Buyout: Taking Control and What Changes After

A buyout is the purchase of enough of a company's shares to control it. The buyer can then appoint and remove the board and decide a sale without asking anyone else. Governance is what changes the day after: the board is reconstituted, a list of matters needing the new shareholder's written agreement takes effect, and the reporting the company owes changes.

Control is not a feeling and it is not influence. Control is the ability to make a decision stand without anyone else's agreement, and inside a company that ability lives in exactly two places. The votes at a general meeting decide who the directors are. The seats at the board decide how the company acts between those meetings. A buyoutBuying enough of a company's shares to control it. buys both. Everything that changes the day after a buyout completes is a consequence of the fund holding both of those things, and nothing that changes is a consequence of the fund having paid a particular price.

What is a buyout, and what exactly is being bought?

A corner sweet shop run by two brothers holds the whole distinction inside it. Money can go into that shop by paying for a new oven and taking a stake in exchange, in which case the shop now has an oven it did not have before. Or an investor can pay one brother for his half of the shop, in which case the shop has exactly what it had yesterday and one brother has the money in his pocket. Same amount of money, two transactions that share almost nothing.

A buyout is the second of those, and a purchase of shares from an existing holder is a secondary purchaseBuying shares from an existing shareholder, so the money goes to that shareholder.: the shares already existed, somebody already held them, and the buyer is paying that person. Nilgiri Growth Partners Fund II, invented, is a closed-end growth and buyout fund managed by Nilgiri Alternatives Advisors Private Limited, also invented. In Fund II's Year 1 Q3 it paid Rs 55,00,00,000 for shares in Sahyadri Diagnostics Private Limited, invented, and those shares were held by the founding shareholders. The money went to them. Sahyadri Diagnostics had exactly the same cash the day after completion as it had the day before. Not one rupee of the Rs 55,00,00,000 went into the company.

The same fund did both, so hold one route against the other. In Fund II's Year 2 Q4 it paid Rs 50,00,00,000 for shares in Bhavani Speciality Chemicals Private Limited, invented, and those shares did not exist beforehand. The company issued them and the fund subscribed for them. All of the Rs 50,00,00,000 went into Bhavani Speciality Chemicals, and no shareholder of that company received any part of it. One manager, two entries fifteen months apart on the same clock, and the cash landed in opposite places.

Readers get this wrong more often than anything else about a buyout, and it is worth being blunt. A buyout does not fund a company. A buyout pays that company's shareholders. In any reported transaction one fact settles whether the business itself received anything, and that fact is whether the shares changed hands or were newly issued. The size of the number settles nothing at all.

Where does control actually live inside a company?

Picture a housing society for a moment. The members vote at the annual meeting, and that vote decides who sits on the managing committee. The committee then decides what gets painted this year, picks the contractor and fixes when the tank is cleaned. Somebody who has collected more than half the members' votes but holds no seat on the committee can replace the whole committee at the next meeting and can do nothing whatever about the painting this week. Somebody who sits on the committee with no votes behind them can decide about the painting today and can be voted off in a month.

A company works the same way, and this is where controlHolding more than half the votes, so a decision stands without anyone else agreeing. actually lives. The votes at a general meeting decide who the directors are. The seats at the board decide how the company acts between those meetings. Control is more than half the votes, and that is the whole of the definition worth carrying: more than half the votes, so a decision stands without anyone else agreeing to it. Notice what the definition leaves out. The definition says nothing about a price, nothing about a stake described as large, and nothing about a relationship with the people running the business.

More than half the votes buys the power to decide who the directors are, and deciding who the directors are is a different thing from being one. The distinction sounds pedantic until the gap between the two comes into view. Between the moment a fund holds the votes and the moment the board has actually been reconstituted, the fund can carry precisely nothing inside the company. Every decision taken in that window is still taken by directors somebody else appointed, in a room the fund is not in. The gap is exactly why the first item on the list of things a fund does after a transaction lands is not a plan for the business. The first item is the board.

What happens on the day the transaction completes?

