Professional Documents
Culture Documents
RECONSTRUCTURING
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A series of reforms, such as the formulation of takeover code,
simplification of the laws on mergers and amalgamation, diluting of
MRTP Act and introduction of AS-14 etc. are the efforts that are
taken in this direction. The liberalization of foreign investment
norms, the entry of foreign players through Joint Ventures and direct
investment has added the heat of corporate restructuring.
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penalize the monopolistic powers and can also reject the acquisition
of corporations involved, if not in the interest of nation and public.
3
It is difficult to define these terms with reference to restructuring of
one type with the other. Generally, it refers to a situation when two or
more existing entities combine together and form terms used for the
said purpose that are explained as under:
The merger of first Tata Oil Mills Ltd. (TOMCO) and Brook Bond
Lipton (India) Ltd. into Hindustan Lever Ltd (HLL) were cases of
Absorption
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company, and
b. but the other company whose control is so acquired, remains a
separate company and is not liquidated, but there is a change in
control
5
AS-14 deals with the accounting procedure to be followed for
amalgamation, merger and acquisition. The term amalgamation
is classified as:
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DIFFERENCE BETWEEN AMALGAMATION IN THE
NATURE OF PURCHASE AND MERGER
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Reimbursement of Liquidation Reimbursement of Liquidation
Exp. of Vendor company by the Exp. of Vendor company by the
6 Purchasing Company are purchasing company are debited
adjusted/written off from to Goodwill a/c.
General Reserve or P/L a/c.
Equity share holders of Vendor Equity share holders of Vendor
Company are paid in shares only company can be paid either in
7 (except fractional shares) in Equity shares, Preference shares,
purchasing company Debentures, Cash or any
combination of the above
8
companies are dissolved and only the new company continues to
operate.
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bid target firm has no prior knowledge of offer. Usually, acquisition
refers to purchase of a smaller firm by a larger one. Though,
sometimes a smaller firm may buy a larger one (e.g. takeover of Patni
Computers by I Gate). But in this case it will be called ‘Reverse
Merger’.
10
Some of the benefits available under the I.T. Act, are
summarized as under:
1. Depreciation – The amalgamated company continues to claim
depreciation on the basis of W.D.V. of assets transferred to it by
the amalgamating company. However, unabsorbed depreciation, if
any, cannot be assigned to the amalgamated company and hence
no tax benefit is available for such depreciation
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ii. The amalgamation paves the way for revival of the business of
amalgamating company
iii. The scheme of amalgamation is approved by the prescribe
authorities
iv. The amalgamating company is not financially viable
v. The amalgamation is in public interest, and
vi. The amalgamated company continues to carry on the business of
the amalgamating company even after merger without any
modification, except bringing uniformity in accounting policies
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ACCOUNTING TREATMENT IN THE BOOKS OF
TRANSFEROR (VENDOR) COMPANY
Step 2. Transfer all Assets (except fictitious assets) to the Debit side of
Realisation A/c., given as under:
Realisation a/c. Dr.
To Individual Assets a/c.
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amalgamation in the nature of merger, these two accounts must be
transferred in Realisation a/c.
d. Goodwill and other intangible assets like trademarks, patent rights,
copyrights etc. are also transferred to Realisation a/c.
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Pref. Shares in Transferee Co. a/c. Dr.
Debt Securities a/c. Dr.
To Equity Share Holder’s a/c.
Step 6.: When expenses are paid and borne by the transferee
company:
Realisation a/c. Dr.
To Bank a/c.
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Step 9. Payment to Preference Shareholders:
When payable at Par:
Preference Share Capital a/c. Dr.
To Preference Share holders a/c.
Step 10. Transfer Equity Share Capital a/c., accumulated profits and
reserves in to Equiy Share Holder’s a/c., given as under:
Equity Share Capital a/c. Dr.
Reserves & Surplus a/c Dr.
Security Premium a/c Dr.
Revaluation Reserve a/c Dr.
Capital Redemption Reserve a/c. Dr.
Sinking Fund a/c. Dr.
Workmen’s Compensation Fund a/c. Dr.
To Equity Share Holder’s a/c.
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To Exp. on Issue of Shares/Deb. a/c.
To Discount on Issue of Shares/Deb. a/c.
To Profit & Loss a/c. (if loss)
With the result of all the above steps taken all the accounts
of vendor (seller) company will be closed
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ACCOUNTING TREATMENT IN THE BOOKS OF
TRANSFEREE (PURCHASING) COMPANY
While the accounting procedure is same for all types of amalgamation in the
books of transferor (vendor) company, but the accounting treatment in the
books of Transferee Company depends on the nature of amalgamation. As
per AS-14, amalgamation may be either in the nature of purchase or merger.
a. Book Value of Assets & Liabilities – All the assets (including fictitious
assets, such as Preliminary exp., Discount on issue of Shares/Debentures,
Advertising, Suspense a/c., Underwriting Commission etc.), liabilities and
all types of Reserves (capital, revenue or revaluation reserve) of the
Vendor Company are recorded by the Purchasing Company at their book
values in the same form as shown in the books of Vendor Company as on
the date of amalgamation.
However there is an exception to this rule, that the book value of an item
of an asset or liability may be adjusted or changed to conform the
accounting policy
b. Profit & Loss, Reserves and Surplus of the Transferor Company should
be aggregated with the corresponding balance of the Transferee Company,
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because, in an amalgamation in the nature of merger, the identity of P/L
and Reserve & Surplus is maintained and are shown in the B/S. of the
transferee Company. As a result, the P/L a/c. and Reserves & Surplus
which were available for distribution as dividend before amalgamation
would also be available for distribution as dividend even after
amalgamation
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charged to P/L Adjustment a/c. in the books of the
purchasing company]
20
Step 5. For recording Liquidation Expenses – When the liquidation
exp. are paid and born by the transferee company, cost of the
business taken over increases by the amount of such expenses
is adjusted in Profit & Loss a/c., stated as under:
1. Assets and liabilities that are taken over from the transferor
company are shown in the following manner:
21
Hence, it is necessary to carry forward such reserves in the
books of the transferee company for legal compliance for a
specified period, which is achieved with the following entry:
22
Step 1. Recording the Purchase of Business
Business Purchase a/c. Dr.
To Liquidator/s of Transferor Company
[with the amount of purchase consideration]
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To Equity Share Capital a/c.
To Preference Share Capital a/c.
To Debentures a/c.
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Capital Reserve a/c. Dr.
To Goodwill
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MOTIVES/OBJECTIVES AND BENEFITS OF MERGER- The
benefit of synergy of merger and the resultant expectation of risk
reduction may affect both the acquiring firm and the target firm. If
benefit is perceived to exist in a takeover, the value of combined firm
would be greater than the sum of the values of the target firm and the
acquiring firm, enumerated as under:
B = CV - (T+A)
Cost = MP – T
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CV = Combined Value of New Firm
A = Present value of acquiring firm
T = Present value of target firm
MP = Merger Price paid
It may be observed from the above that for the acquiring firm, merger
cost is the excess of merger price paid over the value of the target
firm. In capital budgeting, the net benefit is defined as under:
Take case, The value of firm A Ltd. and firm T Ltd. is Rs.
2,50,00,000 and Rs. 15,00,000 respectively, the merger benefits are
Rs. 10,00,000. If A Ltd. acquires T Ltd. and agrees to pay Rs.
22,00,000, then
B = CV – (T +A)
= Rs. 2,75,00,000 – (2,50,00,000 + 15,00,000)
= Rs. 10,00,000, and
Cost = MP – T
= Rs. 22,00,000 – Rs. 15,00,000
= Rs. 7,00,000
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= Rs. 3,00,000
Hence, it may be seen that the total benefits of the merger i.e. Rs.
10,00,000 are divided between A Ltd. (Rs. 3,00,000), and T Ltd. (Rs.
7,00,000). If the NPV of the net Cash Flows from the target firm is
positive, then the merger is viable proposition otherwise not. in the
above case the NPV is simply the difference between the price paid
and the present worth of the future expected Cash Flows from the
target firm.
