This article is written by Pulkit Mohnot, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho.
India has become one of the brighter prospects in the mergers and acquisitions regime. According to 2018-19, the activity in India registered a growth of US $ 129 and 64 billion respectively. During 2019, Private equity investment in India surged 13.8% in terms of valuation. private equity transactions in India traditionally consist of a minuscule amount of investment in Indian companies. However, conducive market conditions and eased regulatory restrictions have provided private equity firms with an opportunity to go for buyout transactions. Private equity firm investing in India now has a good stronghold on what risk the Indian market holds regarding regulatory and governance risk. According to data, buyouts contribute around 25% of transactions completed in the previous three years. Buyout transaction enables private equity firms to control various aspects such as the structure of capital, management, and exit.
What are leveraged buyouts?
A Leverage buyout refers to the process where there is the acquisition of business operations of, mainly developed and mature company by a group of financial investors. Their primary focus is to exit investment in a few years and contemplate an IRR of 20% on its investment. If we see the meaning of the term leverage, it represents debt used to finance the transaction. The main objective of leveraged buyout is to enable the investor to make the giant acquisition without committing a large chunk of capital. Here, the basic structure of transaction involves forming a particular purpose vehicle funded by the pool of financial investors and management of such a target company. Here the mechanism is that assets of such target company can be used as collateral for securing the debt. Such capital consists of various debt instruments such as bank facilities that are prepayable and bonds that offer high yield debt. Such new debts taken are not for long-term purposes. The primary purpose of leveraged buyout is to gain excess capital by increasing profit margins, selling the assets, and cost shaving. Then the excess cash generated is used to cover the debt undertaken during leveraged buyout. Also, there is the provision of giving managers their stake in business operation through directly owning the shares and stock options.
The term buyout refers to the control of the majority equity of the target company. The motive is to convert the target company private after leveraged buyout. Private investors own it through partnerships who can sell if things got dicey. The profit-making leveraged buyout tends to go public when they have covered all their debts, and there has been an increase in the target company’s performance.
Structuring considerations required for leveraged buyouts in India
There are two major buyout structures through which leveraged buyout can be executed; Foreign holding company structure and Asset buyout structure.
Foreign holding company structure
The mechanism for using foreign entities to undertake leveraged buyout in India started when the pool of financial investors finances and incorporated holding company incorporated abroad using debt and equity. Foreign banks are mainly used for raising their debts to finance their transactions. The foreign holding company uses such equity and debts to acquire equity in the Indian company that should align with press note 9 of FIPB. Also, the money invested in an Indian company to buy a stake in it proceeds as Foreign Direct Investment. The seller belonging to the operating company of India can receive securities through participation in Buyout as payment such as equity rollover and seller notes. The operating assets of such a business of Indian company are considered a corporate entity. In the process, the flow of cash is generated by the operating company, whereas the foreign company has the hold of principal and interest payment. Also in return operating company pay back dividend and share buyback payments to holding company, which later serves as sources for them to cover the debt. Here is a schematic representation of such a buyout structure.
Lien on assets
The following leveraged buyout has given above, both the assets and operating assets form two separate legal entities. The operating company is generally not able to give collateral for the assets for covering the debts of the holding company. This can be a problem for companies looking for secured leveraged buyout to cover their debts, though it can be less beneficial for the target company specializing in Business Process Outsourcing or IT services. Investors might look for placing certain assets as collateral and generate cash flows for the holding company. Contracts between the Foreign Holding Company and the Indian Operating Company will satisfy India’s transfer pricing regulations.
Provision of non-deductibility of Interest payments
There is no provision for deduction of payment of interest from the operating income of an Indian company. This factor is not essential for various companies in export business based out of SEZ zone or software tech parks in India. It takes incentives that significantly decrease their tax rates.
Risk of foreign currency
There is a significant risk to the foreign holding company as revenues incurred by Indian companies are measured in terms of Indian currency. In contrast, debt taken is monitored in terms of foreign currency. It can increase the resultant cost of leveraged buyout’s. Suppose there is a condition where revenues of an Indian company are measured in terms of foreign currency. In that case, there can be an allayment of risk as foreign currency denominated reserves provide a natural hedge.
