Macro Factors Affecting LBOs in India

What do the big ticket deals of Tata/Corus, United Spirits/White & Mackay and Suzlon/RE Power have in common? The answer, of course, is that they are all outbound acquisitions by Indian companies through leveraged buyouts.

In outbound deals and LBOs, both Indian and foreign corporates who have full flexibility while structuring LBOs in most countries, suddenly find there hands tied while doing deals in India. Why is this?

Restrictions on Foreign Investments in India

There are two routes through which foreign investments may be directed into India – the
foreign institutional investor (FII) route and the foreign direct investment (FDI) route. The FII route is generally used by foreign pension funds, mutual funds, investment trusts, endowment funds and the like to invest their proprietary funds or on behalf of other funds in equities or debt in India. Private equity firms are known to use to FII route to make minority investments in Indian companies. The FDI route is generally used by foreign companies for setting up operations in India or for making investments in publicly listed and unlisted companies in India where the investment horizon is longer than that of an FII and/or the intent is to exercise control.

Limits on FII investment

The Government of India has laid down investment limits for FIIs of 10% based on certain requirements and the maximum FII investment in each publicly listed company, which may at times be lower than the sectoral cap for foreign investment in that company. For example, the sectoral cap on foreign investment in the telecom sector is 100%. However, cumulative FII investment in an Indian telecom company would be subject to a ceiling of 24% or 49%, as the case may be, of the issued share capital of that telecom company.

Restrictions, caps and Foreign Investment Promotion Board (FIPB) approval

Sectors where FDI is not permitted include railways, atomic energy and atomic minerals, postal service, gambling and betting, lottery and basic agriculture or plantations with specified exceptions. Further, the government has placed sector caps on ownership by foreign corporate bodies and individuals in Indian companies and 100% foreign ownership is not allowed in a number of industry sub-sectors under the current FDI regime.

Under the FDI route, FIPB approval is required for foreign investments where the proposed shareholding is above the prescribed sector cap or for investment in sectors where FDI is not permitted or where it is mandatory that proposals be routed through the FIPB.

Regulatory developments in FDI

Despite the detailed guidelines for foreign investment in India, regulations relating to foreign investment continue to get formulated as the country gradually opens its doors to global investors. The evolving regulatory environment coupled with the lack of clarity about future regulatory developments create significant challenges for foreign investors. For example, the Indian government lifted a ban on foreign ownership of Indian stock exchanges just three weeks before the NYSE Group, Goldman Sachs and other investors bought a 20% stake in the National Stock Exchange of India.

Limited Availability of Control Transactions and Professional Management

Private equity firms face limited availability of control transactions in India. The reason for this is the relative small pool of professional management in corporate India. In a large number of Indian companies, the owners and managers are the same. Management control of such target companies belongs to promoters/promoter families who may not want to divest their controlling stake for additional capital.

In management buyouts, promoters have spun off or divested and private equity players have bought the businesses and then partnered with the existing management. The managements themselves don’t have the resources to engineer such a buyout.

Underdeveloped Corporate Debt Market

Bank loans

India has a bank-dominated financial system. The dominance of the banking system can be gauged from the fact that the proportion of bank loans to GDP is approximately 36%, while that of corporate debt to GDP is only 4%. As a result, the corporate bond market is small and marginal in comparison with corporate bond markets in developed countries.

Private placements

In the corporate debt market is that a bulk of the bulk of debt raised has been through private placements. During the five years 2000-01 to 2004-05, private placements, on average, have accounted for nearly 92% of the total corporate debt raised annually.

Preference for rated paper

The data on ratings suggest that lower-quality credits have difficulty issuing bonds. The concentration of turnover in the secondary market also suggests that investors’ appetite is mainly for highly rated instruments, with nearly 84% of secondary market turnover in AAA- rated securities. In addition, the pattern of debt mutual fund holdings on 30 June 2004 showed that nearly 53.3% of non-government security investments were held in AAA-rated securities, 14.7% in AA-rated securities and 10.8% in P1+ rated securities.

