Chapter 14 Funding of Acquisitions

CHAPTER 14

Im so excited about our India deal, I feel warm all over.

Are you sure, it isnt the Aaloo Parantha with butter you had for breakfast.

Acquisition of a target company is one type of an investment in an expansion or a diversification project.

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METHODS OF EFFECTING

PAYMENT OF CONSIDERATION

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Issue of Equity Shares of the Acquirer Company

In this method, an acquirer company issues its shares to the shareholders of the target company in exchange of shares of the target company in a specified ratio known as a swap ratio and hence this method is commonly known as Share Swap Method.

Swap Ratio or Exchange Ratio is the ratio of price offered for acquiring one equity share of the target company divided by the valuation of one equity share of the acquirer company.

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Illustration:
ABC Limited has made an open offer to acquire 20 per cent of the equity capital of XYZ Limited at Rs 200 per share. ABC Limited shares have been valued at Rs 100 per share. Swap ratio will be 2:1, i.e., two shares of ABC Limited would be issued to the shareholders of XYZ Limited for every one share of XYZ Limited tendered by them and accepted by ABC Limited.

ABC Ltd.

XYZ Ltd.

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An Indian Experience:
Birth of a refinery titan Reliance share swap favours RPL

The share swap ratio for the merger of Reliance Industries with Reliance Petroleum has been fixed at 1:16, meaning one share of Reliance Industries will be exchanged for 16 of the latter. Reliance Industries Limited (RIL) will issue 6.92 crore shares to the nearly 22 lakh shareholders of Reliance Petroleum Limited (RPL), in a move seen to be benefiting RPL shareholders.

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Issues in using Share Swap Method

To determine the correct swap ratio.

The swap ratio, i.e., the minimum price that an acquirer has to offer in the open offer, is determined. [Regulation 20 of SEBI Takeover Regulations]

To determine correct long-term intrinsic value of the acquirer companys shares that is acceptable to the target companys shareholders.

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Issues in using Share Swap Method

The acquirer companys promoters would not prefer to issue a large chunk of their own companys shares to the promoters of the target company and probably even to institutional shareholders.

Provisions of the Income Tax Act, 1961 create a hurdle in the use of pure swap method.
Under the Act, there is no exemption nor deferment available from payment of capital gains tax even if there is no cash consideration flowing from the acquirer to the tendering shareholder in the pure swap method, though in some countries such exemption is available.

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Issues in using Share Swap Method

Swap Ratio Method assumes that the tendering shareholder would accept shares instead of cash if he feels that the valuation of acquirer companys shares used for determining swap ratio is substantially lower than its intrinsic value. At the same time, the tendering shareholder also expects that the value of acquirer companys share considered for the swap ratio is at a significant discount to its current market price. Share Swap Method normally leads to making acquisition more expensive for the acquiring company.

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Issues in using Share Swap Method

The Swap Method leads to dilution of the earnings per share (EPS) as also of the stake of the acquirer companys promoters in the acquirer company.
Where the target company is bigger than or is comparable to or is not much smaller than the acquirer company in terms of total market capitalization or intrinsic valuation, swap ratio is not a desirable method from the acquirers point of view. This method can be effectively used when one is acquiring relatively much smaller company.

Due to all these issues, in India, swap method is not preferred either by acquirer companies or by tendering shareholders.

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Issue of Preference Shares of the Acquirer Company

The SEBI takeover regulations do not permit issuance of preference shares in lieu of payment of consideration for shares acquired from the public during the course of an open offer. Normally, the exiting promoters or institutional shareholders wanting to cash out their investment in the target companys shares would prefer only cash. Hence, even this method is also not much workable.

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Issue of Secured Debt Instruments of the Acquirer Company

If the acquirer company is a well-known company with an excellent financial health, its triple A or double A-rated secured debt instruments carrying attractive coupon rate would be well accepted by the tendering shareholders. However, the chances of acceptance of such instruments instead of cash would be better if the company resorts to differential pricing, and If such debt instruments are listed on a stock exchange with national trading providing liquidity. Used imaginatively secured debt instruments can be an effective method of payment of consideration for those acquirer companies that are not cash rich but have management expertise in substantially improving the performance and cash flows of the target companies.

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Payment in cash

This is of course the most favoured method for effecting payment to the tendering shareholders. It is both clean and transparent and well accepted by the selling shareholders.

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SOURCES OF FUNDS
Like funding of any other investment, funding of acquisitions is also in the form of either equity or debt.

