Acquisition Financing and India's Curious Case In M&A transactions, financing an acquisition is a key consideration for acquirers. Acquisition finance is the raising of debt capital in order to acquire all or some of the shares or assets of a target company. Acquisition financing through bank debt is common in jurisdictions outside India. However, in India, debt-financing acquisitions...
Acquisition Financing and India's Curious Case
In M&A transactions, financing an acquisition is a key consideration for acquirers. Acquisition finance is the raising of debt capital in order to acquire all or some of the shares or assets of a target company. Acquisition financing through bank debt is common in jurisdictions outside India. However, in India, debt-financing acquisitions of capital instruments are restricted, resulting in a significant impact on how M&A transactions are funded in India.
Debt sourced from both domestic banks and foreign lenders is restricted from being used for acquiring capital instruments in India under the Reserve Bank of India's (RBI's) regulations for domestic banks and the External Commercial Borrowings (ECB) Regulations for foreign lenders, with very limited exceptions, including disinvestments and the infrastructure sector. We understand the reasoning to be the illiquidity of capital instruments and their potentially speculative nature.
Furthermore, even where borrowing for acquiring capital instruments is permissible, through borrowings from the non-banking sector or by raising debt instruments like bonds and debentures, it is difficult to secure this borrowing via the target's assets, as is typical in other jurisdictions. We should, however, note and clarify at the outset that lending for the acquisition of businesses and assets of the target rather than shares, and control over the target, is permissible even to banks.
As a result, debt financing of acquisitions of capital instruments and control over targets (likely the simplest form of acquisition) in India has entailed a structured process, without the involvement of banks. Structures include the issuance of non-convertible debentures (NCDs) by the Indian acquirer, which can be issued to Foreign Portfolio Investors, Indian financial institutions and debt funds, including mutual funds. Special purpose vehicles can raise debt abroad and invest through the FDI route, though this becomes equity or hybrid equity in the Indian acquirer.
Acquisitions are also commonly funded by non-banking financial companies (NBFCs). Overseas bonds have also been issued to fund acquisitions. However, the formal banking sector and foreign lenders remain restricted from financing the acquisition of shares.
Interestingly, and as noted above, similar restrictions do not exist on banks financing acquisitions conducted through business transfers or asset transfers, which, in many situations, lead to outcomes and risks largely similar to acquiring capital instruments.
Restrictions on debt financing of acquisitions by banks are absent in developed jurisdictions. We understand there are no equivalent restrictions in the US, the UK and Singapore. In fact, bank financing of acquisitions is quite prevalent in these jurisdictions. Furthermore, target companies are permitted to secure borrowings at their own level to fund an acquisition of their shares.
In these jurisdictions, we understand that 'whitewash' procedures are often necessary to enable this, entailing board or shareholders' resolutions stating that the target company will not face solvency issues for a stipulated period after the acquisition while securing the acquisition. This is to ensure that the target company is not financially drained just to finance its acquisition.
Similar to these jurisdictions, Indian private companies (which are usually closely held corporations) can provide collateral or guarantees in respect of loans raised by acquirers, provided there is no pre-existing common interest of directors.
However, under the Companies Act, 2013, public companies (i.e. companies whose share capital and control is widely dispersed or can be widely dispersed) cannot provide 'financial assistance' towards the purchase of their own shares. 'Financial assistance' here is understood quite widely, including assistance in the form of loans, guarantees and the provision of security.
There is no possibility of whitewash procedures, effectively rendering unviable several legitimate transactions that do not affect the financial state or capitalization of the target. This concern is amplified in practice for two reasons – first, the securing of debts using the target's assets is all the more necessary in cases of acquisitions of large public companies of high value; and second, the definition of a 'public company' in India includes its subsidiaries that are private companies. Consequently, several private companies in India are also prohibited from offering collateral or guarantees, being subsidiaries of public companies.
Owing to these restrictions, India has not fully unlocked its potential in the M&A space. We must also look at the regulatory regime in China, as a closer comparison. In M&A transactions in China, we understand that domestic banks (including branches of foreign banks) are the predominant source of debt finance. We understand that under Chinese law, while debt raised from foreign lenders has end-use restrictions similar to India, debt-financing by domestic banks, including branches of foreign banks, is permitted in a regulated manner.
Accordingly, for the purchase of equity shares, we understand that companies in China can raise up to 60 per cent of the total purchase consideration through debt finance. Further, we understand that banks are required to stipulate maximum ceilings for loans to a single entity, to borrower groups, and specific industry sectors.
Thus, it is increasingly apparent that the Indian Government's restrictions are not in line with global practices. As a nation attempting to posture itself as a viable investment destination, it is necessary for India to re-examine these restrictions.
Accordingly, we believe that debt financing of acquisitions of capital instruments must be permitted in India, via both domestic banks and foreign lenders. Simultaneously, one needs to be mindful of India's sensitive foreign exchange considerations. For debt raised under the ECB route, minimum tenures can be stipulated, which allays the RBI's concerns of maintaining foreign exchange balances and avoiding the excess pressures of quick redemption.
Finally, following the position in more developed jurisdictions, the government needs to implement guidelines that allow target public companies to guarantee or collateralize loans taken for the purposes of acquisitions, provided appropriate whitewashing resolutions are rendered and the interests of the target are not prejudiced.
We believe these dispensations will permit the closer alignment of M&A in India with long-standing global practices and benefit India as an investment destination, while also providing a fillip to M&A activity within the domestic Indian market.