M&A Funding of Acquisitions

An Overview

Background

Funding of acquisitions are quite different from funding for investment for expansion or diversification. Investors and Banks/FI s perceive acquisitions as more risky than organic growth and diversifications

Background

The apprehensions about acquisitions can be about the correct valuation of the target company while other can be about off balance sheet liabilities. In the case of cross border acquisitions, the sources of funds are quite different and more complex than the domestic acquisitions.

Funding options for acquisitions

a)

b)

An acquiring company has following options to effect the payment of consideration to the target companys shareholders : By issue of equity sharers of the acquiring company, By issue of preference shares of acquiring company,

Funding Options for acquisitions

c) By issue of secured debt instruments of the acquiring company, d) By payment in cash, e) By any combination of above. By issue of equity shares of acquiring company is known as share swap method.

Funding Options for acquisitions

The main issue in the share swap method are the determination of long term intrinsic value of the acquiring companys shares that are acceptable to the target companys shareholders. Further the target shareholders would be willing to accept shares of acquiring company instead of cash if he feels that the valuation of the acquiring companys shares used for determining swap ratio is considerably lower than its intrinsic value so that he can get additional gains by accepting its shares than by accepting cash. Share swap ratio method therefore leads to making acquisitions quite expensive for the acquiring company.

Funding Options in acquisitions

Another issue with the swap method is that it leads to dilution of EPS of the acquiring companys shareholders and also the stake of the acquiring companys promoters in the acquiring company. As such, this method can be effectively used when one is acquiring relatively much smaller company. The acquiring companys promoters would not prefer to issue a large chunk of their own companys share to the promoters of target company. Another issue is that under the Income Tax Act 1961,there is neither exemption nor deferment available from payment of capital gains tax even if there is no cash consideration flowing from the acquiring company to the target shareholders in a pure swap deal.

Funding Options in acquisitions

As regards, payment by issue of preference shares of acquiring company, first of all, SEBI takeover regulations do not permit issuance of preference shares in lieu of consideration for shares acquired from the public during the course of open offer.

Funding options in acquisitions

Though this prohibition of issue of preference shares does not apply to the negotiated block deal entered into with the existing promoters, the exiting promoters wanting to cash out their investment in the target companys shares would prefer only cash instead of preference shares of the acquiring company. Thus, this method is not generally used in India.

Funding Options in acquisitions

Using secured debt instruments of the acquiring company, the method can be used imaginatively especially by those companies which are not cash rich but have the necessary management expertise in substantially improving the performance and cash flows of the target companies after their acquisition. However there are no much known instances of its significant use.

Funding Options in acquisitions

Keeping above in view, payment of cash is almost universally used for acquisitions in India.

Sources of Funds for Domestic Acquisitions in India

a) b) c) d) e) f) g)

Internal accruals ,most commonly used for large and small acquisitions, alike. IPO/FPO is not an effective route. Rights issue , an effective route, for mobilizing funds for repayment of Bridge Loans, taken for acquisitions. PE Funds, as they are astute investors, who can be effectively roped in in as persons acting in concert for acquisitions. Use of GDR/ADR funds for domestic acquisitions is prohibited except in case of PSU disinvestments. Use of ECB proceeds for domestic acquisitions is not permitted. Banks/FI s are not pro active in lending for acquisitions, though, on selective basis, they are considering on case to case basis, subject to prudential per party and per industry exposure caps.

Funding for Cross Border Acquisitions

For cross border acquisitions by Indian Companies, RBI allows remittance of Foreign Exchange up to 400 % of the Net Worth of acquiring company as per its last audited B/S, ( in a financial year).This limit covers internal accruals, domestic and foreign currency borrowings and the notional value of the acquiring companys shares swapped. Additionally, outside this limit, RBI allows remittance out of proceeds of acquiring companys, ADR/GDR issues and acquiring companys balances lying in EEFC accounts.

Sources of Funding for Cross Border acquisitions

a)

b)

c)

d)

Internal accruals : They form a smaller portion of the total funding given that most of the time the total cost of acquisition amounts to a sizeable portion of the acquiring companys Net Worth. Rights issue is an effective method of raising funds for repayment of bridge loans take during overseas acquisitions. Indian Companies use ADR/GDR proceeds for cross border acquisitions. Funds borrowed from Banks/FI s abroad especially by foreign subsidiaries on the security of the target companys assets and cash flows or otherwise and with or without recourse to the Indian acquiring company, have been the main source of funding of cross border acquisitions by Indian Companies.

Conclusion

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