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3. To avoid competition – Competition between the acquiring and
target firm is avoided, because after merger they become one entity
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A Ltd. is acquiring T Ltd. and evaluates three options for offer price
I. Rs. 12 per share (i.e. MP of T Ltd.)
ii. Rs. 30 per share of T Ltd. (i.e. EPS * existing PE Ratio of
A ltd.),
iii. Rs. 35 per share of T Ltd. (i.e. a price higher than i &ii)
See, the affect of all the above three options given as under:
See, when the price offered is Rs. 12 (less than the PE of firm A
Ltd,), the EPS of the new firm A Ltd. increases. When, the price
offered is Rs. 30 (based on EPS of T Ltd. and PE of A Ltd.), the EPS
of acquiring firm A Ltd. is same as that of T Ltd., and when the price
offered is Rs. 35 (i.e. more than the PE of A Ltd. & EPS of T Ltd.),
the EPS of the acquiring firm A Ltd. decreases. Hence, the increase
in EPS might be a main motive of the merger that can easily be
achieved by merging another firm having a lower PE Ratio
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a good idea. The main concern of the financial manager should be to
maximize the market value of the share and not the EPS
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METHODS OF VALUING THE TARGET FIRM:
A. Valuation based on Book Value of the Assets – Under this
method bid value is calculated on the basis of the book value of the
assets of the target firm. This method of finding out bid price of the
target firm is not reliable and reasonably good, because the values of
its assets are based on historical values not on their realizable values
or market price. Symbolically as;
Do (1+g) D1
or, Po = -------------- = -----------
Ke – g Ke - g
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Here, Po = Current Price of Equity Share
Do = Current Dividend
D1 = Expected Dividend in year 1 and so on D2, D3....
Ke = Required Rate of Return
g = Expected Percentage growth in Dividend
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Example: Dividend paid, Rs. 10 per share
10
-------- * 100 = 2.5%
400
Note – For this kind of valuation, earning capacity (i.e. retained
earnings) of the target firm should also be considered
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E. Valuation based on Cash Flows – Value of the target firm may
also be calculated by discounting Cash Flows, as applicable in
finding out the NPV’s of future cash flows. For this, steps taken for
the purpose are as under:
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Cash flows from the point of view of total firm are Net Operating
profit after tax + depreciation + non cash expenses. Hence, the
valuation of firm is equal to the Present Value (PV) of all expected
operating cash flows in future. These cash flows may further be
adjusted for long term investments and change in working capital.
The resultant cash flows may be termed as Operating Cash Flows to
the Firm (OCFF). These flows then may be discounted at WACC, i.e.
‘Ko’
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Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5
20 10 25 20 35
Ko = Ke * Ve + Kd * Vd
= .15 (3/5) + .07 (2/5)
= .09 + .028 = .118
= 11.8%
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* This value includes Rs. 20,00,000 as value of Debt and Rs.
56,60,000 as value of Equity
This value of Equity may further be calculated by discounting future
cash flows to Equity shareholders @ ‘Ke’ 15%, calculated as under:
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on Net worth (RONW) to measure the creation of shareholders value
over a period.
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Curr. Liab. 12,00,000 - I. Tax 3,55,200
70,00,000 70,00,000 PAT 8,28,800
Solution:
Total Funds Employed (Cap + Res. + Debt) = Rs. 58,00,000
Cost of Funds ( 58,00,000 * 15% ) = Rs 8,70,000
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It may be noted from the above that EVA gives an idea of
incremental wealth created by the firm during the period. However,
as pointed out earlier, EVA is not the same thing as accounting profit
After finding out the value of the target firm with the help of
methods, stated as above, the acquiring firm will then have to decide
the technique of merger, i.e. whether the payment to the shareholders
of the target firm is to be made in cash or discharged by the issue of
shares of acquiring firm, elaborated as under:
A. Payment in Cash – In this case, the value per share of the target
firm is paid in cash to the shareholders of the target firm that does not
affect the ownership pattern of the acquiring firm, but needs
availability of sufficient funds to make payment. However, the
payment in cash is subject to the agreement and consent of the
shareholders of the target firm. If both the acquiring and the target
firm agree to merge and the purchase price is payable in cash, then
the valuation of the firm based upon assets, cash flows and earnings,
etc. will be the price consideration for the merger.
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The future earnings of the acquiring firm will now be shared by both
these groups of shareholders. This type of merger is only acceptable
and beneficial, provided long term return per share of the acquiring
firm is improved. Similarly, the shareholders of the target firm are
better off, if the cash or securities received in the merger deal are
worth more than the pre-merger situation
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A common method of analysis examines present as well as
anticipated future earnings per share with and without merger.
Earnings, like cash flows, can be viewed as a measure of the firm’s
capacity to pay dividends and therefore, represent a basis for
determining the value of the firm. Generally, the shareholders want
an increase in the level of long term earnings as a result of merger.
The firms will therefore, try to negotiate merger terms which increase
their earnings per share after merger. So, in order to arrive at the
number of shares that acquiring firm ‘A’ will issue to the target firm
‘T’ following considerations are to be made:
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exchange of shares after merger.
Solution:
A. SHARE EXCHANGE RATIO on the basis of EPS
S.E.R = EPS of Target Firm / EPS of Acquiring Firm
= 1.5 / 4
= .375
Hence, acquiring firm A Ltd. will offer .375 of its share for every one
share of target firm T Ltd. hence, A Ltd. will issue 22,500 shares (i.e.
60,000 * .375) to T Ltd. Therefore, after merger;
Total shares of A Ltd. would be = 5,22,500 (5,00,000 + 22,500), and
Total Earnings of A Ltd. = Rs, 20,90,000 (i.e. 20,00,000 + 90,000)
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See, in the above example shareholders of T Ltd., holding 100 shares
will get 37.5 shares (100 * .375) in A Ltd. The earnings of the target
firm, as well as of its shareholders, even after merger remain
unchanged, given as under:
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EPS of T Ltd. is increasing @ 8% p.a. Hence,
EPS of T Ltd. after 5 yrs. will be = Rs. 1.5 (1+.08)* = 1.5 * 1.4693
= Rs. 2.21 (approx.) [2.204]
EPS of A Ltd. after 5 Yrs. will be = Rs. 4 (1+.o2)* = 4 * 1.1041
= Rs. 4.42 (approx.) [4.4164]
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Hence, SER Ratio of .5 (approx.) maintains the Market Value and
also increase in the earnings available to the shareholders of T Ltd.
after merger
Hence, it is clear that the shareholders of T Ltd. would not agree for
any shares worth less than Rs. 15,00,000 and A Ltd. would not offer
any price more than Rs. 25,00,000 (i.e. Rs. 15,00,000 + merger
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benefits of Rs. 10,00,000) Arithmetically, it can be expressed as
under:
Hence, acquiring firm will issue 30,000 shares (.5 * 60,000) to target
firm T Ltd., Then:
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In this case the merger proposal will be acceptable, because there is a
merger benefit of Rs. 28,302 (1,18,302 – 90,000) to the shareholders
of T Ltd.
Hence, the acquiring firm will issue 12,000 share (.2*60,000) to the
target firm T Ltd., then:
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As stated earlier, the Acquiring Firm can pay bid consideration to the
shareholders of Target Firm in different forms i.e., in cash, in equity
shares or even in other types of securities. The different forms of
consideration have different implications and affects that are
elaborated as under:
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has to pay more than the market value of the target firm
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acquisition is called ‘Management Buyout’. Generally, in such cases
the firm is delisted from stock exchange
Prior to such acquisition, the acquiring firm offers higher price than
the prevailing market price to the stock holders of the target firm,
thus attracting shareholders to tender their shares in favour of
acquiring firm. The acquisition price, in the context of mergers &
consolidations is the price per share paid by the acquiring firm to the
share holders of the target firm. This price is usually based on
negotiations between the acquiring firm and the management of the
target firm. In tender offer or open offer, the acquisition price is the
price at which the acquiring firm receives enough shares to gain
control of the target firm. The price may be higher than the initial
price offered, if there are other firms in bidding process for the same
or if insufficient number of shareholders opting initial offer.
