Why Leveraged Buy-outs (LBOs) fail

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FOR Koushik Chatterjee, Tata Steel’s vice-president of finance, the elation over hiscompany’s $12.1-billion winning bid for theUK’s Corus Group was as short-lived as thetime it took to make the announcement ofthe deal. The finance veteran’s first taste ofthe going rates in leveraged buy-out (LBO)funding — one of the world’s most infamous

financing tools because of the string of corporate failures theycaused in the late 1980s and early 1990s — left him a bitshaken.

While Tata Steel was paying an interest rate of 50 basispoints over Libor on its current external debt of $1.5 billion (Rs6,150 crore), the bankers Chatterjee approached for the $7 bil-lion (Rs 28,700 crore) he needed to fund the Corus takeoverdemanded 372 bps over Libor. With Tata Steel’s finances al-

ready stretched by a massive $6.75-billion (Rs 27,675-crore)domestic expansion plan, this wasn’t exactly the op-

tion the company was looking for. Chatterjeewanted to convince the banks to lend Tata

Steel, which produces five million tonnes ofsteel annually, the LBO money it needed to

buy Corus, which makes 22 milliontonnes of steel annually, at corporateloan rates. But no one was biting.

So, Chatterjee and his team con-vinced the Tata Steel board to hike the eq-uity component of the Corus purchase byanother $500 million (Rs 2,050 crore).

BUSINESSWORLD 25 30 JULY 2007

Then, they sat down to assiduously remove the classic LBO-like elements of the deal, such as high-yield bonds (9.4-10.4per cent) from the proposed funding. Chatterjee thenknocked at the doors of a different set of financiers and pre-sented them with the combined face of Tata-Corus, completewith integration plans, the firm’s corporate governance ap-proach and the corporate credit history of Tatas. The moveworked. The lenders agreed to commit $6.7 billion (Rs 27,470 crore) to various Tata Steel entities at 197 bps overLibor, allowing Chatterjee and his team to save $1 billion overthe 7-9 year tenure of the loan.

But most other companies throwing themselves into theGreat Indian Leveraged Buy-out rush haven’t jigged theirbrains quite as much. Over the past 17 months, about a dozencorporations, large and small, have taken on debt of nearly$15 billion (Rs 61,500 crore) to buy foreign companies 3-5times their size, triggering an LBO phenomenon (see ‘TheGreat Indian Leveraged Buy-Out Rush’) that is now seducing

Indian companies aretaking over entitiesmuch bigger thanthemselves throughleveraged buy-outs.What must their stake-holders worry about? By Rajeev Dubey

The incredible weight of the LBO

EXECUTIVE SUMMARYThe thirst for LBOs has led Indian companies totake loans totalling Rs 60,000 crore

Cash-rich western bankers have been happy tomake the loans. But repaying them will be tough

Many LBOs involve commodity players. Downturnsin commodity prices could sink these companies

The Great Indian Leveraged Buy-Out RushAcquirer Acquiree Primary SPV Funding Equity Debt

Feb-06 United Phosphorus Advanta UPL, Mauritius €100 m €30 m €70 mMar-06 Dr Reddy's Labs betapharm N.A. €480 m €80 mn €400 m

Arzneimittel

Apr-06 Suzlon Hansen AER Holdings, €465 m €465 mTransmissions the Netherlands

Jun-06 Aban Offshore Sinvest Aban Singapore $ 446 m $111.6 m $ 334.5 m

Jan-07 Tata Steel Corus Group Plc Tata Steel UK $10.3 bn $ 3.6 bn $ 6.7 bn

Feb-07 Hindalco Ind. Novelis AV Metals, Canada $ 6 bn $ 2.4 bn $ 3.55 bn

May-07 Suzlon RePower SE Drivetechnic, Germany €1.35 bn €225 m ** €1.1 bn

May-07 United Spirits Whyte & Mackay N.A. $1.18 bn $505 m $ 675 m

Jun-07 Rain Calcining CII Carbon Rain Commodities,US $ 595 m $120 m $ 475 m

**Rest of the funding is still to be arranged Source: BW research

cstory main.qxd 7/19/2007 5:17 AM

world leader in aluminium rolling,and getting Whyte & Mackay hasturned the UB Group into theworld’s second largest liquormaker, behind the UK’s Diageo.

