The Hindu Business Line : Why MBOs win over simple M&As

Management buy-out (MBO) deals help in reducing the scope for disputes. Mind you, some disputes can derail the entire transaction. All that we get to hear after such a `failed deal' is one scorned party voicing its opinion, if at all. "As the buyer is fully aware of the business, there are fewer chances for dispute about the quality of the business. MBOs do really add value to the M&A deals through greater synergy value flowing from independence and autonomy to the management and strategy, backed with sufficient commitment on investment. Such higher synergy value provides for sufficient cushion for the buyer and seller to compromise on many areas of dispute," notes Mr M. R. Rajaram, a chartered accountant by profession, who has been associated with ICI India for more than 35 years. But to realise synergy values and benefits with MBO, there are certain prerequisites, Mr Rajaram adds, over an email interaction. To find out what these are, read on..

Excerpts from the interview:

Why M&A disputes?

M&A deals are always high profile transactions attracting a lot of attention. This itself acts as a catalyst for disputes. Further, there are limited opportunities for acquisitions for the buyers leading to aggressive biddings; and parties losing out in the bidding process try to jeopardise the deal. In the absence of any clear benchmark for value, the seller always has a nagging doubt whether he has negotiated the maximum potential value for the transaction.

Added to this, the M&A process itself is a complex one. A successful M&A deal requires very close teamwork between the businessman and functional experts/advisors such as lawyers, accountants, actuaries, etc. Also, there is a time lag between signing of the contract and its implementation. If the deal involves approval for transfer of land from State Government, this could stretch the period to over a year. During such delays in implementation of the M&A deals, the business scenario could drastically change which could tempt parties to break the deal by raising frivolous disputes.

What impact do these disputes have on M&A deals?

It is difficult to generalise the impact of M&A disputes. The impact is really dependent upon the type of disputes. Some of them could be severe so as to totally derail the transaction. Others could result in delay in the implementation. However, the common area of disputes is in settlement of the value after implementation of the transaction.

Can you elaborate on the various types of disputes and their implications?

M&A deals will always have a force-majeure clause. Also, M&A deals do provide for `material adverse' clause. Such clauses are necessary considering the time required for implementation. These clauses give the right to the buyer either to terminate the deal or renegotiate the price. There could always be arguments about what is covered under these clauses. This again is capable of being interpreted differently by various parties. Any disputes here will result in either derailing the deal itself or delay the implementation depending on the final outcome of such disputes.

Another potential area of dispute is about valuation. For tax optimisation, the preferred structure for sale of businesses is `slump sale'. In case of slump sale, overall value for the business is fixed without apportioning values for various parts of the business.

One of the key elements required to be reflected in this valuation is net working capital. While working out the `slump sale' price, generally notional working capital value is factored and agreements provide for adjustment in the price based on the difference between notional working capital and actual working capital on the day of sale.

Determination of the actual working capital is one of the complex areas, as the method of valuation of various items such as stock, provision for debtors are judgmental, and there are different accepted accounting principles followed by various companies and accepted by auditors. Reaching a common value between the buyer and the seller on this account is a great challenge.

Do existing employees pose a concern for the acquirer?

Yes. M&A transactions involve transfer of employees to the buyer without break in their service. The purchaser assumes the retiral benefit obligations of the transferring employees for their past services. However, the seller has to ensure that these obligations are fully funded. Determining the value of such obligations is a complex actuarial exercise and the values can swing widely depending on the assumptions for future interest rate, mortality rate, etc.

Another area of dispute is regarding the method of determination of additional consideration under `earn out' formulae. When there is gap in the perception of value of the business between the buyer and seller, `earn out' formulae come in handy for `stitching' the deal. But working out the outcome under these formulae at a later stage has its own challenges as the business comes under the management of the buyer post implementation of the deal and he has to pay more for better performance.

Most of the M&A deals will have restricted covenants on the seller by way of `non-compete' obligations. Many a time the seller tries to wriggle out of this constraint either through benami transaction or challenging the restriction as amounting to restrictive trade practice.

Approvals from authorities.

An interesting area of dispute is around internal or external regulatory approvals. These are used as a good excuse by the parties to wriggle out of the deal. Few years back, there was a famous case of a seller of shares of a company owning a famous FMCG product, where after signing an agreement for sale with an MNC, the seller unsuccessfully tried to resell the shares to another MNC at a higher price using the argument that the first deal was invalid in the absence of shareholders' approval.

Another interesting aspect here is that in addition to the deal, third parties can also use this provision for stopping the deal. My company itself had this experience from both sides. ..When ICI tried to buy minority stake in Asian Paints, the same was stopped by other promoters of Asian Paints under the FIPB regulations. When Astra announced its intention to buy majority stake in a pharmaceutical company, ICI objected to the same resulting in delay in the deal.

What precautions should be taken to avoid these disputes?

Selection of the right party, complete and fair disclosure of the state of the business during negotiations, and speedy implementation of the deal are critical in minimising the disputes. Also, efforts should be taken to finalise all tricky issues at the time of signing the agreement as generally the best of relationship exists between the buyer and seller at that point of time.

The agreement should also provide for proper arbitration clauses with specific names of the arbitrators who have the relevant expertise. Further, MBO deals also help in reducing the scope for disputes.

How do MBOs help in this regard?

As the buyer is fully aware of the business, there are fewer chances for dispute about the quality of the business. In addition, MBOs do really add value to the M&A deals through greater synergy value flowing from independence and autonomy to the management and strategy, backed with sufficient commitment on investment. Such higher synergy value provides for sufficient cushion for the buyer and seller to compromise on many areas of dispute. However, to realise this benefit and also to protect the sellers' exposure, there are certain prerequisites.

What are these prerequisites?

These depend on the type of MBO deals. MBO could be for controlling shareholding interest in a company or a strategic business unit (SBU) within a company. To my mind, if it is the former, it is easy to realise the full potential of the deal as the private equity (PE) players involved in this deal bring to table the financial resources and their experience in managing the board/shareholding. There will also be continuity of management with greater involvement and commitment coming out of their wider participation.

However, when it comes to divestment of SBUs, the equation becomes a bit more complex. Prior to the deal, in fact there were three different management skills involved in running the business, namely, the line managers of the relevant SBU, the corporate team within the company, and the shareholders/board.

All three of them play distinctly different roles. Business line managers try to aggressively grow the business, the corporate team brings in necessary checks and balances and challenges so as to ensure the business team deliver the value with least risk. The board/shareholders provide the direction and the cash for the business.

In case of an MBO of the SBU, only the business team goes with the business and the corporate team stays back with the seller. Post the deal, while the business will continue to have the same line managers, PEs take over the role of board/shareholders. The absence of the corporate team could create some gap in some skill sets. If this gap is not properly filled up by the PEs, the business could pursue aggressive strategy without adequate checks and balances which could lead to destruction of shareholders value.

What are the precautions required to be taken in MBOs?

Extracting the maximum value by the seller could prove a challenge, especially when the managers who know business more in detail are part of the buyers! This risk could be exploited by PEs in price negotiation. Hence, it is important for the seller to use the right PE for the deal. Also the timing for MBO should be chosen carefully. A well-timed MBO with the rightly chosen PE with a clear fallback strategy in place will always create a win-win-win situation for seller, PE and the management. I am sure India will witness larger number of MBOs in the coming days.

D. MURALI
KUMAR SHANKAR ROY

Related Stories:
Delay and dispute in M&A deals
MBO: Management or `managed' buyouts?

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