Leverage buyout

Acquisition of a company financed largely by borrowing.

•Underlying strategy is to restructure the co, rapidly improve its performance and increase the cash
flows generated by the firm’s assets in order to repay most of the initial debt within reasonable
period of time.

•In other words, the acquired co’s profits are used for repayment of the debts taken for its
acquisition

•In most of LBOs the purchase price of acquisitions have been financed with debt and tangible assets
of the target co have been used as collateral for the loans

•Sometimes when the target is a public co, the LBO leads to it becoming private, because the entire
equity is purchased by a small group of investors and so no more publicly traded. Consequently the
investor group may attempt to realise a return on their investment by again taking the company
public through a public offering or by selling it to a strategic buyer.

Variants of LBO

•Management Buy-in (MBI)

–LBO sponsor replaces the incumbent management with a new team

–The new team is offered an equity stake in the co

•Management Buy Out (MBO)

–Management of the co decides to take over its publicly held co/division and consequently make it
private.

–In a typical MBO, the acquisition price is paid by a very small amount of contribution from
management and rest from a mix of debt and venture funding.

•Buy in Management Buy Out (BIMBO)

–Hybrid of the above two methods.

–LBO sponsor combines some of the old target management with new outside managers

•Reverse LBO

–Company goes private after an LBO and becomes public again at a later date after improving its
performance
Slump sale
As per section 2(42C) of Income -tax Act 1961, ‘slump sale’ means the transfer of one or more
undertakings as a result of the sale for a lump sum consideration without values being assigned to
the individual assets and liabilities in such sales.

• As per Explanation 1 to section 2(19AA), ‘undertaking’ shall include any part of an undertaking or a
unit or division of an undertaking or a business activity taken as a whole, but does not include
individual assets or liabilities or any combination thereof not constituting a business activity.

• Explanation 2 to section 2(42C) clarifies that the determination of value of an asset or liability for
the payment of stamp duty, registration fees, similar taxes, etc. shall not be regarded as assignment
of values to individual assets and liabilities. Thus, if value is assigned to land for stamp duty
purposes, the transaction will be a qualifying slump sale under section 2(42C)

• A sale in order to constitute a slump sale must satisfy the following quick test:

–Business is sold off as a whole and as a going concern

–Sale for a lump sum consideration

–Materials available on record do not indicate item-wise value of the assets transferred

Explanation

•The subject matter of slump sale shall be an undertaking of an assessee.

•An ‘undertaking’ may be owned by a corporate entity or a non-corporate entity, including a

professional firm.

•Slump sale may be of a single undertaking or even more than one undertaking.

•The undertaking has to be transferred as a result of sale.

•The consideration for transfer is a lump sum consideration. This consideration should be arrived at
without assigning values to individual assets and liabilities. The consideration may be discharged in
cash or by issuing shares of Transferor Company.

•Possibility of identification of price attributable to individual items (plant, machinery and dead
stock) which are sold as part of slump sale, may not entitle a transaction to be qualified as slump
sale — CIT vs. Artex Manufacturing Co., [227 ITR 260 (SC)]. However, in case of slump sale which
includes land/building where separate value is assigned to it under the relevant stamp duty
legislation, the slump sale will not be adversely affected in the light of Explanation 2 to section
2(42C).

•Transfer of assets without transfer of liabilities is not a slump sale

Offer price in an open offer by acquirer under SEBI Takeover Code 2011
Min offer price in case of a direct acquisition of target co or an indirect acquisition that is treated as
direct acquisition under Reg 5(2)

Highest of the following –

•The highest negotiated price per share of the target co for any acquisition under the agreement
attracting the open offer

•The volume-weighted avg price paid or payable for the acquisition by the acquirer during 52 weeks
immediately preceding the date of PA of the OO

•The volume-weighted avg market price of such shares for a period of 60 trading days immediately
preceding the date of the PA as traded on the stock exchange where maximum volume of trading is
recorded for the target co during such period

•The per share value computed under Reg 8(5) in respect of an indirect acquisition that is treated as
direct one under reg 5(2).

In case of companies with shares not frequently traded, [Reg 8(4)] instead of the market price and
their averages, the price (fair value) is determined by the acquirer and manager to the open offer by
taking into account valuation parameters including book value, comparable trading multiples, etc.
that are customary to the valuation of shares of such cos.