There are other reasons whycompanies are going the debt-laden LBO route. For one, ReserveBank of India guidelines prohibitdomestic companies from leverag-ing more than three times their networth for acquisitions. Two, thoughmerger with the acquiree companyis an option, it has two downsides:one, cross-border mergers comewith enormous legal and statutorycomplications that LBOs helpavoid, and two, current sizes andmarket capitalisations of domesticcompanies is so small in relation tothe acquiree’s that a share swap ra-tio would reduce the Indian pro-moter’s equity substantially.

Finally, of course, majors suchas Tata Steel — which came out un-scathed from the downturn of1999-2002 by tightening their beltsand reducing cost of operations —were more confident of taking big-ger risks in a global environment.

So, the current surge in LBOs ofIndian companies is akin to the

wave of Spanish investments in Brazil and Mexico in the early2000s soon after their economic slowdown. Spanish compa-nies went on to dominate the telecom, power and bankingsectors in these Latin American nations. Telefonica Movilesbought Motorola’s cellular business in Mexico for $2.64 billionand then merged its Brazilian investments in Portugal Tele-com to create a $10-billion firm. Banco Santander Central His-pano bought Brazil’s state-run Banespa for $3.6 billion to en-ter the banking space in the country and then bought Mexico’sGrupo Financiero Serfin for $1.5 billion. In 2000, Spanishcompanies accounted for one-fifth of Latin America’s M&As.

While the Spaniards led the first wave, the second rush wasled the by volume-driven Chinese manufacturing companiesbetween 2004 and 2006. Lenovo acquired IBM’s computingbusiness, and TCL acquired Thomson’s CTV arm. And thoughthe China National Offshore Oil Company’s (CNOOC) $18.5-billion unsolicited bid for Unocal was scuttled by the US law-makers, Chinese corporates had already left a mark on theglobal canvas with their bold moves.

It is now the turn of Indian companies — most of whomare lean, mean and hungry for acquisitions. India’s currentLBO phenomenon has deep roots in what is now turning outto be the world’s most stable economic environment in overfour decades. Global liquidity is at its peak and interest rateregimes are at their most benign. According to estimates ofThe Bank of England, global liquidity has doubled in the pastfour years and is expected to go up sharply once China decides

seeing the tip of the nose and they are seeing beyond that.”Credit rating downgrades have only accentuated the reac-

tion to the LBOs. Following the Corus acquisition, ratingagency Crisil downgraded Tata Steel from ‘AAA/rating watchwith negative implications’ to ‘AA+/Stable’. “The acquisition ofCorus... is expected to vitiate the consolidated entity’s capitalstructure,” Crisil said. Soon after, Hindalco’s acquisition ofNovelis was met with another ratings downgrade from Crisilfrom ‘AAA/Rating Watch with Negative Implications’ to‘AA/Stable’. Hindalco was rated lower than Tata Steel becauseof a mammoth $3.1-billion (Rs 12,710 crore) loan it took on itsown balance sheet to fund the acquisition. The loan has re-course to Hindalco and its assets.

Lure Of LiquidityIndia Inc.’s hunger for global giants underlines how CEOs see awindow of opportunity to raise their scale and compete on aglobal scale. “Aspirations to be a global leader, innovative fi-nancing options and under-levered balance sheets are en-couraging Indian companies to acquire assets globally for ac-cess to new markets, advanced technologies and experiencedmanagement,” says Sanjay Nayar, CEO, Citi India.

