Treading with care at a new frontier: RBI cautious on banks' M&A funding

Mint Road's proposals on banks' M&A funding are cautious even as entrants root for more elbow room, and weigh business models

Ask Debadatta Chand about his plans for BoB Capital Markets, and he tells you: “We can play a good role on the advisory side as far as mergers and acquisitions (M&As) are concerned.” The managing director and chief executive officer (CEO) of Bank of Baroda (of which BoB Capital is a subsidiary) gives you a glimpse of his ambitions. “If need be, we can evaluate the scope for collaboration to augment the capacity for M&A advisory. It is potentially a good business to be in.” It is. There is no sizing study on the M&A space and it has been the turf of foreign banks (even as funding remains offshore) and select shadow banks. But now domestic banks of all hues get free play with M&As set to reshape India Inc; annual deal volumes are well above the $100 billion mark. 

Mint Road’s draft circular on ‘Commercial Banks — Capital Market Exposure’ though is cautious, as banks have little experience in this high-stakes game. Even as it opens a new frontier: Segue lenders with a collateral-backed legacy with the equities markets. Banks’ aggregate acquisition finance exposure is not to exceed 10 per cent of their Tier-I capital; it’s to be extended only to listed companies with a “satisfactory” net worth and profit-making record of three years. They can finance only up to 70 per cent of the acquisition value; the rest is to be brought in by the acquirer as equity using its funds. It is clear that only the bigger banks get to play a meaningful role in this area. 

Step-by-step 

Are the new norms for banks in M&As restrictive? 

As Sunil Sanghai, founder and CEO of NovaaOne Capital, sees it, while the proposed Tier-I exposure for M&As aims to provide an additional check on market risk, it needs to consider that banks already operate well-established underwriting frameworks and sophisticated risk-assessment capabilities for other asset classes. “Given the maturity of the banking system and its ability to independently assess exposure based on deal-specific factors, such prescriptive checks may be less essential,” says Sanghai, who is also the chair of the Federation of Indian Chambers of Commerce and Industry’s National Committee on Capital Markets. As for the 3x debt-to-equity (D/E), the proportion varies across sectors, reflecting differences in business models, cash-flow patterns, and capital requirements. “Applying a fixed D/E limit may not fully capture these nuances. Allowing banks to rely on their own underwriting judgement, tailored to sector-specific leverage norms, would be a more prudent and flexible approach. This will also ensure that risk assessment remains aligned with practical industry requirements,” he adds.

The clamour for revisiting the draft norms is gaining decibels; and back-channel discussions with North Block and Mint Road may be in the offing. 

Anish Mashruwala, finance chair and partner at JSA Advocates & Solicitors, reasons the draft has a clear regulatory lens in signalling the proposed relaxation. Besides the value limit cap, there’s also the fact that Tier-I capital of banks will be at varying levels and that may itself not provide a level playing field as the restriction will not apply equally in terms of value. “Having said that, I understand that even banks having larger Tier-I capital reserves have voiced that the value limit based on the 10 per cent cap is limiting in the current market scenario,” he says. 

 

What of the proposed 3X D/E? Mashruwala is “surprised” that the RBI has actually specified a D/E cap of 3:1 on a post-acquisition basis. While this is prudent from a market standard perspective (a recognised conservative debt to equity metric is 2x), in his view, this should be left to the lender(s) in terms of its credit appetite and business realities. The RBI’s draft regulations have a condition that financing can be up to a maximum of 70 per cent of the acquisition value with the rest being bought in by the buyer as equity. “To then supplement it with the post-acquisition ratio is probably only a signal that the RBI does not want to open up the avenue of acquisition finance to targets that are already heavily indebted. If there is a specific regulatory issue that the RBI is concerned about, then it may very well outweigh any business considerations,” he adds.   

