How Indian firms finance their overseas M&As

Most people would not think of United Phosphorus when discussing mergers and acquisitions.

Yet, this Punjab-based exporter of agrochemicals has emerged as a star player, buying up no fewer than six companies overseas in 2006, and spending Rs 1,100 crore (Rs 11 billion) in the process - about 10 times its post-tax profit.

Among the companies United Phosphorus bought during the year was the Dutch seeds firm Advanta Netherlands - and the case is typical of how relatively small Indian companies are buying up much bigger overseas businesses.

Having acquired Advanta in February for ¤100 million, United Phosphorus has gone on to float a public offer of Advanta shares; the money raised will be used to clear the debt taken for the acquisition.

The United Phosphorus case is not unique. For India Inc went on an unprecedented shopping spree this year, sealing 145 mergers and acquisitions worth $7.8 billion till October, compared with 136 deals amounting to $4.3 billion in all of 2005, according to Grant Thornton.

The takeover deals point to the soaring ambition of Indian companies as they covet entities bigger than themselves and pay amounts that dwarf their annual turnover numbers. Consider the following:

The Hyderabad-based pharma company, Dr Reddy's Laboratories (2005-06 turnover: Rs 2,100 crore (RS 21 billion), paid Rs 2,600 crore (Rs 26 billion) for the German generics company Betapharm.

Subex Systems (2005-06 turnover: Rs 184 crore (Rs 1.84 billion) bought Azure Solutions of the UK for Rs 630 crore (Rs 6.30 billion).

Aban Offshore (2005-06 turnover: Rs 500 crore (Rs 5 billion) bought 34 per cent in Norwegian drilling company Sinvest ASA for over Rs 2,000 crore (Rs 20 billion).

Tata Steel is locked in a battle to acquire Anglo-Dutch steelmaker Corus, four times its size, and Reliance Communications is ready to shell out $15 billion for Hutchison Essar.

If those last two deals materialise in January, overseas acquisitions in a little over 12 months will have equalled the combined net profits of the 1,000 largest companies in the country last year.

Says Neeraj Swaroop, CEO in India for Standard Chartered Bank, which was involved in over $3 billion of acquisition financing for Indian companies during the year: "With financing options getting more innovative, we expect the number of cross-border deals and their average deal size to increase significantly in 2007. Bids like the Tatas' for Corus will only fuel the ambitions of Indian promoters."

It has helped that most of the target companies have been closely held, and that most of the sellers have been private equity players. Says Jai R Shroff, executive director of United Phosphorus: "Privately-held companies are easier to take over. There are fewer formalities and this saves time."

The secret to how minnows can swallow whales is of course the leveraged buyout method of financing, which leverages the target company's balance sheet to fund the acquisition.

"The acquirer's equity dilution is often a very small component of the deal size," said Ganeshan Murugaiyan, executive director, investment banking, UBS Securities India. The trend will last as long as the benign interest rate regime does, he added.

Two other elements address the risks inherent in such financing: One is the confidence of Indian companies that they can improve the performance of the acquired company - thus delivering the cash flow required to service the debt. The other is risk-mitigation through financing structures that cap the danger from interest rates climbing.

Facilitating the trend has been the progressive easing of foreign exchange restrictions by the Reserve Bank of India, which has made it possible for companies to take out the equity portion of deal finance, up to a specified proportion of their net worth.

The acquisition spree would gather momentum if Indian companies could trade their stocks while buying abroad. Till now, most acquisitions have been cash-based.

An important component has also been the growing confidence of global financiers in Indian companies, thanks to their sustained growth - 20-25 per cent annually - over the last four years. With rising profitability, the Indian corporate sector had cash flows of Rs 200,000 crore (Rs 2,000 billion) to show in 2005-06.

An emerging trend when it comes to financing is earn-out deals, where shareholders of the target company earn their payments as their company meets a fixed target in a stipulated time. The payment is made in tranches.

This financing method is getting popular with mid-sized software companies, and is usually adopted if the management team owns the company and continues to hold a stake after the change in majority shareholding.

Hexaware, KPTI Cummins and Geometric Software are some examples of this kind of financing.

But the scale of ambitions has been growing too. The average deal size for Indian M&A aspirants in 2005 was $32 million. By the first half of 2006, it was $47 million (Rs 210 crore (Rs 2.1 billion), according to Grant Thorton.

"The appetite of corporate India is increasing, and so is its risk taking ability. Indian companies now are not just looking for assets overseas but also for brands," said Swaroop.

Meanwhile, the refrain among deal-makers is: "A company needs to have a strong balance sheet and aspirations. To strike a deal is the banker's responsibility."