In May 2010 Piramal Healthcare Ltd and Abbott Laboratories Private Ltd announced sale of Piramal’s Healthcare Solutions (branded generics) business to Abbot for rupee equivalent of USD 3.72 billion; Abbott to pay USD 2.12 billion upfront and four annual instalments of USD 400 million each from 2011 for Piramal's Healthcare Solutions business.

This handout has been compiled from published sources; it is to be used as a basis for class room discussion. Though, alternative routes / scenarios have been developed on different aspects of the deal it is not intended to illustrate either effective or ineffective handling of a management situation.

Information on the deal has been collected from sources considered to be reliable but it is strongly suggested that this document should not be used as a primary source of information on the deal or on the companies. Its only objective is to introduce M&A concepts in a classroom.

Sachidanand Singh July 2010

Introduction to M&A (Illustrated with the Piramal-Abbott Deal)

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On May 21, 2010 National Stock Exchange posted on its Corporate Announcements page: "Piramal Healthcare Limited to sell its Domestic Formulations (Healthcare Solutions) business to Abbott Laboratories". The accompanying Press Release revealed the following details: on May 21st Piramal’s Board approved the Company entering into a definitive agreement with Abbott of Illinois, USA for Abbott to acquire Piramal’s Domestic Formulations (including mass market) business for INR equivalent of USD 3.72 billion. USD 2.12 billion is payable in Indian rupees on closing of the sale and USD 400 million is payable in Indian rupees on each of the next four anniversaries of the closing starting from 2011. The sale is conditional upon Piramal’s shareholders’ approval and other customary closing conditions. As a term of the sale Piramal (the Company) and Piramal Enterprises Ltd (PEL, the promoter) are not to engage in the business of generic pharmaceutical products in finished form in India for a period of eight years following closing. However, Piramal would be free to continue its retained business. As PEL is to give a guarantee for performance of all the obligations of Piramal and its affiliates, Piramal’s Board agreed, subject to shareholders’ approval to pay PEL and its associates INR 350 crores, representing approximately 2% of the consideration amount.

On announcement the shares of Piramal Healthcare fell by 9%, before recovering and closing at about 1% below the last close. Shares of Abbott (on NYSE) registered a handsome gain of 4.7%.

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Date of announcement 21.05.2010

The Deal

Market’s Reaction

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Why did the selling company’s shares fell? Normally in an acquisition the target’s shares rise and the acquirers’ fall. The reason for this behaviour of share prices lies in the deep rooted belief of the markets that acquirers usually overpay for targets. In words of Warren Buffet: “The competitive nature of corporate acquisition activity almost guarantees the payment of a full - frequently more than full price when a company buys the entire ownership of another enterprise”. To be sure, Abbott competed with other suitors for Piramal Healthcare's branded generics business, which according to media reports included Pfizer, Sanofi-Aventis and GlaxoSmithKline. Only two days before the announcement of the sale of Healthcare Solutions business to Abbott, National Stock Exchange had asked the company to comment on the media reports that Pfizer might buy a controlling stake in Piramal Healthcare Limited. Piramal Healthcare responded "We hereby confirm that there is no proposal by the Promoter for selling any stake in the Company." It seems the market-men were expecting an open offer from the acquirer for 20% of shares held by other shareholders; (other than the promoter group, who were expected to ink a deal with the acquirer). The general expectations, it seems, were that the promoters of Piramal Healthcare would agree with the acquirer to sell their shares at a very high premium to the prevailing share prices; and the acquirer would be required to make open offer at such high price to the remaining shareholders. The price chart shows a steady rise in share prices from middle of March 2010, peaking around second week of May. The volumes chart (next page) supports this hypothesis. Market-men consider restructuring of listed firms as arbitrage opportunities. Most arbitrage operations are based on takeovers, friendly and unfriendly. With acquisition fever rampant, and with bids sky-rocketing, arbitrageurs have generally made money. Many buy on rumours of

Overpayment in Acquisitions There is substantial evidence that acquirers overpay for target firms. This overpayment is attributed to:

a. Managerial self interest, i.e. an acquisition is made to expand the domain of managers

b. Hubris- it is a Greek word that denotes pride which ultimately becomes the cause of ruin.

c. Over estimation of synergies – particularly when many firms pursue one target an acquirer may over-bid and receive what is called “winners’ curse”

Public Announcement to Acquire Shares SEBI (SAST) Regulations prescribe three threshold points (of shareholding) for different types of shareholders, based on their present shareholding. Whenever these threshold points are reached the shareholder is required to make a public announcement to acquire certain percent of shares in an open offer. In each case, for reaching the threshold point, combined shareholdings of persons acting together with one purpose (persons acting in concert) is to be considered. For example if I and you are acting together with one purpose then threshold will be reached when our shareholdings taken together meets the threshold point even though neither of us alone has enough shares for meeting the threshold. Persons with existing

holding Threshold

1. 0% to <15% 15% 2. 15% to <55% 5% in a year 3. 55% to <75% One share in a year

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takeover, often with borrowed funds, and when they see that the deal is not likely to materialize the way it was expected they get out of the shares very promptly. The price chart indicates selling pressures building up two or three days before the date of announcement. The volume chart shows the massive increase (some 50 times the average volume) during the three days around date of announcement. Operators perhaps got the whiff that no open offer was forthcoming.

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Piramal Healthcare: shares traded in lacs

Overpayments for acquisitions are often justified as control premiums or as price of synergy. Since deal price is higher than the market price, the open offer comes at a higher price pushing the market price up.

Control Premium It is the extra amount, over and above the market price of the target’s share that is paid by the acquirer. It is paid to control the target. Is it justified? Only when by controlling the target the acquirer can create more value i.e. when the acquirer can operate the target more efficiently than the target’s management OR when the target and acquirer becomes more valuable together than what they were separately. Usually it is described as synergy. Synergy Synergy is the difference between values of A and B when together (i.e. after merger or acquisition) and sum of values of A and B when they were separate. Together they become more valuable – or so it is said. Synergy is claimed to be the reason for acquisitions in most cases.

Arbitrage Traditionally, the word arbitrage, applied only to simultaneous purchase and sale of securities or foreign exchange in two different markets to exploit tiny price differentials that might exist between, say, ICICI trading in dollars in New York and in rupees in Mumbai. Arbitrage - or “risk arbitrage,” as it is now sometimes called - includes the pursuit of profits from an announced corporate event such as sale of the company, merger etc. In most cases the arbitrageur expects to profit regardless of the behaviour of the stock market. The major risk he usually faces instead is that the announced event won’t happen. (If the operator takes a position before announcement of a deal i.e. based on hearsay, he also faces the risk of the deal not being announced.)

