Financing of Corporate Buyouts in India – The Legal Framework

A buyout is the acquisition of the major stake or in other words a controlling interest in a company and is used synonymously with the term acquisition or takeover.

If the stake is bought by the firm’s own management, it is known as a management buyout and if high amounts of debt are used to fund the buyout, it is called a leveraged buyout. Buyouts often occur when a company is going private. For example, if a company named X purchases 51% shares of a company named Y, there is a change in control and sometimes even value. This is termed as a ”corporate buyout”.

Some examples of corporate buyout are: Tata Motors’ acquisition of luxury car maker Jaguar Land Rover for the price of $2.3 billion, in 2008 and Walmart’s’ acquisition of 77 % Flipkart for $16 billion, making it the largest acquisition involving an Indian company, in 2018.

What is corporate buyout financing?

Corporate Buyout financing is a term used to describe the method of raising money or funding to finance the acquisition of a company by another commercial entity, thus adding time value by supplying the funds needed to close the transaction and smoothen the process, allowing the acquirer to speed up the process and enjoy the benefits of acquisition as soon as possible.

How does it work?

As most of the financing is done via borrowed funding, a most common way of acquiring such funding is through a line of credit which is also known as an overdraft facility in some parts of the fund. It does not disburse actual funds at the time of establishing the line, but it sets up an upper limit of the amount that can be withdrawn.

When the borrower actually withdraws the funds, he is charged interest on the same from the date of borrowing and not from the date of establishment of the credit line. This interest is charged for the time when the amount and interest is not repaid.

This reduces the interest burden of the borrower as he can conduct the acquisition in a staggered manner and pay for only the time during which the money is borrowed. The acquirer may acquire the assets it wants to sell off in the first phase to immediately pay off the loaned amount and therefore keep the interest burden at the minimum.

What are the types of corporate buyout financing?

• Stock Swap Transaction

The acquirer will swap its stock with the target company if it owns publicly traded stock. For private companies, stock swaps are popular because the target company’s owner wishes to keep a piece of the acquired entity because they will possibly be involved in the operations. The ability of the target firm’s owner to work efficiently is often relied on by the purchasing firm.

• Acquisition through Equity

In acquisition finance, equity is the most expensive form of capital. Equity financing is often desirable by acquiring companies that target companies that operate in unstable industries and with unsteady free cash flows. Acquisition financing is also more flexible, due to the absence of commitment for periodic payments.

• Cash Acquisition

Shares are usually exchanged for cash in an all-cash acquisition. The parent company’s equity part of its balance sheet is unchanged. When the business being purchased is smaller and has less cash reserves than the acquirer, cash transfers during the acquisition are more common.

• Acquisition through Debt

One of the favourite and most common ways to fund acquisitions is by debt financing. Most companies are unable to pay in cash because their balance sheets do not permit it. Debt is also the most cost-effective way to finance a purchase, and it comes in a variety of shapes and sizes.

The bank examines the target company’s forecast cash flow, profit margins, and liabilities before approving funds for an acquisition. A preliminary examination of both the acquiring and target companies’ financial health is required.

Asset-backed financing is a method of debt financing where banks can lend funds based on the collateral offered by the target company. Collateral may include fixed assets, receivables, intellectual property, and inventory. Debt financing also commonly offers tax advantages.

• Acquisition through Mezzanine or Quasi Debt

Mezzanine or quasi-debt is an integrated form of financing that includes both equity and debt features. It usually comes with an option of being converted to equity. Mezzanine financing is suitable for target companies with a strong balance sheet and steady profitability. Flexibility makes mezzanine financing appealing.

• Leveraged Buyout

A leveraged buyout is a financing strategy that uses a combination of equity and debt to fund a purchase. It’s one of the most popular ways to fund an acquisition. Both the purchasing and target companies’ properties are used as protected collateral in an LBO.

LBO companies are typically mature, have a solid asset base, produce stable and strong operating cash flows, and have few capital requirements. A leveraged buyout’s main goal is to force businesses to produce consistent free cash flows that can cover the debt used to purchase them.

• Seller’s Financing / Vendor Take-Back Loan (VTB)

Seller’s financing is where the acquiring company’s source of acquisition financing is internal, within the deal, coming from the target company. Buyers usually resort to the seller’s financing method when obtaining capital from outside is difficult. The financing may be through delayed payments, seller note, earn-outs, etc.

• Aquisition through acquiring company’s owner’s funds.

This comes into play when the owner of the buying company invests his/her own money (in any form, i.e., cash, shares etc) into acquiring the seller’s company. He/she can either note it as a loan and procure interest or add it to their own asset management lists.