Typically operating company tends to remit share buyback in place of dividends to holding company. The Companies Act, 1956 governs the size of buyback and number of shares. Section 77A governs the company about buyback with certain conditions.
Provision of facilitating exit by foreign listing
It speaks for providing the investor a perfect and clean exit from the investment. Also, it allows companies incorporated in foreign on the US or European stock exchange with the option of not listing Indian stock exchange.
Asset buyout structure
In asset buyout structure, the investor instead incorporates a domestic holding company and finances it using the same method as the foreign company holding structure. The debt raised depends on the signing of the purchase agreement to acquire operating assets. Assets secure these on project loans and working capital, secured and permissible for domestic banks. Also, the process of acquiring assets by way of the asset by asset basis starts, for example, machinery, building, and land. The Foreign Direct Investment route is the most trusted route for investing in the equity of a Domestic holding company.
Liability based on stamp duty and risk of executing it
The domestic holding company is liable to pay stamp duty on assets purchased. The stamp duty adds an extra 10 percent to the total transaction cost, which depends upon depending on many factors such as state rate of stamp duty and purchase of assets. The assessment of the cost of each asset purchased is to be carried separately. Therefore leveraged buyout of an asset-intensive company becomes a strenuous task.
Tax liability inflicted on the seller
There is SET (Sectionurities transaction tax) of 0.125% on listed share and 10 to 20 percent tax on Long term capital gains tax. However, according to the provisions of the Revenue Act, sales of assets is considered a type of business income where there is a tax rate of 30 percent along with a surcharge of 10 percent and education cess around 4%.
Challenges faced in leveraged buyouts in India
They are two methods through which foreign investment can reach India- the Foreign Institutional Investment route and the Foreign Direct Investment route.
Restriction faced under Foreign Institutional Investment
Foreign Institutional Investment is mainly used for the company making small type investment in the Indian company. These are used mainly by pension funds, mutual funds, investment funds companies that are based abroad. Various private equity investment occurs through Foreign Institutional Investment route. Here ceiling limit in the case of paid-up capital is 10 percent, whereas, in total, the limit should not exceed 24 percent equity of an Indian company. It is at the company’s discretion to exceed the limit subject to the board’s approval. The approval of FIPB is required to increase the limit if not prescribed by the private equity firm.
Restriction by RBI
The RBI has installed some restrictions, and it talks about the investment made through Foreign Institutional Investment by either a private company or an unlisted public company. Then such investment is governed by RBI. According to the Master circular on Advances and loans released in 2015, RBI proscribes financial institutions either to grant loans for subscriptions or purchase shares in an Indian company. It also prohibits private equity firms from using assets as collateral of the target company to facilitate the financing of target company shares. This is done in order to ensure the survival of domestic banks concerning proceeding with shares.
How leveraged buyouts in India has fared till now
The biggest leveraged buyouts in India have been related to BPO’s companies are Aricent, which was earlier a Flextronics software system, and Genpact, which was earlier called GECIS. The most viable options for leveraged buyouts in India would be service, outsourcing, and high-tech companies. The advantages possessed by these industries, such as the labor-intensive industry and the availability of English-speaking people in India, make leveraged buyout successful in India.
In India, major leveraged buyout took place after 2007. According to Thomson Reuters, out of 83 deals completed after 2007, 68 have been completed after 2007. India is basically in an entirely developing state regarding leveraged buyouts compared to other Asian countries. This same trend is seen across other developing markets as well. An Indian company that targets companies has shown a significant growth rate up as high as 20 percent and sometimes 60 percent. According to Mckinsey and NASSCOM, in 2005, it predicted an annual growth rate of 42 percent for BPO’s in India. The NASSCOM-McKinsey report estimates that the offshore business process outsourcing industry will grow at a 37.0% compound annual growth rate, from $11.4 billion in fiscal 2005 to $55.0 billion in fiscal 2010
India has seen a massive surge in cash flow in the form of Foreign Direct Investment and Foreign Institutional Investment. This trend is fuelling the growth of leveraged buyout in India. Great e g. of its Singapore government, the second-largest investor in India, has shifted its stance to buyout capital. Singaporean Temasek holding collaborated with Standard chartered private equity to set up a fund worth 100 million dollars in India. The conglomerates work in various diverse areas to several minority areas in India. These are good targets for leveraged buyout in India as they have very well-organized and established management.
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