Sources of Funds for Domestic Acquisitions

Equity
Internal Accruals IPO/FPO Right Issue Private Placement/ PE Fund

Borrowed Funds

Banks and FIs

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SOURCES OF FUNDS DOMESTIC ACQUISITIONS

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Equity

Internal Accruals: For most of the domestic acquisitions, the primary source of funding is internal accruals. Examples- In October 2002, when Hindalco made an open offer for acquisition of 25.5 per cent of the voting capital of Indal, the entire cost of Rs 218.19 crore was funded purely through internal accruals. Recently in December 2008, Dabur India Limited acquired Fem Care Pharma Limited at the total cost of over Rs 250 crore, which was mainly funded through internal accruals.

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Equity

IPO/ FPO: Initial Public Offering (IPO)/ FPO by an unlisted company, with major objective of mobilizing funds for acquisitions is unlikely to be successful in the market, because markets would not be comfortable to fund such a company whose performance in the stock markets is yet to be tested. Moreover, FPO (like IPO) is a very time-consuming and expensive process. Hence, one may conclude that FPO is not an effective route for mobilizing funds for acquisitions.

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Equity
Rights Issue: Rights issue is an effective post-acquisition route to mobilize funds for repayment of bridge loans taken from the banks and financial institutions for acquisition.

Example- In October 2008, Tata Motors came out with a rights issue of Rs 4145 crore for prepayment of part of the short-term bridge loan availed by Jaguar Land Rover Ltd, a step-down subsidiary of Tata Motors, to partially fund the purchase consideration for the acquisition of Jaguar Land Rover from Ford.

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Equity
Private Placement/ PE Funds: Private Equity funds or PE funds are astute investors who understand the acquisition game very well. They are also prone to taking high risks. Further, the process of mobilizing funds from PE funds is much faster. Hence, this is one very much viable route of mobilizing funds for acquisitions. ADRs/GDRs: Use of funds mobilized through issuance of American depository receipts (ADRs) and Global depository receipts (GDRs) is not permitted for acquiring a company or a part thereof in India except that the ADR/ GDR proceeds can be utilized for the first stage acquisition of shares in the disinvestment process of public sector undertakings/ enterprises and also in the mandatory second stage offer to the public.

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Borrowed Funds

Banks and FIs: Amongst the banks in India, private sector banks and branches/ subsidiaries of foreign banks are more proactive in lending for acquisitions as compared to PSU banks. Further, so far as the domestic acquisition funding is concerned, banks normally prefer to extend short-term funding, though they are open to lending medium-term loans also. Financial institutions like IDFC and HDFC are known to have better appetite for lending medium-term loans for acquisitions. Example- When in May-June 2007, Kingfisher acquired Deccan Airways, the funding of the preferential allotment by Deccan Airways was done through two medium-term loans- Rs 400 crore term loan of three-year tenure from IDFC and Rs 100 crore term loan of threeyear tenure from HDFC.

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Borrowed Funds
External Commercial Borrowings (ECBs): Use of ECB funds is not permitted for acquiring a company or a part thereof in India.

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Hybrids
An acquisition can involve a combination of cash and debt, or a combination of cash and stock of the purchasing entity.

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Factoring
Factoring can provide the necessary extra to make a merger or sale work. Factoring is a financial transaction whereby a business sells its accounts receivables at a discount. Factoring differs from a bank loan in three main ways The emphasis is on the value of the receivables, not the firm`s credit worthiness. Factoring is not loan- it is the purchase of an assets A bank loan involves two parties whereas factoring involves three.

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Bank Financing
Financing capital may be borrowed from a bank, or raised by an issue bonds.altenatively, the acquirer's stock may be offered as consolidation. Acquisition financed through debt are known as leveraged buyouts if they take the target private, and the debt are will often be moved down on to the balance sheet of the acquired company.

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Leverage Buy-out
A merge of a company which is substantially financed through debt is known as leverage buy-out. debts usually, forms more than 70% of the purchase price. The share of such a firms are concentrated in the hands of a few investors and are not generally, traded in the stock exchange.

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Tender offer
Under this method the purchaser, who is acquisitioned of some company, approaches the shareholders of the target firm directly and offer them a prices to encourage them sell their share to them. it is method that results into a hostile or forced takeover.

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CROSS-BORDER ACQUISITIONS

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Cross-border acquisitions by Indian companies

Peculiarities of cross-border acquisitions

Size of the Acquisition:

Most of cross-border acquisitions involve/have involved investment by Indian companies of a sizeable portion of their net worth, if not in excess of their net worth.

