Financing Indian M&As needs a new orientation. It is high time the Reserve Bank of India (RBI) realises that absence of bank lending for corporate takeovers is seriously hampering the growth of Indian M&A activity. The numerous financing constraints that continue to dog the Indian M&A scene should become a matter of great concern for the central banker.

The basic issue is that RBI continues to have archaic rules which do not allow banks to finance corporate acquisitions. The warped rationale behind these rules: banks should stay away from financing speculative activities. But, mergers and acquisitions are not speculative activities. Says Sunil Gulati, managing director of Bank of America and head of its investment banking group: "Acquisition of a strategic controlling stake in a company is an economic activity. It creates value." That is why acquisitions need to be financed like any other economic activity.

RBI initiative needed
Not just bank finance, even institutional finance is not available for funding corporate takeovers. However, there are a few foreign banks which have found ways to get around the archaic RBI guidelines preventing banks from lending against shares. These foreign banks have been financing Indian M&As for quite sometime now. For instance, BankAm financed Gujarat Ambuja for acquiring DLF Cement and funded Grasim for acquiring the brands of Coats Viyella. But, such M&A financing deals are few and far between.

The only financial institution which is taking some interest in financing M&A deals is the ICICI. The French cement major Lafarge partly financed its takeover of Tisco's cement division through loans from ICICI and HDFC.

Meanwhile, Lafarge is planning to part-finance its acquisition of Raymond's cement division through domestic loans. After all, money is fungible. So, banks and FIs should provide financial assistance to companies for various purposes. And M&A is certainly one economic purpose which needs funding.

What is needed now is a plan of action to enable public sector banks finance corporate acquisitions. Since these banks are guided by RBI's lending norms, it is essential that the central banker takes the initiative and frames clear and focused guidelines for M&A financing by banks. Says Gulati of Bank of America: "The RBI should not prescribe M&A financing guidelines, but just provide them." What Gulati means is that the RBI should turn more proactive.

There are RBI guidelines setting out sectoral funding limits to protect a bank's portfolio. Similar guidelines can be provided by the RBI in the area of M&A financing. Such M&A financing guidelines should make takeover funding easier and transparent. And the RBI's stipulation that banks are not allowed to finance corporate acquisition should be done away with.

Junk bonds needed
One area in M&A financing that needs attention is this: we need to create a debt market for raising takeover finance. Equity financing is not so much of a problem. For, there are venture capitalists around. But, debt financing for M&As is the real issue where quick and sensible reforms are needed.

One such reform pertains to the need for creating a junk bond market in India. Junk bonds are securities that lie somewhere between equity and senior debt. Creating a market for junk bonds should allow takeover aspirants gain access to the mezzanine finance market. What is this mezzanine finance market? It is the market which responds to junior or subordinated debt issues. RBI should allow players from the Indian banking sector, players active in the overseas capital markets and domestic rating agencies to enact proactive roles here. Says Gulati of Bank of America: "Sebi can come out with guidelines here."

Fine, but the ground reality is quite different. Investors interested in debt usually shun non-investment grade paper. That is why players in junior debt from the overseas markets should be allowed to come here and create a market for junk bonds. If domestic players in senior debt and overseas players in junior debt begin looking at the Indian debt market, Indian M&A should take off.

Focus on cash flows
Alongside, we need to create a diversified debt market for raising finance for funding acquisitions. Today, bankers are driven by asset cover and are guided by the Tandon and Chore Committee norms. Since more borrowings mean more asset cover from the borrowers, it is not possible for Indian banks to fund M&As. That is why we need to create a range of new instruments to suit various risk profiles. Says Rana Kapoor, managing director of Rabo India Finance: "We need specialised risk-takers. Create a mezzanine market for financing M&As." It is here that the financial institutions (FIs ) can play a vital role.

How? FIs need to change their mindset and start focusing on cash flow lending. They should get over their obsession with asset covers. They should shift their accent from collaterals to cash flows and earn-outs. But, this requires commitment and ability. For, cash flow lending plays an important role in mega takeovers. Shifting to cash flow lending should enable the FIs fund acquisitions through mezzanine finance. That is why the shift to cash flow is vital for making funds available for acquiring large companies.

True. Smaller companies can be easily acquired by just leveraging the balance sheet of the acquirer. But, large acquisitions demand much more. They call for looking at future cash flows. That is precisely what happens in a leveraged buyout (LBO), where debt is serviced through the cash flows generated by the target companies.

If the lending focus shifts over to cash flows, there is no reason why LBOs such as the Tata-Tetley deal cannot be replicated in India. Says Sanjay Dhir, assistant director (investment banking) with the Mumbai-based Jardine Fleming India Securities: "Banks need to develop credit assessment skills for financing LBOs." Many Indian companies want to become multinationals and they would not mind going for cross-border acquisitions. Leverage is the best way to do it.

Rating agencies too have a role to play here. They should be able to rate various subordinated papers. They should develop fool-proof methodologies for rating primary and secondary papers. The traditional bank loan market might not respond to subordinated papers, but should be able to look at these papers in some way. We need merchant bankers who can create a market for these papers and take the leveraged path in the Indian M&A scene.

Consider this example. The Infrastructure Leasing and Financial Services and the Infrastructure Development Finance Corporation recently extended mezzanine finance to the holding company Bharti Televentures for acquiring telecom licences in Karnataka and Andhra Pradesh. This was leveraged financing. Banks need to finance LBOs and should look earnestly at earn-out models.

There is yet another step that could be taken to augment funds available for M&A deals. Put in place securitisation norms and collateralise new businesses. Better still, go a step ahead and create a secondary market in securitised new businesses.

Financing cost
All these reforms should help lower the takeover funding costs. Currently, they are hovering between 13 and 14 per cent, which is still high. The ideal rate: less than 10 per cent. In the international markets, this rate ranges between five and six per cent. Takeover funding costs in India are not guided by an administered rate but by a rate pegged to what is paid on deposits. Says Ashok Wadhwa, managing director of the Mumbai-based Ambit Corporate Finance: "As deposit rates are expected to be freed during the next three years, takeover funding rate too should come down."

Dissenting voices
While all these M&A financing issues remain to be sorted out, the Confederation of Indian Industry (CII) is crying wolf. CII maintains that takeover of Indian companies by foreign majors should be financed by foreign sources and not by domestic financial institutions and banks. Local companies too have joined in chorus. Their argument: financing Indian acquisitions by foreign players goes against the objectives of allowing in foreign direct investment and so foreign companies should not be allowed to fund their Indian acquisitions with finance sourced from local funding agencies.

However, the emerging trend indicates that cash flow financing is slowly catching up in the Indian M&A turf. We are in the first level of equity and venture capital funding now. "What is missing is the third level of funding," says Munesh Khanna, country head (corporate finance) of Arthur Andersen India. Sooner such a third level of funding evolves, the better it is .