Corus has turned Tata Steel into the world’s fifth largeststeel producer, and the CII Carbon acquisition has made RainCalcining the world’s largest producer of calcined petroleumcoke, a raw material used in aluminium and titanium dioxideproduction. Purchasing Novelis has turned Hindalco into the

companies such as Chennai-based oilfieldequipment producer Aban Offshore, Hy-derabad-based Dr. Reddy’s Laboratoriesand Vijay Mallya’s United Spirits. WhileAban Offshore’s total consolidated equitywas just $65 million (Rs 267 crore) as of thisMarch, it acquired a 33.76 per cent stake inNorwegian oil rig producer Sinvest for $446million (Rs 1,829 crore) via its subsidiaryAban Singapore. The company raised $100million in equity through a foreign currencyconvertible bonds issue this February, butthe rest of the deal was paid for with debt.This, counting previous loans, left Aban andits subsidiaries with a debt of $2.1 billion (Rs 8,610 crore).

And United Spirits has acquired Glas-gow-based whiskey maker Whyte & Mackayfor $1.18 billion (Rs 4,838 crore), $675 million(Rs 2,768 crore) of which was raised throughloans. Similarly, in early 2006, pharma majorDr. Reddy’s bought German generic drugmaker betapharm for $570 million (Rs 2,337crore), $475 million (Rs 1,948 crore) of which

came from loans.

Reading The SignalsFor investors, these rapid fire LBOs have largely come as arude shock and they have given the deals a lukewarm re-sponse. Hindalco’s stock, which was at Rs 145 when the Nov-elis deal was announced, modestly rose to Rs 154 a fortnightlater. “Hindalco is a laggard right now,” says Harsh Pannalal, aMumbai-based shareholder of the company. “It won’t getgreat returns.”

Hyderabad-based Rain Calcining, which funded its $595-million (Rs 2,440-crore) acquisition of the US-based CII Car-bon with a debt-equity ratio of 4:1, saw its stock jump to Rs42.50 on 4 June, the day the deal was announced. But it closedat Rs 40.30 a month later. “Non-appreciation in the stocks hasbeen disappointing,” says Sushil Dalal, an investor who hasalso had Hindalco in his portfolio for over 10 years. “But as ourcountry is growing, we have to take on the world. Maybe I am

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rmuch of corporate India. While in mostcases, the companies’ have been lionisedby financial press, their moves have beenfrowned upon by the stockmarket. In theirfrenetic bid for growth, not only are thecompanies taking on debt that is 4-5 timestheir net worth, they are also opting to payinterest rates as steep as 8-9.5 per cent ontheir LBO loans. From the shareholder’sperspective, it raises a lot of flags. Mostly, itraises the question of whether these com-panies are getting themselves into a knotthey cannot untie if things go wrong.

Gluttons For DebtFor years, debt was a dirty word in corpo-rate India. And trepidation with whichcompanies took loans only grew afterdozens of debt-heavy companies (such asEssar Steel) suffered heavily during the eco-nomic slowdown of 1999-2002. Memoriesof debt recovery tribunals and the pain ofdealing with the Board of Industrial and Fi-nancial Reconstruction (BIFR) still send achill down the spine of many a promoter who suffered in thatphase. All that changed with the Corus deal, which saw TataSteel taking loans of about $7 billion (Rs 28,700 crore), morethan twice its net worth.

A month later, on 15 May 2007, India’s largest aluminiumproducer, Hindalco Industries, with revenues of $4.57 billion(Rs 18,737 crore) and a manufacturing capacity of 461,000tonnes, acquired the $9.8-billion (Rs 40,180 crore) Novelis ofCanada for $6 billion (Rs 24,600 crore). This wasn’t a classicleveraged buy-out like Tata Steel’s Corus deal, where a specialpurpose vehicle takes on debt against the assets of the ac-quiree. But Novelis already had a debt:equity ratio of 7:1. As aresult, Hindalco’s options were rather restricted when it cameto taking on $3.1 billion in debt on its own balance sheet: that’sfive times the company’s $650 million (Rs 2,665 crore) netprofit in 2006-07, nearly as much as its net worth and 70 percent of its 2006-07 revenues.

