Project Assignment II – Aviation Law II

MERGERS, ACQUISITIONS AND TAKEOVERS

IN INDIAN CIVIL AVIATION: A CRITICAL ANALYSIS

By

Kotnis K

1. INTRODUCTION

Mergers and acquisitions is one of the most interesting aspects of any industry. Even more, in the aviation industry since it has the potential to change the very market dynamics in the environment in which it operates. Aviation is an oligopolistic sector in India with very few players in the market. Any merger or acquisition in this sphere has a great impact as seen in the case of the Jet-Sahara or the Kingfisher-Deccan merger. Usually M&A have multiple reasons behind them. In the case of Indian civil aviation it is often done to increase market share and acquire rights to fly international routes.

Before getting into the details of M&A in the Indian civil aviation, let’s look at mergers and acquisitions in a very generic sense. A merger is a combination of two or more distinct entities into one; the desired effect being not just the accumulation of assets and liabilities of the distinct entities, but to achieve several other benefits such as, economies of scale, acquisition of cutting edge technologies, obtaining access into sectors/markets with established players etc. Generally, in a merger, the merging entities would cease to be in existence and would merge into a single surviving entity.

Very often, the two expressions "merger" and "amalgamation" are used synonymously. But there is, in fact, a difference. Merger generally refers to a circumstance in which the assets and liabilities of a company (merging company) are vested in another company (the merged company). The merging entity loses its identity and its shareholders become shareholders of the merged company. On the other hand, an amalgamation is an arrangement, whereby the assets and liabilities of two or more companies (amalgamating companies) become vested in another company (the amalgamated company). The amalgamating companies all lose their identity and emerge as the amalgamated company; though in certain transaction structures the amalgamated company may or may not be one of the original companies. The shareholders of the amalgamating companies become shareholders of the amalgamated company.

While the Companies Act does not define a merger or amalgamation, Sections 390 to 394 of the Companies Act deal with the analogous concept of schemes of arrangement or compromise between a company, it shareholders and/or its creditors. A merger of a company ‘A’ with another company ‘B’ would involve two schemes of arrangements, one between A and its shareholders and the other between B and its shareholders.

Mergers may be of several types, depending on the requirements of the merging entities:

a. Horizontal Mergers: Also referred to as a ‘horizontal integration’, this kind of merger takes place between entities engaged in competing businesses which are at the same stage of the industrial process. A horizontal merger takes a company a step closer towards monopoly by eliminating a competitor and establishing a stronger presence in the market. The other benefits of this form of merger are the advantages of economies of scale and economies of scope.

b. Vertical Mergers: Vertical mergers refer to the combination of two entities at different stages of the industrial or production process. For example, the merger of a company engaged in the construction business with a company engaged in production of brick or steel would lead to vertical integration. Companies stand to gain on account of lower transaction costs and synchronization of demand and supply.

Moreover, vertical integration helps a company move towards greater independence and self-sufficiency. The downside of a vertical merger involves large investments in technology in order to compete effectively.

c. Cogeneric Mergers: These are mergers between entities engaged in the same general industry and somewhat interrelated, but having no common customer-supplier relationship. A company uses this type of merger in order to use the resulting ability to use the same sales and distribution channels to reach the customers of both businesses.

d. Conglomerate Mergers: A conglomerate merger is a merger between two entities in unrelated industries. The principal reason for a conglomerate merger is utilization of financial resources, enlargement of debt capacity, and increase in the value of outstanding shares by increased leverage and earnings per share, and by lowering the average cost of capital. A merger with a diverse business also helps the company to foray into varied businesses without having to incur large start-up costs normally associated with a new business.

e. Cash Merger: In a typical merger, the merged entity combines the assets of the two companies and grants the shareholders of each original company shares in the new company based on the relative valuations of the two original companies. However, in the case of a ‘cash merger’, also known as a ‘cash-out merger’, the shareholders of one entity receive cash in place of shares in the merged entity. This is a common practice in cases where the shareholders of one of the merging entities do not want to be a part of the merged entity.

f. Triangular Merger: A triangular merger is often resorted to for regulatory and tax reasons. As the name suggests, it is a tripartite arrangement in which the target merges with a subsidiary of the acquirer. Based on which entity is the survivor after such merger, a triangular merger may be forward (when the target merges into the subsidiary and the subsidiary survives), or reverse (when the subsidiary merges into the target and the target survives).

