Martin Thorp's style is quintessentially English: quiet and understated. Strangely enough, he spends his work-life at Arthur Andersen dealing with the merchandising aspects of M&A. In other words, he spends his time telling companies all over the world how they can dress themselves up to enhance their value. And when this diligent deal-maker finds time to kill, he dresses up hedges and flower-beds too. BT's Roshni Jayakar caught up with Thorp, who was in Mumbai recently to scour India's corporate landscape, for a value-enhancing hour. Excerpts from an exclusive interview.

Q. Mr Thorp, globally, M&As have been regularly hitting the headlines in recent times. What is the driving-force behind them now?

A. M&As are, essentially, being driven by the need to enhance and create value-by improving efficiencies. The driving-force behind them is globalisation. As businesses continue to globalise, there are huge opportunities to improve efficiency through M&As.

The lexicon has changed over the years. There is now more talk of deal originators, who actually structure a deal. What is the need for structuring in M&A?

One role of us deal originators is to spot value-enhancing opportunities through M&As, and reconcile the value-expectations between bidders and sellers. Many corporate groups, including some in India, have grown into massive, fairly-inefficient conglomerates, and it should be possible to drive them towards focus through sell-offs or partnerships. In the case of brand-led businesses, it is possible to enhance the value of the intangibles by acquiring, or controlling distribution-capability through franchising. Other opportunities lie in consolidating smaller business units, or buying similar and congruent businesses elsewhere, thereby addressing the issue of excess capacity.

Often, a transaction is conceived of as part of a series of transactions. Hypothetically, you could have a group that has half-a-dozen non-core businesses that are too small to be efficient. Instead of divesting those businesses straight away, you can choose to actually acquire new businesses to achieve critical mass, and then go in for a divestment. So, it is a long-term gain. As a result, the M&A process has become increasingly complicated. And the global capital markets facilitate corporate M&As by making debt and equity available to fund such transactions, which are actually aimed at an end-game that is 2 or 3 transactions down the road.

While structuring a deal, how do you avoid or bridge the expectation gaps?

Value is nebulous. At one end, you have the inherent value of the business as perceived by its shareholders. This is the discounted net present value of future cash- flows or earnings. At the other end, you have the strategic value of the business as perceived by the company keen on acquiring it. In staged M&As, you end up negotiating between the base value to the seller and the strategic value to the buyer. This range can be dramatically large.

Somewhere between the buyer's value and the seller's value is the actual value of the business, which is arrived at after a long- drawn-out process of negotiation. But, if the differences seem irreconcilable, earn-out mechanisms can be used to structure the deal, especially in instances where there are differences of opinion. Thus, a company can acquire a minority stake in another for a certain base-price, and promise to acquire an additional stake a year, or so, later if a certain performance criterion is met. In effect, a part-consideration is structured as a performance-linked incentive.

A corporate finance consultant helps package the bride as a preparatory step to negotiating its value. This is a function of the evolutionary stage at which the company finds itself. Start-ups-like technology- or media-companies, which are, essentially, new businesses, with good products but little else-can use a number of instruments that can help them increase their value. They are, invariably, convertible instruments, where the conversion-price is contingent on the future performance of the company. This arrangement allows the business to perform over a period of time, at the end of which it would have clearly established its value.

Another way in which a consultant can prepare a business for negotiation is by stripping it down to its basics, and repackaging it. So, if a company owns a business that runs 3 factories, and one of them is unprofitable, the company can close it down. The company will then become more profitable, and you have managed to enhance its value.

Aggregation is another route to enhancing value. Suppose a modest-sized business is about to be sold, and that it would be a more attractive proposition if it were a little larger. What should you do? Well, you can go to 2 other entrepreneurs running similar businesses, convince them that it is in their interest to merge, and offer all 3 businesses, jointly, for sale.

What, apart from the basic desire to increase the offer-price by an acquirer, drives the need for structuring?

The essence of structuring is to offer the investor exactly what he values most. This could be in terms of the right industry, the right risk-profile, and the right returns in terms of size; the time it will take for those returns to be realised; and the nature (of the returns). It could be dividends, or capital-appreciation. And, obviously, structuring should also offer investors the opportunity to put their money in the right markets.

Let us look at how AT&T restructured to meet divergent investor expectations. It was in the business of retail and wholesale telephony, business networking solutions, and Internet services. Then, AT&T acquired TCI, which is, basically, a cable TV company that owns high-capacity, broadband networks that can deliver multi-media applications. The risks associated with AT&T's traditional businesses were low, but so were the returns. The risks and returns associated with the businesses TCI was in were higher.

After acquiring TCI, AT&T now offers wholesale communication solutions that appeal to investors with low-risk appetite, who prefer regular dividend-paying stock. It also offers fully-integrated communication packages, including e-Commerce solutions and video-entertainment. This appeals to investors with a higher risk-appetite, who want high capital-appreciation even at the cost of zero dividends.

The company has also decided to enter the media-production business, and has plans for a tracking stock-a separate class of stock that tracks the performance of a business unit, and separates asset-ownership from an economic interest in those assets. While the shareholders of the parent company will still own the assets of the new unit, the risks and benefits of the new unit will only be shared with those investors who want to share in them. That is an excellent case of structuring.