Even more audacious have been the acquisitions made by

Global deals by Indian companies

More ambition, more risk

Year Total Amount deals ($mn)

2006 47 2,200.02005 134 3,696.22004 51 1,532.52003 50 852.22002 29 1,005.42001 32 384.42000 50 957.01999 14 45.81998 6 29.81997 4 320.31996 1 5.01995 4 46.8

Source: Dealogic

Source: BW research

LBOs have resulted in rating downgrades across the boardBefore After Agency Reason cited

acquisition acquisitionTata Steel BBB BB S&P Corus continues to carry a weak business profile

Tata Steel, UK N.A. BB- S&P Outlook positive

Hindalco AAA/rating watch AA/stable Crisil Financial risk profile is likely to be strained Industries with negative

implications

Novelis Ba3 B1 Moody's Probability of default rating

Corus BB BB- S&P Material enhancement in performance unlikely

Aban Offshore Medium risk High risk Citigroup High leverage, revenue concentration, cyclical nature


Figures are closing prices on BSE in Rs Source: BW research

Aban Offshore Dr Reddy’s Lab

Hindalco IndustriesRain Calcining

Suzlon Energy

Tata Steel Tata Tea

3,500

3,000

2,500

2,000

1,500

1,000

500

024 July2006

21 Sep2006

22 Nov2006

23 Jan2007

28 Mar2007

30 May2007

17 July2007

The Market’sResponse HasBeen Less ThanEnthusiastic

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to invest its $178-billion trade surplus. Under the Basel IIagreement — which is scheduled for implementation in Eu-rope in January 2008 and in most other countries, includingthe US and India, by January 2009 — capital allocation wouldbe on the basis of the risk of assets. So the world’s largest banksare cleaning up their balance sheets by diversifying debt port-folios and offering capital to be converted into credit deriva-tives and debt securities.

The desire to do this and yet disperse financial risks is fu-elling demand for instruments like credit-default swaps(CDSs), and collateralised debt obligations (CDOs) where amultitude of buyers of such securities share the risk of failure(see ‘How Banks Disperse LBO Risks). Such reassurance hasbrought new zest into driving capital towards high-risk assets,including LBOs. An estimated 80 per cent of bank debt in theUS and over 50 per cent in Europe has been sold in theCDS/CDO markets.

According to the Bank for International Settlements, theCDS market has been doubling every year for the past fiveyears and now stands at $20 trillion (20 times the size of India’sGDP) in cumulative outstandings. Similarly, about $489 bil-lion worth of CDOs were issued in 2006, double that of 2005, asper the Bond Market Association data.

Then, a lot of capital is getting diverted to private equitywhere fund-raising has never been such a cakewalk. PE firms,which provide the maximum funds to LBOs, raised $430 bil-lion in 2006 and are projected to raise $500 billion in 2007.That is 20 per cent higher than Pakistan’s GDP. This money isfuelling a frenetic M&A activity that hit an all-time high of $3.7trillion in 2006. That’s almost four times India’s economy, andmuch larger than the previous best of $3.3 trillion in 2000 —the year that posed one of the biggest threats to global eco-nomic stability and led to a downturn that the world has justabout managed to overcome. “Private equity benefits fromlow interest rates and low risks,” says Rana Kapoor, managingdirector and CEO of Yes Bank, but who was the chief architectof India’s first LBO, the Tata Tea-Tetley deal. “When interestrates rise, private equity will be challenged.”

Vicious Cycles Of DebtLBOs, it is said, don’t fail, they just get re-financed. But somefind themselves in such a vicious cycle of re-financing thatthey struggle to come out of it, barring a miracle (see “WhenLBOs fail” on page 30). India’s first major global LBO, Tata Tea’sacquisition of UK’s Tetley Tea, was one such case. Luckily, thecompany was saved when it made a windfall proft of $523 mil-lion by buying and then quickly selling a 30 per cent stake inUS-based Energy Brands, better known as Glaceau. The cashwill be used to pay off the $600-million debt Tata Tea took on tobuy Tetley.