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In Feb. 1998, Sterlite Company made a bid for 10% stake in Indal at
Rs. 90 per share. Indal’s Canadian Parent, Alcan with 34.6% in Indal
made a counter offer at Rs. 105, and then Sterlite stepped up it to Rs.
115 per share. Alcan responded to Rs. 120 per share. In May 1998,
Sterlite offered Rs. 221 per share through a mix of cash and
preference share to each shareholder of Indal. Alcan responded Rs.
175 per share cash down. Finally, Alcan offered Rs. 200 per share to
all share holders of Indal and the deal was finally settled. Hence,
during the bidding process bidding price per share went 3 times. But
soon after the final deal, market price per share of the Sterlite came
down to Rs. 66
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DEFENCE AGAINST TENDOR OFFER, OPEN
OFFER OR HOSTILE BID
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order to make such refusal successful and upheld by the court
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fixation of the issue price of such convertible preference shares and
debentures is a difficult exercise, because rules and regulation
provided under takeover code for the said purpose are to be
followed.
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TYPES OF MERGER
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3. CO-GENERIC OR CONCENTRIC MERGER - When two
merging firms are engaged in the same type of business, but both the
merging firms have no mutual customers or supply relationship, is
called Concentric Merger such as the merger between a bank and
leasing company, e.g. Prudential’s acquisition of Bache & Company.
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In certain cases, the management of the target company has a
negative list of acquirers to whom they don’t want to sell out their
business. Hence, if an offer is received from such prospective
acquirer whom they don’t want to sell out their business that was
followed by hostile takeover, the target company can take steps to
stop takeover bid made by such type of acquirers, if possible.
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information required for valuation and facilitates due diligence and
cooperates in carrying out legal formalities for acquisition process.
In hostile takeover, an acquirer has to depend upon information
available in public domain only and forces his way for due diligence
and regulatory compliance.
There are always better chances of getting best deal and fulfillment of
conditions in friendly takeover, chances of the acquirer allowing
Promoter and Management of the target company to continue having
important role post acquisition are better, e.g. Ranbaxy’s takeover by
Daiichi Somkyo of Japan, wherein erstwhile promoter and CEO of
Ranbaxy, Mr. Malvinder Singh continued as its CEO post
acquisition.
In India, most of the takeovers are friendly, though there are some
hostile ones like demerger of Larsen and Toubro’s (L&T) Cement
from Ultra Tech Cement Ltd. which was then taken over by Grasim
TAKEOVER TACTICS:
1. DAWN RAID – In this tactic, brokers act on behalf of Acquirer or
Raider swoops down on Stock Exchange by buying all available
shares before the target company comes to know. This is not a good
tactic. This way the acquirer buys a chunk of shares. Secondly,
whether the target company wakes up or not, this would certainly
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increase the price of its share, hence, requiring the acquirer to shell
out much more money. Sensing the acquisition, investors may hold
back their stake offered, thereby, reducing the liquidity and making
the ‘Dawn Raid’ fail.
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acquiring proxy right is called ‘Proxy Fight’. However, this method
of control is not sustainable for all the time to come in future, because
every time the acquirer will have to keep on acquiring ‘Proxy Right’
from the shareholders of the target firm. Also such control over the
target company will be treated as an acquisition and will require an
open offer to the public shareholders. Hence, it is not sustainable and
viable tactic of hostile acquisition.
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6. POISON PILL OR SUPPER POISON PILL – Generally the
term ‘Poison Pill’ is referred to such strategy that creates negative
financial results and destruction in the value of target firm after
successful acquisition. This term is derived from warfare
terminology. Poison Pills were pills laced with poison that spies used
to carry with them to consume, when captured, in order to avoid the
possibility of being interrogated by the enemy. It also represents an
anti-takeover defence, wherein the current management team of the
target firm threatens to quit en masse. Hence, the acquirer would be
left without experienced management following takeover. Other ways
can also be used to achieve this strategy that is given as under:
c. The target company may borrow long-term funds for its own
genuine need, with the condition of paying off immediately if
takeover is exercised by the acquiring company. The long term loan
can also be taken for making one time huge payment of dividend to
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the shareholders. This tactic is called as ‘leveraged cash out’ that
may discourage the acquirer for takeover
There are two plans of such strategy viz. ‘Flip-over and Flip-in’.
A flip-over plan provides for a bargain price of the acquirer’s share, a
flip-in plan provides a bargain price of the target company’s share.
While a ‘Poison Pill’ does not prevent an unwanted takeover, but it
strengthens negotiating position of the management and promoter of
the target company.
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additional drain on the cash requirements for the completion of the
deal.
While a ‘Poison Pill’ may not stop hostile takeover, but certainly
slowdowns the takeover process, paves the way for more intense
negotiations and hence, will open the doors for more attractive offers
made by the acquirer
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and opens the door for discussion during the transitional process of
acquisition. It helps the company to retain key employees, who may
feel threatened by a potential acquisition. It also helps the
management to address personal concerns, while acting in the best
interest of the stock holders. It becomes effective, when an acquirer
exceeds a specified percentage of ownership in the target firm. This
tactic is used in friendly takeover. The conditions of ‘Parachutes’
may be used even without the approval of stock holders. ‘Parachutes’
can be of three kinds, stated as under:
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simply pay a premium price over and above the price paid by such
shareholders at the time of purchasing such a large chunk of shares
in the target company. It is a technique that can be used in a hostile
takeover. However, paying ‘Green Mail’ may be counterproductive
with less than desired effects that may invite other acquirers stepping
in to receive their ‘Green Mail’ as well
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original acquiring company, then its ‘War Chest’ is greatly reduced,
thus it may be too large and complicated for the hostile acquirer to
afford, assimilate and manage the hostile bid. Moreover, this type of
strategy is not common in India. While, in U.S.A. it is a common
practice of acquisition.
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14. GREY KNIGHT – In this tactic, the services of a friendly
company or a group of investors are engaged to acquire shares of the
raider itself to keep the raider busy defending himself and eventually
forcing a truce in favour of the target company. Such type of tactic is
commonly used in India
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could be by stipulating a super majority merger, say 90% would be
required to approve a merger, thereby making the merger more
difficult. But such a case is rare. In most of the cases, an acquirer can
achieve his objective through an acquisition without going for
merger.
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FORMS OF CORPORATE RESTRUCTURING – It can be done
in the following manner:
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2. AMALGAMATION/CONSOLIDATION – This term is used in
India only. It includes both merger and consolidation. The term
amalgamation is rarely used and consolidation is not so frequently
practiced. Examples of one company taking over the other and merge
that other with itself are most common. Even if three companies
combine into one, the preferred route is to merge two companies with
the third rather than consolidating all three companies into a new
company. The rationale behind this is to preserve the identity of the
company or companies with the best brand and take advantage for the
combined business. Consolidation is used to combine a large number
of companies of which at least two to three largest companies are of
comparable size.
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company whether listed or unlisted in stock exchange.
d. by simply acquiring management control through a formal
or informal understanding or agreement for control of the
target company.
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b. Split-Up – It involves transfer of all or substantial assets and
liabilities of the company in favour of two or more companies. Like
spin-off, the shares in each of the new companies are allotted to the
original shareholders on a proportionate basis, but in split-up the
transferor company ceases to exist.
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shares of the transferee company in the proportion held by them in
the transferor company
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Normally, Joint ventures are formed to pool the resources of the
partners and carry out a business or a specific project beneficial to
both the partners
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exchange as a form of corporate restructuring, we are mainly
referring to delisting of its equity shares.
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pushed up Tata Steel’s ranking from fifty-sixth global steel company
to fifth largest global steel company. Same way Grasim Industries
ranked third cement industry in India after acquisition of L&T.
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cash needy companies at a much lower valuation than their potential
worth of business and present market value of shares. Induction of PE
funds transfers the wealth from existing share holders to them (i.e. PE
fund managers), without any strategic intention of running these
companies by themselves. In case of unlisted companies it is easier
for PE funds to acquire equity shares at a lower price than their
present intrinsic value of shares. But in case of listed companies
SEBI and its Disclosure and Investor Protection guideline, 2000 has
specified minimum acquisition price based on the average market of
past 26 weeks and/or past 2 weeks high and lows of the prices of the
shares, below which shares can’ t be allotted to PE fund managers.
