Acquisition and Leveraged Finance, in a broad sense, involves debt being raised from banks (mostly) to fund an acquisition, based primarily on the financial strengths and credit-worthiness of the target.
In commercial banking, this is a fairly sophisticated product, wherein the financing package has to include sufficient safeguards for the lenders, at the same time, allowing the borrower adequate leeway for its regular operations and growth.
In Anglo-Saxon usage, Acquisition Finance refers to financing for a deal where the acquirer is a corporate, while in Leveraged Finance, the acquirer is a financial sponsor or private equity fund. "Acquisition Finance" term is sometimes used for both the situations, and is used as such in this write-up also.
Availability of requisite financing is an essential element in development of a robust M&A market. This has been amply demonstrated in Europe and US, where such corporate 're-organisation' is an on-going process, leading to efficient allocation of capital, and allowing owners to exit businesses and use their resources elsewhere.
India has not seen significant number of such Leveraged Buy-out ("LBO") deals, for various reasons - some of them are external, whilst others are inherent to banks:
Reluctance of owners to sell majority stake: It is a common feature that owners would like to retain control of their business and look for 'investors' in their businesses who could hold, say 20-30% stake, at least to start with. Whilst this perspective is changing and we are seeing more owners willing to sell a controlling stake, the change is at a slow pace.
From a financing structure perspective, acquisition financing requires the buyer to own at least a majority stake in the target, allowing him to use the cash flows and assets of the target to raise debt. Minority stake doesn't really lend itself to acquisition financing.
Reserve Bank of India norms: Due to certain malpractices in the past wherein bank loans were misused by borrowers to speculate in stock market, RBI requires banks to classify any loan where the primary security is shares, as an unsecured loan; and banks are encouraged to minimise unsecured loans on their books. In a typical acquisition financing structure, the primary security for the loan (at least initially) is shares of the target.
PE firms have mostly been minority investors: Whilst most global PE firms are present in India, their main activity has been to invest growth capital (minority stakes), and work with existing owners to grow the business, and thereby the value of their investment.
There have only been few instances where PE firms have been able / willing to take a majority stake in the business and run it independently. This is unlike the developed economies where PE firms own and manage large businesses, which is both a cause and effect for development of acquisition finance.
Well-run corporates in India have been growing at a steady pace in line with the growth in the economy. Hence, PE investors generally tend to make decent returns on their investment, if inter alia their entry price was not unduly high.
In the developed economies, since corporate growth rates are low, PE firms need to do significant financial engineering, which primarily means maximising the use of debt, to achieve the required return on their equity investment.
Approach of banks: Except some large private sector banks, most other banks feel more comfortable in taking a more traditional lending approach, whereby they have recourse to both the acquirer and target's assets and cash flows.
If the acquirer is a PE fund, it does not have any business to support such acquisition debt; if the acquirer is a corporate, such approach complicates its existing banking relationships.
Industry profile of targets: IT / ITES and the related service sectors have developed rapidly in India over the last 20 years, and have seen a large number of PE investments. Firms in such industries, by their very nature, are asset-light; the only security for a lender in an LBO would be the cash flows, which need to be predictable and sustainable.
Except for large and well-established firms, predicting cash flows over a long term for these firms is a difficult exercise. Most banks (including international banks) do not feel comfortable taking a long-term credit risk on this basis.
Nascent Debt Capital markets: Internationally, most LBO loans are granted initially by banks, but are refinanced through bonds after a few years. Such refinancing is on less stringent terms, since the business would have deleveraged by then and become less risky; refinancing also frees up lending capacity at banks.
In India, the local bond markets are dominated by goverment entities or high-grade corporates, and there is very little appetite for lower-grade paper.
The other route used by banks to manage their balance sheet exposure to LBO loans is to securitise them through Collateralised Debt Obligations ("CDOs"), which are rated and then sold to institutional investors. Again, this market is still in its infancy in India.
It is hoped that over the next few years, a vibrant M&A market will develop in India in sync with an active Acquisition Financing market.
The views expressed in this column are the author's own and do not necessarily reflect this publication's view, and this article is not edited by Asian Banking & Finance. The author was not remunerated for this article.
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Sandeep Aggarwal is a banker based in New Delhi.