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Key features of the deal announced by Piramal and Abbot were: 1. It is sale of business, not sale of the

company. Piramal hived off a particular business and sold it to Abbott.

2. Piramal is paying INR 350 crores to the promoter group (PEL and associates) for ensuring that all obligations under the sale agreements by Piramal and the promoters are fulfilled

A company’s business can be sold in two ways. One would be that the company itself is sold in which case the buyers actually buy the shares of the company and the company continues with its business the other would be that the company sells its business and after sale the company will not have any business but a whole lot of cash that it would receive as the consideration for the business it sold. Suppose company A owns two office blocks in Nariman Point, Mumbai. Its operations consist of letting out the office space on medium term leases. A can sell the office blocks in which case after the sale A would have no operating assets (i.e. no buildings to let out) but it would have the cash it would receive for the office blocks it sold. On the other hand, the shareholders of A can also sell the company A itself. In which case A will continue to own the office blocks but the shares of A will be owned by the buyers and not by the earlier shareholders. The first case would be sale of business and the second would be sale of company. What is more, the shareholders of A can decide to sell one office block and retain the other. In this case A will continue to own one office block and its shareholders will remain the same. Piramal has many manufacturing facilities in India and abroad: India

Pithampur, Dist. Dhar, M.P. Mahad, Dist. Raigad, Maharashtra Balkum, Thane, Maharashtra Enravur Village, Chennai, Tamil Nadu Digwal Village, Medak District, Andhra Baddi, Dist. Solan, Himachal Pradesh Pawne, Navi Mumbai, Maharashtra Village Matoda, Sanand, Ahmedabad

Deal structure

Slump Sale Slump sale means transfer of one or more undertakings as a result of the sale for a lump sum consideration without values being assigned to the individual assets and liabilities. Any profit arising from slump sale shall be taxable as Long Term Capital Gains (LTCG) if the undertaking(s) is/are owned or held for more than 36 months and as STCG if held for not more than 36 months. Undertaking Undertaking includes any part of the undertaking or a unit or division of the undertaking or a business activity as a whole but does not include individual assets or liabilities or any combination thereof not constituting a business activity. The net wealth of the undertaking (aggregate value of the total assets of the undertaking minus the value of liabilities as appearing in books of accounts) shall be to be the cost of acquisition and the cost of improvement for the purpose of computation of capital No indexation would be given.

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Overseas Morpeth, Northumberland, UK Grangemouth, Stirlingshire,

UK Aurora, Ontario, Canada Bethlehem, Pennsylvania, USA

Piramal has organised its operations in three different business groups: Healthcare Solutions, Pharma Solutions and Piramal Critical care. In the instant deal, Piramal has sold its Healthcare Solutions business along with its plant at Baddi, Himachal Pradesh to Abbott on a slump sale basis. (Its Healthcare Solution is also called its Branded Generics business.) If we assume that the sale will get closed in December 2010 (Piramal has announced that the sale is likely to close in second half on 2010) and rupee dollar parity will be around INR 48/USD over the next four years and that Piramal’s cost of equity is 19%, we can compute the per share consideration of the deal. Since whole of the company’s business is not on sale we need to compute the approximate contribution of the business on sale to the market price of Piramal’s’ shares. Piramal’s Healthcare Solutions business grew by 24.6% to reach Rs. 20.0 billion in FY 2009-10. Its total sales at Rs 36.7 billion registered a growth of 11.9%. It seems the business that was sold contributed over 50% of operating income and was growing at a rate faster that the company’s growth rate. But we need to accept that the remaining businesses – Pharma Solutions (which had negative growth in 2009-10) and Critical care Solutions have excellent growth potential. We are of the view that conservatively, without doing a detailed analysis, Healthcare Solutions can be valued at about 50% of the firm’s value. Thus with average market price of Rs 450 a share, it is reasonable to assign the Healthcare Solutions Business at Rs 225 per share. As against this 225, the table shows that the company is getting a

Purchase Price Allocation In a slump sale a business is sold for a lump sum. The business would have a number of assets, qualifying for different depreciation rates. The buyer of the business cannot write off depreciation on the assets unless he has the prices paid for individual assets, which is not available in a slump sale. This problem is resolved by Purchase Price Allocation (PPA). PPA is done in accordance with the accounting standards, internationally (soon in India too) in accordance with IFRS 3. The PPA process allocates the cost of an acquired business to the Fair Value of assets acquired and liabilities assumed and it establishes useful lives for identified assets. Whatever amount is seen to have been paid over and above the fair value of assets acquired is treated as goodwill. We will see more on PPA in M&A accounting.

Valuing sale price per share Cost of equity 0.19 Expected date of

inflow Amount in billions Time in

years Present value USD INR

31-Dec-10 2.12 101.76 0.5 93.28

31-Dec-11 0.40 19.20 1.5 14.79

31-Dec-12 0.40 19.20 2.5 12.43

31-Dec-13 0.40 19.20 3.5 10.44

31-Dec-14 0.40 19.20 4.5 8.78

139.72

Number of shares outstanding (in billions) 0.209

Outstanding stock options (in billions) 0.001

0.210 Sale price per share (diluted) 665.58

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whopping Rs 665 per share for this business. However, on post tax basis the deal value would be considerably less than Rs 665 per share. The sale consideration is around Rs 17,500 crores but as only about Rs. 10,000 crores will be received later this year, and rest over four years, we are valuing the consideration at present value, Rs 14,000 crores. Though the present value of the sale is 14,000 crores, the Piramal will have a tax liability (LTCG and STCG) assuming that the selling price was Rs 17,500 crores. With this selling price, as a very rough estimate, we will keep taxes at Rs 3800 crores – to be paid on closure of the deal. As this is about 6 months away, PV of this amount today with the same discount rate would be Rs 3500 crores. Deduct it from 14000 crores and divide the result with 21 crores (diluted number of shares - the table has figures in billions; one billion = 100 crores) and we get post tax per share sale price around 495. Since market price is around 450 a share (which has both the business under sale and the remaining business of Piramal) we reach an absurd conclusion that the market is assigning the remaining business of Piramal a negative value or at best zero. To structure a deal in which the company would have had no tax liability, Piramal would have needed to demerge its Healthcare Solutions business. In the present deal it hived off the business. Demerger is not defined in the Companies Act. But the Companies Act provides for carrying out “reconstruction” of a company in Chapter V. The schematic describes the deal structured by