At times, the target company owner provides the funds for the acquisition in exchange for an annuity payment inclusive of interest over a predetermined time period. This is done when the target company owner or the seller is reasonably sure that the company has a cash flow stream good enough to generate the required annuity payments.

Legal Framework

The key pieces of legislation that governs corporate buyouts and their financing are listed below:

• The Companies Act, 1956

The Companies Act is the primary legislation governing all companies in India.  All corporate transactions, be it mergers, primary/secondary acquisitions or PE funding must be implemented in accordance with the provisions of the Companies Act, 2013 and read with the rules framed thereunder.

• The Competition Act, 2002

The Competition Act, 2002, read with the Competition Commission of India (Procedure in regard to transaction of business relating to combinations) Regulations, 2011, regulate “combinations” and govern those M&A transactions likely to cause an appreciable adverse effect on competition in India.

• Foreign Exchange Management Act 1999 (FEMA) and Foreign Direct Investment (FDI) Policy

The foreign exchange laws relating to issuance and allotment of shares to foreign entities are contained in The Foreign Exchange Management (Transfer or Issue of Security by a person residing out of India) Regulation, 2000 issued by RBI vide GSR no. 406(E) dated 3rd May, 2000.

These regulations provide general guidelines on issuance of shares or securities by an Indian entity to a person residing outside India or recording in its books any transfer of security from or to such person. RBI has issued detailed guidelines on foreign investment in India vide “Foreign Direct Investment Scheme” contained in Schedule 1 of said regulation.

• Income Tax Act 1961

Acquisition/Merger has not been defined under the ITA but has been covered under the term ‘amalgamation’ as defined in section 2(1B) of the Act. To encourage restructuring, merger and demerger has been given a special treatment in the Income-tax Act since the beginning.

The Finance Act, 1999 clarified many issues relating to Business Reorganizations thereby facilitating and making business restructuring tax neutral. As per Finance Minister this has been done to accelerate internal liberalization. Certain provisions applicable to mergers/demergers are as under: Definition of Amalgamation/Merger — Section 2(1B).

• Insolvency And Bankruptcy Code, 2016 (IBC)

The National Company Law Tribunal, being the regulating body as constituted in accordance with the IBC, regulates the dealing of distressed assets under the corporate insolvency resolution process.  The IBC has been one of the major contributories to the M&A deal table since it was codified as law.

• SEBI Takeover code 1994

SEBI Takeover Regulations permit consolidation of shares or voting rights beyond 15% up to 55%, provided the acquirer does not acquire more than 5% of shares or voting rights of the target company in any financial year [Regulation 11(1) of the SEBI Takeover Regulations].

However, acquisition of shares or voting rights beyond 26% would apparently attract the notification procedure under the Act. It should be clarified that notification to CCI will not be required for consolidation of shares or voting rights permitted under the SEBI Takeover Regulations.

Similarly the acquirer who has already acquired control of a company (say a listed company), after adhering to all requirements of SEBI Takeover Regulations and also the Act, should be exempted from the Act for further acquisition of shares or voting rights in the same company.

• Mandatory permission by the courts 

Any scheme for acquisitions or mergers has to be sanctioned by the courts of the country. The company act provides that the high court of the respective states where the transferor and the transferee companies have their respective registered offices have the necessary jurisdiction to direct the winding up or regulate the acquisition or merger of the companies registered in or outside India.

Observations

Corporate Buyout Financing is, as the name suggests, the process of obtaining capital earmarked for a particular acquisition or for the acquisition purpose in general for companies that regularly undertake the same. It adds value by providing the required funds when they are most needed and therefore prevents the delay in the acquisition process.

There are various modes of acquisition financing, as in any kind of financing, and therefore, choosing the right option may help the acquirer in keeping the funding cost to the minimum. Further, it gives the acquirer an incentive to go for only those targets which can lead to a positive NPV (Net Present Value) but it may also make the acquirer more inclined to avoid risk. So, it is a trade-off that the acquirer needs to weigh before entering into financing.

About the Author – Aditya Pratap

Aditya Pratap is a lawyer practising in Mumbai. He argues cases in the Bombay High Court, Sessions and Magistrate Courts, along with appearances before RERA, NCLT and the Family Court. For further information one may visit his website adityapratap.in or view his YouTube Channel to see his interviews. Questions can be emailed to him at aditya@adityapratap.com.

This Article is made by Aditya Pratap in assistance with Ishaan Dhaddha.

Cases argued by Aditya Pratap can be viewed here.