Hostile Takeover Strategies

Example of a Hostile Takeover

For example, Company A is looking to pursue a corporate-level strategy and expand into a new
geographical market.

Company A approaches Company B with a bid offer to purchase Company B. The board of directors
of Company B concludes that this would not be in the best interest of shareholders in Company B
and rejects the bid offer. Despite seeing the bid offer denied, Company A continues to push for an
attempted acquisition of Company B.

In the scenario above, despite the rejection of its bid, Company A is still attempting an acquisition of
Company B. This situation would then be referred to as a hostile takeover attempt.

•Dawn Raid
A dawn raid refers to the sudden sweeping purchase by a potential acquirer of a substantial number
of a target company’s shares the moment the market opens (“dawn”). A dawn raid is typically
undertaken by a potential acquiring company in the context of a hostile takeover attempt.

For example, let’s assume that Company B wants to take over Company A, for whatever reason
(usually because they see that Company A offers some value or advantage that Company B can use
to increase revenues and profitability). The moment that the market opens in the morning – dawn –
Company B attempts to purchase a massive amount of Company A’s outstanding shares – ideally at
least 51%, which will give Company B a controlling interest in Company A.

Once it has obtained a controlling equity interest, Company B can restructure the board of directors
and management team of Company A so that it will agree to Company B’s merger terms.

•Bear Hug

In business, a bear hug is an offer made by one company to buy the shares of another for a much
higher per-share price than what that company is worth in the market. It's an acquisition strategy
that companies sometimes use when there's doubt that the target company's management or
shareholders are willing to sell.

A bear hug can be interpreted as a hostile takeover attempt by the company making the offer, as it's
designed to put the target company in a position where it is unable to refuse being acquired.
However, unlike some other forms of hostile takeovers, a bear hug often leaves shareholders in a
positive financial situation.

The acquiring company may offer additional incentives to the target company to increase the
likelihood that it will take the offer. Because of this, a bear hug can be extremely expensive for the
acquiring company and it may take the company longer than usual to see a return on investment.

Refusal to take the bear hug offer can potentially lead to a lawsuit being filed on behalf of the
shareholders if the target company cannot properly justify the refusal. Since the business has a
responsibility to the shareholders, refusing an offer that otherwise may seem too good to be true
could be considered a poor decision.

•Saturday night special

A Saturday Night Special is now an obsolete takeover strategy where one company attempted a
takeover of another company by making a sudden public tender offer, usually over the weekend.
This merger and acquisition (M&A) technique was popular in the early 1970s when the Williams Act
required only seven calendar days between the time that a tender was publicly announced and its
deadline. Catching the target company off guard and over the weekend, effectively reducing its time
for a response, often afforded the acquiring company an advantage.

A tender offer is basically an attempt to takeover control of a company by asking shareholders to sell
their shares at a specified price (usually above market). If enough shareholders sell their shares, the
takeover is complete. The Saturday Night Special was effective when the Williams Act required a
minimum of seven days between the public announcement of the tender and its deadline. When the
time period was extended to 20 days, this technique failed to be the quick strike it was originally
intended to be. In addition, acquisitions of 5% or more of equity now need to be disclosed to the
Securities and Exchange Commission (SEC).

•Proxy fight

Also known as a proxy battle, this hostile takeover method is aimed at the board of directors. The
acquirer will attempt to get a proxy vote by convincing the target company's shareholders to vote
out the current board of directors and appoint new management that would favor the takeover.

•Market accumulation followed by open offer

•Negotiated deal with FIs followed by open offer

•Negotiated deal with breakaway promoter group

•Direct offer to the shareholders

Hubris hypothesis in Takeovers
“Managerial hubris is the unrealistic belief held by managers in bidding firms that they can manage
the assets of a target firm more efficiently than the target firm's current management. Managerial
hubris is one reason a manager may choose to invest in a merger at premium higher than the real
price”. [Richard Rolls, 1986]

•Rolls States that if Hubris Hypothesis explains the takeover, the following should occur to the
takeovers motivated by hubris –

–The stock price of the acquiring firm should fall after the market is aware of the takeover bid

–Stock price of the target should go up with the bid of control

–The combined effect of the rising price of the target and falling price of the acquirer should be
negative. This takes into account the cost of the transaction.
Drivers of M&A Ansoff’s Product Market Matrix

E.g. GTB merger with OBC – OBC made foray into Southern India and also acquired the tech savvy
modern banking practices of GTB 22

Kotler’s approach: 3 classes of opportunities – intensive, diversification and integrative growth

The matrix was developed by applied mathematician and business manager H. Igor Ansoff and was
published in the Harvard Business Review in 1957. The Ansoff Matrix’s helped many marketers and
leaders understand the risks of growing their business.

