Leveraged buyouts of distressed Indian companies

Amidst the brouhaha surrounding the new Companies Act, a framework for revitalizing distressed assets in the economy became fully effective on 1 April. The framework envisages, at least in spirit, a paradigm shift in the legal regime on leveraged buyouts (LBOs) in India. The Reserve Bank of India (RBI) had released the framework at the end of January, following a discussion paper on the issue in December 2013.

An LBO, simplistically stated, implies the acquisition of controlling interest in a company, where the purchase price (or a majority of it) is financed through leverage, i.e. borrowing.

This development is significant when you consider the law which affects LBOs in India. Under the RBI’s master circular on loans and advances, promoters’ contributions towards the equity capital of a company were to come from their own resources and a bank was not allowed normally to grant advances to take up shares of other companies.

‘Specialized’ entities

Among other proposals under the framework, the RBI has decided that banks can now extend finance to “specialized” entities established to acquire troubled companies, subject to the general guidelines applicable to advances against shares, debentures or bonds as contained in the RBI’s master circular on loans and advances, and other regulatory and statutory exposure limits. Lenders are obligated, according to the framework, to assess the risks associated with such financing and ensure that these entities are adequately capitalized and their debt-to-equity ratio is not more than 3:1.

In this regard, a “specialized” entity is defined as a body corporate exclusively set up for the purpose of taking over and turning around troubled companies, and promoted by individuals and/or institutional promoters (including the government) having professional expertise in turning around “troubled companies” and eligible to invest in the industry or segment to which the target asset belongs.

The significance of the change proposed becomes evident when one considers the various obstacles to an LBO under Indian law, apart from those in the master circular on loans and advances.

First among these is section 67 of the Companies Act, 2013, which replaces section 77 of the Companies Act, 1956, and restricts a public company from giving, directly or indirectly, loans, guarantees, securities or any financial assistance for purchase or subscription of its shares or those of its holding company. This prohibits a public target company from providing security to lenders such that its managers or potential acquirers can acquire shares in the target.

The extant foreign direct investment policy requires Indian companies making “downstream investments” to bring in requisite funds from abroad and prohibits them from leveraging funds from the domestic market for this purpose. Further restrictions on LBOs are contained in the external commercial borrowing policy of the RBI, which specifically prohibits companies from borrowing for investment in capital markets or acquiring a company (or a part of it) in India.

Indian law also restricts LBOs through restrictions on lenders. The RBI’s master circular on exposure norms states: “The question of granting advances against primary security of shares and debentures including promoters’ shares to industrial, corporate or other borrowers should not normally arise.” However, it allows for such securities to be accepted by banks as collateral for secured loans granted as working capital or for other “productive purposes” from borrowers other than non-banking financial companies.

Non-residents are permitted to pledge shares of the Indian investee company, subject to prescribed conditions, in favour of Indian banks for bona fide business purposes of the Indian investee company, and in favour of overseas banks for bona fide business purposes overseas and not for direct or indirect investments in India.

Looking ahead

LBOs allow acquirers to obtain control over a company without the risk of capital, usually by providing the assets of the target entity as security to lenders. The debt is usually repaid using the target’s revenues (through tighter management control which conserves more capital and generates more profits) or through a sale of its assets.

While the framework may not yet provide solutions to all the current regulatory challenges in undertaking LBOs in India, it paves the way for entities to obtain financial assistance for the acquisition of troubled entities. Such entities would have to meet various RBI requirements and specific requirements of lenders, the exact nature of which is yet unknown. Presumably, one of the most stringent conditions would be maintaining a debt-to-equity ratio of not more than 3:1. Although the framework is far from concretizing LBOs as a mode of acquisitions in India, it is a positive step which hopefully signals a change in regulatory mindset.

Anuj Prasad is a partner, Anu Susan Abraham is a principal associate designate and Anandita Kaushik is an associate at Amarchand & Mangaldas & Suresh A Shroff & Co. The views expressed in this article are those of the authors and do not reflect the position of the firm.