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target firm, because they over estimate their own ability and
capability of valuation. In the takeover exercise the acquiring firm
identifies a potential target firm and values its net worth. If the
valuation is below the market value of the target firm, then no offer is
made. Takeover exercise will only be initiated when the bid amount
is more than the market value of the target firm. If there are no
synergies or other take over gains, the average value of both the
valuation (i.e. bid price and market value of the target firm) would be
considered as takeover price of the target firm. Offer and counter
offers are made when the market valuation of the target firm is too
high. The takeover premium is a random error, a mistake made by the
bidder. The ‘Hubris Hypothesis’ assumes strong efficiency of
markets and the share price reflects all public and non public
information.
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firm is willing to pay for the target firm. The price is approximated in
each case by the discounted value of the expected post merger
earnings. As a general rule, the ‘best fit buying firm’ will pay at least
marginally above the highest price offered by the ‘best fit firm’. A
key assumption of both the merger contingency framework and
Asymmetric Theory is that the value added is a function of
relatedness.
SYNERGIES
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3. MARKETING SYNERGY – These benefits are achieved with
the increase in sales, distribution channel or media to push the
products and brands of both the acquirer and Target Company at
lower costs than the different cost of the companies before merger.
Marketing benefits also depend on leverage of brand equity of one of
the two companies to push the sale of the other product of the
company.
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HISTORY OF TAKEOVER CODE IN INDIA
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Creeping Acquisition Limit:
The acquirer holding 25% or more voting rights in the target
company can acquire additional stake to the extent of 5% of the total
voting rights in any financial year, up to a maximum permissible non-
public shareholding limit of 75% Acquisition of voting rights
exceeding 5% in any financial year automatically triggers open offer
obligation
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and companies owned
by them
Acquisition pursuant to
scheme
a. no condition prescribed
a. U/s. 18 of SICA
b. no condition prescribed
b. Of arrangement or
reconstruction
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involving the target
company, including
merger or demerger,
pursuant to an order
of a court or compet-
ent authority under
c. 1) consideration in cash and its
any law, Indian or
equivalents should be less than 25%
foreign
of the total consideration being paid
c. Of arrangement, not
pursuant to the scheme
directly involving the
2) Person directly or indirectly holding
target company,
at least 33% of voting right in the
including merger or
combined firm should be the same
demerger, pursuant to
as those who held the entire voting
an order of a court or
rights before implementation of the
competent authority
scheme
under any law, Indian
or foreign
Acquisition of voting
rights on preference
4 No condition prescribed
shares u/s. 87(2) of
Companies Act, 1956
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3 B. Exemption from Open Offer obligation in case of substantial
acquisition of share or voting rights
S.N. Transaction Key conditions
1 Increase in voting rights of The shareholder needs to reduce
any shareholder exceeding his or her shareholding so that the
24.99%, pursuant to buy voting rights fall below the
back threshold of 25% within 90 days
86
2. The target company may apply to SEBI seeking relaxation from strict
compliance with any procedural requirement of open offer process and
other obligations
87
offer
Offer Price: The minimum offer price should be highest of the following,
computed with reference to the cut-off-date
Direct Acquisition Indirect Acquisition
1. Highest negotiated price 1. Highest negotiated price
2. Volume weighted average price 2. Volume weighted average price
Paid or payable by the acquirer paid or payable by the acquirer
prevailing during the preceding 52 prevailing during the preceding 52
weeks weeks
3 .The highest price paid or payable 3. The highest price paid or payable
By.The acquirer during preceding By.The acquirer during preceding
26 weeks 26 weeks
4. 60 trading day’s volume weighted 4. The highest price paid or payable
average market price in case of By.The acquirer during the date of
frequently traded shares*, the price contracting or announcing the
determined by the acquirer and the primary acquisition (PA) and the
manager to the open offer taking date of PA in India
into account valuation parameters 5. 60 trading day’s volume weighted
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5. The per share value of the target average market price, in case of
company, if computed (in case of frequently traded shares
indirect acquisition where value of 6. The per share value of the target
the target company exceeds 80% of company (if value of the target
overall transaction) company is not more than 80% of
6. Cut-off-date: Date on which PA is the overall transaction)**
made 7. Cut-off-date: The date on which
the PA is contracted and the date on
which intention or decision to make
primary acquisition (PA) is
announced
**If the value of the target company is more than 15% but limited to
80% of the overall transaction, the per share value of the target
company needs to be specifically computed and disclosed along
with detailed description of the valuation methodology in the
letter of offer (LO)
Mode of Payment of Offer Price – Offer Price may be paid through any one
or a combination of any of the following:
1. Cash
2. Issue, exchange or transfer of:
a. listed equity shares* of the acquirer or PACs
b. listed debt instruments issued by the acquirer or PACs
c. convertible debt securities entitling the holders to acquire
listed shares* of the acquirer or PACs
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issuer company must have redressed at least 95% of the
investor’s complaints, impact of auditor’s qualification etc.
Conditional Offer:
1. An acquirer may make an open offer conditional as to
minimum level of acceptance. If the offer is in pursuant to an
agreement, such agreement must contain a clause to the
effect that in case minimum level of acceptance is not
achieved, the acquirer will not acquire any shares under open
offer
2. During the period of such offer, the acquirer will not acquire
any share in the target company
Competing Offer:
1. Competing offer can be made within 15 working days from
the date of announcement made by the first PA
2. Unless the first open offer is a conditional offer, the
competing offer cannot be made conditional as to the
minimum level of acceptance
3. A competing offer is not regarded as a voluntary and hence,
all the provisions of Takeover Code, including that of offer
size, apply accordingly
4. On PA of competing offer, an acquirer who has made a
preceding offer is allowed to revise the terms of his open
offer, if the terms are more beneficial to the shareholders of
the target company. The upward revision of the offer price
can be made any time up to 3 working days prior to
commencement of the tendering period
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acquisitions attracting the obligation to make an open offer is
refused
2. The acquirer, being a natural person, dies
3. Any condition made in open offer is not met for reasons
beyond control of the acquirer
4. Such other circumstances as in the opinion of SEBI, merits
withdrawl
Extension:
If the acquirer is subject to any statutory approval (e.g. CCI
approval takes time), SEBI may grant extension of time,
provided the acquirer agrees to pay interest to the shareholders
of the target company at a specified rate for the delay
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of assets, buyback and issue of shares, material
contracts etc. in it or any of its subsidiaries, only by way
of special resolution passé by the shareholders of the
target company to be passed through postal ballot.
iii. restriction on fixing record date for a corporate action,
during the specified period
iv. constitute committee of independent directors to provide
reasoned recommendations on open offer and publish
the recommendation
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8. Disclosures:
Events based disclosures*
Regulation Triggering Event Disclosure Disclosure
by to
29(1) Acquisition of 5% or more Acquirer Target Co. & stock
shares or voting right exchange(s)
29(2) Acquisition or disposal of Acquirer or Target company &
2% or more shares or voting seller stock exchange/s
rights by the acquirer
alreadyHolding 5% or more
shares or voting rights
31(1)/(2) Creation or innovation or Promoter Target co. & stock
release of encumbrance** exchange/s
on the shares held by
promoter or PACs
Continuous disclosures*
Regulation Disclosure by Disclosure to
30(1) Acquiring holding 25% or Target company and stock
more shares or voting rights exchange/s
30(2) Promoter and PACs Target company and stock
exchange/s
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Notwithstanding such repeal, an offer for which
acquisition was made under the 1997 Code will be
required to continue and completed as per the 1997 Code
itself
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GIST OF SEBI’s New Takeover Code & Few
Historic Takeovers
Takeover Trigger Point 15% to 25 %
Open Offer Size 20% to 26%
Non-Compete Fees Removed
Era of Takeover May Begin-Threat of takeover may begin,
provided the equity participation (% stake) of promoter’s along with
their friends and relatives is increased to the extent of more than 50%.