But before that, Tata Tea’s $427-million Tetley buy-out in2000 went through three rounds of re-financing. First, be-cause the management failed to achieve the revenue andprofitability targets in the two years. Second, to get betterterms at lower rates. Third, to club the existing debt with moredebt for the Glaceau acquisition.

Tata Tea was lucky. Its quantum of debt was not as big aswhat is being raised today. And it could ride the rough times bymatching up to performance targets. But there is little margin

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INDIA’S first global LBO — Tata Tea’s buy of UK’sTetley in March 2000 — went through a scare in itsearly years, only to recover later, thanks to a mas-

sive financial gain by Tata Tea from the Glaceau deal.While funding Tetley, Tata Tea floated a special pur-

pose vehicle, Tata Tea GB in the UK, by capitalising itwith £71 million (£60 million from Tata Tea, £10 millionfrom Tata Tea Inc. and £1 million from Tata Sons). Thecompany was then financed by £210 million, compris-ing: 140 million of seven-year senior debt, £40 millionof nine-year mezzanine debt and £30 million of otherdebt. Typically, senior debt is secured through collat-eral on which the lenders have the first lien. It is priori-tised for repayment in the event of a liquidation. Mez-zanine debt is subordinate financing, an unsecured,high-yield, subordinated debt or preferred stockswhere lenders get priority repayment over the com-pany’s shareholders in the event of a liquidation.

The deal was first refinanced in March 2003 whenTetley’s performance was short of target but still show-ing signs of improvement. That extended the payoutperiod from the original 2007-2009 to 2012. In 2001-02, the net margin of the consolidated Tata Tea was afeeble 3.43 per cent. Tata Tea GB paid off the previousloan and took on £174 million. By 2005, Tetley wasperforming better than its target. The loan was then re-financed for the second time with £142.5 million,pulling back the payout by two years to 2010.

Finally, when Tata Tea was acquiring the 30 per centequity in Energy Brands (Glaceau), the existing debt wasclubbed with the extra requirement to raise £284.3 mill-ion in 2006. The final payout was in 2016 but is now ex-pected to be pre-paid out of the $523 million profits fr-om the Energy Brands sale proceeds. “As you pay somedebt, the opportunity for refinancing increases becausea combination of cash flows becomes available for re-finance,” says L. Krishna Kumar, CFO, Tata Tea. �

Tata Tea’s close call

SCRAPED THROUGH: It was the Glaceau deal that endedthe interminable rounds of refinancing of the Tetley LBO

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for error in some of the recent LBOs. Their debt is far higherand interest component is larger. Besides, most of these arefirst-timers.

Choppy business cycles can play havoc with companiesunder-prepared for a trough. For instance, Suzlon Energy,which acquired Germany’s RePower Systems for $1.8 billion,hasn’t accounted for any downside in its business. “There areno sector weaknesses or downsides,” says Tulsi Tanti, chair-man, Suzlon Energy. “The industry is in good, high growthmode. Demand is high and supply short. We are not in any ad-verse industry conditions. We are accelerating.”

Though the success of Hindalco-Novelis actually dependson the aluminium cycle, Hindalco Industries CFO S. Talukdarinsists, “Novelis is one of the most risk-free business models”.Novelis watchers don’t think so. Ratings agency Moody’s inJune confirmed Novelis’s corporate family rating at B1 (proba-bility of default rating). “Novelis’s cash flows could be nega-tively impacted should its ultimate parent, Hindalco, elect towithdraw cash via upstream dividends to service its own debtburden,” Moody’s said in June.

Novelis has been acquired at the peak of the ongoing alu-minium cycle, but rates are only expected to slide from here.During the first quarter of 2007, aluminium traded inthe range of $2,550 and $2,875 per tonne on the Lon-don Metal Exchange with a three-month average of$2,746 per tonne. By the end of the decade, however,rates are expected to soften 15-20 per cent. Eventu-ally, they are projected to go down to the 2005-06 lev-els of $2,000 per tonne.