An acquisition or takeover is the purchase by one company of controlling interest in the share capital, or all or substantially all of the assets and/or liabilities, of another company. A takeover may be friendly or hostile, depending on the offeror company’s approach, and may be effected through agreements between the offeror and the majority shareholders, purchase of shares from the open market, or by making an offer for acquisition of the offeree’s shares to the entire body of shareholders.

a. Friendly takeover: Also commonly referred to as ‘negotiated takeover’, a friendly takeover involves an acquisition of the target company through negotiations between the existing promoters and prospective investors. This kind of takeover is resorted to further some common objectives of both the parties

b. Hostile Takeover: A hostile takeover can happen by way of any of the following actions: if the board rejects the offer, but the bidder continues to pursue it or the bidder makes the offer without informing the board beforehand.

c. Leveraged Buyouts: These are a form of takeovers where the acquisition is funded by borrowed money. Often the assets of the target company are used as collateral for the loan. This is a common structure when acquirers wish to make large acquisitions without having to commit too much capital, and hope to make the acquired business service the debt so raised.

d. Bailout Takeovers. Another form of takeover is a ‘bail out takeover’ in which a profit making company acquires a sick company. This kind of takeover is usually pursuant to a scheme of reconstruction/rehabilitation with the approval of lender banks/financial institutions. One of the primary motives for a profit making company to acquire a sick/loss making company would be to set off of the losses of the sick company against the profits of the acquirer, thereby reducing the tax payable by the acquirer. This would be true in the case of a merger between such companies as well.

Acquisitions may be by way of acquisition of shares of the target, or acquisition of assets and liabilities of the target. In the latter case it is usual for the business of the target to be acquired by the acquirer on a going concern basis, i.e. without attributing specific values to each asset / liability, but by arriving at a valuation for the business as a whole. An acquirer may also acquire a target by other contractual means without the acquisition of shares, such as agreements providing the acquirer with voting rights or board rights. It is also possible for an acquirer to acquire a greater degree of control in the target than what would be associated with the acquirer’s stake in the target, e.g., the acquirer may hold 26% of the shares of the target but may enjoy disproportionate voting rights, management rights or veto rights in the target.

Having looked at the difference between mergers and acquisitions, the next section of this paper focuses on M&A in the Indian civil aviation sector.

The three mergers are as listed below:

1. Jet-Sahara merger2. Kingfisher-Deccan merger3. Air India - Indian airlines merger.

Each of these mergers have been game changing in the industry in terms of market shares, number of people employed, aircraft acquisition and more importantly price related issues for the consumer.

Jet-Sahara Merger:

Jet airways is one India’s premium domestic and international airline. It was set up in 1993 after the government opened civil aviation to private investment. It overtook India’s national airline in early 2000 in terms of number of passengers carried. By 2005, it had been listed on the national stock exchange. However during 2006-2007, Jet Airways’ dominance in the domestic market was severely challenged due to the entry of low cost carriers and its market share declined by 7% in early 2006. Moreover Jet had struggled to keep pace with the industry’s capacity expansion. Having realized its position Jet wanted to take immediate measures to counter its problems. It needed measures to handle congestion time at airports, avoid delays in purchase of new aircrafts, wanted to enter into the LCC segment in a big way and more importantly it wanted to reduce the number of players in the market and achieve a pricing power.

