LEVERAGED BUYOUTS OR “FINANCIAL ASSISTANCE”?

What if you wanted to acquire majority shares in a company with a huge market capitalization? A company whose addition increased the capitalization of the NGX by a whooping N3.04trn.

To own a company, you simply have to agree to own the shares in it. Quite simple.

A lot of people do not know this, but you can simply agree in writing to take up shares in a company without actually paying cash upfront for it. The mere agreement to take up the shares at a named price makes you the owner of these shares.

Here is the Companies and Allied Matters Act 2020 (Nigerian law):

105. — (1) A subscriber of the memorandum of a company shall be deemed to have agreed to become a member of the company, and on its registration shall be entered as the member in its register of members.

(2) Every other person who agrees in writing to become a member of a company, and whose name is entered in its register of members, is a member of the company.

An agreement in law is so powerful that Twitter could rely on it to sue Elon Musk to complete the deal he signed to acquire Twitter.

Later on the company can ask you to bring the cash or a portion of the cash. This is why it is called share capital, the company is entitled to it for the purpose of business. It is the capital you contribute to the company. When the company makes this request, we say there has been a call on your shares. Here is the Nigerian law again:

158. — (1) Subject to the terms of the issue of the shares and of the articles, the directors may make calls upon the members in respect of any money unpaid on their shares…

…

(4) If a sum called in respect of a share is not paid before or on the day appointed for payment, the person from whom the sum is due shall pay interest on the sum from the day appointed for payment to the time of actual payment…

160. …the shares of a company and any premium on them shall be paid up in cash, or where the articles so permit, by a valuable consideration other than cash or partly in cash and partly by a valuable consideration other than cash

161. — (1) Shares are not deemed to have been paid for in cash except…the company shall have actually received cash for them at the time of…the agreement to issue the shares.

Take note of a very crucial point here: the person who agrees to own shares is the person responsible for paying for the shares. You can source the funding however you wish, but you are responsible for the payment.

So how do you fund paying for shares?

OPTION 1: PAY FROM POCKET

You can simply pay for shares from your pocket. You know, the way you would do in any normal transaction. You could sell your house, cars, maybe even sell part of your shares in another company.

The crucial point here: the person who wants to own shares is the person who takes the financial hit to be able to pay for the shares. You pay for the shares but at a cost to your own asset and net worth.

OPTION 2: ARRANGE A PRIVATE LOAN

You could take things a step further and arrange for a private loan. Get some funding under an arrangement where you pledge your own assets as security. You can then take this cash and pay for the shares.

The crucial point here: the person who wants to own shares is the person who takes the financial hit to be able to pay for the shares. You obtained a loan but at a cost to your own asset and net worth.

It would then seem that to acquire a thing of worth, like a company, you must part ways with a thing of worth (paying from pocket) or agree to part way with a thing of worth in future (arranging a loan).

UNSATISFACTORY OPTIONS

What if you wanted to acquire majority shares in a company with a huge market capitalization? Maybe a company whose addition increased the capitalization of the NGX by a whooping N3.04trn.

Here is a problem with Option 1 (paying upfront): this is way too much cash to come up with for the purchase of a company. Even if you were able to come up with it, it is not exactly smart financial planning to sink in such an amount.

Same problems applies to Option 2 (a private loan), except that you are pushing the responsibility further into the future. Ultimately, you have to pony up the money.

OPTION 3: LEVERAGED BUYOUTS (LBOs)

Here is an amazing piece of financial engineering:

1. Incorporate a new company (Purpose Company) for the purpose of buying the company you want to acquire (Target Company)

2. Purpose Company has close to zero assets on its balance sheet

3. Purpose Company takes a loan to buy Target Company, the loan is usually anything from 70% - 90% of the purchase amount,

4. Now the Purpose Company has zero assets and a huge liability from the loan on its balance sheet. This is where the term “leveraged” in “leveraged buyout” comes from. Leverage means use of borrowed funds.

5. The loan is agreed to be repaid by the Target Company to be acquired. Yes, the Purpose Company agrees with the lender that the Target Company it is yet to acquire will repay the loan.

6. Purpose Company acquires the Target Company.

7. The Purpose Company merges with the Target Company, creating a new Combined Company (Combined Company) with a merged balance sheet.

8. Combined Company has the assets of Target Company on its balance sheet, but it also has liabilities of Purpose Company.

9. Combined Company starts to pay off the liabilities it owes which originally belonged to the Purpose Company, using cashflow and asset it owns which originally belonged to Target Company.

10. The time frame is usually 5 - 7 years for the loan to be repaid.

It is easy to miss something very important that has happened here: the company that was acquired, the one for which you are supposed to lose some worth for, is now paying the loan that was used to acquire it. It is almost like you are getting the company almost for free and the discount is provided by the company.

Remember in Option 1 and Option 2, we said “the crucial point here: the person who wants to own shares is the person takes the financial hit to be able to pay for the shares.”

Well, with a leveraged buyout, the company you acquired takes the financial hit instead. 

Chances are high that:

1. The Combined Company does not make enough money to (i) pay its operating expenses, (ii) repay the loan and (iii) still be profitable.

2. So the Combined Company sells part of its net assets to meet up with the loan.

3. This reduces the net assets of the Combined Company gradually

This is where the problem lies. The problem is what is known in law as “financial assistance”.

