LEVERAGED BUYOUTS IN INDIA : AMAN GUPTA
What is leveraged buyout?
Leveraged
Buyout (LBO) is one of the investment strategies of a Private Equity (PE) Firm.
PE Firm, generally, raises funds from institutions and high net-worth
individuals, which are invested further in the purchase and sale business. When
a PE Firm purchases a company it is known as a Buyout, further, when its
purchase consideration involves a major chunk of debt and a minor chunk of its
own equity fund (preferably, a ratio of 70% debt to 30% equity), the strategy or
transaction is then termed as Leveraged Buyout.
LBO
is an acquisition transaction that aims to achieve a controlling interest in a
company. The transaction is financed through borrowings or loans by
collateralizing the assets and operations of the acquiring company.[i] The
PE Firm adds value to the acquired entity and repays its debt through the
cash-flow of the target company to secure and maximize its internal rate of
return (IRR) and convert entire debt into equity within a span of 5-10 years.
LBOs
are advantageous since the debt remains secured and the acquired entity pays
for itself. It provides a viable exit to a seller and tends to restructure the
target company in a more efficient manner. LBOs can be demanding since it can
assure a much greater return on equity. Consider the following two scenarios:
Scenario 1: Firm
A wants to purchase Firm B (costing $7.5 billion) through the LBO strategy. A
invests $2.5 billion equity funds and the remaining amount i.e. $5 billion is
borrowed as loan @10% interest. With sufficient cash flows and stable
operation, we assume the Earnings before Interest and Tax (EBIT) at $1 billion.
Interest being $500 million is deducted and the remaining $500 million is
further deducted @ 30% tax thereby left with earnings of $350 million after
an investment of $2.5 billion equity funds.
|
Particulars |
Amount |
|
EBIT |
1,000,000,000 |
|
(-) Interest [10% of $5
billion] |
500,000,000 |
|
EBT |
500,000,000 |
|
(-) Tax @ 30% |
150,000,000 |
|
EAT |
350,000,000 |
Scenario 2: With
the same scenario as above, this time Firm A invests $7.5 billion equity funds
with no interest (since no bank borrowings) and only tax @ 30% is deducted
thereby left with earnings of $700 million after an investment of $7.5
billion equity funds.
|
Particulars |
Amount |
|
EBIT |
1,000,000,000 |
|
(-) Interest |
0 |
|
EBT |
1,000,000,000 |
|
(-) Tax @ 30% |
300,000,000 |
|
EAT |
700,000,000 |
Analysis: Although,
the earnings in Scenario 2 are twice that of Scenario 1, it is not proportional
with the equity investment. The difference in investment i.e. $5 billion in
Scenario 2 can be used for other business operations. Thus, the LBO strategy gives
enhanced return on equity with two benefits:
(a) Reduction
in owner’s equity;
(b) Tax
shield on interest payment.
Criticism
Critics
have argued that LBOs risk the growth of the business since the cash flow from
the operating assets is routed to service leveraged debts thereby curtailing
expenses for repair and replacements, lack of investment in R&D, etc. The nightmare
is the scenario of an unsuccessful LBO i.e. large amount of leverage or loan might
turn into a Non-Performing Asset (NPA) where cash flows would remain
insufficient to repay debts, which might force the company into bankruptcy.[ii] Moreover,
high-interest rates on LBO debt might damage the credit-worthiness of the
company.
What are the restrictions to leverage buyout in India?
The
Indian regulations prohibit procuring loans from banks/financial institutions
to invest in acquiring a stressed company by collateralizing the assets of such
a company. Following are the restrictions faced by the investors for carrying
out LBOs in India:
1. Master Circular of
Reserve Bank of India (RBI) dated August 28, 1998,[iii] specifies
that the bank should not grant advances for the promoter’s contribution to the
equity shares of the company reason being that the advances should come from
the promoter’s own resources.
2. Section 67(2) of the
Companies Act 2013, prohibits directly or
indirectly a public company to lend any financial assistance for the purpose of
purchase or subscription of shares in the target company. However, this
provision is exempted for private companies.
3. FIPB’s Press Note 9 dated
April 12, 1999[iv]
bars a foreign company or investor to borrow from Indian Banks for acquiring
shares in an Indian Company and states that foreign-owned holding companies
would have to bring in requisite funds from abroad and not leverage funds from the
domestic market for such investments. However, the domestic companies can
invest through debt financing in a Foreign Joint Venture.
These
regulatory frameworks restricting LBOs in India have exclusively challenged the
LBO model to persist in India.
Looking ahead
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