Sahara airlines was established on 20th September 1991 and started operations on 3rd

December 1993 with two B-737 aircraft. Initially services were concentrated in the Northern regions of India with Delhi as its base, later operations expanded down south. It was rebranded as Air Sahara on 2nd October 2000. On 22nd march 2004 it became an international carrier by operating a flight on the Delhi-Colombo route. Its market share fell by over 45% in a span of one year, during 2006 to 2007. The mismanagement of the airline was adding burden to the Sahara group and it was looking to exit the aviation business. Moreover, it had huge long term and short term liabilities. So it was in need of money to pay of its debts.

The situation of Jet and Sahara lead to its merger post 2007. Sahara airlines was a perfect target for Jet since Sahara had vast parking bays and slots at important metros, had a fleet strength of 26, and was operational on 24 domestic and 4 international routes. All these were a perfect strategic fit to Jet’s scheme of things in the year to come. Sahara’s fleet consisted of B-737 aircrafts and on merger it would optimise maintenance activities due to commonality in fleet.

The entire business of Air Sahara was valued at 2300 crore by Jet Airways, where as Ernst and Young valued Sahara at 3382 crores. The merger was proposed to acquire only assets of Sahara and not its liabilities. Post this Jet faced losses of around 100 crores within few months of operations and sought for revaluation. Sahara did not concur with the revaluation clause and launched an appeal against Jet. Jet on the other hand was stuck with the 500 crores it had paid as a refundable deposit towards the merger. However Jet managed to win the cause since the deal was not final due to regulatory concerns. Since the first valuation of 2300 crores, Jet had lost 35% of the market capitalization and hence the second valuation was done at 1450 crores. At the same time Air Sahara got a beating on its valuation due to failure of the deal. So it proposed new negotiations at revised valuations.

Finally the deal came through and Jet paid 400 crores upfront in addition to the 500 crores it had already deposited ad advance. The balance amount of 550 crores was to be paid four interest free annual equal instalments. Hence Sahara became a 100% subsidiary of the company. From 15th May 2007, Sahara airlines was renamed as Jet Lite. This merger led to Jet airways enjoying a 42% market share.

Post merger integration was done in phases. Phase 1 of operational integration where aircrafts of Sahara were brought into service and approximately 200 crores were spent on fleet refurbishment. Bulky insurance policies were removed to short term cost effective policies and office spaces and premises that were unnecessary were sold off.

Phase 2 of operational integration was done by removing 2 CRJ’s and ATR’s were leased to reduce maintenance costs of a different aircraft. Ticketing costs for JetLite were reduced by moving to a web based platform. At the same time, business class was withdrawn and loss making flights were discontinued. Similarly on the HR front, training programmes of 90 days duration were implemented for Sahara employees with support from Lufthansa technik. Cultural clashes were avoided since Sahara was converted to a low cost carrier.

The merger was marred by legal issues. Jet and Sahara had made a pact outside the court that all contingent liabilities had to be borne by Sahara itself. But then, the Income Tax department raised certain tax obligations against Sahara for 87 crores. Air Sahara refused and hence, Jet had to pay the amount. Jet and Sahara rang the court for non payment of 87 crore and the HC ordered Jet in 200 to pay the remaining 478 crores including 9% interest on the same. Post this legal battle, Jet’s stock fell by 6%.

Though HR and legal issues were present in abundant, this merger was beneficial to both since it helped Jet Airways consolidate their position in the market and also gain entry into the low cost segment through Jet lite. Similarly it benefited Sahara by doing away with its liabilities and exit the aviation market to concentrate on its lucrative real estate market.

Kingfisher-Deccan Merger:

Kingfisher Airlines, a private airline owned by Liquor baron, Vijay Mallya of the UB group, started operations on May 9th, 2005. It started off with a fleet of 4 brand new A-320 and operated its first flight on the Mumbai-Delhi sector. It proved to be a stiff competition for other domestic airlines due to its brand new aircraft, stylish red interiors, stylishly dressed cabin crew and ground staff. For the first time passengers were treated to in-flight entertainment even on domestic flights. However the airlines faced a worsening economic scenario in 2008 and it needed to get out of the crunch quickly in order to survive.