Demerger S19AA of the Income Tax Act defines “Demerger". Demerger means the transfer, pursuant to a scheme of arrangement under sections 391 to 394 of the Companies Act by a company of its one or more undertakings to any resulting company in such a manner that -

§ The transfer of the undertaking is on a going concern basis;

§ All assets and liabilities of the undertaking, being transferred by the transferor company (referred to in the I T Act as the demerged company), immediately before the demerger, becomes the property of the resulting company by virtue of the demerger;

§ The assets and the liabilities of the undertaking(s) being transferred are transferred at values appearing in the books of account immediately before the demerger;

§ The resulting company issues, in consideration of the demerger, its shares to the shareholders of the demerged company on a proportionate basis;

§ The shareholders holding not less than three-fourths in value of the shares in the demerged company become shareholders of the resulting company or companies by virtue of the demerger;

Chapter V of the Companies Act 1956: Arbitration, Compromises, Arrangements and Reconstructions This Chapter provides most of the legal processes to be followed in M&A activities. “Arrangement", here, means, among other things, a reorganisation of the share capital and includes division of shares. If a company spins off a business, a new company is created to take over the business being spun off and all shareholders of the company become proportionate shareholders in the new company. A “Scheme of Arrangement” is prepared for this purpose and after it approved by the shareholders and creditors in different meetings it is submitted to the Company Law Appellate Tribunal (earlier High Court). The Tribunal can approve the Scheme and allow for transfer of the company’s undertaking, allotment of shares in the new company and even dissolution without winding up of the transferor company (if it transfers all its undertaking

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way of an arrangement to create a new company to undertake the Healthcare Solutions business of Piramal.

In this structure as Piramal Healthcare Ltd (the company) is merely dividing business, for the first stage i.e. demerger, there is no tax implication. For the second stage i.e. sale of shares in Piramal Generics again tax would be applicable to only those shareholders who sell their shares. In the current structure tax is being borne by the company i.e. by all members of the company. But such a structure would need to follow a lengthy procedure and a deal with this structure cannot be consummated expeditiously. First, a “Scheme of Arrangement” is required to be prepared; then approval of the scheme needs to be obtained from shareholders and creditors; finally sanction is required from Tribunal etc. Firms that actively contemplate selling a business usually have that business organised as a subsidiary to make the process a little smoother. Clearly sale of the branded generics does not appear to be culmination of a strategy nurtured over years. Abbott offered excellent valuation and missing it to have a structure only for saving some taxes could perhaps have been counterproductive.

§ Piramal promoters sell their stake in this company to Abbot; § Abbot comes out with an open offer for 20% (or more) shares; § Sale of shares will attract capital gains tax at the hand of

shareholders § Indexation benefit is available in computing capital gain for sale of

shares, but not available in case of slump sale

Demerges Healthcare Solutions business

Piramal Healthcare

Piramal Healthcare

Without Healthcare Solutions

Piramal Generics

Imaginary name has been given to the new company being spun off. All shareholders of PHL automatically become proportionate shareholders in this company and this company gets listed without any IPO.

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Another major feature of the deal was that Abbott insisted that Piramal Enterprises Limited (PEL) and its associates (i.e. the promoter group, PEL is a closely owned company that has invested in Piramal Healthcare and other ventures of Ajay Piramal) give a guarantee that Piramal Healthcare would fulfil all the obligations under the business sale agreement and that neither Piramal Healthcare nor PEL and its associates will operate in branded generics market in India for eight years from the date of closure. The Companies Act provides (in Chapter V, referred earlier) that sale of an undertaking be approved by the shareholders in a general meeting. The Act also provides for obtaining shareholders’ approval through a postal ballot. Piramal has sought a postal ballot to expedite the closure. The notice for postal ballot informed the share-holders of the deal as follows:

Piramal Healthcare Limited proposes to sell its Domestic Formulation (including the Mass Market Branded Formulations business) as a going concern on a slump sale basis, together with all its assets except cash) and current liabilities to Abbott Healthcare Private Limited (the Purchaser) for a total consideration of rupee equivalent of USD 3,720 million.

The assets to be transferred include the manufacturing facilities at Baddi, Himachal Pradesh and rights to some 350 brands and trademarks.

There is a non-compete covenant for eight years following completion of the sale and give guarantee for the performance of PH’s obligations under the sale.

Board has approved payment of Rs 350 crores to PEL & associates by way of guarantee commission.

Passing of resolutions by postal ballot S 192A of the Companies Act provides:

• A listed public company may get any resolution passed by means of a postal ballot, instead of transacting the business in general meeting of the company.

• A notice to all the shareholders, along with a draft resolution explaining the reasons is required to be sent by the company by registered post to all shareholders requesting them to send their assent or dissent in writing on a postal ballot within a period of thirty days from the date of posting of the letter.

• A resolution assented to by required majority of the shareholders by means of postal ballot, is deemed to have been duly passed at a general meeting convened in that behalf.

• Explanation- For the purposes of this section, "postal ballot" includes voting by electronic mode.

Transfer of an undertaking

S 293 of the Companies Act prohibits the Board of Directors of a public company, or of a private company which is a subsidiary of a public company from doing certain activities except with the consent of members of the company (or subsidiary) in general meeting.

In terms of Sub-Section 293(1)(a) of the Companies Act Board must obtain members’ consent in a general meeting to sell, lease or otherwise dispose of the whole, or substantially the whole, of the undertaking of the company, or where the company owns more than one undertaking, of the whole, or substantially the whole, of any such undertaking. The term ‘Undertaking’ in the present context means a unit, a project or a business as a going concern. It does not include individual assets and liabilities or any combination thereof not constituting a complete business.

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The explanations attached to the Notice gave the following information: Piramal Healthcare has the following businesses: Domestic formulations, Custom manufacturing, Critical care, OTC consumer products, Manufacture & supply of API, vitamins and fine chemicals, and Diagnostic services.

Only domestic formulations are being sold to Abott. The Board feels that the sale is in shareholders’ best interests. The sale proceeds will allow Piramal to invest in the remaining businesses with “renewed vigour” and will also open up other avenues for diversifying its business.

The NCF constitutes only 2% of the sale consideration and is far lower than what is often paid to promoters. The notice also mentioned how the company would benefit from the sale. Essentially the sale would give funds that can be invested in the remaining businesses and would also enable the company to pursue new businesses. This leads us to motives of the two parties.

