The Hindu Business Line : Deal space post meltdown

There is a near equal division among the constituents of the global economy - those who blame `mark to market' accounting for the onset of the credit crunch itself and those who credit it for the early detection of the crunch..

Mr Shinoj Koshy, Associate, Cleary Gottlieb Steen & Hamilton LLP, London.

The falling Sensex and the erosion of market cap may make some of the Indian companies likely targets for acquisition, primarily because a large number of the Indian blue chips have fundamentally robust business models and with falling demands in the West, companies with a thirst for expansion will have to look towards India and China, says Mr Shinoj Koshy, a London-based law expert specialising in M&A.

"We can expect a correction in the property market in India as the attractiveness reduces due to: (1) reduction in demand due to reduced liquidity in the domestic market; and (2) reduced investment in the real estate FDI (foreign direct investment) due to large unsold stock due to which the developer's books may not look healthy and, therefore, unattractive for a foreign investor," said Mr Koshy, during the course of a recent email interaction with Business Line.

A product of the National Law School of India and a winner of the Honourable Justice V. G. Ramachandran Gold Medal for Excellence, Mr Koshy is a solicitor of the Supreme Court of England & Wales. He worked for Linklaters LLP at its offices in London and Dubai before his current role as Associate in Cleary Gottlieb Steen & Hamilton LLP, London.

His practice focuses on corporate transactions, particularly joint ventures, mergers and acquisitions (M&As). Mr Koshy has advised several corporates and private equity funds on cross-border mergers and acquisitions and on foreign direct investments into emerging markets like India. He also has experience of several transactions in the Middle East.

Excerpts from the interview in which Mr Koshy expresses his personal views on areas ranging from deals to investment, from the financial meltdown to the way forward.

What has changed in the deal space post financial meltdown?

The credit crunch had begun to set in from the last quarter of 2007. However, at that point the Sensex was cruising at 20,000 points and the INR/USD was 1/40. The inflated market capitalisations of Indian companies ensured that finance was easily available to them in the initial phase of the crunch.

A weak dollar, falling asset prices and valuations of the companies in the West, and the general decline in the availability of finance in the US and Europe led to the belief that Indian companies will be the next big wave of shoppers.

All this changed with the events in September 2008. The bite of the crunch was felt across markets and it was soon felt that India was not totally "decoupled".

The Sensex began to crash and is now below 10,000 points, eroding a little more than 50 per cent of the value. The US government's liquidity push of $700 billion wiped out the gains that rupee had made in the forex markets. Now the rupee is 48 to the dollar.

Clearly, this is putting a lot of pressure on the pipeline deals in terms of getting financing, as pre-existing rupee commitments are falling short to get the requisite dollar amounts. The larger the size of the debt component in the acquisition finance, the larger the shortfall. Consequently, several deals are being delayed as financing is being renegotiated. However, the silver lining is that Indian companies, can still look at acquisitions and a lot of this also includes mid-market acquisitions ($25 million).

The volatile markets have ensured that capital markets work has practically dried up, as no one wants to run the risk of making an issue when share prices are on a free fall.

Have any sectors now become attractive for Indian businesses interested in overseas acquisitions?

The valuations have gone down particularly for companies serving the financial sector. For example, the IT (information technology) services sector and the India companies have taken advantage of the situation and made some significant acquisitions in this sector.

Due to the depreciating rupee, the IT companies are shoring up profits and falling evaluations allow them to grow into the Western markets through acquisitions. The recent acquisitions have been HCL outbidding Infosys to acquire the UK-based Axon and TCS snapping up Citi's captive Indian BPO, Citigroup Global Services for $505 million.

In addition to this, for the first time, in 2007, the Indian in-bound investment into US was higher than the total US FDI into India.

How do you see companies that made acquisitions just prior to the meltdown coping with the value erosion? What are their strategies?

There is a near equal division among the constituents of the global economy, who blame "mark to market" accounting for the onset of the credit crunch itself and those who credit it for the early detection of the crunch. The fact is that this is the accepted method, when operating internationally.

As a consequence, depending on the way the documents are drafted, there could be the occurrence of events of default and payment events under the finance documents and the margin loans when market valuations of assets fall.

This particularly affects acquirers who used a large amount of leverage in their acquisition. To cope with this many have started negotiations with the lenders for waivers and in many cases refinancing of existing loans. In the context of margin loans, typically the lenders have cooperated because it is in their interest to see the borrower revive rather than enforce the security in a market where share prices are falling each day.

What are the apt financing options for deals, and also the deal structures, currently?

Reduced liquidity levels leave very limited financing options. Therefore, the recent easing of ECB (external commercial borrowing) norms will not particularly help given the liquidity crisis. Considering the crisis of confidence among lenders, we can expect a decrease in the level of leverage used to make acquisitions. There will be an increased focus on the financial covenants included in the documents. "Covenant-lite" loans will become a thing of the past for the foreseeable future.

The time taken for deal completion will increase, as extremely cautious credit committees will be reluctant to give approvals unless they are completely confident about the borrower and the underlying assets.

Any impact on the India-bound investment?

India has continued to be the second most-preferred global location for foreign investment in 2008, lagging (as it has been for a number of years and on a number of economic indicators) behind China.

Despite the fact that companies plan investment decisions several months in advance they have to factor in the significant change in market conditions. The global liquidity crunch has no doubt affected fresh FDI inflows into India. The GOI (Government of India) had set a target of $40 billion for the fiscal 2008-09.

In the present market conditions, this figure looks unrealistic, as big-ticket inflows like those in infrastructure such as ports and airports have been put on hold. But despite the crunch in real terms, there has been an increase in the FDI flows, and during April-August 2008 India received FDI of $14.8 billion which is a 114 per cent increase over the corresponding figure for 2007.

The flight of funds due to the exit by the FIIs (foreign institutional investors) has contributed to reducing liquidity in the domestic market. The liberalisation of the ECB regulations and the increase in the cap are likely to help, but with a global liquidity crisis there is only so much to borrow from overseas.

Any analysis of inbound investment must make the distinction between FDI and investment by the FII. Typically, the former is a long-term outlay and existing FDI is less affected by a liquidity crisis. Whilst fresh inflows of FDI might get adversely affected due to the reduced liquidity and the extent of growth may be lower than expected, India, even with a 7 per cent growth, is still a relatively more attractive destination than the US, the UK and Europe which are experiencing recessionary trends.

Your take on FDI with respect to pharma and aviation.

Here are my preliminary thoughts:

Pharmaceutical: The government has allowed FDI up to 100 per cent in the sector since 2005. However, this has not led to any significant increase in the investment by foreign players. To my mind there are several reasons like, for example, other regulations dealing with the industrial and drug licensing have not kept pace with the FDI reforms; the absence of product patents does not inspire confidence in foreign players to launch new drugs into the local market.

Additional reforms, particularly in the patents regime, allowing product patents would allow the Indian market access to new drugs.

Aviation: At present foreign airlines are not allowed to acquire any direct or indirect equity stake in domestic airlines. However, with the recession in the global markets affecting the developed western economies more than the emerging markets there is bound to be increased interest by foreign players in the domestic civil aviation sector.

For instance, the courting of Kingfisher by several foreign airlines. In such a case it would be advisable to gradually allow foreign airlines take equity stake, provided it is done in a phased manner, such that the local players can be prepared for increased competition.

Allowing phased FDI will also ensure that the local players have easier access to technology and capital. This would be welcome, especially in the present economic climate, when the local players are struggling to stay afloat through various measures such as mergers (Kingfisher and Jet).

(Illustration by R. Rajesh)

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