The four strategies of the Ansoff Matrix are:

Market Penetration: It focuses on increasing sales of existing products to an existing market.

Product Development: It focuses on introducing new products to an existing market.

Market Development: Its strategy focuses on entering a new market using existing products.

Diversification: It focuses on entering a new market with the introduction of new products.
Of the four strategies, market penetration is the least risky while diversification is the riskiest.

The Ansoff Matrix: Market Penetration

In a market penetration strategy, the firm uses its products in the existing market. In other words, a
firm is aiming to increase its market share with a market penetration strategy.

The market penetration strategy can be done in a number of ways:

1. Decreasing prices to attract existing or new customers

2. Increasing promotion and distribution efforts
3. Acquiring a competitor in the same marketplace

For example, telecommunication companies all cater to the same market and employ a market
penetration strategy by offering introductory prices and increasing their promotion and distribution
efforts.

The Ansoff Matrix: Product Development

In a product development strategy, the firm develops a new product to cater to the existing market.
The move typically involves extensive research and development and expansion of the product
range. The product strategy development strategy is employed when firms have a strong
understanding of their current market and are able to provide innovative solutions to meet the
needs of the existing market.

The product development strategy can be done in a number of ways:

1. Investing in R&D to develop new products to cater to the existing market

2. Acquiring a competitor’s product and merging resources to create a new product that better
meets the need of the existing market
3. Strategic partnerships with other firms to gain access to each partner’s distribution channels
or brand

For example, automotive companies are creating electric cars to meet the changing needs of their
existing market. Current market consumers in the automobile market are becoming more
environmentally conscious.

The Ansoff Matrix: Market Development

In a market development strategy, the firm enters a new market with their existing product(s). In
this context, expanding into new markets may mean expanding into new geographies, customer
segments, regions, etc. The market development strategy is most successful if (1) the firm owns
proprietary technology that it can leverage into new markets, (2) consumers in the new market are
profitable (i.e., they possess disposable income), and (3) consumer behavior in the new markets
does not deviate too far from the existing markets
The market development strategy can be done in a number of ways:

1. Catering to a different customer segment

2. Entering into a new domestic market (expanding regionally)
3. Entering into a foreign market (expanding internationally)

For example, sporting companies such as Nike and Adidas recently entered the Chinese market for
expansion. The two firms are offering the same products to a new demographic.

The Ansoff Matrix: Diversification

In a market development strategy, the firm enters a new market with a new product. Although such
a strategy is the riskiest, as market and product development is required, the risk can be mitigated
through related diversification.

There are two types of diversification a firm can employ:

1. Related diversification: There are potential synergies to be realized between the existing business
and the new product/market. For example, a leather shoe producer that starts a line of leather
wallets or accessories is pursuing a related diversification strategy.

2. Unrelated diversification: There are no potential synergies to be realized between the existing
business and the new product/market. For example, a leather shoe producer that starts
manufacturing phones is pursuing an unrelated diversification strategy.
Factors Responsible for M&As
Exogenous Factors

•Industrial and Regulatory policies

–Nationalisation of insurance businesses in 1956

–The National Textile Corporation took of a large number of sick textile units

–Liberalisation in 1991 triggered many M&As

•Competitive Impact –TOMCO’s take over by HLL

–Ranbaxy in 1996-97 acquired 3 cos to become market leader by relegating Glaxo and Cipla to #2
and #3 position respectively

•Pre-emptive motive

–Acquisition of Premier Tyres by Apollo

Endogenous Factors

•Growth

–Murugappa Group acquired 12 cos in less than 15 years after liberalisation (EID Parry, Coromondal
Fertilizers, Bharat Pulverizing Mills, Sterling Abrasives etc)