Is structuring, in effect, a process by which companies can enhance the value of their offerings to investors by defining it in a particular fashion?

That's correct. A software company, for instance, would need to address 4 issues while inviting private equity. One, should the investment be routed into the Indian holding company or its foreign subsidiaries? Two, given their varying risk-profiles, should project companies be segregated from product companies? Three, where should the intellectual property rights reside? And four, which stock exchange should the scrip be listed on?

One option is to get the investor to buy into the holding company, which may have wholly- or partially-owned subsidiaries abroad. This allows the investor greater control over the organisation, and also facilitates the better use of domestic tax-incentives. And, with the intellectual property rights continuing to reside with the holding company, its value-perception is certain to be high.

An alternative structuring option could envisage no dilution in the holding company, but with each of the subsidiaries having a local venture capital or private equity partner. This can provide the company access to international funding. And the partners will have an exit option once the company gets listed on the international stock exchanges.

Infosys is a case in point. The infotech major, which is, essentially, in the projects business, has a product-oriented subsidiary, Yantra, in the US. This subsidiary can attract venture capital investments there, with the promise of a NASDAQ listing. While doing this will present such investors with an exit option, Infosys' exposure to the products business will remain limited.

In Europe and the US, most non-core business activities are divested through auctions. Is this a better approach than the traditional way of seeking a buyer, and then negotiating a value?

An auction is a controlled sales-process aimed at optimising the value for the seller. Just about every major divestiture in London and New York is conducted through this process. However, an auction actually comes with elaborate preparation. This requires a seller to understand the dynamics of the business it wishes to divest, and present its offering in the most effective manner. The preparation-process could take a couple of years, may be longer. Typical components include blind bids, or bids against an information memorandum, and, of course, the entire issue of negotiation, due diligence, and closure.

The typical auction process can be either sealed-bid or English. The sealed-bid auction is a straightforward bidding-process, with each bidder's quote hidden from the others. Usually, a participant is allowed only one bid, which means that the process of preparing the bid is critical. Such auctions can be conducted with or without a reserve-price, depending on the bidders' appetites. This is the preferred route to privatisation, both in India and abroad.

In an English Auction, the auctioneer begins with the lowest-acceptable price, and proceeds to solicit successively higher bids until no one is willing to increase the bid. The sale is, ultimately, made to the highest bidder. Sometimes, the auctioneer will start the bidding process without revealing the lowest-acceptable price. One reason for this is to prevent cartels from rigging the bidding process.

The English Auction is made more complex by the fact that several bidders get carried away. The Winner's Curse-paying more for an item than its value-is a widespread phenomenon in this kind of auction as inexperienced participants often bid up prices. Variants of the process can also be applied to the sale of individual businesses as part of a larger corporate restructuring.

The Dutch Auction is a descending-price auction, and uses an open format rather than a sealed-bid method. Bidding starts at an extremely high price, and is progressively lowered until a buyer puts in a firm bid. In this first-bidder-is-the-winner auction, understanding the psychology of competing bidders is as critical as an assessment of the price. Take the British Rail privatisation example.

Six years ago, it was decided to privatise the railway system in the United Kingdom. The British government undertook to restructure the bidding process by breaking it up into separate bids, including those for the maintenance of tracks, optimising the land around tracks, running trains, managing the stations, and leasing trains. A pricing-structure was put in place to determine the profitability of these ventures. And a management team, backed by private equity investment, bid for some parts of the privatisation, won them, and sold them at a profit a year-and-a-half later.

Does private equity, in general, serve as a catalyst to M&A?

I'm basing my response on what happened in the UK in the late 1970s and the 1980s. Private equity does stimulate M&A activity, primarily because of its entrepreneurial nature. Private equity houses are prepared to take risks. When they buy businesses, they recognise that there is a risk involved. However, they display a willingness to outbid others because they know that, if their portfolio is wide enough, they stand to get significant returns. What they do is to exploit the upside, stabilise the business, and sell it to a strategic buyer, or take it public through an Initial Public Offering. The increase in value is colossal.

What do investors expect from M&As?

To begin with, they look at the country or the geographical location of the business, and see what it has to offer. For instance, what can India offer? There could be opportunities in infrastructure, distribution, and healthcare. You are certain to find external investors with strong brands eyeing Indian businesses that are inherently strong in distribution. You might actually encounter issues in valuation where you have to arrive at, say, the value of a distribution chain. Such transactions truly enhance shareholder value.

An M&A transaction can truly change the market's perception of the value of a business by transferring it to other shareholders, who might be able to look at it differently. The reason to shift a business from an existing set of shareholders to a new set of shareholders could be either that the new shareholders will be able to do something different with the business, or to put the 2 businesses together with the aim of cutting costs, increasing marketshare, and enhancing throughput. And each of these improves profitability, and adds shareholder value.

What about the expectations-gaps in India Inc.? Do you think they are likely to hinder M&A?

One issue that any Indian group will have to address is that a lot of capital is caught up in industries where value is just not there. Capital is employed in industries that have managed to create only assets, not intangibles. Obviously, there is a huge expectations-gap in terms of the historical costs of acquisition of these assets, and what they are worth in the marketplace today. The solution? Someone has to bring expectations down. And that's the role of corporate finance consultants like us.

Thank you, Mr Thorp.

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