Funding of Acquisitions

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Chapter 14

Funding of Acquisitions


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Acquisition of a target company isone type of an investment in anexpansion or a diversification

project.

Im so excited about our India

deal, I feel warm all over.

Are you sure, it isnt the Aaloo

Parantha with butter you hadfor breakfast.


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METHODS OF EFFECTINGPAYMENT OF CONSIDERATION


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In this method, an acquirer companyissues its shares to the shareholders ofthe target company in exchange of sharesof the target company in a specified ratioknown as a swap ratio and hence thismethod is commonly known as ShareSwap Method.

Swap Ratio or Exchange Ratio is theratio of price offered for acquiring oneequity share of the target companydivided by the valuation of one equityshare of the acquirer company.

Issue of Equity Shares of theAcquirer Company
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Illustration:

ABC Limited has made an open offer to acquire 20per cent of the equity capital of XYZ Limited at Rs200 per share. ABC Limited shares have beenvalued 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 shareof XYZ Limited tendered by them and accepted byABC 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 ReliancePetroleum has been fixed at 1:16, meaning one share of Reliance Industrieswill be exchanged for 16 of the latter. Reliance Industries Limited (RIL) willissue 6.92 crore shares to the nearly 22 lakh shareholders of Reliance

Petroleum Limited (RPL), in a move seen to be benefiting RPL shareholders.
http://images.google.co.in/imgres?imgurl=http://www.ruralfire.qld.gov.au/Reliance-Petroleum-4c.gif&imgrefurl=http://www.ruralfire.qld.gov.au/Reliance_Sponsorship.asp&usg=__pgu887xkZF877CYC_k-INjP4SZU=&h=726&w=1849&sz=71&hl=en&start=1&um=1&tbnid=6nzT9UnnzES9KM:&tbnh=59&tbnw=150&prev=/images%3Fq%3DReliance%2BPetroleum%26hl%3Den%26sa%3DN%26um%3D1http://www.fluxonix.asia/img/clients/reliance-industries-logo.png


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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 acquirercompanys shares that is acceptable to the target companysshareholders.

Issues in using ShareSwap Method


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Provisions of the Income Tax Act, 1961 create a hurdle in the useof pure swap method.

Under the Act, there is no exemption nor deferment available frompayment of capital gains tax even if there is no cash considerationflowing from the acquirer to the tendering shareholder in the pure swapmethod, though in some countries such exemption is available.


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 institutionalshareholders.


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Swap Ratio Method assumes that the tendering shareholder wouldaccept shares instead of cash if he feels that the valuation of acquirercompanys shares used for determining swap ratio is substantially lower

than its intrinsic value.

At the same time, the tendering shareholder also expects that the valueof 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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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 notmuch smaller than the acquirer company in terms of total marketcapitalization 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 relativelymuch smaller company.


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


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Issue of Preference Sharesof the Acquirer Company

The SEBI takeover regulations do not permit issuance ofpreference shares in lieu of payment of consideration for sharesacquired 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 companysshares 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 excellentfinancial health, its triple A or double A-rated secured debt instrumentscarrying attractive coupon rate would be well accepted by the tenderingshareholders.

However, the chances of acceptance of such instruments instead of cashwould 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 methodof payment of consideration for those acquirer companies that are notcash rich but have management expertise in substantially improving theperformance 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 acquisitionsis also in the form of either equity or debt.

Sources of Funds for DomesticAcquisitions

EquityBorrowed

Funds

Internal Accruals

IPO/FPO

Private Placement/ PE Fund

Right Issue

Banksand FIs

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SOURCES OF FUNDS

DOMESTIC ACQUISITIONS

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Internal Accruals:

For most of the domestic acquisitions, the primary source of funding isinternal accruals.

Examples- In October 2002, when Hindalco made an open offer foracquisition of 25.5 per cent of the voting capital of Indal, the entirecost of Rs 218.19 crore was funded purely through internalaccruals.

Recently in December 2008, DaburIndia Limited acquired FemCare Pharma Limited at the total cost of over Rs 250 crore, whichwas mainly funded through internal accruals.

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CHAPTER14Equity

IPO/FPO:

Initial Public Offering (IPO)/ FPO by an unlisted company, with majorobjective of mobilizing funds for acquisitions is unlikely to besuccessful in the market, because markets would not be comfortableto fund such a company whose performance in the stock markets isyet to be tested.

Moreover, FPO (like IPO) is a very time-consuming and expensiveprocess.

Hence, one may conclude that FPO is not an effective route formobilizing funds for acquisitions.

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CHAPTER14Equity

Rights Issue:

Rights issue is an effective post-acquisition route to mobilize fundsfor repayment of bridge loans taken from the banks and financialinstitutions for acquisition.

Example-In October 2008, Tata Motors came out with a rights issueof Rs 4145 crore for prepayment of part of the short-term bridge loanavailed by Jaguar Land Rover Ltd, a step-down subsidiary of TataMotors, to partially fund the purchase consideration for the

acquisition of Jaguar Land Rover from Ford.

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CHAPTER14Equity

Private Placement/ PE Funds:

Private Equity funds or PE funds are astute investors whounderstand the acquisition game very well. They are also prone totaking high risks. Further, the process of mobilizing funds from PEfunds is much faster. Hence, this is one very much viable route ofmobilizing funds for acquisitions.