Non Compete Fee (NCF)

Acquirers, when acquiring a company, often pay a non-compete fee to the promoters of the target in consideration for not competing in the target’s line of operations for a certain number of years. SEBI regulations provide that Acquirer offer to buy shares from other shareholders (up to minimum 20%) at the same price as that paid to the promoters. Should this price include the NCF paid to the promoter? Non-promoter shares are in most case not in a position to compete. But if it is allowed that the acquirer need not pay NCF to other shareholders then sale consideration may get skewed with a heavy NCF component to reduce the acquisition cost. At present the Regulations provide that if NCF is more than 25% of the sale consideration then it must be payable to other shareholders. This is a disincentive for the acquirer, who would not find any benefit from increasing NCF component in sale consideration beyond 25%.

Cementrum’s acquisition of Mysore Cement Ltd (MSL) In 2006 Heidelberg of Germany, through its subsidiary Cementrum IB, acquired Mysore Cement Ltd (MSL). The Share Subscription and Share Purchase Agreement (SSSPA) had three parties – acquirer (Cementrum), target (MSL) and some entities of S K Birla Group, promoter sellers. Interestingly S K Birla himself was not part of the “promoter sellers”. In terms of SSSPA the acquirer agreed to purchase from the promoter sellers 8.48 percent of the paid up equity at Rs.58 a share and also agreed to pay Rs 14.50 a share as NCF. Subsequently acquirer came with an open offer at Rs 58 a share. Many shareholders felt that the offer price should have been Rs 72.50 (58+14.50) a share as paid to the promoter seller. They complained to SEBI and SEBI too observed that “In the facts of the instant case, the payment of non-compete fee to the selling promoters does not appear to be justified”. What were the facts of the instant case? The target was a sick company. Though S K Birla Group entities were subject to non-compete clause, S K Birla himself was free to compete! The promoter sellers of the target company were only shareholders and not taking any active part in the business and were not quite capable of competing. Acquirer, however, appealed to Securities Appellate Tribunal (SAT) that observed that whether NCF should be paid and if so, how much is a matter to be decided by the acquirer and the target. If NCF is more than 25% of share price then it should be added to the offer price as stipulated by regulation 20(8) of the SEBI (SAST) Regulations. In this case it was just 25% (58/4 = 14.5) and so the appeal was allowed.

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In 2008 Ranbaxy was sold to Japan’s Daiichi Sankyo. Abbott has valued Piramal's formulations business at about eight times its sales, which is almost twice that of what Daiichi paid for its USD 4.6 billion purchase of a controlling stake in Ranbaxy Laboratories in June 2008. Clearly Piramal got a much better valuation. (Incidentally in 2008, because of the global financial crisis, financial asset prices had taken a nosedive.) But did Piramal sell only because the business was getting a very good price? There are some entrepreneurs who build a business to sell and move on to build another. Ajay Piramal has not been one of those, not till now at least. Pharma has not been a family business of Piramals. Ajay Piramal had inherited a defunct textile mill. He bought Nicholas Pharma in 1988 when its market capitalisation was about 6 crores. He successfully nurtured the business, seizing new opportunities as they emerged and in less than twenty two years he is selling about half of the business for over Rs 17,000 crores. That is some growth! Clearly he can create value. He has gone on record that when the money is received from Abbott Piramal Healthcare would retire debts totalling Rs 1300 crores. We hope not. Considering the company’s conservative debt equity ratio it is not called for and doing so is unlikely to add value. On a TV show, talking to Anil Singhvi and Menaka Doshi soon after the announcement of the deal, Ajay Piramal gave three reasons:

a. 45% of the business stays with Piramal Healthcare, b. Money that’s now coming can be used to retire some Rs 1,300 crores in debt, c. It will also provide funds for expanding the existing businesses and for undertaking new

businesses.

Why did Piramal Sell?

Why M&As?

Only rational justification of M&A is creation of long term shareholder value. M&A’s help firms achieve it through different paths:

Economy of scale: Combined companies can reduce fixed costs by removing duplications in operations; can also get better deal on purchases (cheaper by a dozen), thus increasing margins; merging firms are in same line of activity Economy of scope: Same operating assets and processes can be used for different products – Godrej engaged in personal care products used its distribution network to market Good Knight a mosquito repellent. Cross-selling is but one example of economy of scope. Increased market share: Gives better pricing power to the combined entity, (risk violating competition laws) Geographical or other diversification: Acquisition of an existing player can save a lot of time in reaching critical mass in a new geography or in a new product range Vertical integration: This refers to acquisition of a supplier or of a buyer. It assures supplies (steel plant acquiring an iron ore mining firm) but assumes that in-house processes are more efficient and economical than administering long term contracts. Taxation: A company with high taxable income can buy a loss making one reduce its tax liability and also acquire assets.

Synergy is often cited as a motive. In fact synergy is the extra value created by combining of the firms and this extra value will come from any of the factors mentioned above.

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The second point is not a reason. There is no urgency / imminent need to retire debts as explained in the box. But there is no doubt that if Piramal had to sell it is perhaps the best time to sell. The business has clocked over 24% annual growth for two years; with growing income the healthcare expenditure of Indians is set to rise; and Indian pharma market is attracting the global players like never before. But selling only to realize top value does not gel with the entrepreneurial spirit of Ajay Piramal. Piramal seems happy to keep the remaining business and get funds to expand it. It suggests that some changes in the corporate priorities (strategies for growth) have been brewing in the Group.

Even technology, the great motivator in M&A arena seems, to have no role. Piramal has sold branded generics, where technology does not appear to be an issue. On the other hand, some of its retained businesses are technology driven. There are reasons to believe that the patent regulations relating drugs that changed in 2005 may undergo further changes to ensure that the generic products are bioequivalent to original branded products. Bioequivalence needs some explanation.

It seems same drug manufactured by two companies having the same molecular structure may not have the same effect even when administered in same molar doses. (Molar doses imply dose adjusted to the body weight for orals, blood quantity – in case of injections and so on.) This is

Some Dubious Motives

In practice most M&A’s do not deliver the expected value. The reason at times is poor execution of post merger operations. Many a time reason can be dubious motives of merger. Some of the dubious motives are:

Diversification: Since shareholders can achieve diversification faster and cheaper, they would not generally pay a premium for a diversified firm. Hubris: manager's overconfidence about expected synergies from M&A which may results in overpayment for the target Empire-building: Managers want to lord over larger operations, caring little for what value it creates. It is rumoured that Tatas acquired Tinplate because it had the best golf course in town! Manager's compensation: If managers are paid on the basis of total profit instead of profit per share, acquisition can be used by them to improve their compensation.

Sellers’ motivations

Seeking retirement: Not uncommon in West where an entrepreneur having made a fortune and no heir in sight sells out. Nor common in India, given our prolific families, not having an heir is quite rare.