Otherwise there is every possibility of Hostile Takeover. Cases of
few of the following companies are given as under that shows the
stake in their own promoted companies, thereby inviting threat
perception from the acquirers:
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2. PRAJ
Promoters + 26.22%
Institutions + 25.29%
96
take control of ITC, in which it already owned a stake.
Here too, political opposition and regulatory hurdles
forced BAT to give up its ambitious plan to strengthen
its presence in India
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Raasi Cements in 1998 after winning over key
shareholders, public shareholders as well as some
members of the promoters group
9. ARUN BAJORIA vs. BOMBAY DYEING
In 2000, Kolkatta based Arun Bajoria bought 15% in
Bombay Dyeing, and threatened to make an open
offer to public shareholders. He finally sold out his
stake to the Wadias, the promoters of Bombay Dyeing
at a profit
10. ABHISHEK DALMIA vs. GESCO
In 2000, Abhishek Dalmia cornered 10.5% stake in
the Sheth’s controlled GESCO Corporation and made
an open offer for another 20%. But rather than
dislodging the existing promoters, Dalmia sold his
stake to them for a profit of Rs. 9 crore.
11. R.K. DAMANI vs. VST INDUSTRIES
In 2001, stockbroker Radha Kishen Damani made an
open offer for BAT controlled VST Industries, but
was foiled by ITC which entered the fray as a ‘White
Knight’ with the support of BAT. Damani still holds
26% in VST
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12. HARISH BHASIN vs. DCM SHRIRAM
INDUSTRIES
In 2007, stock broker Harish Bhasin bought 25% in
DCM Shri Ram Industries through a combination of
open market purchases and an open offer. But the
promoters countered the move by issuing warrants to
themselves and increasing their stake
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GIST/SUMMARY OF TAKEOVER CODE, 2011:
100
It means that any agreement entered into between two persons for
acquiring the shares in future will also be covered within
acquisition for the purpose of takeover code.
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target company
Whenever an If an acquirer The rationale behind
acquirer, already holding 25% or creeping acquisition
holding 15% or more shares in a is that the
more shares, but target company shareholders are
less than 55% of will have to make given an opportunity
Creeping shares, acquired a mandatory public to exit every time a
acquisition more than 5% offer, if he major shareholder
voting rights in the acquires more than increases his
target company in a 5% voting rights in shareholding in the
Financial Year, the target company target company by a
then he had to in a Financial Year material percentage
make another man- (SEBI considers 5%
datory public offer as the material
to the remaining percentage)
shareholders
If the holding of an With the increase in
acquirer in the the limits of initial
Limit of target company acquisition and the
55% - 74% reaches 55%, then No such provision minimum offer size
he has to bring a in the new takeover
mandatory public code, this provision
offer, every time he has become almost
acquires even a redundant
single share in the
target company
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Under this code the The payment of
acquirer could non-compete fees to
Non make a payment up No such payment the seller promoters
Compete to 25% of the offer in the nature of results in differential
fees price to the seller non-compete fees pricing, which is
promoters to is allowed under against the principle
prevent the later the rules of new of equity*
from entering the takeover code
same business
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restrict their holding in the company to less than 15% if they did
not want to make an open offer. But with the new takeover code,
the institutional investors, especially the PE firms will now be able
to acquire up to 24.99% without triggering an open offer, which
means that the listed companies do not necessarily have to depend
only on public markets for capital.
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Step 2. Acquirer makes a public announcement for public offer
at least to the extent of 26%
Step 3. Any other person may make a public announcement of
counter offer in within 15 days from the date of earlier public
announcement
Step 4. Public offer is actually made to the public shareholders (i.e.
other than promoter’s)
Step 5. Shareholders may accept or reject Year he offer
Step 6. The acquirer makes the payment to the shareholders who
accept the offer and completes the process of offer
Step 7. Subsequently, if the acquirer acquirers in a Financial Year
more than 5% voting rights in the target company, then again
he has to make another public offer in the same manner.
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target company
Step 4. within 5 days (14 days in the old takeover code) from the date
of public announcement, file a draft letter of offer with SEBI along
with non refundable fee (calculated on the basis of consideration
payable under the offer)
Step 5. 1. SEBI can give its comments on the draft letter of offer
within 15 days (21 days in the old takeover code) from the
date of receipt of such draft letter of offer.
2. if SEBI specifies any change, then make such changes in
the letter of offer (LO) before dispatching to shareholders
3. if no comments are specified by SEBI, then it shall be
deemed as approved by the SEBI [Reg. 16(4)]
Step 6. within 7 days from the receipt of the comments from SEBI or
where no comments are offered by SEBI within 7 days, the
LO should be dispatched to shareholders.
Conclusion:
Though the new takeover code has increased the threshold limit and
the minimum offer size, but it is still felt that the RBI should do away
with the restriction on banks to fund domestic acquisition.
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LEVERAGED BUYOUT (LBO)
LBO is defined as the acquisition financed largely by
borrowing against all the assets or few of the assets of the
acquired company by a small group of investors. Acquirer
group may consult advisors and investment bankers that
arrange such deal. A LBO debt financing typically represents
50% or more of the purchase price. The debt is secured by the
assets of the acquired firm and is usually amortised over a
period of less than 10 years and is paid off from the funds
generated from operational activities or form the sale of assets
of the acquired firm. Following completion of the buyout, the
acquired firm is usually run as a privately held company. The
combination of high debts with its threat of bankruptcy pays
the way of creating incentives for managers to improve the
company’s performance.
Generally, in more than 90% of the LBO transactions,
purchase price of an acquisition has been financed with debt.
The tangible assets of the target firm are used as collateral for
the loan. Hence, LBO is a financing technique used by the
acquirers. Bank loans are primarily secured by the liquid
assets of the acquired company such as receivables and
inventories, while a portion of long-term senior financing is
secured by the acquirer’s assets. Subordinate debt or junk
bond is used to raise the balance amount of the purchase price.
In a typical LBO, a group of investor’s purchase a presumably
underperforming firm by raising an unusually large amount of
debt relative to equity capital (may be up to 5 as debt-equity
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ratio). The strategy is to restructure the firm, improve its
performance and increase the cash flows generated by the
firm’s assets in order to repay a large part of the initial debt
within a reasonable period of time, say 3 to 5 years. The new
shareholders do not normally receive any cash dividends
during restructuring period.
Improperly structured LBOs can be disastrous and may lead to
bankruptcy, if a highly leveraged transaction is not backed by
sufficient cash flows. The new company created by the LBO
must be strong enough to meet its obligations to its creditors
and investors.
The ability to execute LBO transaction depends on the level of
market prices and the availability of high yield financing.
Leveraged Buyouts are now international phenomena and
have become global in scope. They play an important role in
the renewal of the economic system. The pricing for an LBO
depends on the debt capacity of the company and the return
required by investors. Debt capacity determines how much is
left for equity holders at exit time.
PROCESS OR STAGES FOLLOWED IN LBO - Basically
there are four stages in LBO operation that are stated as
under:
In the I stage, the target company is identified and selected,
there after the LBO firm enters into the lengthy process of
“Due Diligence and Deal Structuring”, if satisfied, then a
detailed business plan and financial details of the transaction
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are negotiated with the current owner. Generally, the equity
base of the new firm, say 10% is contributed by the top
management of the acquirer. Outside investors provide the
remainder of the equity. About 50% to 60% of the required
cash is raised by borrowing against company’s assets in
secured bank loans. The rest of the cash is obtained by issuing
senior and junior subordinated debt in a private placement or
from public offering.
In the II stage of operation, the acquirer buys all the
outstanding shares of the company or purchases all the assets
of the company.
In the III stage, the management tries to increase profits and
cash flow by cutting operating costs and changing marketing
strategies. It may even lay-off employees, cut spending on R
& D.
In the IV stage, the investor may take the company public
again, provided the company emerges financially stronger and
the goals of the group are achieved.
HISTORY OF LBO - Immediately after WW II,
entrepreneurs in USA, who were considering retirement, were
concerned with the continuity of their family businesses. They
were also worried about the impact of estate taxes upon their
death. Consequently, in the 1950s and early 1960s, they sold
their businesses at or below book value to the new generation,
who were willing to expand the newly acquired businesses.
