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Monday, 23 October 2017

India 2007: Indian M&A powers ahead

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On August 15 India completed its 60th anniversary of its independence from colonial rule, marking a roller coaster ride for the country that now occupies centre stage in the world of Asian finance. Today, its corporates are at the crossroads of the global economy, making history with their M&A pursuits and providing the bulk of the opportunities for M&A financiers in Asia despite regulations that are not conducive for such financings.

India Inc has been on a song in the past couple of years with its M&A activity. Data from Thomson Financial shows that Indian M&A deals reached a record US$57.16bn in the year to mid-August. Cross-border M&A by Indian companies in the year to mid-August nearly quadrupled to US$19.33bn, compared to the same period in 2006, while inbound M&A volume increased more than five times to US$32.9bn. (See chart.)

This was thanks largely due to the UK’s Vodafone buying Hutchison Essar for US$18.2bn in February. That deal was 2007’s largest Asian (ex-Japan) deal and catapulted the telecom sector to the most active industry for M&A by volume.

Yet Vodafone’s acquisition of Hutch Essar was a disappointment to Asian lenders as it did not lead to any acquisition financing. Lenders, nonetheless, have had enough acquisition financing opportunities elsewhere in India to keep them busy.

The loan market first got a taste of these financings when Genpact (formerly General Electric Capital International Services) tapped a US$210m acquisition loan in February 2005. That financing was the first loan for a business process outsourcing company from India but, more importantly, it kick-started a wave of cross-border M&A deals that shows no sign of stopping. India appeals to offshore lenders because of the abundance of opportunities, attractive pricing on loans and the breadth and diversity of financings.

“This kind of frenetic M&A activity involving Indian companies was unimaginable a few years ago,” said Sanjay Nayar, CEO of Citi’s India operations. “It has come about as a result of the ability of the Indian companies, including some small and mid-cap names, to bring synergies and depth of management combined with the cost of capital advantage from the equity and debt markets.”

Remarkably, most M&A activity has been outbound with Indian corporates gobbling up European and US assets in their bid to become global players. Since Genpact’s financing in early 2005, which some consider to be India’s first leveraged buyout (LBO), there has been only one other LBO – a US$368m seven-year loan that funded private equity firm KKR’s acquisition of Software Development Systems from Singapore-listed electronics components manufacturer Flextronics.

Those two transactions are the only inbound acquisition deals into India that have led to financing opportunities in recent years. This is primarily because Indian regulations restrict repatriation of dividends and cash flows by domestic companies to their offshore parents, making it difficult to structure debt to fund acquisitions by foreign companies. Indian companies are also prohibited from borrowing offshore to fund domestic acquisitions, leaving only the outbound M&A situations to provide any opportunities for lenders.

However, even outbound M&A financings are not totally free from Indian regulations. Market participants are piqued by continuous efforts on the part of Reserve Bank of India (RBI) to make offshore borrowing difficult. Key among the recent changes made to guidelines was one announced in late April that stipulated Indian companies could not lend cash or provide a guarantee for their offshore subsidiaries for more than three times their net worth. Previously, Indian companies could lend cash to their offshore subsidiaries up to twice their net worth or provide guarantees for up to four times the net worth.

“The biggest obstacle to Indian cross-border M&A is the institution called RBI,” said one frustrated loan banker with a foreign bank in Hong Kong. “Its regulations are unfriendly, unworkable and hinder companies from obtaining an optimal and efficient form of financing to support their overseas acquisitions,” he said, alluding to the fact that companies cannot provide security for recourse financings.

The restriction on providing guarantees forces the Indian acquirer to raise funds at the target level giving rise to non-recourse financings.

Typically non-recourse financings in acquisition situations are put together where the acquirer is a financial sponsor, which looks to put in minimum equity and leverage off the target company’s cashflows,” said Farhan Faruqui, managing director and head of global loans Asia Pacific at Citi. “Non-recourse financings being employed in acquisitions involving trade buyers is unusual in the rest of the world, but has been seen quite a lot in Indian M&A situations.”