Financial distress: Sale of Exide by S K Birla, reportedly to tide over his losses in trading Malaysian palm oil. Sale of Mysore Cements Limited that had persistent negative cash flows to Heidelberg of Germany.

Selling when on top: Sale of the first mosquito repellent in Indian markets, Good Knight, by Mohan Kumar to Godrej could make an example. There are other lesser known sales of this category in IT space.

Technology changes:

Increased competitive pressure: Sale of confectionary business (Parry’s) by EID Parry to Lotte Confectionery Company Limited of Korea in 2004; sale of aerated beverages business by Parle to Coca Cola

Strategic change or changed corporate priorities: Tata Steel’s sale of its cement business to La Farge.

Changes / anticipated changes in the regulatory regime: Piramal?

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because drugs manufactured with different processes may get absorbed at different rates. This phenomenon has given rise to “bioequivalence”, which is defined as the absence of a significant difference in the rate and extent to which the active ingredient in pharmaceutical equivalents becomes available at the site of drug action (in the body) when administered at the same molar dose under similar conditions.

In a way bioequivalence has arisen out process patent regime (the earlier Indian patent regime) that recognized patents on pharmaceutical processes but not on pharmaceutical products. This had spurred Indian companies to reverse-engineer molecules of the branded and patented drugs of western companies and employ different processes to get the same molecules. Molecules synthesized by different processes may lack bioequivalence with the original patented drug. (A very crude example could be sugar cubes and sugar powder having the same molecules but dissolving in water at different rates.)

The regulatory regimes in many countries including India do not require generic drugs to be bioequivalent to the original products; they require them to have the same active ingredients. But that is changing. Mexico, for example, is in the process of changing its regime to require generics to be bioequivalent. It may have the effect of putting a lot of domestic companies out of business. Piramal might have had to, and now Abbott may have to confront this regulatory change if and when the rules change in India.

Debt, Shareholders’ value and Restructuring

Since cost of debt is generally lower than cost of equity, as long as a firm has investments that yield return at a rate higher than the cost of debt, increasing leverage would add to shareholders’ value. However debt increases the risk of a firm. Different firms, taking into account their business risks decide on a leverage ratio (i.e. debt equity ratio) that is ideal for them.

In the short run the Pecking Order Paradigm comes into play and a firm’s leverage may deviate from its target leverage, calling for capital restructuring.

Selling a business to retire debts

Many companies have been forced to sell businesses to retire debts. Some fifteen years back India Cement had gone on a shopping spree buying cement plants to augment its capacity. It had acquired businesses with borrowed money and when debts became due it sold some of the businesses to meet the pressing creditors’ claims. B M Khaitan of Kolkata had raised a lot of debt acquire the Eveready business of defunct Union Carbide by leveraging the Group’s assets. In the following years B M Khaitan Group hived off and sold some of its tea assets to repay its maturing debts.

Does Piramal need to retire its debts?

On stand alone basis Piramal’s debt add up to only 661 crores. It includes working capital loans of Baddi plant, which will be assumed by Abbot. In consolidated accounts debts do add up to 1300 crores, but still the debt equity ratio is a comfortable 0.77. To be sure some debt restructuring is a must as the secured debentures of the company are secured with, among other assets, movable and immovable assets at Baddi that are part of the business being sold.

No company can create shareholder value by retiring debts contracted at fair cost, unless the cost has since reduced substantially.

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Piramal seem to have reached a fork in its operations. On one side was generic business with the threat of bioequivalence looming over it. On the other side are custom manufacturing, critical care, OTC consumer products, manufacture of API, vitamins and fine chemicals, and diagnostic services. Generic was a big business and though it grew at 25% during last two years, big pharma companies are gunning for emerging markets and competition is going to become very

The margin on generics is getting thinner in developed markets. Generics are being sold there on generic name basis, not on brand names. The pharmacist has become the key person in generic sale, there, not the doctor. It is quite different from the Indian model and the price realized on a generic product is around 80% of the branded product. Price has become the main driver of sale and the need of an expensive sales force is vastly reduced, as Dr Reddy’s Lab learnt after its USD 570 million acquisition of German firm Betapharm. The trend towards low cost generics will only strengthen with time. With reduced margins, only huge volume players will thrive in generics. That attracts global biggies. Indian pharma majors on the other hand cannot become global players as they do not have the resources. It seemed for some time that Ranbaxy will become the first Indian MNC in pharma, but the promoters did not have the long term commitment needed for that and sold out.

The reasons for Piramal’s selling can be summarized as under:

With the entry of Big Pharma in Indian generics the margins will suffer and competing with them will require considerably more resources. Thus continuing with generics may imply committing resources where the returns are likely to get lower.

Can we have a truly global Indian pharma firm? In 2000 Ranbaxy, then an Indian owned firm had acquired Basics GmbH; in 2002 it took a 10% stake in Nihon Pharmaceutical Industries, Japan with an option to hike its stake in future. The option gives inkling to Ranbaxy’s strategic thoughts. The Japanese pharma market is second in size only to the US market. With an aging population the Japanese government is trying hard to bring down the cost of health care. The generic market, Ranbaxy expected, is set to explode in Japan. In 2004 Ranbaxy acquired RPG (Aventis) in France. Other Indian companies too have acquired generic firms in Europe / USA. Wockhardt acquired Walis Laboratories of UK in 1998 and again CP Pharmaceuticals of UK in 2003. Dr Reddy’s acquired BMS Laboratories and Meridian Healthcare in the US. Sun Pharma MD Dilip Sanghavi’s words in this regard are worth noting. Sanghvi says that the acquisition would be driven by the breadth of the portfolio of the target, its customer coverage in the area of interests to him and manufacturing abilities in defined products. The rush of Indian pharma majors to acquire companies abroad was attributed to seeking operating synergies through growth in size and through product & market extensions. It was expected that some Indian Pharma firms may emerge as global players. It wa not all smooth sailing though. Dr Reddy’s strategy in Germany backfired. In the US many Indian Pharma manufacturers (Ranbaxy, Dr Reddy’s, Sun) were / are facing regulatory problems. And then Ranbaxy sold out. Many leading Indian pharma firms have grown after 1970, when FERA regulations made it difficult for MNCs. Piramals’ growth too owes to acquisitions in India: Roche, ICI, Rhone-Poulenc, Boehringer Mannheim, etc. Pharma players seem to have thrived (vs. MNC’s) on regulatory arbitrage and do not seem to have the long term commitment of a Premji or a Ratan Tata.

