The changing face of M&A

The international liquidity crisis and the growing financial muscle of Indian corporations have changed the nature of mergers and acquisitions

Alfred Romann explains

Holcim purchased a controlling stake in Gujarat Ambuja Cement. Hindalco Industries, part of the Aditya Birla Group, acquired Novelis. Wockhardt bought Negma Laboratories in France. The Essar Group took over Algoma Steel in Canada. Dr Reddy’s Laboratories snapped up a division of the Dow Chemical Company. Let’s not forget Vodafone’s takeover of Hutchison-Essar and, most symbolically, Tata’s acquisition of iconic British motoring brands Jaguar and Land Rover. The list goes on. But the players have changed.

The majority of India-related M&A activity over the last year has been industry-specific. It has been driven not by investment banks or funds seeking attractive investment opportunities but by companies looking to develop larger domestic and international footprints. The shortage of credit and the economic slowdown in the US and Europe has all but taken the speculative investors out of the M&A game while making potential acquisition targets more accessible to corporate buyers.

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Old game, new players

“You had a four, five-year run when the financial players were at the forefront of all of the investment that was transversing the globe, primarily because there was a tremendous amount of access to capital,” says Waajid Siddiqui, a partner at US law firm Hogan & Hartson. “As that kind of access is beginning to shrink you are seeing the traditional strategics once again starting to become active … paying premiums that are more akin to what was happening 10 years ago.

“Growth for the strategics … hasn’t changed over the last 10 years. The growth really is in Asia; it is in Latin America and they are continuing to invest in those places,” he says. “What has changed is [that] their ability to compete for those opportunities has just gotten better.”

Prior to 2007, fewer deals were undertaken in pursuit of market dominance. Rather, they were driven by money managers trading one property for another to make better returns. “You didn’t see a deal like the Corus deal, where the Tatas actually wanted to grow a footprint in steel production around the globe,” says Siddiqui.

The big global M&A dealmakers are now well-funded industrial players from countries like India and China with plenty of their own money and their sights set on expansion.
“Factors such as a rise in the standard of living, especially of the urban and semi-urban population, a vast untapped rural market, the popularity of plastic money, the continued growth of the economy, global exposure and availability of easy finance have increased the demand for a wider range of quality products [and] services such as fast food, clothing, electronic goods, children’s articles, segmental and niche products and professional services,” explains Preeti Mehta of Kanga & Co, a law firm in Mumbai.

The combination of these factors has boosted Indian companies and spurred many of them to expand their capacities and establish international footprints. In the first half of 2007, more than 500 India-related M&A transactions were completed with a combined value of around US$55 billion. Most of these deals were under US$100 million, undertaken by well-funded small and mid-cap companies setting out on the path to expansion. But a significant number were measured in billions rather than millions of dollars, grabbing the global headlines and underscoring India’s emerging status as a home of corporate titans.

India’s insatiable appetite

“There are plenty of companies around the world with cash that want to do M&A in India, and Indian companies that want to do outbound M&A,” says John Chrisman, a London-based partner at Dorsey & Whitney. But “everybody that requires funding is waiting. The capital markets are very slow.”

Will Kirschner, a partner at White & Case, expects one of the most interesting developments in the next few years to be “an increased number and size of strategic deals between Indian corporates and companies in other nations in Asia, as well as the Middle East and Africa.

“We would not be surprised to see these deals outpace strategic deals with corporations in the US and Europe” he says.

“I’ve noticed in the last year, just the tremendous amount of cash companies have to spend,” enthuses Chrisman. “I’m not just talking at the top end, I’m talking about the mid-cap companies that relative to their size, have a lot of cash that they are using to look for deals, which is fantastic.”

“The Indian companies are in a high-growth stage so they are buying things to help their existing business or expand their existing business,” he adds.