Such buyers generally provided equity amounting to 20% to
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25% of the purchase price and borrowed the remainder from
financial institution, using the assets of the target firm as
security to the lender in order to pay their dues. A portion of
the purchase price thus received was utilized to pay any taxes
owed by the seller.
By the early 1970s, in the wake of escalating bankruptcies and
sky-high price-to-earning (P/E) ratios, the interest of the
public got shattered. Therefore, a renewed interest in LBOs
emerged in the late 1980s. Great depression of 1930s created
discontentment amongst investors on account of the poor
response for financing of debt that followed WW II.
Though LBO in India is not as popular as in foreign countries,
but this phenomenon is being witnessed from the year 2007
onwards, when about a dozen companies have taken debt of
nearly $1.5 bn. to buy foreign companies, which were about 3
to 5 times bigger their size. The observed trend is that the
companies are taking debt of about 4 to 5 times their net worth
at a steep rate of interest, as high as 9% to 10% on their LBO
loans.
India’s first global LBO was Tata Tea buyout of U.K’s
Tetley in March 2000. For funding the acquisition of Tetley,
Tata Tea floated a special purpose vehicle (SPV) Tata Tea GB
in UK, by capitalizing it with £71 million, consisting £60
million from Tata Tea, £10 million from Tata Tea Inc and £1
million from Tata Sons.
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In ------Tata Steel took loans of about $7 bn., more than twice
of its net worth for the Corus deal and created a special
purpose vehicle (SPV) to take debt against the assets of the
acquiree. The acquisition of Corus made Tata Steel world’s 5th
largest steel producer.
In 2007 India’s largest aluminum producer Hindalco
Industries, with revenues of $4.57 bn. and a manufacturing
capacity of 4,61,000 tons acquired $9.8 bn. Novelis of Canada
for $6 bn. The debt component of deal amounted to $3.1 bn.,
which was about 5 times the company’s net profit of $650
million and 70% of its revenues in the year 2006-07. Hindalco
became a world leader in aluminum after the acquisition of
Novelis.
United Spirits acquired Glasgow based whisky maker Whyte
& Mackay for $1.18 bn., of which $675 million was raised
through loans. UB group, after acquisition was catapulted into
the position of world’s liquor maker, behind UK’s Diageo
In 2006, Dr Reddy’s bought German generic drug maker
Betapharma for $570 million, of which $475 million was
raised through loans.
Hyderabad based Rain Calcining funded its Rs. 2,440 cr.
acquisition of the US based CII Carbon with a debt-equity
ratio of 4:1. CII carbon acquisition made Rain Calcining
world’s largest producer of calcined petroleum coke, a raw
material used in aluminum and titanium dioxide production.
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There are many reasons for Indian companies adopting the
debt laden LBO rout, because RBI prohibits domestic
companies from leveraging more than 3 times their net worth
for foreign acquisitions. Hence, companies have to take debt
on their own balance sheets.
REASONS TEMPTING FOR LBO:
Firms having good financial structure are more vulnerable to
takeovers.
Firms having better cash flow relative to their current stock
prices, highly liquid B/S, large amount of excess cash reserves,
and favourable security port folio are more attractive targets.
Companies with steady cash-flows, significant unused debt
capacity and steady growth are the main candidates for LBO.
Another reason for promoting LBO is the period of sustained
economic growth since 1982, which has pushed the growth of
merger and acquisition activity
REMEDIES TO STOP LBOs TAKEOVER - Anti takeover
measures can be divided into preventive and defensive
measures, given as under:
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tactics, such as poison pill, parachutes and buy back of shares
etc.
Sometimes, an LBO or MBO or announcement of going private
is a defensive measure against a feared or unwanted takeover,
which may sometimes stimulate competative bids by outsiders.
TYPES OF LEVERAGED BUY OUTS - LBOs are either
asset based or cash flow based. As there are high chances of
bankruptcies in the overleveraged cash flow based LBO, the
most common form of LBO today is asset-based. This type of
LBO can be accomplished in the following ways:
1. The sale of assets by the target company to the acquiring
company, or
2. A merger of the target company into the acquiring company
(direct merger), or
3. Merger of a wholly-owned subsidiary of the acquiring company
(subsidiary merger)
4. LBO
5. MBO
6. MBI (Management Buy In) – In this case, the team of managers,
who are proponents of the initiative are external to the target
firm.
7. BIMBO (Buy Out Management Buy In) – In this case the
nucleus of the proponent, is composed of some managers
operating within the target firm, who are in a position to involve
in the initiative.
8. FBO & FBI(Family Buy Out & Family Buy In) – FBO happens
when a group of shareholders inside the owning family, takeover
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the share of other members who are not interested in the
maintenance of their investment in the target firm. If a part of
the owning family decides to exit from the firm in reference to
try to buy another corporate entity using a LBO, then it is called
a family buy in (FBI)
WBO (Workers Buy Out) – This type of deal is widespread in
the United States, which envisions that the acquisition is done
by the dependent workers of the target, through the intervention
of pension funds and the use of employee stock ownership plan
(ESOP)
CBO (Corporate Buy Out) – In this case the acquirer is a
company desirous of growing through external means without
inserting the acquired company directly into its corporate
family. On the other hand, the transaction would be visible and
connectable with the acquirer at the time when the latter would
be considered a part of the group
REVERSE LBO - A reverse LBO occurs when a company
goes private through an LBO and becomes public again at a
later date. This may be done if the buyers who take the
company private believe that it is undervalued, perhaps
because of poor management. They may buy the firm and
bring in various changes, such as replacing senior
management and other forms of corporate restructuring. If the
new management successfully converts the company into a
more profitable private enterprise, it may be able to go through
the initial public offering (IPO) process again. This may make
the assets of the LBO candidate undervalued in a poor market
and possibly overvalued in the bull market.
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VALUE CREATION OR MERITS OF LBO - Debt is
always cheaper than equity and can create more value as
compared to the firm having more modest level of debt.
Because a high debt level increases the tax savings that
increases its EPS and thereby, making an increase in the value
of firm. LBOs are expected to create value through:
1. the discipline of debt that reduces the abuse of free cash flows
2. efficient monitoring done by buyout specialists
3. better alignment of managerial interests with the interest of
equity and debt holders.
4. expropriation of lenders through high leverage and making high-
risk investments
5. expropriation of government through tax subsidies on high debt
levels
6. reduction in agency cost
7. increase in efficiency, because a private firm is much
more efficient in taking decision
8. tax benefits.
9. increase in operating profits.
DIFFERENCE BETWEEN LBO AND AN
ACQUISITION: LBOs are structured transactions, where a
sponsor company uses another company or creates special
purpose vehicle (SPV) to borrow the funds for acquiring the
target firm. In an acquisition, usually the company that is
being acquired is used to raise the funds to ensure no financial
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liability flows back to the sponsor. The acquirer gives
managerial and operational support to the project but shuns
financial responsibility for it.
FEATURES OR CHARACTERISTICS OF LBO - There
are certain characteristics of LBO that the lenders would look
for in a prospective LBO candidate. A few of them are given
as under:
1. Stable cash flows (Sustainable and regular cash flow) –
Statistical measures, such as the standard deviation, may be used
to measure the variability of cash flow. The more erratic the
historical cash flows are, greater the perceived risk in the deal
would be. Even in cases where the average cash flow exceeds
the loan payments by a comfortable margin, the existence of
high variability may worry a lender. The lender must make a
judgment as to whether the past will be a reliable indicator of
what the future will hold.
2. Stable management – Lenders feel more secure, when the
management is experienced and it has been with the firm for a
reasonable period of time that will indicate that there is a greater
likelihood that the management will stay on after the deal is
completed.
3. Scope for substantial cost reduction – If the target firm has
potentiality of cutting costs in some areas, such as cut in extra
employees, reduction in capital expenditure, elimination of
redundant facilities, tightening cost controls on operating
expenses and so on. Cuts in R&D expenditure may cause the
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company to fall behind its competitors and eventually lose
market share, hence acquirer should take care of these cuts.