FINANCIAL ASSISTANCE

Financial assistance makes it illegal for a company to do anything to help a person acquire its own share. It is a very wide rule that ranges from:

1. gifts

2. guarantees

3. any form of security or indemnity

4. a loan or any form of credit

5. release

6. waiver

7. novation or assignment of right

8. any other scheme where the net assets of the company are thereby reduced materially (interpreted strictly to be as little as a 1% reduction in net worth or more)

Again, the financial assistance rule is very wide. LBOs will generally fall under the “any other scheme…” part. 

You can read more about the origin of this rule against financial assistance in “The Financial Assistance Prohibition: Changing Legislative And Judicial Landscape (Opens As Pdf)” by Maisie Ooi.

Well, why is the law particular about this? Here’s some suggested reasons:

1. Capital Maintenance: A company is a separate person in law and whatever it owes its creditors is not owed by the shareholders. The shareholders can only be asked to bring the amount they agreed to pay for the shares. It is the company’s capital that creditors can make claims on. This is the whole concept of limited liability. Therefore, a company is not allowed to do anything that amounts to returning this capital to shareholders or that amounts to the shareholder not actually paying the money they agreed to pay for the shares. This way, financial assistance protects creditors.

2. Prevent Asset-Stripping Takeovers: An LBO makes it easy to take over control of a company and thus gain access to the assets of the company. The assets are then sold to repay the loan. If done, the previous creditors and minority shareholders are left with insufficient assets they can make claims over. This way, the rule against financial assistance seems to serve to protect creditors and minority shareholders.

The effectiveness of the rule against financial assistance in achieving the purposes above is debated in “Are Sinners Lending to Sinners? Financial Assistance in Belgium and the UK - An Elegy (opens as PDF)” by Elke Hellinx

So why are LBOs even popular and even accepted now when it could also be interpreted as financial assistance?

There has been a huge change in the perception of LBOs. LBOs have moved from being seen as a corporate malpractice to being seen as a potent financial instrument. LBOs have some potent economic advantages, even to the Target Company itself:

1. It gets much needed cash to continue operations, this helps especially when the company is distressed and the previous shareholders could not provide cash.

2. Because the debt is repaid by the company, it becomes tax-deductible. So there is some marginal tax-benefit to the Target Company.

3. Employees get to maintain their employment and earn a living, this would not be possible if the company closes up instead.

4. It would also seem that companies’ efficiency improves after LBOs possibly because efficient operations are needed to keep the company functional while repaying the loan.

Rules against financial assistance do not exist in the US, hence LBOs are more common there. In the UK, where Nigeria imported the law from, the rule against financial assistance does not apply to private companies anymore. In fact, in the UK, after using a loan to acquire a public company, you can re-register as a private company first before rendering the financial assistance (See Note 990 of the Explanatory Notes to the UK Companies Act).

It would seem that countries are recognizing that financial assistance is not always a net negative, sometimes it is the only way a distressed company can access desperately needed funding.

In actual fact, LBOs are majorly used in the financing of speculative-grade companies, companies that have a greater degree of risk. If the company was investment-grade, they would have gotten finance via corporate credit or some investment options directly.

FINANCIAL ASSISTANCE AND LBOs IN NIGERIA

Nigeria still has financial assistance rules and it still applies to public and private companies.

Here is the Nigerian law:

183.— (1) In this section — 

(a) “financial assistance” means a gift, guarantee, any form of security or indemnity, a loan or any form of credit or any other financial assistance given by a company, the net assets of which are thereby reduced by up to 50%, or which has no net assets;

(b) “net assets” means the aggregate of the company’s assets, less the aggregate of its liabilities (“liabilities” to include any charges or provision for liabilities in accordance with the applicable accounting standards applied by the company in relation to its accounts).

(2) Subject to the provisions of this section— … (b) where a person has acquired shares in a company and any liability has been incurred (by that or any other person), for the purpose of this acquisition, it shall not be lawful for the company or any of its subsidiaries to give financial assistance directly or indirectly for the purpose of reducing or discharging the liability so incurred

To translate:

1. if a company does anything that reduces its own net worth by more than 49%, it has provided financial assistance

2. if a person borrows to acquire a company (LBO), the acquired company cannot help the person pay back the loan if doing so will reduce its own net worth by more than 49%

3. It is not that the company can not pay back the loan, or that it cannot pay more than 49% of the loan. It is that whatever it is paying back, it cannot reduce its net worth by more than 49%

Unlike other countries where a 1% reduction in net worth is considered to have broken the financial assistance rule, Nigeria allows up to a 49% reduction in net worth before it considers that there has been financial assistance. This applies to all companies as well, whether private or public.

To this extent, LBOs can happen in Nigeria with no problems at all, you just have to ensure that net worth of the Target Company does not reduce beyond 49%.

IS A 49% REDUCTION IN NET ASSETS SUFFICIENT IN A LEVERAGED BUYOUT?

How feasible is it really? That the net worth of a Target Company will not reduce beyond 49%?

If you take a loan to acquire a 3.04trn company, what are the chances that you can structure a repayment that does not reduce net worth beyond 49%? Run the model and simulate.

Some available options are:

1. Increase net assets of the company: If you are able to make the business wildly profitable, perhaps you can reduce the reduction of the company’s net asset to under 49%. Huge problem is that your most realistic case scenario cannot bring such as huge increase in your profitability. The required macroeconomic conditions are not in your control.

2. Increase the tenor of the loan to 10 - 15 years: This is something within your control to an extent. If you spread the repayment across more years, the amount to be repaid yearly is reduced, and this reduces the reduction of the company’s net asset to under 49%. Huge problem is that this makes the loan unattractive for the lender.

Is there any other option available if we think critically? It is why investment bankers are hired, isn’t it? How do you beat a law that locks you on all sides?

What do you think?