THE LEVERAGED BUY OUT DEAL OF TATA & TETLEY
The case 'The Leveraged Buyout Deal of Tata & Tetley' provides insights into the concept of Leveraged Buyout (LBO) and its use as a financial tool in acquisitions, with specific reference to Tata Tea's takeover of global tea major Tetley. This deal which was the biggest ever cross-border acquisition at that time, was also the first-ever successful leveraged buy-out by any Indian company. The case examines the Tata Tea-Tetley deal in detail, explaining the process and the structure of the deal. The case helps to understand the mechanism of LBO. Through the Tata-Tetley deal the case attempts to give an understanding of the practical application of the concept.
"We were very clear that the burden on Tata tea should be such that the company would be able to absorb it. And it would not materially affect Tata Tea's bottomline."
- N.A.Soonavala, Vice-Chairman, Tata Tea.
"It was important to make the right decision on the comprehensiveness of the transaction. The model has been driven by existing and future earnings potential of the Tetley group and the resultant post-acquisition cash flows to immediately justify the business and financial model."
- Rana Kapoor, MD, Rabo India Finance Ltd., Commenting on the deal.
Introduction
In the summer of 2000, the Indian corporate fraternity was witness to a path breaking achievement, never heard of or seen before in the history of corporate India.
| In a landmark deal, heralding a new chapter in the Indian corporate history, Tata Tea acquired the UK heavyweight brand Tetley for a staggering 271 million pounds. This deal which happened to be the largest cross-border acquisition by any Indian company at that time marked the culmination of Tata Tea's strategy of pushing for aggressive growth and worldwide expansion.
The acquisition of Tetley pitch forked Tata Tea into a position where it could rub shoulders with global behemoths like Unilever and Lawrie. The acquisition of Tetley made Tata Tea the second biggest tea company in the world. (The first being Unilever, owner of Brooke Bond and Lipton). |
Moreover it also went through a metamorphosis from a plantation company to an international consumer products company.
Ratan Tata, Chairman, Tata group said, "It is a great signal for global industry by Indian Industry. It is a momentous occasion as an Indian company has been able to acquire a brand and an overseas company." Apart from the size of the deal, what made it particularly special was the fact that it was the first ever leveraged buy-out (LBO) by any Indian company. This method of financing had never been successfully attempted before by any Indian company. Tetley's price tag of 271 mn pounds (US $450 m) was more than four times the net worth of Tata tea which stood at US $ 114 m. This David & Goliath aspect was what made the entire transaction so unusual. What made it possible was the financing mechanism of LBO. This mechanism allowed the acquirer (Tata Tea) to minimise its cash outlay in making the purchase.
The Tale of Tata Tea
Tata Tea was incorporated in 1962 as Tata Finlay Limited, and commenced business in 1963. The company, in collaboration with Tata Finlay & Company, Glasgow, UK, initially set up an instant tea factory at Munnar (Kerala) and a blending/packaging unit in Bangalore.
| Over the years, the company expanded its operations and also acquired tea plantations. In 1976, the company acquired Sterling Tea companies from James Finlay & Company for Rs 115 million, using Rs 19.8 million of equity and Rs. 95.2 million of unsecured loans at 5% per annum interest. In 1982, Tata Industries Limited bought out the entire stake of James Finlay & Company in the joint venture, Tata Finlay Ltd. In 1983, the company was renamed Tata Tea Limited. In the mid 1980s, to offset the erratic fluctuations in commodity prices, Tata Tea felt it necessary to enter the branded tea market. In May 1984, the company revolutionized the value-added tea market in India by launching Kanan Devan tea in polypack. |
In 1984, the company set up a research and development center at Munnar, Kerala. In 1986, it launched Tata Tea Dust in Maharashtra. In 1988, the Tata Tea Leaf was launched in Madhya Pradesh.
In 1989, Tata Tea bought a 52% stake in Karnataka-based Consolidated Coffee Limited-the largest coffee plantation in Asia, in order to expand its coffee business. In 1991, Tata Tea formed a joint venture with Tetley International, UK, to market its branded tea abroad. In 1992, Tata Tea took a 9.5% stake in Asian Coffee-the Hyderabad based 100% export oriented unit known for its instant coffee, through an open offer. This offer was the first of its kind in Indian corporate history. Later, in 1994, Tata Tea increased its stake in Asian Coffee to 64.5% through another open offer. This helped it to consolidate its position in the coffee industry. In 1995, Tata Tea unveiled a massive physical upgradation program at a cost of Rs 1.6 billion. The upgradation program, spread over four years, was meant to improve its production facilities. In the same year, the company, along with a Sri Lankan partner, bid successfully for a group of 20 tea estates in the famous Watawala plantations in Sri Lanka.
In 1996, Tata Tea felt the need to develop into a truly national brand. It identified an opportunity to enter the leaf tea segment in the South. Between 1996 and 1998, the company launched Tata Tea Premium in Karnataka, Andhra Pradesh, Kerala and Goa.