–Others include HUL, RPG Ent, Shaw Wallace, UB Group, Ranbaxy etc)

•Portfolio strategy

–TOMCO acquisition by HLL

–Take over and merger of Brook Bond Lipton India Ltd by HLL

•Scale Economies and synergies

–Brooke Bond and Lipton whose had overlapping businesses merged in 1993

–During 1995-96 BBLIL took over 3 key players in ice cream market, Kwality, Dollops, Milkfoods,
which together with its own brand Walls gave half the share of market to BBLIL

•Corp control and defensive strategy

–GE Shipping, Finolex Cables, Indian Rayon – went for share buyback to prevent hostile takeover and
to increase the promoter control on the cos

•Tax Shield

–HLL – BBLIL merger to utilize accumulated losses and unabsorbed depreciation

•Long term financial considerations

Creeping acquisition
Creeping acquisition governed by Regulation 11 of the Takeover Code refers to the process through
which the acquirer together with persons acting in concert (Acquirer) increase their stake in the
target company (Target) by buying up to 5% of the voting capital of the company in one financial
year.

An acquirer (along with PACs) almost reaches 25% of voting rights in the course of acquisition of
shares [Reg 3(1)]

•Creeping Acquisition

–No acquirer who (along with persons acting in concert) is holding such no of shares that entitle him
to exercise 25% or more voting rights (but less than max permissible non-public holding), can acquire
such no of add shares /voting rights in a financial year that entitle him to exercise more than 5% of
the voting rights, without making a public announcement of open offer. This is called Creeping
Acquisition

Spin off, Equity carve out and split off

SPIN OFF
The parent company (ParentCo) distributes to its existing shareholders new shares in a subsidiary,
thereby creating a separate legal entity with its own management team and board of directors.

•The distribution is conducted pro-rata, such that each existing shareholder receives stock of the
subsidiary in proportion to the amount of parent company stock already held. No cash changes
hands, and the shareholders of the original parent company become the shareholders of the newly
spun company (SpinCo).

•Existing shareholders enjoy the benefit of holding shares of two companies instead of just one
company. The hidden motive is to allow the Spin-off to have a distinct identity from parent
company’s management.

Equity Carve-out
•In an equity carve-out, also known as an IPO carve-out or a subsidiary IPO, the parent company
(ParentCo) sells a portion or all of its interest in a subsidiary (SubCo) to the public in an initial public
offering. The carve-out creates a new legal entity with its own management team and board of
directors, and provides a cash infusion with proceeds distributed to the parent, subsidiary, or both.
•equity carve-outs can be used to achieve the following additional strategic objectives:

–Cash infusion – Cash proceeds can be distributed to ParentCo, SubCo, or both

–Preparation for complete separation – Establish a public market valuation for SubCo in preparation
for a subsequent spin-off or split-off of ParentCo's remaining interest

Equity Carve-out

–Demerger into a subsidiary. The shares of subsidiary are allotted to the transferee co and not to its
shareholders.

–the parent company sells part of their interest in the new subsidiary to the public in a registered
public offering (IPO) for cash proceeds instead of just existing shareholders

–also known as a partial spin-off

–When a corporation needs to raise capital, selling off a portion of a division while still holding
control, proves to be a win-win situation for the company

–Sometimes a company might feel that a particular division has hidden potential and might perform
well once it is spun-off. A separate stock garners more attention and enables investors to value the
business independently

–Equity carve-outs are commonly followed by a tax-free spin-off or split-off of ParentCo's remaining
interest in SubCo

SPLIT OFF
•Restructuring an existing corporate structure in which the stock of a business unit or a subsidiary is
transferred to the shareholders of the Parent Company in lieu for stock in the latter

•While on the other hand in Spin-off, stocks in subsidiary are distributed to all existing shareholders
just like the dividend

•In a split-off, the parent company gives a Tender offer to its shareholders to exchange their shares
for new shares of a subsidiary. This tender offer usually gives a premium in order to encourage
existing shareholders to go for the offer. This privilege of “premium” tells why split-offs usually end
up being oversubscribed.

•If the offer is oversubscribed, it means that more of the Parent shares are tendered than that of the
subsidiary. When the shares are offered, the exchange happens on a pro-rata basis.