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Bioequivalence is hanging like a Damocles’ sword on generics business; if and when bioequivalence appears in the India regulatory regime, generic manufacturers may have to commit much more resources in developing or buying appropriate technologies.

The remaining businesses of Piramal have lots of potential. Globally the governments (and the insurance companies) are very keen on bringing down healthcare costs. This will put pressure on manufacturers to reduce cost of drug and pharma manufacturing will shift from developed world to a country like India. Piramal is already present in custom manufacturing space with Rs 1000 turnover and will have a significant advantage in this business running it out of India (and from its global sites.)

Competing with Big Pharma in international generics markets require a lot more resources than what Piramal can raise or commit.

Abbott is 122 years old and has been present in India for 100 years. It has some very popular brands such as the antacid Digene and painkiller Brufen. The sales turnover of Abbott India Ltd (listed on NSE) is however only around 8 crores a year. Abbott comes eighth in the global pharmaceutical rankings with 2009 revenues of $30.77 billion, which is about half of industry leader Johnson & Johnson's revenues of $61.9 billion for the same year. It wants to catch-up with its bigger rivals. This acquisition may be one of the ways to differentiate itself (from its bigger rivals) by gaining a strong toehold in an up and coming market like India. Buying a running operation is, many ways, more

Why did Abbott Buy?

Buyer Motivations

Motivation can vary depending on whether the buyer is a strategic buyer or a financial buyer. Strategic buyer goals

Diversify into new products/services/markets Technology/skill sets/resources Management leverage Reduce competitors

Financial buyer goals Efficiency - reduce costs, economies of scale Growth - revenue, margin, profit Accretion of earnings Return on investment Tax benefits

Big Pharma: Global League Table

Rank Company USD Bn Country

1 Johnsons& Johnson 61.90 USA

2 Pfizer 50.01 USA

3 Roche 45.34 Switzerland

4 GlaxoSmithKline 44.42 UK

5 Novartis 44.23 Switzerland

6 Sanofi-Aventis 40.87 France

7 AstraZeneca 32.80 UK

8 Abbott Laboratories 30.77 USA

9 Merck & Co 27.43 USA

10 Bayer Healthcare 22.23 Germany

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efficient than starting a new operation, particularly in pharma:

1. A drug company has to take approval from the regulatory authorities before it can start selling its products. It is a time consuming process.

2. Retailers have a large number of generic labels and they are wary of adding more. 3. Brand awareness needs to be created among doctors and public. This takes time and costs

money. 4. An acquisition comes with sales and distribution mechanism already in place. A new

company will have to recruit and train field staff, set up warehouses and establish the distribution channel.

Abbott had purchased pharma business of Belgian chemical giant Solvay for about USD 6.4 billion in September 2009. That acquisition too was in the direction of strengthening its presence in emerging markets in Asia and Eastern Europe. Solvay was present in India through its subsidiary Solvay Pharma India Ltd (SPIL, listed on BSE). The product portfolio of SPIL, broadly spans women’s health, psychiatry, ENT, neurology, gastroenterology, and vaccines. SPIL’s sales in the year ended Dec 2009 stood at Rs 248 crores, previous year 213 crores, annual growth over 16 percent. SPIL has a very profitable operation as evidenced from its dividend payment record. The combined turnover of SPIL and AIL is in the range of 269 crores a year. Piramal’s Healthcare Business had recorded sales of Rs 2000 crores for the year ended March 2010. Piramal's products cover dermatology, anti-infectives and nutritionals, while Abbott India is focused on gastroenterology, pain, neurosciences and metabolic disorders, among other categories. The acquisition increases Abbott’s product portfolio sharply. Increasing portfolio can make sense only if Abbott wants to expand in India; and why should it not? Abbott expects emerging markets will in the next few years account for 70% of the growth in the global pharmaceutical industry, and India is "an important and critical part". Abbotts expects its Indian revenue to grow to USD2.5 billion in the next decade, up from the current revenues of about

Forces driving Mergers & Acquisitions Over last twenty years Deregulation and Technology have been reshaping all businesses. Growing economic liberalisation has made it possible (even desirable) to enter markets that were earlier considered “difficult”. Support services for manufacturing such as banking and insurance are getting as sophisticated in emerging markets as they are in major money centres of West. Another fundamental force is changing demographics of the developed world. Improved healthcare and growing preference for small families have increased the proportion of elder persons with a smaller workforce in the society. This has stopped the markets from growing rapidly and has also spurred shifting the production facilities to emerging markets with abundant labour and where the market size too is expanding. This has led to a consolidation phase and for immediate growth the firms are looking at acquisitions. Last year (2009) saw a number of big ticket merger and acquisitions in pharma: Pfizer and Wyeth, Merck & Co. and Schering Plough, and Roche and Genentech. Frequent restructurings, mainly to adjust to the changing demographics and decoupling of developed markets from emerging markets, are likely to stay with us for some time.

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USD500 million (Abbott’s revenue combined with the acquisition’s). If we take the next decade to mean some 9 years, this projection envisages a little less than 20% compounded growth. (Since pharma business in emerging markets is expected to grow at 17%. Abbott foresees an increase in its market share as well.) In any case, pharma sector is growing only at 3 to 6% in developed markets and it makes sense for an international pharma major to ramp up its operations in emerging markets, particularly India. Abbot may find it difficult to win market shares from its peers in developed markets. Big pharma companies in developed markets are facing two challenges: slow growth and matured products that are difficult to replace with new blockbuster drugs. The earlier wave of M&A in pharma sector internationally had been aimed at acquiring super brands. That has now dried up growth is expected from geographical diversification and that is going to be the theme song of the new wave of global pharma M&A. Abbott’s only chance of improving its rank in the pecking order is, it seems, by beating its peers in gaining a formidable presence in emerging markets. Abbott’s motivations, thus, can be summarized in one sentence: to ensure first mover advantage in emerging markets, among the Big Pharma. It can, of course, use the Indian manufacturing facilities it is acquiring for producing generics for developed economies but that does not seem to be an immediate objective.