Tata Motors’ acquisition of Jaguar and Land Rover is a case in point. “This is a landmark deal for Indian companies making overseas acquisitions in the traditional manufacturing sector. Possibly even more so in terms of ramifications than Tata’s acquisition of Corus,” says Nikhil Mehta, a partner at Cleary Gottlieb Steen & Hamilton. “It paves the way for other Indian groups to be regarded as viable bidders in international acquisitions in comparably older sectors with a manufacturing base.”

Global slump, Asian trump

Some observers predict that emerging economies like India and China (and possibly even Brazil and Russia) will not only mitigate the effects of a recession in the US and Western Europe, but perhaps keep the world economy on a path of growth. Both India and China are expected to continue prospering, with Indian growth likely to hover at around 8% this year.

On the other hand, the new reality of global economic interdependence makes it difficult to predict how financial problems might spread from one economy to the next. “Every month and every week everybody is poised to see what is going to happen with the other shoe. When is it going to fall?” asks Siddiqui.

Arguably, the effects of the credit crunch and the decline in economic activity in the US have not yet been felt to any great extent in India. Hogan & Hartson, for example, enjoyed an exceptional first quarter in terms of deal work in India. The century-old Washington firm advised Tata Chemicals on its acquisition of a soda ash business in the US and worked with Ford on the sale of Jaguar and Land Rover.

It may even be the case that the slowdown in much of the West is a driving force behind outward M&A deals from emerging markets like India: “Indian companies looking overseas with war chests may find the international marketplace to be an even more fruitful hunting ground. The volume of transactions may diminish but there are still likely to be some significant successful ones,” says Mehta of Cleary Gottlieb.

“Valuations [in the West] have become so enticing that everyone in the East that has access to capital wants to go on a shopping spree,” adds Siddiqui.

Dee Rajpal, a partner at Stikeman Elliott, who heads the Canadian firm’s India initiative, sees this as a real possibility on his own turf. “If the Indian economy continues to be robust in light of any global economic slowdown, we would expect that Indian companies may take advantage of opportunities to acquire Canadian companies at reduced values,” he says.

His firm has extensive experience in India, having worked on Tata’s acquisition of Jaguar and Land Rover, Essar Group’s acquisition of Algoma Steel, and the takeover of Arcelor by Mittal Steel. Canadian M&A activity remains strong, says Rajpal, but it is “subject to a lower level of activity at the high end of the market as a result of the recent debt market turmoil. This has led to an increased presence of strategic international buyers, particularly in the natural resource and mining sectors.”

Capital triumphs over debt

In India, as in China, many companies have significant capital, not only from their own expansions, but also from an ability to borrow against impressive rates of growth. This may well translate into even bigger outbound deals in the future. “They should absolutely use this leverage and they are,” says Siddiqui. “You are going to see larger and larger deals coming from the East into the West.”

David Roberts, a partner at London firm Olswang, agrees. “Given that Indian acquirers typically use their own funds and have an aversion to third-party debt to fund deals, I can only suspect we will see an increased number of cashed-up Indian acquirers hunting for bargains over the next six to 12 months,” he says.

Indeed, India’s aversion to third-party debt combined with strict regulations on foreign borrowing have so far played a part in insulating its corporates from the international liquidity crisis. Siddiqui expects the economic slowdown to catch up with India towards the end of this year, during a time when the West could very well be on the road to recovery. But most observers don’t believe that its effects will be very serious.

“We do not expect a huge impact on M&A activity, though the focus may shift from large acquisitions to joint ventures requiring smaller investments,” says Rajiv Luthra, managing partner of Luthra & Luthra, a New Delhi law firm with extensive experience in regulatory matters. Luthra is optimistic about the country’s prospects in the face of a slowdown: “We still feel that India will continue to be a strong magnet for foreign investment and that substantial amounts of available liquidity in the global market will continue to gravitate towards India for greater returns,” he says.

