The Indian stock market is abuzz with the news of a hostile takeover. Larsen and Toubro, which is one of the largest and the most iconic information technology firms in the country is trying to forcefully acquire Mindtree which is a medium-sized information technology company. The news is abuzz about how Mindtree promoters do not want to sell to L&T and how L&T is trying every trick in the book to acquire this company.

Prima-facie, the L&T Mindtree takeover seems to be fuelled by the same greed that most hostile takeovers are fuelled with. However, it is also a perfect case study about how regulatory actions indirectly affect the business of all firms working in the industry. The reality is that the Mindtree acquisition bid has less to do with the attractiveness of Mindtree as a target. Instead, this bid is being driven more by the internal conditions which are being faced by L&T.

In this article, we will have a closer look at the internal conditions as well as the regulatory factors which prompted L&T to launch this unsolicited hostile takeover bid.

The Background at L&T

L&T has found itself in a position where it has a lot of excess cash. The company wants to channel this cash into creating higher growth rates. The software industry provides one of the highest rates of return in India. This is the reason why L&T has decided to make an acquisition in the software space, and Mindtree came into the picture.

• Excess Cash and the Failed Buyback Bid: L&T currently has more than $2 billion in cash reserves. The company is expected to add another $1.5 billion in terms of free cash flow by the year 2020. This excess cash is currently invested at a rate of 5%. This is obviously dragging down the overall return on equity for the company.

  It is important to note that Mindtree was not the first choice for L&T when it came to deploying these additional funds. Instead, the company wanted to buy back outstanding shares from the market. This $1.5 billion bid was foiled by the Securities and Exchanges Bureau of India (regulator). The regulator did not allow the buyback offer to go through. SEBI objected because, after the buyback, the debt to equity ratio of L&T would have crossed 2:1. This is against the compliance norms laid down by SEBI.

  L&T was not left with too many other options either. The company has already been paying excess dividends. The dividend paid in the year 2016 was a mind-boggling 33% of the annual profit of the company. The problem with raising dividends is that they set expectations for the future. Hence, if dividends are raised now, they cannot be reduced in the future without a sharp reaction from the market. This is the reason why L&T did not choose to take the dividend route.

• Offloading Non-Core Assets: L&T is also under pressure to increase its return on equity. The company’s return has fallen from 24% to as low as 9% in the past decade. L&T has stabilized its ROE at a respectable 15% at the moment. However, the shareholders are hungry for more. This is why L&T is being forced to sell off non-core assets and deploy the proceeds in high margin business like the software industry.

The Plan to Take Over Mindtree

Mindtree came onto the radar of L&T after its strategic investor tried to offload 20% stake in the company. L&T was quick to pounce on the opportunity and negotiate with VG Siddhartha, who is also the founder of the famous Indian coffee shop chain, Cafe Coffee Day. VG Siddhartha agreed to sell his stake at $600 million. After it became clear that L&T can easily acquire 20% of Mindtree’s business, L&T started aiming for the full company.

The result has been the three-fold plan which is playing out now:

• L&T plans to buy 20% of the stake from VG Siddhartha
• The company would then buy a 25% stake from the open market
• Lastly, it would give an offer to all shareholders to sell their stake to L&T for Rs 980 per share. The intent would be to take control of as many shares as possible from the free float

Given the present circumstances and opportunities, L&T feels that Mindtree is the easiest acquisition bet and is hence the best way to increase the return on equity in the short run.

Why Are Mindtree Promoters Not Selling?

There are rumours that Mindtree promoters are aware of the fact that they don’t really have a choice in the sale. VG Siddhartha’s 20% stake sale seems to have sealed the fate of the company. However, the promoters seem to be negotiating for a better price. They believe that L&T is undercutting them when it comes to the price. L&T has quoted Rs 980 per share. The promoters feel it is a lower bid because Mindtree has been recently priced at 1081 per share. However, L&T seems unlikely to give in. It is insisting that the current price makes Mindtree a value-neutral acquisition. If the share prices are raised the viability of the entire deal may be in jeopardy.

To sum it up, the unsolicited L&T offer and all the takeover drama that followed happened because SEBI disallowed share buybacks and also because a strategic investor wanted to offload his stake quickly.