The net worth of the banking sector was more than Rs 27 trillion till the last quarter end. At 10 per cent Tier-I limits on banks to fund M&A, then at the systemic level, the available funds are above $30 billion. Sanjay Agarwal, senior director at CareEge Ratings, points out: “The limit seems reasonable to start with. As banks undertake transactions, the markets and regulators gain more confidence, we could expect some relaxations on the type of transactions and ceiling on individual bank limits over a period of time”. He notes that “based on experience and discussions, it is likely that the regulators would expand the boundary conditions.” Yes, it helps to keep the ball on a string. 

Wallet side of the story 

The other interesting aspect is the payouts which need to be given to M&A staff — these will be hefty. Bonuses run into a few crores even for mid-level M&A staff in foreign banks and mid-market shadow banks in the trade. A few state-run banks house this business in their capital market subsidiaries. And given the specialised nature of this business, is it possible that these banks forge partnerships, as BoB’s Chand appears to suggest? In the 90s, you had I-Sec: J P Morgan; Kotak Mahindra: Goldman Sachs; DSP: Merrill Lynch, and J M Financial: Morgan Stanley. All of them learnt, and then went their separate ways, but in the case of state-run banks, there is a steep learning curve to be dealt with before deal-making can begin. 

 

Dinesh Khara, former chairman of State Bank of India, looks at it differently. His take: M&A financing will be by way of a loan. “So, it is essentially corporate credit for which bankers are well-trained and take decisions based on stringent underwriting standards.” That now while bankers may have to acquire some additional skills for assessing M&A financing proposals, “This being an M&A loan, bankers are not stitching deals or transactions. Hence, I don't think there’s an issue about compensation for attracting and retaining talent”. 

Rohan Lakhaiyar, partner (financial services-risk) at Grant Thornton Bharat, believes that we have a deep enough talent pool when it comes to M&As, unlike in the early 90s. But a matter of detail is whether this is to be housed within the capital market arms of banks or in the banks. “More so given the payouts to be given to M&A professionals. So too, the case for partnerships.”

Banks are on a new frontier. They will have to tread carefully.

 

All that is needed for deal-making

 

Much as India Inc, bankers, corporate lawyers and the wider investment banking fraternity make a case for more liberal financing norms for mergers and acquisitions (M&As), ghosts that still lurk have to be exorcised. 

Take bank board oversight. This has been found wanting for some time now. With banks financing M&As, independent directors (IDs) with a proven track record in this area will be needed. Bank board remuneration for IDs has to move northwards. Data sharing among banks in M&A arrangements will have to become sharper, and this will be critical if a transaction is to go awry. Banks will be sharing space with private equity and venture capital firms, and coordination between them will be needed. It remains to be seen if in the interests of the stability of their loan-plus-equity exposures, banks will read governance covenants to suit them. A related aspect is whether banks financing M&As should get to have board positions on the companies they fund.

An issue which bankers say in private is that even within a consortium, there are at times “club deals” with the same borrower. And as a result what you get is a (financial) platypus, a semi-aquatic egg-laying mammal which the naturalist George Shaw was inclined to dismiss as hoax as “there might have been practised some arts of deception in its structure”. Banks not being on the same page has created hassles for resolution under the Insolvency and Bankruptcy Code, 2016. 

Borrowers also play with information asymmetry. As the Aditya Puri Committee Report (Data Format for Furnishing of Credit Information to Credit Information Companies, 2014) noted about derivatives: “Borrowers have, in general, not been forthcoming in sharing such information with lenders, particularly with banks that are not part of the consortium”. Again, a major area of concern is the non-uniformity in processes to identify red-flagged accounts (RFA) based on an indicative list of early warning signals. In several cases, banks were unable to confirm RFA-tagged accounts as frauds, or otherwise within the prescribed period of six months. 

Changes to the Banking Regulation Act, 1949 may need to be made as well.

 

Disclosure: Entities controlled  by the Kotak family have a significant shareholding in Business Standard Ltd.