Contributed by Siddharth Sengupta

Introduction

A year ago, the world witnessed the hostile takeover of social media giant Twitter by Elon Musk. The headlines covering the transaction focused on primarily two aspects: the mechanics of the hostile takeover itself and the labour law implications of the mass layoff that followed. However, what was very interesting was the way the acquisition was financed– through a leveraged buyout (“LBO”). The concept of an LBO is particularly important in India due to its immense scope as a tool for corporate restructurings in the growing economy, and due to the plethora of regulations that make its legality unclear at best.

An LBO is a transaction in which one company acquires another where a significant portion of the acquisition cost is raised through debt. LBOs first became famous in the U.S. in the 1980s, which saw a growing trend of small/mid-sized corporations having inadequate capital acquiring conglomerates through hostile takeovers via LBOs. Today, it is widely used by PE and VC firms globally for their investment activities.

What makes LBOs particularly attractive today, even for investors having more than enough capital, are the tax considerations. Debt has a reduced cost since interest payments often reduce corporate income tax liabilities, whereas dividend payments do not. This lower cost of financing enables for higher gains to accrue to the equity. In fact, the increased use of LBOs in the U.S. and then the U.K. during the ‘80s, for massive restructurings, infused capital into their economies the likes of which had never been seen before.

Unfortunately, in India, LBOs are not permitted in most scenarios, domestic or foreign, due to restrictions under the Companies Act, and two aged RBI Master Circulars, preventing a similar breakthrough in its economy. This article delves into these regulatory restrictions that negatively impact private equity in India, before suggesting reforms that can encourage foreign investment and tap into India’s commercial potential.

Understanding Leveraged Buyouts (LBOs)

In an LBO, one entity acquires another by predominantly using debt to finance the acquisition. The acquiring entity first borrows a large portion of, or even the entirety of, the funds required for the acquisition of the target company, from one or multiple lenders. The acquirer here can be a company, partnership firm (through its partners), trust, AIF, etc. A lender can be any legal person with enough capital to finance the transaction. However, commercial banks generally try to avoid lending for LBOs due to a very high associated risk of default.

These risks arise since the sum borrowed is usually enormous and there is a substantial risk of the buyout ultimately failing to materialise. Thus, the loans also carry a sizeable rate of interest.

Despite the risk, what makes LBOs very attractive for the acquirer/borrower is that usually, the assets of the target company are utilised as security for the borrowing instead of those of the acquirer. However, in rare occurrences, the latter is used as additional security when the target company’s assets are insufficient.

After the acquisition is complete, the loan is repaid with the earnings received from the business or assets of the acquired company.

An LBO can be utilised to serve a plethora of business goals. For example, it can be used to finance a hostile takeover, as was the case with Twitter. Leverage can also be used to defend against a potential hostile takeover, by a leveraged buyback or to finance a white knight defence. The wide range of purposes an LBO can serve emanate from the convenience of financing it. Even small companies can raise billions of dollars to fund their M&A activities. The LBO of RJR Nabisco in the 1980s was a perfect example of this.

Laws Regulating LBOs in India

It is not the case that India has never witnessed an LBO involving domestic entities. However, the target company in each such instance has been a foreign entity. The main reason for this trend is the strict restriction imposed by multiple regulations on Indian banks, companies, and overseas lenders from lending to any corporation, domestic or foreign, for acquiring shares of an Indian company.

First, an RBI Master Circular from July 1, 2015, under para 2.3.1.9, restricts lending by an Indian bank to any entity, domestic or foreign, for the purpose of acquisition of shares of an Indian company. It also explicitly prohibits the potential borrower/acquirer from utilizing the target company’s assets as security for the loan. The investor is expected to pay for the investments out of their own pocket rather than relying on domestic banks to offer loans based on shares of the target entity. RBI’s cautious approach to ensuring the safety of domestic banks serves as the foundation for this provision.

Second, RBI’s Master Circular on External Commercial Borrowings and Trade Credits under the Foreign Exchange Management Act, 1999 (“FEMA”), under para I (A)(vii) which deals with end uses not permitted under the automatic route, does not permit Indian corporations from borrowing from oversees lenders if the ‘end use’ is “investment in capital market or acquiring a company in India.” External Commercial Borrowings comprise of “commercial loans in the form of bank loans, securitized instruments like floating rate notes and fixed rate bonds, non-convertible, preference shares (convertible or non-convertible), buyers’ credit, suppliers’ credit, etc. availed of from non-resident lenders, having a minimum average maturity of 3 years.” Hence, borrowings in all these forms, from overseas lenders, are prohibited.