Similarly, Tata-Corus will have to cope with a de-clining steel cycle, which is already off-peak due tosoftening of demand from China. In 2006, Chinatransformed itself from a net steel importer to a netsteel exporter. As of July 8, 2007, the price of HR Coils,the benchmark for steel, was down 8 per cent in thelast 30 days to $585 per tonne. This represents a con-tinuous slide since 2005-06 when global HR coilprices climbed to the $800 per tonne level, over fivetimes their 30-year low of $150 per tonne in 2001. “Wedo not expect material enhancements to its (Corus) opera-tions, despite new ownership by Tata Steel, which will limitfurther upside potential... much higher leverage will act as aconstraining factor,” Standard & Poor’s said while downgrad-ing Tata Steel in early July.

“Novelis and Corus are commodity plays,” says AnilSinghvi, MD, Ican Investment, a fund management company.“Right now, there is sweet spot in commodity cycle. But canCorus generate $12 billion (Rs 49,200 crore) over seven years? Idoubt it. If it can’t, you have taken a very high risk. Growth forthe sake of growth is no growth, it’s monstrous growth.”

The biggest threat of industry cycles is to a small companylike Aban Offshore, which is sitting on a debt of $2.1 billion (Rs8,610 crore). A Citigroup analyst report in April 2007 said,“Aban’s consolidated net debt of $2.1 billion presents a veryhigh level of gearing given its equity base of $65 million (Rs266.5 crore)... Slowdown in offshore services demand growthcould have a huge impact on Aban given its high gearing.”

Says Prahlad Shantigram, managing director (corporate fi-nance and advisory) of Standard Chartered Bank, “Markets go

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L EVERAGED buy-out is a term used to describean acquisition (of a large company by a smallercompany) by leveraging the assets and cash

flows of the target. Nobody knows when the world’sfirst LBO was financed but it is believed that “bootstrapacquisitions”— the precursors of present day LBOs —came into being nearly three decades after World WarII (1937-45). The Great Depression that followed theWar forced companies to keep debt low. As a result,for nearly three decades, very few companies useddebt as a major source of funding growth.

But the race in early 1960s to build conglomeratesrequired raising resources far greater than what com-panies were generating. LBOs are believed to havebeen born in this era. What was a trickle till the 1980sbecame a torrent in the following decades with a fairshare of spectacular failures. Jerome Kohlberg andcousins Henry Kravis and George Roberts, founders of

PE firm Kohlberg Kravis Roberts & Co were at the heartof that LBO boom, and bust. They paid $31.4 billion forRJR Nabisco via an LBO in 1998. The most famousfailure was also the collapse of RJR Nabisco in 1990after the company gave its pre-buyout shareholders acapital gain of over $13 billion.

The deal, immortalised by the book Barbarians AtThe Gate and in a film by the same name, led to a se-nior bank debt of $15 billion and a subordinate debt of$5 billion (including the largest offering of junk bondsin history). It collapsed because its cash flows were in-sufficient to pay off the huge debt. That busted a lot ofother major LBOs of the era, including Robert Campe-au’s retail business comprising Allied and Federatedstores that fell in 1989 with $10 billion of debt. Othersthat went into bankruptcy proceedings included Seven-Eleven Stores, Resorts International and Revco. �

When Things Go Wrong...

BURNT OUT: LBOs can singe, as RJR Nabisco found out

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through excesses. There will be periods when there will be ex-cesses. Downturn in business, rising interest rates and lack ofliquidity end up collapsing LBOs.” Not accounting for down-turns is a certain recipe for disaster.

Clearly, a lot of the acquirers are banking on a substantialuptick in the performance of the acquired company to pay offthe unprecedented debt raised by the parent company andthe special purpose vehicles. But, in almost all cases, the cur-rent financial state of the parent and the acquiree is notenough to take them through. Tata Steel, for instance, mustpay back nearly $800 million (Rs 3,280 crore) every year if it in-tends to pay off its debt within the nine-year period. That’s notcounting the $1-billion debt that Corus has on its balancesheet. And Tata Steel must also spend $700 million-800 mil-lion every year on its own capex requirements. In 2006, Corusmade a net profit of just £229 million.