Air Deccan was India’s first low cost carrier. A wholly owned subsidiary of Deccan aviation and Promoted by Capt Gopinath, Capt KJ Samuel and Capt Vishnu Singh, it was incorporated as a private limited company on Jun 15,1995. It was converted into a public limited company in 2005.

Rationale for the deal for KF airlines was expansion to start international operations and do away with the losses of 577 crores. For Air Deccan the rationale was to make profits and overcome losses and negate the cash crunch it had been facing. Hence a merger seemed the right way ahead for both companies. The merger anticipated that it would have access to 65 airports and its ground infrastructure, 71 aircrafts and synergies in other realms of airline operations. Moreover both companies had placed orders for aircrafts from Airbus industrie and hence this would add to the overall synergy post merger and help increase market share to a great extent.

On 1st June 2007, the board of Air Deccan approved the allotment of equity share of 26% to UB group and its nominees. The shares were allotted at Rs.155 per share, a 10% premium for the current market price. UB group paid the money in 2 instalments, 150 crore upfront and the balance amount by the end of June. UB group made a further open offer to acquire 20% stake costing 418 crores. Hence the total deal size was 968 crores for 46% stake. The UB group became the single largest shareholder in the Deccan aviation ltd.

Initially branded as Simplifly Deccan post the merger, it was later renamed to Kingfisher Red in 2008 and the name and brand of Deccan was totally done away with. The merger did help both companies gain a larger market share, however the present financial health of Kingfisher does not speak much about the success of the merger on a long term basis.

Air India-Indian Airlines Merger:

After many debates and discussions the government approved the merger of Air India and Indian airlines on 1st March 2007. A new company, NACIL was incorporated under the companies act, 1956 on 30th March 2007. The Authorised and paid up capital of the merged entity was 15,00,05,00,000. Both companies were wound up without being dissolved.

According to the government the merger was supposed to improve competitiveness and create one of the largest airlines in India comparable to leading airlines in Asia. It was supposed to provide an international/domestic footprint which would enhance customer proposition and allow easy entry into one of the three world alliances present in 2008. It would enable optimum use of existing resources and improve load factors and yields on commonly operated routes. The merged entity of NACIL had a fleet of 119 aircraft operating 392 daily flights to 140 destinations.

However the performance post merger has been poor. Losses accumulated were to the tune of 7200 crores during March 2009. Most services were not meeting the cash costs or total costs both in domestic and international sectors. In 2009 Air India employed about 300 staff per aircraft and 2 sets of employees continued to exist in Air India post merger. Staffs from Indian Airlines were still being paid lower than their Air India counterparts and human resources strategic fit miserably failed due to constant tensions amongst employees of both companies. Market surveys revealed that Air India was no longer a preferred brand and customer satisfaction levels were at an all time low. Air India failed to meet its minimum standards for membership into the Star Alliance. As of 31st July 2011, Air India’s entry into the alliance was suspended. As of 2009-10 the total borrowing was 2.87 times the total revenue. Even the working capital loan was 1.38 times the total revenue.

The merged entity had been overly dependent on debt funding with a very narrow equity basis which dramatically increased the financial risk. The merged entity’s decision to acquire B-787 aircrafts at a high cost was also ridiculed and severely criticized by people. Its market share has declined by almost 30% since the merger until 2011.

As of March 2011, Air India has accumulated a debt of Rs. 42,570 crore (approximately $10 billion) and an operating loss of Rs. 22,000 crore, and is seeking Rs. 42,920 crore from the government.For the past three months (June, July, August 2011), the carrier has been missing salary payments and interest payments and Moody’s Investor Service has warned that missing payments by Air India to creditors, such as the State Bank of India, will negatively affect the credit ratings of those banks. A report by the Comptroller and Auditor General (CAG) blamed the decision to buy 111 new planes as one of the major causes of the debt troubles in Air India; in addition it blamed on the ill timed merger with Indian Airlines as well.