High yield bonds

High-yield bonds are non-investment grade bonds and have a higher risk of defaulting, but typically pay high yields in order to make them attractive to investors. Unlike most bank debt or investment grade bonds, high-yield bonds lack ‘maintenance’ covenants whereby default occurs if financial health of the borrower deteriorates beyond a set point. Instead, they feature ‘incurrence’ covenants whereby default only occurs if the borrower undertakes a prohibited transaction, like borrowing more money when it lacks sufficient cash flow coverage to pay the interest. There is a sharp contrast in bond spreads of US and Indian companies.

Credit derivatives

The credit derivatives market is virtually non-existent in India due to the absence of participants on the sell-side for credit protection and the lack of liquidity in the bond market.

Foreign capital market

Indian enterprises now have the ability to raise funds in foreign capital markets. Indeed, an underdeveloped domestic market pushes the better-quality issuers abroad, thereby accentuating the problems of developing the corporate debt market in India.

Reserve Bank of India Restrictions on Lending

The Reserve Bank of India (RBI) has issued a number of directives to domestic banks in regard to making advances against shares. These guidelines have been compiled in the Master Circular Dir.BC.90/13.07.05/98 dated 28 August 1998. As per these guidelines, domestic banks are not allowed to finance the promoters’ contribution towards equity capital of a company, the rationale being that such contributions should come from the promoters’ resources.

The RBI only allows accepting securities such as primary security of shares and debentures including promoters’ shares to industrial, corporate or other borrowers as collateral for secured loans granted as working capital or for other ‘productive purposes’ from borrowers.

Prohibition on Borrowing from Indian Banks – FIPB Press Note 9

FIPB’s Press Note 9, dated 12 April 1999, bars a foreign investment company from borrowing from an Indian bank to buy into a company in India. Foreign investors argue that dismantling the norm will not only raise the return on the equity they contribute in, but also make it possible for them to pay a higher price for the shares of local companies they buy.

Restrictions on Public Companies from Providing Assistance to Potential Acquirers

Companies Act, 1956, Section 77(2) states that a public company (or a private company that is a subsidiary of a public company) may not provide either directly or indirectly through a loan, guarantee or provision of security or otherwise, any financial assistance for the purpose of or in connection with a purchase or subscription made or to be made by any person of or for any shares in the company or in its holding company.

Under the Companies Act, 1956, a public company is different from a publicly listed company. The restrictions placed by this section on public companies implies that prior to being acquired in a LBO, a public company, if it is listed, must delist and convert itself to a private company. Delisting requires the company to follow the Securities and Exchange Board of India
(Delisting of Securities) Guidelines – 2003.

Restrictions Relating to Exit Through Public Listing

The most successful LBOs go public as soon as debt has been paid down sufficiently and improvements in operating performance have been demonstrated by the LBO target. SEBI guidelines require mandatory listing of Indian companies on domestic exchange prior to a foreign listing. Indian companies may list their securities in foreign markets through the ‘Issue of Foreign Currency Convertible Bonds and Ordinary Shares (Through Depositary Receipt Mechanism)’ scheme 1993. Prior to the introduction of this scheme, Indian companies were not permitted to list on foreign börses.

In order to bring these guidelines in alignment with the SEBI’s guidelines on domestic capital issues, the Government incorporated changes to this scheme by requiring that an Indian company, which is not eligible to raise funds from the Indian capital markets including a company which has been restrained from accessing the securities market by the SEBI will not be eligible to issue ordinary shares through Global Depository Receipts (GDR). Unlisted companies, which have not yet accessed the GDR route for raising capital in the international market, would require prior or simultaneous listing in the domestic market, while seeking to issue ordinary shares under the scheme. Unlisted companies, which have already issued GDRs in the international market, would now require to list in the domestic market on making profit at the beginning of financial year 2005-06 or within three years of such issue of GDRs, whichever is earlier.

SEBI listing regulations require domestic companies to identify the promoters of the listing company for minimum contribution and promoter lock-in purposes. In case of an IPO, the promoters have to necessarily offer at least 20% of the post-issue capital. In case of public issues by listed companies, the promoters shall participate either to the extent of 20% of the proposed issue or ensure post-issue share holding to the extent of 20% of the post-issue capital.