M&A: A Key Driver For Growth

Mergers and Acquisitions (M&A) are synonymous to marriages and they happen only when there is compatibility between entities in terms of future plans, business objectives and strategies. In an M&A, entities may have strategic interest or their interest may be purely financial in nature viz.

where the investing party is primarily interested in the return on the capital invested. In the present scenario, companies cannot ignore this means of achieving (inorganic) growth.

The driving factors for a strategic M&A are access to new markets, entry in new line of products, increased production capacities or creation of larger market share. The basic concept of a strategic M&A is to create value to each of the entities, and that can be achieved only when the merged entity can create higher potential value than the value of entities determined separately.

One of the deals that happened recently is the Disney – UTV deal whereby Disney acquired UTV to leverage on the stronghold that UTV has in the movie, television and gaming business. In recent times, Indian companies including small and medium enterprises (SMEs), mainly manufacturers, have been indulging in M&A activities with European and US companies, to have access to better technology, machinery and know-how. On the other hand, a financial investment will generally be made with its own set of goals, preferences and investment strategies.

Such investments are usually made by a private equity firm, a venture capital firm or an angel investor. Companies raise funds by these means to cater to their working capital requirements, funding their expansion plans or for research and development purposes. Private equity is also a key source of funding for M&A deals. Private equity firms have supported SMEs in exploring growth opportunities in the western countries by funding them to make overseas acquisitions.

Inbound M&A deals are on a rise and the same is indicative of an increasing presence of global companies in India. The volume of inbound M&A in India has touched USD 26 billion, by way of 229 transactions, in the first half this year, which is more than double the amount announced in the same period last year1. India is the second most favored emerging market destination for inbound M&A deals, after China, and the primary reasons for the India growth story is strong Indian economy, demand for goods and services in India, and better rate of return on investments.

The Government of India has also been supportive of this growth and has contributed by liberalizing the foreign direct investment policy and with a strong intent to further liberalize policies and by allowing investments in sectors like multi-brand retailing and elevating caps on investments in certain sectors like insurance, media, etc. At the same time, we are witnessing a surge in outbound M&A activities in India. India has scaled up in the global takeover league table as several Indian companies being cash rich and also in search of technology and new markets.

In recent times, sturdy corporate valuations and financial strength favor more overseas acquisitions by Indian companies than the other way round. Indian companies, which have in the past mostly depended on the domestic market, have been aggressive in acquiring assets in the US and other developed economies. Any M&A transaction involves three major aspects -

1. commercials of the deal (including due diligences and investigations and valuation of the target)
2. legal matters (including documentation and negotiation, approvals and permits); and
3. post completion integration.

Commercials

As business grows, the companies explore opportunities to achieve inorganic growth to access and tap new markets, entry in new line of products, increase production capacities or creation of larger market share. Thus, the search for M&A target starts, which leads to deal negotiations, business due diligence, valuations and arriving at commercial agreement to form the basis for the M&A. With the help of lawyers and tax consultants the structure of the transaction is created to make it optimal in terms of cost, efforts and time.

Legal Matters

While framing the deal structure, legal framework governing the transaction is of utmost significance. The complexity of a deal structure depends upon the nature of business, nature of the companies involved (listed or unlisted), tax regime and regulatory framework applicable to the business, size of entities involved, geographical coverage of the businesses, the nature of investment instrument (whether equity, quasi equity, debt), etc. M&A activity can be structured in the best possible manner to ensure the same is the most efficient in terms of tax liability, payment of stamp duties, seeking regulatory approvals, etc. M&A deal can be structured as a merger or an acquisition.

Mergers refer to consolidation of two or more business entities in which any one or all entities lose their legal existence. Mergers (or amalgamations) of Indian companies are highly regulated and require various approvals – firstly by the board of directors, then by the shareholders and creditors, then by Central Government (through Regional Director of Ministry of Corporate Affairs & Official Liquidator) and finally by the High Court(s) concerned. If the merger involves one or more listed companies, then additionally, prior approval of the Stock Exchanges where the securities of the company are listed would also be required. Acquisitions refer to the takeover of controlling stakes of one company by another.

In acquisition of an Indian company which is listed on any stock exchange the SEBI (Substantial Acquisition of Shares & Takeover) Regulations (also called 'Takeover Code'). The Takeover Code mandates an open offer. This is meant to give an exit opportunity to public shareholders who might not be interested to continue with the new management. In October this year, the initial threshold for trigger of the open offer has been increased from 15 % to 25 % of the voting rights. The open offer now needs to be made for 26 % of the voting rights as against 20 % of the voting rights under the old Takeover Code.

Thus, by acquiring of 26 % of the voting rights in an open offer in addition to the 25 % voting rights, the acquirer will have acquired 51% of the voting rights of the target company resulting in control over the target company. In acquisitions, involving Indian companies where none of the companies are listed, the process is much simpler in terms of legal compliances and the commercial considerations and cost aspects due to tax and stamp duties play a significant role. The transaction is carried out through private agreements to capture the commercial understanding.

