The Hindu Business Line : Get over the idea of leverage as `bad'

Chennai March 15 Wars for acquisition targets often see corporates head to head with PE (private equity) houses. Who are the usual winners? PEs, concedes a recent report from KPMG, UK.

Do PEs enjoy an advantage in the acquisition situations? If so, where does that edge come from? Can it be overturned? These are some of the questions the report begins with. Though the study is based on the FTSE companies and the UK situation, the report's findings may be of relevance to companies closer home too. More so those that have UK targets on their radars.

First, PEs seem to enjoy many pluses. One, they are `more aggressive in processes'. Two, speed; they are more `fleet of foot'. Three, `even where they have more due diligence to do when making an acquisition, they still manage to move quicker than quoted companies, especially where vendor due diligence has been carried out'.

PEs are real deal machines, says Mr Michael McDonagh, Corporate Finance Partner of the firm's PE Group. "Private equity players usually don't have the synergies that corporates can enjoy with a takeover target, but they don't have the negative synergies either of making two different businesses fit. Post-completion they go straight in and make changes to drive profit growth."

How do the two compare, in raising finance? Contrary to popular thinking, both corporates and PEs appear to be on `a fairly level playing field', measured by WACC (weighted average cost of capital). KPMG's research finds the WACC of FTSE 350 companies to be between 10 and 11 per cent, `compared to the PE houses' average figure of between 11 and 13 per cent for deals greater than £500 million'.

Advantage base

A wide variation, however, is seen in the leveraging. "The FTSE 350's net debt to EBITDA (earnings before interest, tax, depreciation and amortisation) ratio averages 1.2 times, versus PE-backed businesses' net debt to EBITDA of 7.7 times." What is the message, therefore? By increasing leverage by just a little bit, corporates may be able to increase the financial advantage, suggests KPMG.

"Companies are starting to get over the idea of leverage as `bad'," reads a quote of Mr Neill Thomas, Partner and Head of KPMG's Debt Advisory Services. "With the ability to hedge, some are now comfortable with high levels of debt, especially if they are locked into lower, longer-term rates. They're saying, `If private equity players can outbid us and use particular techniques to take public companies private, then why can't we use those techniques ourselves?'"

Since leveraging has a risk baggage, the report counsels corporates not to aim at the high levels that PEs work at. "They can leverage way short of the PE houses, and still achieve an efficient balance sheet."

No one is going to call corporates irresponsible if the debt ratio doubled to between 2 and 2.5 times, postulates the report.

Value creation

To those who say that adding debt can increase interest expense line, which in turn would dampen expected net profit growth rates, Mr Thomas says, "This is arguably an outdated form of valuation." There are other measures of value creation, such as economic profit or cash flow based analysis, he points out.

"Corporates need to consider different approaches to financing and in the process test conventional methods of thinking. Companies should be leading the way, not waiting to follow," urges Mr Thomas.

In sum, here is the action plan for corporates that are on the look out for targets: `Put in place clear decision-making processes and short reporting lines' rather than `complex matrix structure' before you `identify the right acquisition target', and then `compete effectively in auctions'.

The report concludes on a sombre note, thus: "Many corporates and their boards need to take action or they could either lose out when competing with the private equity community or fall prey themselves."

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