4. Equity interest of owners – The collateral value of LBO
candidate provides risk protection to lenders. The equity
investment of the managers, buyers and outside parties also acts
as a cushion to protect lenders. More participation of the
manager’s equity indicates their likelyhood of staying with the
firm.
5. Debt capacity – Lower the amount of debt on the B/S of the
target firm, greater will be the borrowing capacity of the firm.
Greater leverage (debt-equity ratio) will be more cumbersome to
finance the LBO candidate.
6. Non-core business – If the LBO owns some non-core
businesses that can also be sold off in order to pay off a
significant part of the firm’s post-LBO debts, then the deal may
be easier to finance.
7. Other intangible factors – The existence of unique or
intangible factors may provide the impetus for a lender to
provide financing. A dynamic growing and innovative company
may induce lenders with sufficient incentives to overlook some
shortcomings. Both lenders and the incumbent managements of
LBOs need to identify in each LBO candidate, the existence of
different products or services with a different history.
FINANCING OPTIONS AND CAPITAL STRUCTURE
FOR LBOs -The LBO buyer has a number of financing
options and the ideal objective is to finance the transaction out
of cash held by the target firm in excess of normal working
capital requirements. But such situations are rarely found.
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Venture capital investors are also available to fund the LBO
transaction. However, it may represent very expensive
financing, since at times the buyer may have to give up as
much as 70% of the ownership of the acquired company to the
venture capitalists. The seller may be willing to accept debt
issued by the buyer if an up-front cash payment is not
possible. The use of a public issue of the long-term debt to
finance the transaction may minimize the initial cash outlay,
but it is also subject to restrictions as to how the business may
be operated by the investors, who are buying the issue.
Moreover, public issues are expensive in terms of
administrative, marketing and regulatory reporting costs. For
these reasons, asset-based lending has emerged as an attractive
alternative.
FINANCING OF LBO - Generally, two types of debt, such
as Senior debt and Junior subordinate debt are employed in
LBO, given as under:
1. Senior debt consists of loans secured by liens on particular
assets of the company. The collateral, which provides the risk
protection required by lenders, includes physical assets such as
land, plant and equipment, accounts receivable and inventories.
Lenders usually will give 85% of the value of the accounts
receivable and 50% of the value of the target inventories
(excluding work-in-progress)
2. Junior debts or mezzanine debt financing has both equity and
debt characteristics. For such type of financing, lenders receive
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warrants that may be converted into equity in the target firm in
future.
Debt referred as subordinated junior debt has a secondary
claim on the assets of the target firm. Junior debts are not only
subordinate to senior debts but also to trade creditors.
Unsecured financing often consists of several layers of debt
each secondary (subordinate) in liquidation to the next most
senior debt. Those with the lowest level of security normally
get the highest yields to compensate for their higher level of
risk. The warrant allows the holder to buy stock in the firm at
a pre-determined price within a defined time period.
JUNK BOND - A high yield or ‘junk’ bond is a bond issued
by a company that is considered to be a ‘higher credit risk’.
The credit rating of a high yield bond is considered
‘speculative’ or below ‘investment grade’
A case study of LBO of Tetley (UK) by Tata Tea:
In 2000 Tata Tea Ltd. acquired the ‘UK heavy weight brand’
and the world’s second largest tea producer Tetley for £271 m
through a cross border LBO deal, giving a good signal of
acquiring global brand which was the first ever LBO deal by
an Indian company. This method of financing had never been
successfully attempted before by any Indian company.
Tetley’s price tag of £271 m ($450 m) was more than 4 times
the net worth of Tata Tea that stood at $114 m. In 1976 Tata
Tea also acquired Sterling Tea companies from James Finlay
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& Company for Rs. 115 m, using Rs. 19.8 m of equity and Rs.
95.2 m of unsecured loans at 5% p.a.
Tata Tea created a Special Purpose Vehicle (SPV) as Tata Tea
GB (Great Britain) to acquire all the properties of Tetley, to be
capitalized as under:
Equity contributed by Tata Tea £ 15 m
GDR Issue £ 45 m
Total Equity £ 70 m
Debt * £ 235 m
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management must offer them a premium above the current
market price.
MBO occurs when the management of a company buys out a
distinct part of the business which the company is seeking to
divest. MBOs usually arise because a parent company decides
to divest a subsidiary company for strategic reasons, e.g. it
may decide to exit a certain activity to concentrate on its core
activities.
When the management feels that the business has great
potential as compared to the parent company, MBO is called
purchase driven. Many managers thrust an MBO, when the
existing owners feel a particular part of the business, as a non-
core to the company and hence, may be planning either to sell
or close it. Therefore, they may be more open to MBO offers.
Family-run businesses are frequently taken over through
MBOs, because the existing directors might not have any
children interested or capable in running the business. In these
circumstances, they may be keen to ensure the business and its
workforce continues to work successfully.
Generally, companies prefer MBO, because it gives them the
best value, without running the risk of exposing trade secrets
to the competitors.
MERITS OR MOTIVATIONS FOR MBOs - There are
various factors that drive the managers to become owners of
their businesses being run under the direction and control of
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their parents. Generally, in MBOs managers invest hardly 1%
in equity of the total funding for a buyout, but it may still
represent a substantial part of their individual wealth. Various
studies have shown that one of the most important reasons is
the desire to run one’s own business. Some of the important
managerial motivations in MBOs are stated as under:
Fees £ 1.00 ,,
Financed by:
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Management equity £ o.50 ,,
Mezzanine 4.00 ,,
£ 23.35 million
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EMPLOYEE STOCK OPTION PLANS (ESOPs)
Stock option plans have been used to reward the top
management and ‘key’ employees of an organisation. The
popularity of employee’s ownership and profit sharing has
increased since the late 1980s and seen as an important tool of
human resource management. The rationale behind ESOPs is
that they help companies to retain staff, attract talent, motivate
employees and enable them to share the long term growth of
the company. It gives an employee the right to purchase a set
amount of shares at a fixed price in future.
At present, ESOPs have become the norm in high technology
companies and are becoming popular in other industries as an
overall equity compensation strategy. Basically, ESOPs work
in industries where intellectual capital is precious and attrition
level is high. Dynamic ownership culture symbolizes the
promotion of engaged employee’s ownership, which could
enhance the performance of a company. Financial and
psychological aspects of ownership engage employees in
giving better business results and act as an incentive to
increase productivity and performance
Despite the advantages the ESOPs possess, it has led to many
problems, such as dilution in the interest of outside
shareholders. In fact, shareholders of companies, like
Peoplesoft, Intel, HP and IBM, have recently rejected
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proposals to grant ESOPs to its employees. In Dec. 2003,
Microsoft decided to do away with ESOPs.
One of the main limitations of ESOPs is that it operates
effectively in profitable firms only. The ESOPs trend in India
indicates that maximum companies offering ESOPs are MNCs
Indian companies, working in technology sector.
MERITS OF ESOPs
as a motivating tool to improve worker’s involvement and
productivity
decrease in tax burden
wage concession that increases employee’s income
helpful in making defensive bid for future takeovers.
DUE DILIGENCE
INTRODUCTION – Due Diligence is the process through
which a potential buyer evaluates a target company or its
assets for acquisition. With reference to M&A, it covers the
following aspects of the target company:
1. organizational and managerial structure
2. operational aspects that include production technology, process
and systems
3. financial aspects that include operating performance information
and potential tax liabilities.
4. human resources environment
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5. various legal and regulatory aspects
6. information system
7. qualities of assets and liabilities
8. labour issues
NEED FOR DUE DILIGENCE - These days, organizations
operate in a very uncertain environment that is full of risks,
some of which can be controlled, but most of which cannot.
To understand the past and future earning capabilities of the
entity, one needs to analyse thoroughly the industry and the
environment in which one is expected to operate. DD becomes
important due to the following reasons:
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action and keep the system under review. All this can be
achieved through DD.