Acquisition can also be by way of asset acquisition, whereby the entity is not acquired but substantial assets of a company or a business division is acquired. Asset acquisition can further be structured as a slump sale, whereby the substantial assets of the company or a business division is transferred for a lump sum consideration without assigning values to individual assets and liabilities; or in the alternative can be structured as an itemised sale whereby values are assigned to individual assets and liabilities. There are tax considerations to be made while deciding on the structure.

In an M&A, please note that approval under the Competition Act, 2002 shall be required in the following instances:

1. If the combined assets of the companies in India involved in the M&A amounts to Rs. 1,500 crores (approx. USD 333 million); or
2. If the combined turnover of the companies in India involved in the M&A amounts to Rs. 4,500 crores (approx. USD 999 million); or
3. If the combined assets of the group to which the transferee company belongs post amalgamation in India amounts to more than Rs. 6,000 crores (approx USD 1332 million); or
4. If the combined turnover of the group to which the transferee company belongs post amalgamation in India amounts to more than Rs. 18,000 crores (approx USD 3995 million).

The following are the exceptions where approval is not required:

1. A share subscription or financing facility or any acquisition pursuant to any loan or investment agreement by Public Financial Institution or Foreign Institutional Investor or Bank or Venture Capital Fund; are exempted, and a ‘for information only’ filing is required to be made with the Competition Commission within 7 days from the date of the acquisition.
2. The Government has granted an exemption, for a period of five years, to an enterprise, which is being acquired, provided that the assets of such target do not exceed Rs. 250 crores (approximately USD 55 Million) or its turnover does not exceed Rs. 750 crores (approximately USD 166 Million).

Post Completion Integration/ Implementation

The key to a successful M&A transaction is effective integration of two companies into a single business unit, capable of achieving the benefits intended. It is at the integration stage immediately following closing that many well-conceived transactions fail. Although often overlooked in the rush of events that typically precede the closing of the transaction, it is the integration of two entities that results from careful planning and execution which, is essential to a successful transaction.

A well-thought-out, detailed implementation schedule is required to transition responsibilities to new business entities without impairing business performance, employee morale or customer experience. It is advisable for a lawyer to anticipate all the post completion formalities and have the same agreed between the parties in intent and in language to ensure that the post completion integration is smoothly undertaken.

Private Equity

Private equity and venture capital funds have been instrumental in supporting many companies excel. These funds not only contribute by way of capital but they also bring expertise, contacts and better governance more so in case of an SME. They also share risks in a business with the promoter. In return of what these funds contribute to the business of a company they earn substantial profits at the time of their exit. The promoter must weigh the contributions and the earn outs, considering through the implications of the deal to make sure that deal is mutually beneficial to the promoter and investor.

It is advisable for a promoter to undertake due diligence exercise of the company and the PE investor as well before seeking investment. It is always advisable to be clear and transparent with the Investor as the same helps in building confidence and evading disputes in the future.

A promoter may consider the following in respect of a PE deal

1. Type of investment instrument: Usually PE firms make equity investments and exit by sale of shares at the time of an initial public offering (IPO) or a secondary sale. At times, PE firms invest by way of convertible debentures or convertible preference shares. Such instruments by their nature do not carry voting rights, but PE firms seek these rights in the investment agreement using the concept of “on fully diluted basis”. A promoter should (i) consider the terms on which they grant an investor voting rights and other shareholder rights, (ii) be clear on the promoter’s stake being diluted on the investor’s instruments being converted into equity, and (iii) should be mindful of the milestones pursuant to which the investment will be converted into equity.
2. Control and Governance: In most cases, PE firms will seek representation on the board of directors of the company. The promoter should resist substantial dilution of their control over the board of directors. It is typical for PE firms to ask for veto rights on various decisions of the company. A promoter should be cautious in granting such rights and make sure that the ability of the shareholder to control the business affairs of the company is not hampered by granting such rights. The promoter must ensure that only such veto rights be granted which are necessary to safeguard the financial interests of the investor and they do not give the investor the power to control the conduct and affairs of the company. The promoter should well structure the deadlock resolution provisions to ensure that the business of the company is not hindered.
3. Exit: PE investors would like to have a firm commitment on the time frame and offer price for an IPO. In the event IPO does not happen, an investor will insist that the promoter be obliged to acquire the stake held by the investor at a pre-agreed internal rate of return (IRR). It is advisable for a promoter not to commit the happening of an IPO within a specified time but may commit on the steps that would lead to an IPO. Secondly, the promoter need not agree on a buyback at an IRR. In the current capital market scenario whereby proceeding with an IPO not being a feasible option, there have been several disputes where PE investors are demanding buyback of their stake at IRR. The promoter may resist buy-back at IRR and agree on buy-back at the fair market value. At times PE firms may also seek drag along right whereby the investor can sell its shares and the promoter’s stake to a third party.