Even Novelis must fire on all cylinders if the Aditya Birlagroup has to pay back the $2.5-billion debt on Novelis balancesheet and another $3.5 billion (Rs 14,350 crore) on Hindalco’s.Novelis, which incurred a net loss of $275 million in 2006, notonly needs a turnaround but also must make a net profit of atleast $1 billion every year to be able to pay off the debt in a rea-sonable period of 7-9 years. Similarly, Aban Offshore, with adebt of $2.1 billion will have to substantially improve on its2006-07 net profit of around Rs 60 crore to be able to pay offthe debt raised on its Singapore subsidiary.


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T HERE is an increasing trend to use LBOs to fund large acquisitions and infra-structure investments by Indian companies. LBOs are structured transactionswhere a company (sponsor) that is proposing the investment creates or uses

another company or vehicle to borrow to substantially fund the project. In acquisi-tions, usually, the company that is being acquired is used to raise the funds, to en-sure no financial liability flows back to the sponsor. In other words, the sponsor givesmanagerial and operational support to the project, but shuns financial responsibilityfor it. Most Indian managements believe they can manage businesses better, espe-cially operations. In principle, this is a way to contemplate large projects as it keepsthe existing cash flows and debt protection measures on the sponsor unaffected —should the venture run into difficulties, while entitling them to decent returns if theventure succeeds. It allows managements to grow faster than pure organic growth.

However, there are issues with using LBO structures. Even LBO transactions re-quire minimum sponsor participation, which by itself, could be a stretch for thesponsor. These acquisitions are also competitive, demanding a higher price, whichcan make a difference to the viability of the investments. So, there’ll be a significanteconomic incentive for the parent to play an intense role in securing its investments

Thus, sponsors need to prudentially pare risk in keeping with returns and also ob-jectively evaluate the feasibility of the business and its ability to manage the newproject. Those that will finance the new venture need to examine the sponsor’s in-tentions behind not making its cash flows available for debt payment of the new in-vestment. Those who are already financiers of the sponsor also need to evaluate therisk of the over-extension of sponsor’s financial support beyond stated limits.

That’s bittersweet. While we can be proud of our world-beating entrepreneurs, itis also a serious wake-up call that none of these big deals have accessed the Indianfinancial system (banks, capital markets, etc.) for any financing at all. �

R. Ravimohan, managing director & CEO, CrisilBLO

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Making A Virtue Of NecessityAcquiring companies have tried to soothe the nerves of do-mestic shareholders by promising to ring-fence them fromthe dangers of these huge acquisitions. The most commonmethod they are using to accomplish this is to conduct theirpurchases through a special purpose vehicle. Ostensibly,these have no recourse to the parent companies, whose risksare limited to the equity contribution in the SPV. But, there is acatch there. First, the interest rates of non-recourse funding ishigher than that of recourse funding. Two, very often, the SPVtakes a bridge loan that is guaranteed by the parent. There arealso upstream guarantees by the acquiree and downstreamguarantees by the parent. Besides, there are cross-guarantees.Simply put, ring-fenced acquisitions are a mirage.

As a result, rating agencies, for instance, do not recognisenon-recourse funding independent of the parent company.They rate companies on the basis of their consolidated debt.Says Roopa Kudva, executive director and head of ratings,Crisil, “We look at it on a consolidated basis, as the moralobligation of the parent to service the debt.”

