Munish Sharma of Dua Associates examines the range of funding options available for mergers and acquisitions
There is a vast range of options available to finance an M&A transaction, from a simple equity financing to a layered transaction with multiple levels of debt and equity. Overall, the key factors that affect financing structures are size, complexity of the transaction, acquirer’s cash position, market for the acquirer’s securities, the terms of the purchase price and above all, the local and/or global financial environment.
In many cases, the availability of funding is determined by the target being acquired. A target with little debt, significant assets and strong, predictable cash flows is an excellent candidate for long-term financing. On the contrary, financing options are restricted if the target has poor cash flows, high debt levels and encumbered assets.
Mergers v acquisitions
A merger is the formation by two separate entities of a single company that would be jointly owned and perhaps jointly operated by two merging entities. In several jurisdictions, a merger is achieved through a court process. The resultant entity usually takes over all the contractual and statutory liabilities, obligations and business of the merging entities and issues shares to shareholders of this merged entity. The financing required in a traditional merger is not very significant, unless the resultant entity has also agreed to pay a cash consideration to the shareholders of the merging entities.
An acquisition is where one company takes over another and clearly establishes itself as the new owner. An acquisition could classically be in the form of a share purchase or a subscription to new shares. Financing strategies for each of these would vary based on commercial parameters, regulatory requirements and tax considerations. However, many still consider ideal a financing structure where future business revenues pay for the cost of acquisition. Such a structure enables the acquirer to get back its investment along with returns from the target if the business is successful. It also facilitates optimum use of invested amounts.
Stages of financing
There are three stages to consider while forming a financing strategy: acquisition structure, cash requirements and sources of finance. The acquisition structure is usually guided by applicable laws, regulations, statutory compliances, contractual restrictions and exit options. For instance, one needs to check if investments in the relevant sector of the M&A deal are permitted, or if there is a lien over the shares or assets to be acquired.
After the commercial terms are agreed upon in principle, it is necessary to identify the instruments or securities which will be used to finance the deal and the process for closing. Acquirers must consider whether it will be a straightforward purchase of equity shares, or a combination of equity shares, bonds, share warrants, preference shares or future options. Redeemable preference shares provide considerable flexibility to acquirers to regain investment amounts from the revenue generated by the target through redemption.
A range of options
Indian corporates can remit up to 400% of their net worth and have therefore used foreign currency borrowings in the international capital markets as a major source of financing for overseas acquisitions. Debt funding has somehow emerged as one of the best financing options. Even during the economic crisis, Indian M&A financing did not suffer much, though the interest spreads increased significantly. Strong Indian corporates managed cross-border financing through a structure that allowed reduction in interest spreads with improvements in earnings before interest, taxes, depreciation, and amortization margins in the coming years.
Cross-border financing has emerged as an attractive source of financing, given the interest differential between domestic and international lending rates of OECD currencies. Such cross-border financing is not, however, permitted for domestic acquisitions by Indian companies.
Private equity financing has also been used to finance both domestic and international M&A transactions. Foreign currency convertible bonds and global depository receipts, once used to mobilize resources, are no longer popular instruments. Instead, the domestic equity market has emerged as a major source of growth equity for Indian corporates. Convertible preference shares and rights issues have often been used to raise funds.
Earn out models of financing based on past or future financial performance have been used largely in the service sector to secure continuity of services by the selling stakeholders. Earn out can be viewed as deferred payment of consideration, which may be part-financed from returns on initial investment. To address tax issues, the sale of certain shares against each earn out instalment has been considered. Part-sale of shares may also address long-term capital gains.
Carefully structuring an acquisition is vital for cross-border deals and could lead to considerable savings. Issues for consideration include corporate income tax, capital gains tax on the sale of shares, dividend distribution tax and indirect tax relating to business operations that involve the acquirer and the target.
Some crystal ball gazing at the structuring stage is required to identify future financing requirements of a business, possible financing sources that may be accessed and exit options. For instance, an acquisition could be routed through a holding company in a tax-friendly jurisdiction to allow the holding company to raise finances in the loan market for future investment by pledge of its shares, or dilution of a stake in the holding company. This structure can also be used for transfer of shares to a third party investor to realize value.
Any financing strategy should also minimize a promoter or shareholder’s exposure to the business risk. Ideally M&A financing should be self-sufficient or locked into the revenues of the target or the acquirer. The promoter risk can be limited to pledge of shares or limited personal guarantees. Equally important is the analysis of exit options with minimum tax exposure. This is based on the reality that an acquisition usually has a pre-defined purpose and objective. Such objectives change with business realities and the dynamics of regulatory controls.
The recent issue of Vodafone’s acquisition of Hutchison’s Indian telecom business indicates that financing strategies for M&A can address some, but not all variables. That deal illustrates that even the most carefully thought out structure can fall foul of tax laws.
Munish Sharma is a partner at Dua Associates in New Delhi. He can be reached at email@example.com.