Oil exploration company Cairn India is merging with its parent Vedanta India. Before the merger was announced, there was talk of a ‘reverse merger’ between the two. But Cairn India and Vedanta India have now announced a plain-vanilla merger. What distinguishes a reverse merger from a straight one?
What is it?
A merger usually takes place when a smaller company folds into a larger one through exchange of shares or cash. But when the tables are turned and the acquiring company is weaker or smaller than the one being gobbled up, this is termed a reverse merger. Typically, reverse mergers take place through a parent company merging into a subsidiary, or a profit-making firm merging into a loss-making one.
In the case of Cairn India and Vedanta, the latter is the larger parent company, making this a simple merger.
Reverse mergers are quite commonplace in the US, but are few and far between in India. One example of a reverse merger was when ICICI merged with its arm ICICI Bank in 2002.
The parent company’s balance sheet was more than three times the size of its subsidiary at the time. The rational for the reverse merger was to create a universal bank that would lend to both industry and retail borrowers.
When reverse mergers happen, the resulting entity may either take on the name of the smaller firm or the larger one.
The ICICI group retained ICICI Bank as the brand name for the new entity. But when Godrej Soaps — profitable and with a turnover of ₹437 crore — did a reverse merger with loss-making Gujarat Godrej Innovative Chemicals (turnover of ₹60 crore), the resulting firm was named Godrej Soaps.
Why is it important?
Basic mathematics should tell you that 1+2 is the same as 2+1. So why do a reverse merger? Thanks to taxation, regulations or the legal system, there could be tangible advantages to letting a smaller company survive a merger.
One motive is carrying forward tax losses of the smaller firm, which allows the combined entity to pay lower taxes. In some cases, the smaller entity may have rights to trademark or assets making it imperative for it to survive. Or licence agreements signed by a company may be non-transferable — a reason to hold on to its identity.
Another popular incentive, globally, to opt for the reverse route is backdoor listing on exchanges. A large company may reverse merge with a smaller listed one and go public without an IPO. The Indian Companies Act disallows this, but this route continues to be a favourite with Chinese companies to list in the US.
Why should I care?
Any merger can be complicated and a reverse merger can leave the shareholder with shares in an entity that is loss-making or debt burdened. In the case of the Vedanta merger, Cairn shareholders are trading off their cash-rich, debt-free balance sheet for one with a net debt of ₹31,540 crore.
A reverse merger may also make a company’s books more opaque, especially if the smaller firm is unlisted. Regulators in the US and UK are known to be suspicious of reverse mergers, particularly if done to get quick listing.
Mergers have a patchy record of delivering shareholder value. Reverse mergers may be good for the groups initiating them, but for shareholders they could well put returns into reverse gear.