Due to high fuel and loan costs, Indian government has already pumped 32 billion rupees into Air India since April 2009 and in March 2012 government bailed out Air India Ltd. with 67.5 billion rupees ($1.4 billion). As of 8th May, 2012 the carrier invited offers from banks to rise up $ 800 million via external commercial borrowing and bridge financing.

In a recent interview the civil aviation minister, Mr Ajit Singh accepted that the merger was a mistake by saying, “Their cultures were entirely different. Air India's way of doing things, Indian Airlines way of doing things, their pay scales, their promotion policies and their areas of operation were also entirely different. So that did cause lot of problems and that is why even now they are not really integrated”.

With the recent debt restructuring package and equity infusion of 42,000 crores the carrier expects to return to profitability by 2017. It is to be seen if it happens and when it does, it would speak volumes on success of the merger.

A comparison of airlines post merger is as tabulated below:

As of March 2012, the market share of Indian carriers is as represented below:

The recent economic downturn coupled with high cost of aviation turbine fuel has seen every airline in India report losses except for Indigo. Mergers in the aviation industry in India did have a considerable impact on profitability and load factors post merger. However their effect seems to fade away with Kingfisher dropping to an all time low of 6.4% market share.

However it would not be fair to analyse and conclude on the effectiveness of an airline merger by ignoring present market conditions. Jet Sahara merger resulted in a majority market share for Jet which it continues to enjoy even till today. It is also important that the managements of the merging companies perform a due diligence analysis pre merger and consider market dynamics and have a thorough understanding on how the market would change over the next decade. It is important to realize the synergies that exist and capitalize on them for long term gains and not just concentrate on short term benefits. Kingfisher was believed to have bought majority stakes in Deccan for the primary reason that it could fly international due to the regulations imposed by the DGCA. The low cost principle of Deccan was retained in the form of Kingfisher Red but unfortunately couldn’t retain the load factors or yields enjoyed by Deccan. It came as little surprise that Mallya decided to shut down Kingfisher Red in an attempt to consolidate and plan a better strategy for survival.

HR issues in jet Sahara merger could have been better handled without affecting flight schedules to the extent it actually did. The underlying point here is that mergers and acquisitions are no doubt advantageous in terms of gaining market share and optimizing existing resources but need to be handled better and it is very important to have analysed and weighed in all factors prior to the merger. Short term goals are often realized through M&A’s but it is the long term pursuit of goals and objectives that should essentially determine the success of a merger and/or acquisition.

It is important to observe the roles played by the senior and top managements of the respective companies during a merger. In today’s aviation scenario, the need for customer satisfaction, increased safety and security measures and yet churn out profit on most flights is higher than ever before. A company wishing to acquire majority stake in another carrier must evaluate the consequences of a possible merger and if it fits into the strategic objectives the company wants to pursue over the next few years or even a decade. Often poor management decisions have resulted in failed mergers reasons of which can be attributed to improper forecasting, poor financial planning and complete mismatch of objectives.

Indian aviation is poised for growth and expected to be the world’s third largest aviation market by 2020. However critical issues need to be handled with utmost care and government policies can play a pivotal role in this regard. It is to be seen if future and/or past mergers can yield suitable influence in the Indian aviation market in years to come and the extent to which these M&A’s contribute towards India’s rise in world civil aviation.

BIBLIOGRAPHY

1. A Study of Mergers & Acquisitions in Aviation Industry in India and Their Impact on the Operating Performance and Shareholder Wealth, Nisarg Joshi and Jay Desai, Ahmedabad Institute of technology.

2. Airline mergers and competition, Sunil Barthwal, The Financial Express, March 30 2007.

3. Case study of Merger & Acquisition in Indian aviation industry. 4. Jet-Sahara merger, Deepika Minocha and Pratibha Singh5. NALSAR handbook – PGDALATM course. 6. PGDALATM course – Class notes.