sebi_data/commondocs/fvci_updated_21December2010.pdf