ADRs/GDRs:

Use of funds mobilized through issuance of American depository

receipts (ADRs) and Global depository receipts (GDRs) is notpermitted for acquiring a company or a part thereof in India exceptthat the ADR/ GDR proceeds can be utilized for the first stageacquisition of shares in the disinvestment process of public sectorundertakings/ enterprises and also in the mandatory second stageoffer to the public.

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CHAPTER14Borrowed Funds

Banks and FIs:

Amongst the banks in India, private sector banks and branches/subsidiaries of foreign banks are more proactive in lending foracquisitions 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 areopen to lending medium-term loans also.

Financial institutions like IDFC and HDFC are known to have betterappetite for lending medium-term loans for acquisitions.

Example- When in May-June 2007, Kingfisher acquired DeccanAirways, the funding of the preferential allotment by Deccan Airwayswas done through two medium-term loans- Rs 400 crore term loanof three-year tenure from IDFC and Rs 100 crore term loan of three-year tenure from HDFC.

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CHAPTER14Borrowed 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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CHAPTER14Hybrids

An acquisition can involve a combination ofcash and debt, or a combination of cashand 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 financialtransaction whereby a business sells its accountsreceivables 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 factoringinvolves 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 asconsolidation. Acquisition financed through debtare known as leveraged buyouts if they take thetarget private, and the debt are will often be

moved down on to the balance sheet of theacquired company.

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HAPTER14Leverage Buy-out

A merge of a company which is substantiallyfinanced through debt is known as leveragebuy-out. debts usually, forms more than 70%of the purchase price. The share of such afirms are concentrated in the hands of a fewinvestors and are not generally, traded in the

stock exchange.

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HAPTER14Tender offer

Under this method the purchaser, who isacquisitioned of some company, approaches

the shareholders of the target firm directly andoffer them a prices to encourage them selltheir share to them. it is method that resultsinto a hostile or forced takeover.

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CROSS-BORDER ACQUISITIONS

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Cross-border acquisitions by Indiancompanies

Size of the Acquisition:

Most of cross-border acquisitions involve/have involved investmentby Indian companies of a sizeable portion of their net worth, if not inexcess of their net worth.

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

Peculiarities of cross-border acquisitions

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Corporate and Funding Structure:

The desire of the Indian companies to insulate their Indian entitiesfrom interest costs as also the risk of default on borrowings madeabroad.

RBI Regulations:

Another important factor that governs the funding pattern istheRBI regulations regarding setting up joint ventures (JV) or whollyowned subsidiaries (WOS) abroad, which are also applicable toacquiring in full or in part, shares of existing companies abroad.

Cross-border acquisitions byIndian companies

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Limit:

An Indian party has been permitted to make investment in overseasjoint ventures (JV)/wholly owned subsidiaries (WOS), not exceeding

400 per cent of the net worth of the Indian party as on the date of thelast audited balance sheet.

The ceiling of 400 per cent of net worth would not be applicable wherethe 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.

Conditions of the Circular

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Conditions of the Circular

Sources of Funds:

Investment in an overseas JV/WOS may be funded out of one ormore of the following sources:

i. Drawal of foreign exchange from an AD Bank in Indiaii. Capitalization of exports

iii. Swap of shares

iv. Utilization of proceeds of (ECBs) and (FCCBs)

v. In exchange of ADRs/GDRs

vi. Balances held in EEFC account of the Indian party

vii. Utilization of proceeds of foreign currency funds raised through

viii. 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-borderAcquisitions

EquityBorrowed

Funds

Internal Accruals

ADRs/GDRs

Right Issue Foreign Banksand FIs

ExternalCommercial

Borrowings (ECBs)

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Equity

Internal Accruals:

Since the ticket size of global acquisition, is a significant portion ofor even in excess of the net worth of the Indian acquirer company,

internal accruals cannot be a major or primary source of fundingglobal acquisition.

In Tata Corus case, it can be observed that out of US$13.7 billion paid for acquiringCorus, Tata Steel Limited (i.e., the Indian parent company) invested only US$ 4.9billion (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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Rights Issue:

In October 2008, Tata Motors and Hindalco came out with rightsissues,in October 2008, to mobilize Rs 4145 crore and Rs 5048 crorerespectively.

In case of Tata Motors, the issue was for prepayment of part of the short-term bridge loan availed by Jaguar Land Rover Ltd, a step-downsubsidiary of Tata Motors, to partially fund the purchase consideration forthe acquisition of Jaguar Land Rover from Ford.

In case of Hindalco, its purpose was of using the net proceeds to fundpart of the repayment of bridge loan availed by AV Minerals (Netherlands)B.V., an overseas subsidiary of the Hindalco, for the acquisition ofNovelis.

Equity

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Eq it


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ADRs/GDRs/FCCBs:

In terms of the RBI regulations, not only ADR/GDR proceeds canbe 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 createa war chest before going on acquisition spree.

Bharat Forge Limited is one of the earlier Indian companies to enter

the cross-border acquisition game.

Equity

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Borrowed funds

Foreign Banks and FIs:Foreign banks, funds and even foreign branches of Indian banks havebeen lending to reputed Indian corporate for cross-border acquisitions.

Foreign banks and institutions give long-term loans as well as short-term/bridge loans.

Example :

In case of Tata Tea, for the acquisition of Tetley, Tata Tea Great Britainmobilized GBP 235 million by way of debt against GBP 70 million of itsequity 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

S h d V GBP illi

Funding of Acquisitions

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