Earlier this week, The Hindu Business Line carried a detailed column on various business and financial aspects of management buyouts (MBOs), particularly as such deals are being witnessed (albeit infrequently) in India. Simply stated, management buyouts involve the acquisition of a division of a company or the shares in a company, in each case by the managers who have been handling the affairs of such division or company. Such acquisitions take place when owners desire to sell off a division or a company or even close or liquidate it, while the managers on the hand envision future growth potential and are willing to place their bets on improving the performance of the division or company by acquiring it. Since managers may not possess adequate resources to effect such an acquisition, they are often compelled to seek financing or even a strategic partnership for this purpose.Structuring the Deal
At a general level, there are two broad structures that are followed in giving effect to an MBO transaction:
1. Partnership with Private Equity (PE) Players
In this structure, since managers are not able to self-fund an MBO transaction, they only acquire a small stake in the target, with the remaining major stake being taken up by private equity players who may partner with the managers. Managers are usually required to take as much stake in the business as they can afford to, so that their future is tied into that of the business as a method of properly incentivising these managers who are responsible for running the business. Providing additional stake in the form of ‘earn-outs’ may be another method of incentivising the managers.
So far, such types of MBO transactions have been more popular in the Indian context, at least where acquisitions of shares are involved (for reasons we shall see later). The Hindu Business Line column observes:
“Traditionally, Management Buy Outs (MBOs) involved the management wanting to purchase a controlling interest in the company and working along with financial advisors to fund the change of control.This type of MBO transaction is akin to a standard private equity deal involving execution of appropriate investment or shareholders’ agreements between the promoters (here the erstwhile managers) and the private equity investors. These agreements define the rights and obligations of the parties going forward in relation to the target, including in relation to transfer of shares (and restrictions on those) as well as to management and governance of the target (such as board composition, affirmative voting rights and the like).
Today, MBO activities involve promoters divesting their stake in a firm by selling out to PE players willing to finance the asking price. The PE players are flexible enough to enter into a partnering relationship with the existing management. This sort of arrangement is basically just a stake buyout and not a classical MBO.
It is common in scenarios where owners want to hive off entities with poor results and the management lacks funds to hold on to the entity (and their jobs) and are, in turn, bailed out by the PE firm.”
2. Classic Leveraged Structure
In the international context, the MBO structure followed more commonly is the classic leverage structure that is also popular in the case of leveraged buyouts (LBOs) (where the acquirer may not necessarily belong to the existing management, but could be a third party acquirer of the target company or business).
(a) Share acquisitions
Investopedia defines an LBO as follows:
“The acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. Often, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company. The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital.”In this structure, the acquirers (being the managers) will acquire the entire stake of the target (or at least a large portion of it), for which they will obtain debt financing from lenders or financiers. Managers may also have to commit some capital, but that is relatively minor compared to the large finance obtained through leverage. Here, unlike in the case of private equity type transactions, the managers do not have to cede shareholding to an outside entity such as the private equity players. However, as security for the repayment of the financing obtained by the managers, they would offer as security the assets of the target company.
To illustrate this transaction, manager M may acquire the entire shares of target company T. To finance this, M obtains a loan from bank B. As security for repayment of the loan borrowed by M, company T will create a security over all its assets in favour of bank B.
This classic leveraged structure for MBOs for acquisition of shares in a target company faces almost insurmountable challenges in India. Section 77(2) of the Companies Act, 1956 provides:
“No public company, and no private company which is a subsidiary of a public company, shall give, whether directly or indirectly, and whether by means of a loan, guarantee, the provision of security or otherwise, any financial assistance for the purpose of or in connection with a purchase or subscription made or to be made by any person of or for any shares in the company or its holding company …”By virtue of this provision, the target company cannot provide security (which is construed to be ‘financial assistance’) to the lenders so as to provide finance to the managers to acquire shares in the target company. Any contravention of this provision could not only lead to the security being considered void, but would also expose the target company to punishment in the form of fine. Although the amount of the fine is only a minimal amount of Rs. 10,000, any violation could expose companies to reputation risk.
Section 77(2) is a strict provision with no exceptions (in the context of MBOs and LBOs). The only possible exception that may facilitate such leveraged transactions relates to those involving private limited companies (that are not subsidiaries of public limited companies) as such companies are not within the purview of the prohibition on financial assistance.
In this context, it is relevant to note that the Indian position on ‘financial assistance’ is fairly stringent compared to that in other common law countries. In other common law jurisdictions, there is either no prohibition on ‘financial assistance’ (e.g. most U.S. states, including Delaware) or there are processes to overcome the prohibition through what is referred to as the ‘whitewash procedure’ that is practiced, for instance, in the U.K. and Australia.
The stringency of the ‘financial assistance’ law is the principal reason why leveraged buyouts (whether by management or otherwise) have not acquired popularity in the Indian markets. On the other hand, Indian acquirers have utilised leverage while acquiring companies overseas, especially in the U.K., with prominent examples of such acquisitions being those undertaken by the Tata Group in Tetley, Corus and JLR.
If leveraged transactions are to pick up steam in India, there is a dire need to amend the laws relating to ‘financial assistance’ under the Indian Companies Act. While most other jurisdictions have been progressively liberalising their laws to permit leveraged transactions (with checks and balances being imposed in parallel), the Indian law has remained constant over the years without any indication of change in the near future. It is an appropriate time now to revisit this position.
(b) Business Acquisitions
Although share acquisitions would fall within the purview of the prohibition on ‘financial assistance’, leveraged structures can be utilised for purpose of business acquisitions. This would involve an acquisition by a manager, not of shares in a company, but of the business of the company.
In this structure, manager M will set up a special purpose company M Co. This new company M Co will acquire the business undertaking of company T, for which purpose M Co. will obtain financing from bank B. As security for repayment of the loan, M Co. will secure the assets of the business it acquired from T, which after the acquisition now belongs to M Co. itself. There is no prohibition in respect of such transactions as there is no ‘financial assistance’ for the purpose of acquisition of ‘shares’. What is involved is transfer of a business undertaking and not a transfer of shares.
Leveraging in such business transfers are permissible in the Indian context, but transfers of businesses may not provide as much flexibility as share transfers do, and further may be fraught with several risks and additional costs such as stamp duties, taxes, etc.
Other Issues
Apart from certain fundamental structuring issues discussed above, MBOs give rise to two complexities, viz. (i) information asymmetry, and (ii) conflict of interest. These issues are often required to be handled very carefully in MBO transactions.
As regards information asymmetry, it is clear that managers who are running businesses or companies (they propose to acquire) have greater information about the affairs of the businesses or companies than possibly the owners who may be selling them. Hence, it is necessary to ensure that the acquirers do not have any informational advantage while effecting such transactions, and that all relevant information has been disclosed to the sellers.
These transactions also give rise to a conflict of interest, as managers are on the acquiring side as well as the selling side. Care must be taken to ensure that the interests of the minority shareholders or owners in the selling company are protected and that the sale transaction itself is carried out on arm’s length basis.
Overall, MBO transactions do provide interesting possibilities for buyouts, but there are existing challenges under Indian law which need to be overcome before leveraged structures can be used to give effect to these transactions.