In December 1999, Kanan Devan was relaunched in Kerala in an entirely new pack along with a fresh advertisement campaign. The company also planned to relaunch Kanan Devan in other markets. The new pack, with the revamped Tata logo, incorporated modern graphics with bolder branding whilst retaining the core properties associated with the brand. The back panels on the pack were also made more interactive and informative.
To meet the demands of the American market, Tata Tea Inc. - a wholly owned subsidiary of Tata Tea Limited - was set up in Florida to package and market instant tea in the US. The tea was produced in Tata Tea's factory in Munnar and then processed in Florida. The company also launched Snapple, a ready-to-drink iced tea, in the US. In 2000, it was one of the largest selling ready-to-drink teas in the US.
In order to tap the Japanese tea and coffee market, Tata Tea entered into a joint venture with Hitachi of Japan - Tata Hitachi Sales Limited. Tata Tea had been serving as an agent for Nippon Yusen Kaisha (NYK), one of the largest shipping companies in the world. In the mid 1990s, the company formed a joint venture, Tata NYK, which aimed at playing a major role in transport operations and management of seaports, inland container depots, and container freight stations.
De-Mystifying LBO
The Tata-Tetley deal was rather unusual, in that it had no precedence in India. Traditionally, Indian market had preferred cash deals, be it the Rs.10.08 billion takeover of Indal by Hindalco or the Rs. 4.99 billion acquisition of Indiaworld by Satyam.
| What set the deal apart was the LBO mechanism which financed the acquisition.
LBO is defined as "acquisition of a company, financed by the borrowing of all the stocks or assets of a public limited company by a small group of investors. This buying may be sponsored by buy-out specialists or investment bankers that arrange such deals and usually includes representation by incumbent management". Typically the buying group forms a shell corporation to act as a legal entity making the acquisition. In the stock purchase format, the target shareholders simply sell their stock and all interest in the Target Corporation to the buying group and then the two firms may be merged. In the asset-purchase format, the Target Corporation sells its assets to the buying group. The original shareholders own the target organisation, now merely a pool of cash to make investments with no tangible assets; the target corporation issues a liquidating dividend to its shareholders or becomes an investment company, using the pool of cash to make investments, whose proceeds are distributed to the shareholders. Sometimes the management is the prime moving force in this process; then it is called management buy-out (MBO). In an LBO, debt financing typically represents 50% of the purchase price. The debt is secured by the assets of the acquired firm and is usually amortized over a period of less than ten years. As funds are generated by operations or from sale of assets of the acquired firm, the debt to be paid off is to be scheduled. The sale of assets occurs when the investor group is motivated to take control in part because of what it considers unwise or ill-judged acquisitions by the firm in the past. There may also be limited equity participation on the part of outside investors such as pension funds and insurance companies, often with the provision that the equity interest will be repurchased after a pre-determined period to provide a specific yield. Following completion of the buy-out, the acquired company is usually run as a privately-held corporation rather than a public corporation, at least for a period of time, after which resale of the firm at a profit is anticipated. The LBO seemed to have inherent advantages over cash transactions. In an LBO, the acquiring company could float a Special Purpose vehicle (SPV) which was a 100% subsidiary of the acquirer with a minimum equity capital. |
The SPV leveraged this equity to gear up significantly higher debt to buyout the target company. This debt was paid off by the SPV through the target company's own cash flows. The target company's assets were pledged with the lending institution and once the debt was redeemed, the acquiring company had the option to merge with the SPV. Thus the liability of the acquiring company was limited to its equity holding in the SPV. Thus, in an LBO, the takeover was financed by the target company's future internal accruals. This reduced the burden on the acquiring company's balance sheet and made the entire takeover a low risk affair.
In the case of Tata Tea, its reserves at the time of the deal were just around Rs 4 billion, precluding the possibility of making such a gigantic acquisition on its own. Neither could it afford the debt burden associated with large borrowings. So, it opted for a leveraged buyout.
The deal was so structured, that although Tata tea retained full control over the venture, the debt portion of the deal did not affect its balance sheet. The liability of acquisition was limited to Tata Tea's equity contribution to the SPV. Also, the lenders had no recourse at all to Tata Tea in India.
Its dilutive impact on Tata Tea's earnings was also not substantial. One expert described it as "a classic leveraged buyout of cross-border finance, without recourse to Tata tea, secured solely upon Tetley's assets and cash flow". Interestingly, in the case of Tata Tea the deal helped satisfy it, two major requirements of financing, minimum exposure for Tata Tea but at the same time retaining 100% ownership of the company, a seemingly win-win deal indeed.
