Merger & Acquisition (M&A) activity in India has been accelerating for the last few years. The first nine months of 2007 saw some 780 deals, almost equaling the number during the full previous year (2006). Deal value is estimated at around $65 billion for the first nine months of 2007, up from $36 billion reported for 2006. While this increase in M&A activity is gratifying, we must remember that over $30 billion of the deal value was due to three deals (Tata Corus, Hindalco Novelis and Vodafone Hutch). Industry watchers feel the market could have been more vibrant if there was better support from banks as well as reduction in barriers to doing business in India.

Globally, M&A transactions tend to have a fair element of debt financing with debt forming as much as 60-80% of the price paid for the acquisition. In India, M&As have been traditionally financed by cash and/or equity. This is at least partly due to the fact that the corporate debt market continues to be extremely shallow and banks in India have statutory / regulatory restrictions on lending for acquisitions.

Banks in India are prohibited from lending for acquisition of shares. An exception to this restriction was made to facilitate investment by companies in public sector units privatised by Government. Such lending was however essentially on the balance sheet strength of the buyer. Another exception was made by RBI in 2005, keeping in view the increasing activity of Indian companies in international M&A. The exception allows Indian banks to lend to Indian companies for purchasing equity in foreign entities up to four times their net worth, subject to the limitations with respect to the bank?s total exposure to the capital market.

Total exposure to capital markets including all fund-based and non fund-based facilities granted by banks to individuals or market intermediaries in relation to capital markets, direct investment in equities, convertible debentures, equity oriented mutual funds etc must be within 5% of total outstanding advances. Within this limit, a bank?s direct investment must be within 20% of its (the bank?s) net worth. Corporations may also avail external commercial borrowings within limits as per extant policy. Indian banks also participate in the M&A activity in an indirect way through working capital lending enhancement / restructuring to the combined entity.

There has been a sharp acceleration in outbound activity by Indian corporations. As against 190 outbound deals reportedly closed during 2006, there were about 180 outbound deals already closed during the first nine months of 2007, accounting for more than half the deal values reported during the first nine months of 2007. India?s outbound M&A during the first nine months of 2007 was second only to Australia in the Asia Pacific Region.

These included Tata Steel?s $13.6 billion acquisition of Corus and Hindalco?s $6 billion acquisition of Novelis Inc. A number of these deals were partially debt-funded. While Indian banks did not figure as financial sponsors in some of the deals, some of them have subsequently bought parcels of debt from foreign banks. The main Indian banks participating in this activity are State Bank of India, ICICI Bank and Bank of India.

These banks have geared themselves to finance such outbound activity through their foreign subsidiaries which are subject to banking regulations in the respective jurisdictions. Having their international banking stronghold in India, these banks are closer to the customer. Of course, foreign banks with significant corporate banking presence in India like Standard Chartered Bank, Citibank, HSBC etc are equally, if not better, placed to finance these deals and there is a fair level of competition in this market segment. The loans are typically to special purpose vehicles outside India for a variety of reasons and these are financed on the basis of projected cash flows from the acquisition although banks may take the assets being bought as collateral. This also enables Indian companies to protect the balance sheets of the parent company to a large extent. In many cases, the debt is short term (1-3 years) with the buyer and bank agreeing that during this period, arrangement would be made to raise more equity, restructure the purchased asset, sell a part of the asset or refinance the facility.

Domestic and inbound M&A has also grown over the last few years, but at a slower rate, if private equity deals and the Vodaphone Hutch deal is excluded.

Would M&A get a fillip if the statutory/regulatory restrictions on bank lending for acquisitions were further liberalised? If such liberalisation were to happen, are Indian banks geared up to support the increased M&A activity? I believe that the answer to the first question has to be in affirmative, but at the same time there are many other regulatory and infrastructural constraints that may mean that M&A activity in India continues to be below potential for some time to come. As for the second question, Indian banks have much to do to serve the expected positioning of India as the third largest domestic banking market in the world by 2040 (PricewaterhouseCoopers report titled ?Banking in 2050: How big will the emerging markets get?). One of the key issues is the size of individual banks, which limits the ability to address the M&A financing market for large deals that India Inc is looking at.

Indian banks compare favourably with most banks in the region on parameters such as growth, profitability and non-performing assets (NPAs). However, on scale and size, the big Indian banks are very small compared to global top banks. State Bank of India, India?s largest bank, ranks 72nd (as per FY06 numbers) amongst the top global banks, and is about one-tenth the size of the world’s biggest bank (Citigroup) in terms of assets.

SBI is not even within the first 10 big banks in Asia, where the first three slots have been occupied by Chinese banks. There are only five Indian banks among the top 500 banks as per July 2006 issue of ?The Banker?. As India Inc?s appetite for large deals grows, Indian banks must develop strategies to support these deals, including growth in their own balance sheets, if they are to keep in step with the corporate sector.

?Bharti Gupta Ramola leads the Transactions Practice of PricewaterhouseCoopers . The views expressed by the author are her own