“To say that there is non-recourse funding is a façade. Noamount of financial engineering and restructuring can ab-solve you of the financial and moral responsibility,” says AnilSinghvi. More importantly, projecting non-recourse fundingas a virtue of the funding structure may be misplaced wheremoney required is more than three times the domestic com-

LBOs have skirted the Indian financial system


THE ONES THAT PLAYED SAFE: Suzlon Energy’s M&As involve a large debt component, it has avoided the LBO snare

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pany net worth. Since RBI does not allow a leverage higherthan three times the net worth for foreign acquisitions, non-recourse is a necessity, not a choice. So, companies have hadto take debt on their own balance sheet. Hindalco’s entire$3.1-billion (Rs 12,710 crore) Novelis debt has recourse to Hin-dalco. Suzlon’s entire $1.1-billion debt has recourse to Suzlon.Aban Singapore’s leveraged deal of Sinvest has a $200-millionone-year loan with recourse to Indian parent’s balance sheet.

Then, And NowGlobally, it’s the private equity boom that is leading the globalfinancial liquidity. But most Indian LBOs have been funded bybanks, rather than PE firms, barring Aban’s acquisition of Sin-vest. That, however, is no reassurance against failures. After all,the world’s largest banks are now beginning to participate inLBO funding.

Yet, an argument against raising the red flag for Indiancompanies right away has its roots in the way most LBOs inthe 1980s and 1990s were funded. A wave of non-investmentgrade high-yield bonds, better known as junk bonds, helpedraise billions of dollars of easy money that got redirected to-wards the largest acquisitions of that era. Investment gradebonds are those that are rated BBB- or above. Those rated be-low investment grade on date of issue were called junk bonds.In an LBO, the buyer issued junk bonds to pay for the acquisi-tion. They lured in money by promising yields far higher thanthose of quality bonds. But they also came with a substantiallyhigher risk of default.

Hence, people argue that the LBO wave of the junk bondera can’t be compared with today’s LBO financing that is beingled by private equity. While that is true, there is still an incredi-ble similarity between the two: there was easy money in junkbonds, there is easy money in private equity (see ‘LBO-Ac-quired Firms May Be More Fragile’ on page 36). With moneygravitating towards riskier assets, junk bonds attracted moneyfor high yields. In 1998, for instance, a massive $150 billion

were raised in junk bonds — a record that is yet to be upstaged.Private equity too is attracting money for high returns. In theUS — the world’s biggest private equity market — the US trea-sury is delivering 4-5 per cent, while private equity is expectedto bring in 20 per cent year-on-year.

Worse still, two of the world’s largest PE firms are engagedin an ego clash over the largest buy-out fund. While Black-stone raised $15.6 billion (Rs 63,960 crore) towards the end ofthe year, KKR raised $16.5 billion (Rs 67,650 crore) in its ownfund -the largest buy-out fund in the world today.

Now, Blackstone plans to raise the corpus in its fund to $20billion (Rs 82,000 crore). While raising such colossal money,private equity firms are banking on payouts through the un-precedented sweep of corporate profitability. In 2005 and2006, corporate profits as a percentage of GDP in Europe,Japan and the US were at 12 per cent, the highest ever, and wayabove a two-decade average of 8.5-9 per cent.

Loaded with cash, Blackstone and KKR, regularly slug itout over nearly all corporate assets up for grabs. They are notonly raising the cost of acquisitions for each other, but alsohurtling towards a self-destructive mode where delivering re-turns to investors’ expectations could become increasinglydifficult. In September, 2006, Blackstone beat KKR to winFreescale Semiconductor, a former unit of Motorola, for $17.6billion (Rs 71,750 crore), a premium of nearly 36 per cent overthe going share price. Then, a consortium led by KKR acquiredthe US hospital group HCA for $33 billion (Rs 135,300 crore).

More importantly, the world’s banking system is increas-ingly getting sucked into the private equity frenzy. When KKRbought First Data for $29 billion, it got support from eight ofthe world’s largest banks-Citigroup, HSBC, Credit Suisse,Lehman Bros, Merrill Lynch, Goldman Sachs and DeutscheBank. Morgan Stanley is advising First Data. And that tightensthe LBO noose around global corporate financing. �

With reports from Abhishek Chowdhury


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Why Leveraged Buy-outs (LBOs) fail

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