This has a main bearing on the funding structure of these acquisitions, e.g., Tata Steel acquired Corus Plc.

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Cross-border acquisitions by Indian companies Corporate and Funding Structure:

The desire of the Indian companies to insulate their Indian entities from interest costs as also the risk of default on borrowings made abroad.

RBI Regulations:
Another important factor that governs the funding pattern is the RBI regulations regarding setting up joint ventures (JV) or wholly owned subsidiaries (WOS) abroad, which are also applicable to acquiring in full or in part, shares of existing companies abroad.

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Conditions of the Circular

Limit:

An Indian party has been permitted to make investment in overseas joint ventures (JV)/wholly owned subsidiaries (WOS), not exceeding 400 per cent of the net worth of the Indian party as on the date of the last audited balance sheet. The ceiling of 400 per cent of net worth would not be applicable where the investment is made out of balances held in Exchange Earners Foreign Currency account of the Indian party or out of funds raised through ADRs/GDRs. Such overseas investments would include contribution to the capital of the overseas JV/WOS, loan granted to the JV/WOS and 100 per cent of guarantees issued to or on behalf of the JV/WOS.

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Conditions of the Circular

Sources of Funds:

Investment in an overseas JV/WOS may be funded out of one or more of the following sources:
i.
ii. iii. iv. v. vi. vii. viii.
Drawal of foreign exchange from an AD Bank in India Capitalization of exports Swap of shares Utilization of proceeds of (ECBs) and (FCCBs) In exchange of ADRs/GDRs Balances held in EEFC account of the Indian party Utilization of proceeds of foreign currency funds raised through ADR/GDR issues

In respect of points (vi) and (vii) above, the ceiling of 400 per cent of net worth will not apply.

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SOURCES OF FUNDS
CROSS BORDER ACQUISITIONS

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SOURCES OF FUNDS

Sources of Funds for Crosse-border Acquisitions

Equity
Internal Accruals Right Issue ADRs/GDRs External Commercial Borrowings (ECBs)

Borrowed Funds

Foreign Banks and FIs

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Equity
Internal Accruals:

Since the ticket size of global acquisition, is a significant portion of or even in excess of the net worth of the Indian acquirer company, internal accruals cannot be a major or primary source of funding global acquisition.
In Tata Corus case, it can be observed that out of US$13.7 billion paid for acquiring Corus, Tata Steel Limited (i.e., the Indian parent company) invested only US$ 4.9 billion (35 per cent). Out of this, the use of internal accruals was only US$ 700 million (5 per cent of the total consideration).

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Equity
Rights Issue:

In October 2008, Tata Motors and Hindalco came out with rights issues, in October 2008, to mobilize Rs 4145 crore and Rs 5048 crore respectively. In case of Tata Motors, the issue was for prepayment of part of the shortterm bridge loan availed by Jaguar Land Rover Ltd, a step-down subsidiary of Tata Motors, to partially fund the purchase consideration for the acquisition of Jaguar Land Rover from Ford. In case of Hindalco, its purpose was of using the net proceeds to fund part of the repayment of bridge loan availed by AV Minerals (Netherlands) B.V., an overseas subsidiary of the Hindalco, for the acquisition of Novelis.

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Equity
ADRs/GDRs/FCCBs:

In terms of the RBI regulations, not only ADR/GDR proceeds can be used for acquisition of foreign companies, such usage is outside the limit of 400 per cent of net worth as also without limit. With regard to foreign currency convertible bonds (FCCBs), however, it is a part of the limit of 400 per cent of net worth.

Many large Indian companies use ADR, GDR and FCCB to create a war chest before going on acquisition spree.
Bharat Forge Limited is one of the earlier Indian companies to enter the cross-border acquisition game.

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Borrowed funds
Foreign Banks and FIs:

Foreign banks, funds and even foreign branches of Indian banks have been lending to reputed Indian corporate for cross-border acquisitions. Foreign banks and institutions give long-term loans as well as shortterm/bridge loans.

Example :
In case of Tata Tea, for the acquisition of Tetley, Tata Tea Great Britain mobilized GBP 235 million by way of debt against GBP 70 million of its equity that was contributed by Tata Tea Limited and its US subsidiary Tata Tea Inc. These loans were as follows: Rabobank: GBP 185 million Intermediate Capital Group: GBP 30 million Prudential Mezzanine Capital: GBP 10 million Schroder Ventures: GBP 10 million