“Much of the outward bound Indian M&A is based on the premise of purchasing a front-end customer base offshore and feeding that customer base with product or services that can be manufactured more cheaply at home [India],” said Richard Palmer, head of loan structuring and origination for Barclays Capital in Asia.

“However when acquisition financing is being provided on a non-recourse basis at the target company, it becomes difficult to process that logic from a lender’s perspective, because the target’s operations and credit profile on which the non-recourse financing is based can no longer be analysed independently from the acquiring company’s operations and credit profile,” he added.

In non-recourse financings for trade/strategic buyers there is an added complication of modelling the synergies and other benefits to allocate between the acquirer and target’s financials,” said Faruqui.

While leveraged financiers are rubbing their hands with glee on the prospects available for them to make money, others believe that the non-recourse financings are not the most optimal solution for acquirers. Some believe that the costs on the financings, particularly the non-recourse pieces, are higher as a result. Moreover, if the target company is already leveraged, then the Indian acquirer’s ability to bid aggressively is further restricted by virtue of how much debt can be raised at the target.

Some begged to differ, pointing out that the emergence of non-recourse financings for Indian corporates was a trend driven by the availability of the term loan B investor base that has traditionally been the realm of financial sponsors. “The pricing on a term loan B can be compared to the cost of raising equity and borrowing against equity,” said Mike Nawas, global head of structured finance at ABN AMRO in London.

“There is a deeper economic element to non-recourse financings for corporate acquirers. It allows them to behave like financial sponsors and continue making other acquisitions. Where the companies are making acquisitions at a fast pace, non-recourse financings allow corporate acquirers to rely on cash flows from the target and keep their powder dry for other acquisitions,” added Nawas.

Whether the non-recourse financings for corporate acquirers are sustainable or not is an open question. While there are some similarities with financial sponsor-related acquisition financings, the biggest differentiator is that corporate acquirers show more willingness to support the target by injecting more equity than financial sponsors do. In a downturn, financial sponsors are more than likely to restructure and hive off non-core areas to raise funds for the target rather than pumping more equity.

Those in support of non-recourse financings are sympathetic with the RBI and suggest that it is justified in formulating regulations to achieve its greater goals of monetary policy. Birendra Baid, director at Barclays Capital said, “Assuming an acquirer has a debt-to-equity ratio of 1-1.75 times, which is quite healthy and normal for Indian companies, and if this acquirer provides guarantee for offshore acquisition to the maximum allowable three times of its net worth, the acquirer’s gearing goes up much higher to nearly five times.”

“The 3x net worth restriction on providing guarantees is not a limiting factor. The regulator cannot just open the floodgates and allow unlimited guarantees, especially as the Indian economy still has capital controls,” said Citi’s Nayar.

“In a downturn if the target goes bust resulting in invocation of these guarantees, it may result in the acquirer itself getting into financial difficulties.

Let us not forget that from the regulator’s perspective, during severe economic downturns, the 3x cap on guarantees restricts huge capital outflows from the country that would otherwise lead to a big impact on currency exchange rates and the wider economy,” added Baid.

“We need to give it a few years to see how things pan out and whether these acquisitions work out in the long run. If they do, the financial markets will reward the acquirers handsomely with access to cheaper funding,” said Nayar. “There is nothing like a well-renowned Indian company using the rigours of a financial sponsor to make an acquisition. While in some ways they behave like financial sponsors, the biggest difference is the support they demonstrate for the target with their increased equity injections when things don’t go as planned. We have seen that in a couple of instances last year.

“Indian companies have shown maturity in understanding market conditions and have been receptive to changes proposed – including deferring syndication or flexing the pricing – to original plans for financing acquisitions,” he said.

So long as the Indian companies continue to demonstrate their ability to integrate their acquisitions well, Indian M&A, particularly the outbound variety, has a rosy future. And that will be tantamount to colonialism in reverse by India Inc.

Prakash Chakravarti

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