WHAT DOES DUE DILIGENCE INVOLVE - DD is a
very lengthy process that involves the following:
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PARTIES INTERESTED IN DUE DILIGENCE - Apart
from acquirer and acquiree, there are other parties interested in
the outcome of the DD process. Interest of few of them is
stated as under:
1. Employees – DD is undertaken to address the fears of the
employees that they might be laid off or their salaries may be
reduced after merger.
2. Trade Unions – Trade Unions are interested in DD, because
they want to ensure that no employee faces the axe or cut in pay
post merger. They ensure that the agreement addresses the
concerns of the employees and assures them continuity in
employment.
3. Shareholders and Creditors – Shareholders and creditors have
a financial stake in the business. They are not only concerned
about the principal amount invested by them, but also expect
regular returns from the target firm. DD gives them a fair idea
about the risk involved in the project, which in turn determines
future returns from the business. If DD indicates that the project
is highly risky and returns are uncertain, they may decide
against making an investment in the business and vice-versa
4. Vendors – Vendors are entities who supply various inputs, such
as raw-material, tools and equipment to the business. The
decision of continuing the relationship or distancing one’s
business from the entity is based on the results of DD.
5. Customers – Customers desire that their needs and
requirements should be fulfilled by the company. DD provides
details about the future operational strategy of the business and
helps them decide on their consumption patterns.
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6. Government – The Govt. can decide on the course of action it
needs to pursue to protect the interests of the stakeholders. If it
finds that the merger will have an adverse impact on the
stakeholder’s rights, it may enact laws to prevent or reduce the
adverse impact of the merger.
7. Society – It is important for the society to understand the
consequences of M&A and make itself ready for appropriate
action. This is where the DD process provides it with the much
needed feedback and basis for action.
PROCESS OF DUE DILIGENCE - The most effective due
diligence process begins in the earliest stages of the
acquisition. The due diligence process should help the firm
selecting its target so that value creation occurs with a long-
term perspective, through competitive advantage. If a wrong
target firm is selected, the due diligence process may not have
much value. Dynamic due diligence begins with an
empowered due diligence team with the responsibility and
authority to obtain and analyse information for effective
integration.
A critical part of the due diligence process is analyzing the
firm’s financial resources. This should include return on assets
per employee, economic value added, percentage of revenues
and profits from new businesses. Due diligence process also
carefully and completely analyses customer and marketing
related issues. Customer relationship issues should be
evaluated and a customer satisfaction index be developed.
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The analysis of major processes, like manufacturing and
provisions of services, is another area of importance in the due
diligence process. This analysis may include achievement of
quality goals, assessment of effectiveness of management
information systems and administrative expense per employee.
Due diligence will help firms to minimize the risks involve,
especially for the acquirer. In another perspective, due
diligence also involves mutual review by both the acquirer and
target. The basic aim of DD is to assess the benefits and
liabilities of a proposed acquisition by exploring the status of
the business, particularly the future of business along the
framework of risk.
The role of investment bankers is vital as they can add value
by identifying appropriate acquisition targets. The top
investment banking institutions providing support for mergers
and acquisitions include Merrill Lynch, Morgan Stanley,
Goldman Sachs, Salomon Smith Barney and Amarchand
&Mangal Das
A major DD problem is known as managerial hubris.
Overestimation and hype about the target firm may become
the major reason for the high premium paid for acquisitions
Equity in human resource system can be bought out only by
rectifying differences in compensation structure and
performance appraisal system. Another area of concern is the
grading or organizational structures. Issues related to
management-union relations, number of trade unions and the
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dynamics among trade unions also occupy much significance
in the DD.
DUE DILIGENCE REPORTING – The DD report should
be submitted to the management for consideration and
adoption, which may contain the following issues:
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transaction or in certain circumstances, even recommend
termination of proposed investment. IPRs can be broken down
into four main categories, given as under:
a. Patents b. Copyrights
c. Trademarks d. Trade secrets
4. IT Due Diligence – IT DD involves analyzing the use and
relevance of IT services for business operations, management
information and financial reporting in business. It also involves
finding better ways of deriving value and leverage from IT
assets.
5. Legal Due Diligence – Legal DD consists of scrutiny of all or
specific parts of the legal affairs of the target company with a
view of uncovering any legal risks and providing the buyer with
an extensive insight into the company’s legal matters
6. Operational Due Diligence – Operational DD involves
operational activities of the business and on sight analysis of the
daily proceedings of the target business. The analysis includes
an evaluation of the key employees, managers, independent
contractors, suppliers and other factors that are necessary for the
business to conduct normal operations.
DUE DILIGENCE IN INDIA:
Any M&A in India has to be carefully planned and executed,
cutting through a wide spectrum of tax and regulatory issues,
such as exchange control, income tax, and capital market
regulations, etc. Outbound acquisitions are guided not only by
the tax laws of foreign countries but also by political
relationships, free trade agreements (FFTs) and double
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taxation avoidance agreements (DTAAs or tax treaties)
between the countries. Deal structuring from tax perspective
has become one of the most important, because very few
geographies have similar legal systems.
As per RBI’s guidelines Indian companies cannot bid for
overseas acquisition for more than 2 times of their own net-
worth. As per Indian Company’s Act, if the acquisition value
exceeds 60% of the Indian company’s net-worth or 100% of
its free reserves, then the Indian company is required to take
prior approval from its shareholders for making the investment
in the target company, thereby disclosing vital details about
the target company to the shareholders, including price being
paid.
The business and legal system in India differs from the
systems of overseas. Each country has its own set of issues,
regulatory framework in terms of legal and judicial system,
tax regime, social and cultural issues and business dynamics,
etc. There are geographies that have similar legal systems.
A few cases of failure – Due to improper application of Due
Diligence, certain failed cases of M&A are given as under:
Quaker oats had acquired Snapple beverage co. in 1994 for
$1.7 bn. In 1997, it had to sell Snapple for only $300 million
that was less than 18% of the original purchase price.
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AT&T bought NCR Corporation for $7.5 bn. in 1991.
Afterwards, NCR accumulated almost $4 bn. net losses before
AT&T spun it off as a separate company.
Novell lost almost $700 m. on its acquisition and sale of
World Perfect
Sony’s controversial acquisition of Columbia Studios for $5
bn. Sony had to pay $800 m. to two producers in order to
extricate them as they had signed a long-term contract with
Warner Brothers.
Union Pacific’s acquisition of Southern Pacific is another case
where DD process was ineffective. It had to implement
substantial cost cutting actions immediately after its
acquisition. It had to lay off thousands of experienced workers
and consolidated the rail yard of two companies. But, shortly
thereafter, because of the crisis in the company, Union Pacific
lost its cargo business. In this case, DD process failed to
consider the importance of the experienced employees of
Southern Pacific.
A classical example of cultural issue is of HLL’s acquisition
of TOMCO. The employees of TOMCO had better terms and
conditions of service prior to merger. The employees of HLL
argued that if the TOMCO employees are allowed to work on
their original terms and conditions, it will lead to segregation
of employees into two classes reflecting discriminatory
policies.
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Similar problems cropped up during the merger of Glaxo and
Wellcome Burroughs in 1996. For 7 years the Indian
subsidiaries of these two companies could not merge due to
the different pay structure of the companies. The employees of
Wellcome refused the one time compensation of Rs. 2 lakhs in
1998. Hence, since then the companies are operating as
independent subsidiaries since 1997.
DIFFICULTIES IN DUE DELIGENCE PROCESS IN
INDIA:
1. lack of Adequate Information – Comprehensive information
required for DD process is not readily available with the Indian
companies due to lack of detailed management information
system
2. Quality of Information – the quality of financial statement,
financial infrastructure and business processes are generally
lower and less explicit than what western investors are
accustomed to. This results in the need to explore more risk
areas and take more time for the DD process.
3. Insufficient Disclosure – Inadequate disclosures impede the
ability to access critical information that might alter the
investor’s perception with regard to the value of the company
4. Lack of Corporate Governance – Companies are slowly
realizing the importance of corporate governance. Weak
corporate governance is often supplemented with tardy legal
system, where settlement of dispute takes a long period.
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5. Dilution of control – Very often, founding members of a start-
up company refuse to give up control and want to satisfactory
settlement.
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