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Leveraged Buy-Out:

What do you think when you hear the name Tata-Tetley. Well most of us associate it only to the morning tea that is tastier than most of the other brands available. Only a few in our country know that Tata buying Tetley was India’s first Leveraged Buy-Out or LBO as it is popularly called.

But what exactly is LBO ?

Well it’s like a small fish eating a big one. Not possible! Well in the field of merger and acquisition it is very much possible. LBO is company acquiring another one, which is of size greater than three or four times the size of the acquirer.

For example in March 2000, Tata-Tetley 300 mn pound deal, Tata tea had net worth of less than one third of the net worth of Tetley, whom it acquired.

In LBO an special purpose vehicle (SPV) is formed to carry out the deal in which, the acquirer puts small amount of equity (the capital brought in by itself) into the SPV and rest amount is raised from debt which is 3-5 times the equity. The lenders are given the assets of the company being acquired as the collateral. Thus, there is no net affect on the balance sheet of the acquiring company as the loan is taken by the SPV. Oh ! this sounds great.

After the Tata-Corus LBO, Tata steel is now the fifth largest producer of Steal. Calcine-CII carbon deal made Calcine largest producer of the calcined carbon in the world. So for the organic growth this LBO seems to be mostly used tool. However, this is not something that makes the investors very happy.

Then where is the catch?

Firstly, for the debt the interest rate is very high for LBO, sometimes as high as 8-9.5 %. This puts huge burden on the acquiring company in terms of paying interest, although, the acquiring company is not primarily responsible as the loan is taken by the SPV, but its know to everyone that if there is any default the company may have to pay by liquidating (selling) its own assets. This reduces the value of the firms in the minds of investors, which reflects in the lowering of share price of the company.

Secondly, the rating of the company goes down. After the Tata-Corus deal, the rating of Tata came down from AAA to AA. This makes the company unfavorable for investor to invest in it when the company itself needs some fund later.

Thirdly, the heavy interest payment is thought to be paid by the future cash earnings of the acquired company. For this there is a need of market. Now to find such market the company relies on international market. For example in case of Tata steal India will have to rely on market like China for generating revenue which can be used to pay those heavy interest. Now if the relation with china becomes bad, the company will turn red.

Then again the question comes in mind that if there is such a risk involve than why at all the company go abroad for the leverage buy-out when there is a option of merger?

The reasons are:

i) RBI has regulation that a domestic company can’t raise debt more than three times of the net worth of it. In case of LBO, the SPV is created outside India and it takes loan as much is needed as fall outside the purview of RBI.

ii) Merger can be an option but, cross country merger always has to deal with a lot of regulations and barriers. So the simple way out is acquire that company by floating a SPV in the country where the company being acquired is belongs.

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