“Financing may become more difficult at times but our experience is that a compelling business proposition will ultimately find the funds required for implementation,” adds Benjamin Parameswaran, who works with partner Reiner Krause on the India desk at German firm Hengeler Mueller. “[The] pace of execution may be somewhat slower, but [the] outcome more sustainable.”

Canadian firm Torys, which is now a regular face at the Indian deal table, believes the economy in the subcontinent will continue to prosper even if the global credit crisis affects deals financed by external credit. Partner Pat Koval points to the increasing activity between India and Canada to back up this belief: “The three hottest areas of M&A activity from India to Canada are in mining and metals, life sciences and technology. We do not see any sectors cooling down.” (See Sectors to watch at the bottom.)

The firm represented Hindalco Industries in its US$6 billion acquisition of Novelis, a Canadian aluminium producer. The deal was “unique because of its size and the number of jurisdictions involved for both the acquirer and the target”, Koval explains.

Regulatory impediments

Although the Indian market remains bullish, players in the M&A arena face a number of legal, regulatory and financial hurdles.

“Overseas acquisitions by Indian companies are subject to a complicated legal regime, within which remitting money and raising funds, while essential to the deal, faces tremendous regulatory issues,” says Luthra.

And as Vodafone’s acquisition of Hutchison-Essar illustrates, inbound deals can be equally if not more complex. The difficulty was “not so much with the transaction per se, but the regulatory scrutiny to which [it] was subjected, and the slew of regulations which have been rolled out to address the initial (Hutchison) holding structure,” explains Justin Bharucha of Bharucha & Partners, a newly established law firm in Mumbai.

“It is not always easy to navigate through the rules because the administrative authorities sometimes have an idiosyncratic way of interpreting them in day-to-day cases,” says Daniel Daeniker of Swiss law firm Homburger. Homburger was involved in the 2007 acquisition of a controlling interest in Associated Cement and Ambuja Cement by Holcim, one of the largest cement manufacturers in the world.

Gautam Khaitan of Delhi-based OP Khaitan & Co has also worked on a number of notable deals, including the acquisition of Bharat Aluminium Company by the UK’s Sterlite Group, the acquisition of Rosebys Fashions by GHCL and the US$150 million takeover of Dan River of he US by GHCL, an India-listed company. “SEBI rules for takeovers are quite transparent. However, there are policy constraints which cloud discussions on sectors like retail,” he observes.

Kirschner at White & Case believes that “the government’s apparent desire to try to shelter the Indian corporate sector from foreign players and consequent need to secure regulatory approvals in many contexts from the Foreign Investment Promotion Board and the Reserve Bank of India, often adds unnecessary delay and expense to transactions.”

But perhaps the most significant challenge facing dealmakers is a lack of regulatory clarity and contradictory interpretations of existing legislation. “A substantial concern that we repeatedly face is the ambiguity in the law and the regulatory risks that accompany any decision to invest in India,” says Luthra.

The liberalization of India’s economy has been accompanied by the emergence of an array of expert bodies, each charged with regulating a specific sector. The Insurance Regulatory and Development Authority (IRDA), Telecom Regulatory Authority of India (TRAI) and the Competition Commission are just three examples, the latter of which is responsible for implementing the controversial new Competition (Amendment) Act, 2007, which some believe may deter future M&A deals (see In competition with the law at the bottom).

“Nobody can deny the need for specialized regulatory bodies,” says Luthra. “However, the increase in regulation has brought with it greater regulatory risk, along with an escalation of business costs associated [with] compliance.

“Various ministries often come out with their own rules and regulations, inevitably adding to the conundrum of laws that investors have to comply with, in addition to the sector-specific rules and regulations,” he adds.

Saroj Jha and Mohit Sharma of FoxMandal Little point out that different regulatory bodies are prone to take different views on the same legislation: “Government authorities like the RBI and the Securities and Exchange Board of India differ on many aspects, like in cases of investments by venture capital funds.” SEBI allows these investments but the RBI avoids granting permissions.