Valuation: Theory & Practice I

Value of an asset (or a firm) should be the present value of the cash flows associated with owning that asset. On the other hand where we have active markets for assets we may be lured into believing that the value of an assets is what it will fetch in the market. That is confusing value with price. The two are often different. Valuation methods are of two broad categories: asset based and income based. Asset based methods value the assets of the firm and deduct the liabilities to arrive at the value of the firm. A major conceptual weakness of this method is it equates value of firm with value of the physical assets the firm owns. A running firm often has other strengths that are not reflected in its physical assets. For example its business processes, its customers’ loyalty, its products’ reputation, its employees’ productivity and so on. Income based methods indirectly capture these abstract strengths of a firm because income is a culmination of all these strengths. Income based methods are further classified as DCF Methods and Relative Valuation Methods. DCF method projects the cash flow that would be available in future and discount those cash flow with an appropriate discount rate. Relative methods take one or more parameter and compare how that parameter is being valued by the market in similar firms. For example PE ratio is a commonly used valuation tool. PE of 4 means the price of a share is four times earnings per share, earnings mean net income i.e. profit after tax per share. At times firms are also valued as a multiple of top line e.g. six times its sale. In M&A relative valuation is used quite often. Most of the restructuring cases go to courts and judges find a powerful logic in “similar things selling at similar prices”. If one aluminium smelter has recently changed hands at say Rs X per tonne of its smelting capacity then it is reasonable to assume that another smelter too shall sell at prices derived by same (almost same) formula. Of course adjustments are required to be made for other features – mining license, extent of deposits, useful life of major plants, and power supply arrangements etc. Relative valuation gives an idea of market price, which is not the same thing as value. Two parties may agree on a price to exchange a firm while the value of the firm may be quite different for them.

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The deal value was generally considered by the market to be high. As the entire amount is not being received on closure, the true value of the deal is considerably less than USD 3.12 billion. It is interesting to compare the value of this deal with that of another pharma firm acquired by Abbott in India recently. In Sept 2009 Abbott and Solvay had agreed for sale of Solvay’s pharma, vaccine and diagnostic products businesses to Abbott. Pursuant to this agreement Abbott acquired Solvay’s 68.85% shareholding in Solvay Pharma India Limited (CPIL). In terms of SEBI (SAST) Regulations, Abbott offered to buy up to 20% shares from public shareholders. The purchase price in the offer was Rs 3054.73 per share. This price was arrived at on the basis of SEBI’s pricing formula (please see the box on the next page). Under the purchase agreement with Solvay their 68.85 shareholding in SPIL was allocated Euro 70 million. Based on then (Sept 25, 2009) prevailing rate of Euro this price translates into Rs 1420.08 per share. However, the shares on SIPL, listed on BSE started rising right after the public announcement of the acquisition of Solvay’s global pharma business by Abbott. Astute market men saw an arbitrage opportunity here (refer to the box on page 4). The rise became sharper just before the date of public announcement in India. That’s because on Feb 14 Abbott entered into a

Offer Price in Open Offers

Offer price in open offer to shareholders cannot be less than:

1. The negotiated price between the acquirers and the sellers

2. The average of high and low of weekly closing prices during 26 weeks prior to the public announcement

3. The average of daily high and low of two weeks priors to the public announcement.

Applying the pricing formulae in Solvay case There are two announcements – global and Indian

The average of weekly high and low of the closing prices of shares during the twenty six weeks period prior to the date of the public announcement dated Sept 28, 2009 of the global acquisition

Rs694.75

The average of the daily high and low of the share prices during the two weeks period prior to the date of the public announcement dated Sept 28, 2009 of the global acquisition

Rs795.59

The average of weekly high and low of the closing prices of shares during the twenty six weeks period prior to the date of the public announcement in India

Rs1,466.98

The average of the daily high and low of the share prices during the two weeks period prior to the date of the public announcement in India

Rs3,054.72

Valuation

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definitive agreement with Solvay transferring latter’s pharma business to Abbott and on Feb 15 Abbott filed the required the required information with SEC, the security market regulator of the USA, where Abbott is domiciled. SIPL had 50,49,706 share. Since Abbott paid Rs 1420.08 per share in its negotiated deal, SIPL was valued at approximately USD 151 million. Open offer was made at Rs 3054.72. Taking this as the basis of valuation, SIPL gets valued at USD 324.7 million. SIPL’s turnover for the year ended Dec 2009 stood at Rs 250 crores or USD 52.6 million. SIPL’s valuation as per the negotiated price comes to USD 151 million which is 2.9 times its turnover. As per the offer price in the open offer SIPL gets valued at 6.17 times its turnover. Since the open offer for SIPL shares was made barely three months before the announcement of Piramal-Abbott deal the valuation of SIPL gives right perspective for analyzing the valuation of Piramal’s Healthcare Solutions business. Piramal’s Healthcare Solutions had recorded Rs 2000 crores turnover in 2009-2010. It translates into USD 421 million. Price of USD 3.72 billion means the business is valued at 8.8 times the turnover. It is much higher than even the offer price valuation of SIPL. (It should be noted that both SIPL and Piramal’s Healthcare Solutions had increased their turnover in their last financial years by, approximately, 25 %.) If we assume that Piramal’s cost of equity is 19% the deal value in PV terms becomes USD 2.91 billion (the first payment of 2.12 billion was some six month away in future when the deal was

Valuation: Theory & Practice II

Discounted Cash Flow (DCF) valuation is based on discounting the future cash flows. It has sound economic rationale: value of the business is present value of cash that one expects to receive from the business. The cash expected from a business is the cash left after the business’s expansion needs are met. For growth the business would need to add new fixed assets and would also need to increase its working capital. Thus the cash left for distribution among the owners of the business, called Free Cash Flow of Firm (FCFF) is determined by: Net Profit + Depreciation + Interest*(1-Tax Rate) – Investments (in fixed assets as well as in working capital) This FCFF is estimated for future years and each year’s FCFF is discounted with the firm’s cost of capital. The cost of capital is the weighted average post tax cost of each type of capital availed by the firm. If a firm has only equity and debt and if we assume that the ratio of debt and equity shall remain constant in future, weighted average cost of capital (WACC) is given by: KE*E% + KD*(1-T)*D% KE = Cost of equity KD = Cost of debt T = Corporate tax rate E% = Ratio of equity and equity plus debt D% = Ratio of debt and equity plus debt While determining D% and E%, market values of debt and equity are considered, NOT book values. Cost of equity is usually computed with Capital Market Pricing Model although some analysts do use other models such as Fama & French’s three factors model or the multi factor model. The value arrived at is value of the firm’s operations. If firm has non-operative assets, such as investments in securities or land that are not required for operations, the value of these non-operative assets is added to the discounted value of cash flows. This gives us the Enterprise Value (EV). Value of equity is obtained by deducting value of debt from the EV. DCF is quite popular with investment banking community and equity analysts.

