April 2007
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The looming LBO risk

 As expected, the RBI has further liberalised the regime for overseas investments by India Inc in its latest credit policy: corporates are now allowed to make FDIs up to 300% of their net worth; limits for overseas portfolio investments have been enhanced, among others. These measures are intended to partly offset the impact of large foreign capital inflows on money supply growth and inflation. The big question is whether the new liberal regime has taken into account stability risks.

For a sense of perspective, India Inc had invested $23 billion abroad in January-February 2007. That was more than they invested in 2006 as a whole! But this is only partially reflected in the RBI’s statistics on outbound FDI. Many of these acquisitions are leveraged buyouts (LBOs) through special purpose vehicles set up to tap the international financial market that hardly figure in the database of the central bank. The RBI does recognise the need to put in place a more robust information system, but the latest norms will only give another fillip to LBOs.

Why are LBOs problematic?

IMF’s latest Global Financial Stability Report (GFSR) notes that the current wave of LBOs worldwide differs from the previous ones in the size of deals and degree of leverage. India’s ongoing boom in overseas acquisitions is a part of this larger worldwide trend—M&As hit a record level of $3.6 trillion in 2006—that is occurring against the backdrop of robust global economic growth, low interest rates and strong corporate earnings. India Inc’s outbound FDI also reflects the growing role of private equity funds.

However, this recent M&A wave has introduced new risks: “While the low interest rates, longer maturities, and increasing average size of the deals may make the effective average debt burden on the target more manageable relative to previous M&A booms, all else being equal, higher debt levels potentially increase the vulnerability of acquired firms to economic shocks,” argues GFSR.

Moreover, a rise in leverage tends to precede a spike in corporate defaults. There is also anecdotal evidence suggesting that due diligence performed by investors may be weakening. Though there are no signs as yet of systemic risks in Indian LBOs, the RBI must stay alert to their likelihood.

The upshot is that the global economic environment may be conducive at present to LBOs, but this could change in a trice. LBOs that once appeared promising deals could then pose sudden stability risks.

Source : Financial Express

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