As a result of such ambiguity, legal opinions on M&A deals tend to be so full of caveats that they often include warnings that issues are “not free from doubt and may be interpreted differently by the regulator”, remarks Luthra.

Financial challenges

Yet more regulatory hurdles are thrown up when it comes to the financing of deals. The Companies Act precludes leveraging a company’s assets to raise finance while the exchange control regime imposes valuation norms and pricing guidelines for transfers of shares between residents and non-residents. “The restrictions on Indian companies borrowing from non-resident lenders as well as the limitations on the type of securities which an Indian company can issue to non-residents are new factors which are significant in the M&A practice,” says Bharucha.

Problems also emerge when looking to finance deals not with cash, but through a combination of deferred payouts, share swaps and other structures that are as tax-efficient as possible. “In the case of share swaps, up until recently there were very few examples and, as the transaction involved FIPB approval, it ran risks of coming into the public domain before the deal closed,” says Ravi Singhania of Singhania & Partners in New Delhi.

Another regulation that may complicate future M&A deals came in April 2007, when the Ministry of Finance decided to treat foreign investment in preference shares as foreign debt. “[It] had the effect of significantly reducing the number of financings across sectors, but also opened a Pandora’s box of legal concerns,” says Luthra. “The most obvious absurdity is that the new law treats certain kinds of preference shares as debt.”

The result of this move was to deprive investors of the rights normally available to debt issuers while still enforcing the restrictions that apply to foreign currency debt. Regulations passed later in the year created similar conditions for preference shares.

The turbulent capital markets have posed additional challenges for would-be dealmakers. “The absence of an efficient capital market system makes [the] market capitalization of companies unattractive,” says Sumes Dewan of KR Chawla & Co, a New Delhi law firm that is celebrating a foreign investment deal of its own: In April the firm opened an office in San Francisco.

Dewan explains that “a number of deals were called off due to the dismal state of the capital markets affecting companies’ valuations.” One example is the decision by Maars Software International to call off a merger with Mascon Global after a downturn in IT stocks lowered valuations.

Positive steps

None of these challenges are insuperable, says Mehta of Cleary Gottlieb, a US law firm that has handled several deals in India. Its portfolio includes the acquisition by pharmaceutical major Wockhardt of Negma Laboratories in France, the Essar Group’s buyout of Algoma Steel, and Fortress Investment Group’s purchase of a stake in Reliance Telecom Infrastructure.

Mehta highlights the “positive relaxations in the aviation sector [and] anticipated ongoing relaxations in retail investment”, as signs that things may be getting easier. He is worried, however, about the “expected renegotiations of some key tax treaties”. (See Paradise lost).

Parameswaran of Hengeler Mueller believes that the regulatory and financial difficulties associated with M&A deals in India can be overcome with carefully laid out strategies and, at times, simple motivation. His firm has been involved in almost every high-profile transaction between India and Germany including the US$1.03 billion acquisition by Suzlon in 2007 of wind energy company REPower, and later of Hanxen Transmissions, together with Reliance’s acquisition of Trevira. The REPower takeover “was the first takeover battle in Germany with a successful Indian bidder”.

“We have consistently seen a remarkable entrepreneurial drive and professionalism on the side of investors from India, which helped getting the deal[s] through. For our outbound advisory practice, we found India to provide an attractive environment for foreign investment,” he says.

Siddiqui agrees: “Everyone has cut their teeth in China in some sense, and has seen what a motivated economy and a motivated regulatory environment can do. You don’t have people pulling their hair out that India’s regulatory environment is impeding their transactions.”

“A secondary market for securitized debt would be phenomenal. A developed corporate bond market would optimize foreign investment like nobody’s business. Better accounting rules and disclosure requirements would make it that much easier,” he adds. “And you see things happening. SEBI quarterly filing requirements are just one step in that direction … You have a very sophisticated deal economy in India that can help you navigate through the regulatory environment.”