Third, Section 67(2) of the Companies Act, 2013 further deters an LBO. The clause prohibits public companies or private companies that are subsidiaries of public companies from offering financial assistance to any other corporation for the purpose of buying or subscribing to a target company’s shares. This further makes it difficult for the acquirer to obtain loans for an acquisition. Like the RBI Master Circular, this clause also prohibits the acquirer from buying shares of the target company by using the latter’s assets as security as that would be a form of “financial assistance.”

Acting together, these regulations make it impossible for an Indian company to be acquired using an LBO using the usual methods prevalent in foreign jurisdictions. India, in this regulatory regime, can only witness LBOs where an Indian company acquires a foreign company by borrowing from an overseas lender. In fact, this has been the case with all Indian LBOs to date.

Unlike the position in India, the regulatory framework in the U.S. has for a long time been very conducive for LBOs. In fact, the U.S. has been witnessing various forms of LBOs right from the 1950s. Banks have always been permitted to lend for corporate restructuring purposes, leading to the PE boom, and nothing short of an “M&A revolution” in corporate America.

Alternative Approaches under the Framework and The Way Forward

Although the RBI Master Circular of 2015 restricts lending by banks, there are no such restrictions on Non-banking Financial Companies (“NBFCs”) in India to lend to a company for the purpose of acquiring shares. In fact, non-banking institutions play a major role in financing LBOs in developed countries. However, the natural problem faced by developing countries like India is that their NBFCs have not matured enough. They do not have the cash or the risk-taking ability to finance an LBO.

Further, Section 67 of the Companies Act restricts lending by only public companies or their subsidiaries for the purpose of acquisition of shares. It does not restrict private companies to do so. Large private companies could be approached by the acquirers in order to obtain the required funding. There have been several such cases in the U.S. However, a similar problem to that of NBFCs arises in India. Even if private companies are capable enough in terms of cash holdings, due to the high risk involved in financing an LBO, and because such a type of lending has never been done in India, they would ultimately be very reluctant to lend.

Considering the problems faced by not only financing an LBO through conventional methods but also by these alternative approaches, it is necessary for the government or the regulators to do away with some of these restrictions.

First, the restriction under the RBI Master Circular of 2015 on lending by domestic banks, must be removed entirely in order to facilitate lending which is safer and more practicable in the present than lending by corporations. Second, the restriction under the Companies Act on public companies should be diluted. Instead of a blanket ban under the Act, a more compliance-oriented regime could be adopted which ensures that the lending is relatively safe for the company, after carefully considering its, and the borrower’s, financials and the amount being borrowed.

Abolishing these two restrictions would go a long way in making the funding required for acquisitions much more readily available, and would massively encourage corporate restructurings through LBOs, and attract more foreign investment consequently.

However, the restriction imposed by the RBI Master Circular under FEMA should be retained, at least for the near future. This is predominantly because of the difficulty that the oversees lenders would face in case of a default by the borrower, considering that cross-border debt recovery and insolvency mechanisms are still in their nascent stages in India, particularly at the stage of execution, which would be relevant even in case of an arbitration award in favour of the overseas lender.

Conclusion

The untapped potential of LBOs stands as a beacon of opportunity for corporate restructuring in India. The restrictive legal framework, deeply embedded in the two RBI Master Circulars and the Companies Act, has restrained the growing economy from embracing the transformative power of LBOs.

While the world has witnessed the success stories of LBOs propelling economies forward, India finds itself ensnared in regulatory complexities. The stringent restrictions on lending for acquisitions and the prohibitive clauses in the Companies Act have stifled innovation and investment. The possible alternative approaches, like reliance on NBFCs and large private corporations, remain underutilized due to inherent risks and the lack of a mature lending ecosystem.

To unshackle growth, India must embark on a path of regulatory reform. Removing the barriers set by the RBI Master Circular of 2015 regulating lending by domestic banks, and adopting a more nuanced, compliance-oriented approach under the Companies Act can pave the way for LBOs to flourish responsibly. While caution is warranted in the realm of external commercial borrowings, a careful, step-by-step evaluation is essential before relaxing these restrictions. It is through these reforms that India can truly unlock the door to a private equity boom.