Structure of the Deal
The purchase of Tetley was funded by a combination of equity, subscribed by Tata tea, junior loan stock subscribed by institutional investors (including the vendor institutions Mezzanine Finance, arranged by Intermediate Capital Group Plc.) and senior debt facilities arranged and underwritten by Rabobank International.
| Tata Tea created a Special Purpose Vehicle (SPV)-christened Tata Tea (Great Britain) to acquire all the properties of Tetley. The SPV was capitalised at 70 mn pounds, of which Tata tea contributed 60 mn pounds; this included 45 mn pounds raised through a GDR issue. The US subsidiary of the company, Tata Tea Inc. had contributed the balance 10 mn pounds.
The SPV leveraged the 70 mn pounds equity 3.36 times to raise a debt of 235 mn pounds, to finance the deal (Refer FIGURE I). The entire debt amount of 235 mn pounds comprised 4 tranches (A, B, C and D) whose tenure varied from 7 years to 9.5 years, with a coupon rate of around 11% which was 424 basis points above LIBOR. Of this, the Netherlands based Rabobank had provided 215 mn pounds, while venture capital funds, Mezzanine and Shroders contributed 10 mn pounds each While A, B, and C were senior term loans, trench D was a revolving loan that took the form of recurring advances and letters of credit. Of the four tranches A and B were meant for funding the acquisition, while C and D were meant for capital expenditure and working capital requirements respectively (Refer TABLE 1). The debt was raised against Tetley's brands and physical assets. The valuation of the deal was done on the basis of future cash flows that the brand was expected to generate along with the synergies arising out of the acquisition. FIGURE I STRUCTURE OF TATA TEA'S LBO DEAL 
Though the actual cost of the Tetley takeover was 271 mn pounds, Tata Tea spent another 9 mn pounds on legal, banking and advisory services and a further 25 mn pounds for Tetley's working capital requirements and additional funding plans, thereby swelling the total acquisition cost to 305 mn pounds. Since the entire securitization was based on Tetley's operations, Tata Tea's exposure was limited to the equity component of only 70 mn pounds. Thus effectively, for just 70 mn pounds equity exposure, Tata Tea was acquiring a 264 mn pounds company. |
The Way to Go?
Some analysts felt that Tata Tea's decision to acquire Tetley through a LBO was not all that beneficial for shareholders. They pointed out that though there would be an immediate dilution of equity (after the GDR issue), Tata Tea would not earn revenues on account of this investment in the near future (as an immediate merger is not planned). This would lead to a dilution in earnings and also a reduction in the return on equity. The shareholders would, thus have to bear the burden of the investment without any immediate benefits in terms of enhanced revenues and profits. From the lenders point of view too there seemed to be some drawbacks. Because of the large amount of debt relative to the equity in the new corporation, the bonds were typically rated below the investment grade.
LBO as a concept did not seem to have found wide acceptance in the Indian financial system. Given the high rates of interest in the country, such debt did not seem to be forthcoming, especially since banks and financial institutions seemed interested in deploying their funds in high- return investments rather than in an LBO. Also a deal of this sort required the acquiring company's SPV to be leveraged to a far higher extent than the generally acceptable level of 1:1 to 1:2 debt- equity ratio which Indian banks and financial institutions were comfortable with. However, inspite of all the odds, Tata Tea's acquisition of Tetley seemed to have set a new benchmark in the corporate Indian history of cross-border acquisitions. It seemed to have generated considerable interest and appreciation of the concept, as a viable alternative in Indian corporate circles. It remained to be seen how many would follow this new path, nuptials of the leveraged kind.
Important Notes and Terms
Tetley was the second largest brand of packaged tea in the global market, behind Unilever's Brooke Bond and Lipton brands.
The Lectic Law library's Lexicon defines a leverage buyout as "a mechanism under which a company is acquired by a person or entity using the value of the company's assets to finance its acquisition. This allows (for) the acquirer to minimise its outlay of cash in making a purchase."
Brand of Tata Tea that was very popular especially in South Indian markets. The Kanan Devan variety went back over a century and was derived from the tea growing in the Kanan Devan Hills (Tata Tea had tea estates on these hills) located in the eastern part of central Kerala and adjoining parts of Tamil Nadu. The Kanan Devan name was used for decades for selling bulk teas originating from these hills, and this led to a loose tea franchise in southern India, particularly Kerala. With the growth in the branded tea segment, Tata Tea leveraged on the name Kanan Devan to convert this loose tea franchise into a brand so as to move up the value chain.
An SPV is a company floated to act as the holding company for the purpose of acquisition in an LBO. The company is created with an equity base and this equity is leveraged along with the assets of the acquired company to fund the acquisition.
Rana Kapoor, MD, Rabo India Finance Ltd.
Tata Tea raised 45 mn pounds from 7.6 million GDR's issued at $9.87 each, in March 2000.
LIBOR is an abbreviation for "London Interbank Offered Rate," and is the interest rate offered by a specific group of London banks for U.S. dollar deposits of a stated maturity. LIBOR is the base interest rate paid on deposits between banks in the Eurodollar market (A Eurodollar is a dollar deposited in a bank in a country where the currency is not the dollar). It exists for various currencies and for different maturities.