•On the flipside, if the tender offer is under-subscribed, it means that too few shareholders of
parent company have accepted the tender offer. The Parent company will then usually distribute the
remaining unsubscribed shares of the subsidiary on pro-rata through a spin-off.
What Is Economic Value Added (EVA)?
Economic value added (EVA) is a measure of a company's financial performance based on the
residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes
on a cash basis. EVA can also be referred to as economic profit, as it attempts to capture the true
economic profit of a company. This measure was devised by management consulting firm Stern
Value Management, originally incorporated as Stern Stewart & Co.

Understanding Economic Value Added (EVA)

EVA is the incremental difference in the rate of return over a company's cost of capital. Essentially, it
is used to measure the value a company generates from funds invested into it. If a company's EVA is
negative, it means the company is not generating value from the funds invested into the business.
Conversely, a positive EVA shows a company is producing value from the funds invested in it.

The formula for calculating EVA is: Net Operating Profit After Taxes (NOPAT) - Invested Capital *
Weighted Average Cost of Capital (WACC)

Economic value added (EVA) is a measure of a company's financial performance based on the
residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes
on a cash basis.

•EVA can also be referred to as economic profit, as it attempts to capture the true economic profit
of a company.

•This measure was devised by management consulting firm Stern Value Management, originally
incorporated as Stern Stewart and Co.

•EVA = Net Operating Profit After Taxes (NOPAT) – [Invested Capital * Weighted Average Cost of
Capital (WACC)]

•EVA = NOPAT - (Total Assets - Current Liabilities) * WACC = ROIC - WACC

•The goal of EVA is to quantify the charge, or cost, of investing capital into a certain project or firm
and to then assess whether it generates enough cash to be considered a good investment. The
charge represents the minimum return that investors require to make their investment worthwhile.
A positive EVA shows a project is generating returns in excess of the required minimum return.

•EVA assesses the performance of a company and its management through the idea that a business
is only profitable when it creates wealth and returns for shareholders, thus requiring performance
above a company's cost of capital.

•However, the EVA calculation relies heavily on the amount of invested capital, and is best used for
asset-rich companies that are stable or mature. Companies with intangible assets, such as
technology businesses, may not be good candidates for an EVA evaluation
Reasons for DEMERGER
•To focus on core business

•Strategy to enable others to exploit opportunity effectively to optimize returns when the parent
company is unable to do so

•To correct the previous investment decisions where the company moved into the operational field
having no expertise or experience to run the show on a profitable basis

•To help finance an acquisition

•To make financial and managerial resources available for developing other more profitable
opportunities.

•To get rid of sick part of the company

•As part of succession plan / Family settlement

•To attract investors – Demerger typically generates cash which can be invested by the core
company into expansion and/or reducing debts. This increases cashflow for the existing shareholders
and can attract fresh investment.

•To improve valuation – E.g. The combined market capitalization of Sun Pharma and its demerged
R&D firm SPARC went about 10 to 15 per cent higher than the market capitalization of Sun Pharma
since SPARC listed in July 2007

•It unlocks the value of the businesses post demerger. E.g. Crompton Greaves Consumer Electricals
was demerged out of Crompton Greaves Ltd. The two companies have together given 57% return
since its record date of 16.3.2016 during the period when sensex grew 14%.

•Corporate attempt to adjust to changing economic and political environment of the country

Accounting of Demerger

•ICAI has not yet prescribed any accounting standard, however IT Act 1961 has defined the
accounting norms.

•Section 2(19AA) stipulates the accounting treatment that must be mandatorily followed for the
demerger to qualify for tax benefits under the act.

•Only Pooling of Interest method is applicable

•All assets and liabilities of the undertaking must be transferred to the resulting demerged co and
must be transferred at Book values only.

•Any revaluation of asset needs to be ignored

•Specific liabilities of the undertaking being demerged should be transferred to the resulting co
•Specific loans/borrowings incurred and utilized solely for the operations of the undertaking being
demerged have to be transferred to the resulting co

•Common loans/borrowings have to be apportioned to the resulting in the same ratio as the book
value of the assets transferred to the resulting co to the total book value of the assets of the
company prior to demerger