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announced). With USD 2.12 billion as the deal value, the business under sale gets valued at 6.9 times the turnover. Even after discounting the future payments, Piramal got a better valuation than the value of SPIL on the offer price basis, which itself was some 2.15 times the value of SPIL in the deal negotiated between Abbott and Solvay, Belgium. There is no doubt that the deal value is on the higher side. The valuation is appropriate, says Ajay Piramal, chairman of the group's holding company Piramal Enterprises. "It is the best business available in India and has been growing at 25% [annually] in the last two years." We are not convinced; SPIL’s business too grew at 25% in 2009 and at over 19% in 2008. Saikat Chaudhuri, a Wharton management professor, says “the relatively higher valuation makes sense for Abbott. Sure, it is on the higher side, but we are also taking about a lot of potential in these markets and multiple synergies. There are revenue synergies; the reach of generic drugs could be expanded globally, and Piramal's sales and distribution network can be used to more effectively market drugs that are developed elsewhere. On top of that, India is a growing market." It is interesting to note the acquirer’s observation on deal value: “If you want the best

Winners’ Curse

In a competitive bid, where many buyers are bidding for one asset on block, it is clear that all the bidders, except the winner felt that the final price was too high or that the winner has over paid. This thinking may lead to winner regretting its bid and the remorse experienced by the winner is said to come from the winner’s curse.

For “winner’s curse” to happen, the asset must have the same value for all the bidders. If the asset on block is, say, a currency note of Rs 1000, all the bids will stop just short of Rs 1000. But when bidders are bidding for a firm, the value of the firm may be different for different bidders because different bidders may look forward to realising different synergies. They would bid, whatever is the fair value of the asset plus a part of the value of the synergy they expect to realise.

Value of Synergy

Synergy is the extra value created when two firms combine. If value of A is VA and of B is VB and of the combined firm’s is VAB then synergy = VAB-(VA+VB). Synergy can come from operational sources or from financial sources and is usually referred to as operational synergy or financial synergy. Examples of creating operational synergy are acquisition of a firm with idle capacity by one with overflowing orders, acquisition of a firm in a new market where acquirer wants to enter etc. An example of creation of financial synergy is when a firm with high taxable income combines with one that has accumulated losses (tax shields).

If both A and B are bidding for a firm C, and B foresees higher synergy form merger, the target (i.e. C) will be more valuable for B than it will be for A. Expected synergies make the target’s valuation different for different bidders.

Value of Control

If a firm is not operating optimally; for example if a firm has no debt and you feel that by replacing a part of equity with debt you would lower the firm’s cost of funds without increasing risk and thus, make the firm more valuable then control of firm has some value for you. By controlling the firm you will create value that was not there before your control. But if a firm is running optimally and one cannot improve it in any manner then one does not create value by controlling it and one should not pay any control premium.

It may appear paradoxical, but a poorly run firm deserves control premium but an efficiently run firm does not. (Remember, poorly run firm’s value on as is where is will be very low compared to the efficiently run firm)

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companies you will pay a premium; however, we feel it was the right price". But you do not expect any buyer to admit that he has overpaid. Different buyers may expect different degrees of benefits from combining with the target and hence may value the target firm differently. Saikat Choudhuri mentioned multiple synergies but specified only revenue synergy. Revenue synergy arises when the combined entity (here Piramal’s hived off business and Abbott India jointly) generates more revenue than the sum of revenues the two predecessors were generating independently. This mostly happens because of cross-selling. Acquirers’ sales persons also promote the target’s products and vice versa. To make a reasonable estimate of likely synergies one needs much more information on the two businesses than is publicly available. In fact even the acquirers do not know the true details of the financials of the target; though they have all public information on the target and whatever information the target may have provided during the negotiation. The sale agreement invariably makes the closure of the deal subject to certain conditions; these conditions allow the acquirers to satisfy themselves on all aspects of the target. The process of ensuring that the acquirer gets what it had assumed is called “Due Diligence”.

The sale announcement made by Piramal had indicated the closing to take place later in the year and had mentioned that closing is subject to statutory and the usual closing conditions. The statutory conditions can relate to Companies Act (approval of shareholders for sale of an undertaking), RBI (bringing in foreign exchange for direct investment) and compliance of other numerous regulatory provisions. The usual closing conditions relate to the disclosures made by the seller. After agreeing to buy, the buyer demands a right to investigate the business from inside to assure itself that it is actually getting what the seller has assured. This investigation is called “due diligence”. Some twelve years ago, a news item had appeared: “Hindalco Industries Ltd (HIL) is about to acquire 45 percent stake in India Foils Ltd (IFL) of Calcutta. IFL, a BM Khaitan group company, plans to issue 90 lakh equity shares of Rs10 each at a premium of Rs35 each to HIL. It will also be offering 55 lakh warrants. The warrants can be converted into equity shares of Rs10 each at a premium of Rs35 per share on a private placement basis.” Shortly after appearance of such media reports, both Aditya Birla Group and Williamson Magor announced agreement on takeover of IFL by Hindalco. Later no reports came on this subject and it was learnt that the deal was “off”. A team of Birla Group auditors had descended on India Foils and that was the last we heard of the proposed takeover. It is reasonable to assume that in course of their due diligence

Due Diligence

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exercise the auditors found some “deal breaker”, i.e. some such finding that made the deal unattractive for Aditya Birla Group. We suppose Abbott’s lawyers and accountants must be busy going through the records of Piramal’s relating to its Healthcare Solutions business.

What is Due Diligence?

The words “due diligence” have entered the investment banking jargon from the USA’s Securities Act 1933. Suppose I am selling shares of company A, describing it a good investment, you buy on my suggestion and sooner rather than later A goes bankrupt. You will be justified in thinking that I duped you. But I may have a valid defence if I can prove that I did whatever is normally required to be done to collect all information on A. This defence is called “due diligence” defence in terms of USA’s Security Act, 1933. If I have exercised due diligence in my investigations of A and have disclosed to you all my findings, I would not be held liable for non-disclosure of information not uncovered in my investigations.

Generally, due diligence refers to the care a reasonable person should take before entering into an agreement or a transaction with another party. Thus, in M&A transactions due diligence implies an investigation into a potential investment to confirm all material facts – to ensure that I am buying what I think am buying. It is the test to check whether the factors driving the deal and making it look attractive are real or illusory, whether the inside of the house is as attractive as the exterior.

If you buy a used car, you would like to get the car examined by a car expert, who would look under the bonnet, examine the parts and gives you an estimate of its reasonable life and performance. Getting the car examined by an expert would be the due diligence expected of you.

Acquirers assemble a team of legal and accountancy experts to examine the target’s documents, contractual relationships, operating history and organizational structure. The buyers’ team asks the questions and the sellers’ team organizes all the documents. If some undisclosed information is discovered in this process, it will affect the deal value and in some cases may even scrap the deal.