CompletionThe day the transaction takes effect and the shares change hands. is the day the shares actually change hands, and the single thing that happens to the company on that day is that its board is reconstituted. Nothing about the products moves, nothing about the staff moves, and the bank balance does not move. The directors change.

Every one of Nilgiri Growth Partners Fund II's nine holdings has a board of five. The board of five is this invented arrangement's own contracted term, written into its own documents. The same size is set across all nine holdings deliberately, and the sameness is what makes any comparison between them a fair one. At the fund's four control holdings, being holdings 1, 3, 5 and 8, the fund appoints three of the five directors. At four of the five minority holdings it appoints one.

Three of five is a countable arrangement rather than a figure of speech, and it is worth doing the counting. Three of five is a majority of the board, so a resolution the fund's three directors support carries. A resolution they oppose does not carry. At holding 7, Manjira Industrial Services Private Limited, invented, where the fund appoints one director of five, the fund alone can carry nothing at all in that room and needs at least two other directors with it. The difference between a control position and a minority one, at the level of the board, is entirely the difference between three seats and one seat out of the same five.

What can the fund carry, and what can it stop?

One distinction carries everything that follows, and it is the single most useful thing to take away. A board resolutionA decision taken by the directors at a board meeting. is a decision taken by the directors at a board meeting, and three seats of five carries one. A reserved matterSomething a company may not do without a named shareholder's written agreement. is something the company may not do without a named shareholder's written agreement, whatever the board decides, and it does not sit at the board at all. A reserved matter sits in the shareholders agreementThe contract between the shareholders, separate from the company's own constitution., a contract between the shareholders and a separate document from the company's own constitution.

A reserved matter is a veto held under a contract, and a board seat is a vote held in a room. Everything else follows from that sentence, so say it to yourself twice. A vote in a room makes something happen. A veto under a contract stops something happening. The vote and the veto are two instruments doing two opposite jobs, written down in two different places, and a reader who merges them has understood neither.

Seven reserved matters are written into the shareholders agreement of every one of Nilgiri Growth Partners Fund II's nine holdings. The seven are this invented arrangement's own terms, not a standard list and not a requirement of anybody.

Now for the part that surprises people. The seven reserved matters applied at Sahyadri Diagnostics before completion and applied after it, entirely unchanged. Taking control did not create them and did not add to them. The fund holds all seven at every one of its nine holdings, including the five where it appoints one director of five and the one where it appoints none. Completion changed the board, and only the board.

So think about the seven decisions in the table above and count what each one has to clear. Each has to clear a board resolution, and three seats of five settles that. Each also has to clear the reserved matter, and no number of board seats settles that. A reserved matter is not a board question but a shareholder's signature on a contract. A fund with three seats and no reserved matters could carry a great deal and stop nothing. A holder with seven reserved matters and one seat can stop a great deal and compel nothing.

What is on the list for the first hundred days?

The hundred days at holding 1 run from completion in Fund II's Year 1 Q3 into Year 1 Q4. The hundred days are a duration and not a date. Six things are on the list, and this is the invented arrangement's own record of what it did rather than a template of what anybody ought to do.

One: the board is reconstituted, the fund's three directors are appointed and the first meeting is held. Two: the reporting pack and its cadence are fixed, and the first monthly pack lands. Three: the chief financial officer position is settled, either confirmed or filled. Four: the bank mandateThe instruction to a bank saying who is authorised to move the company's money. and the payment authorities are changed, so the fund knows who can move money. Five: the budget for the remainder of the year is approved. Six: the three things the investment case actually depends on are written down and made the standing first item of every board meeting from then on.

Now count the list and notice what is absent from it. There is no strategy on it. There is no restructuring, no cost programme, no new product and no plan for the market. Five of the six items are about information and authority: who reports what, how often, and who is allowed to move the company's money. Only the last one touches the business at all, and even that one is about writing something down rather than doing something.

If that seems anticlimactic, moving into a rented flat has the same shape. Before any furniture is rearranged, a new tenant finds out who else has keys, where the meter is, and who to call when the water stops. Nobody would call that a plan for the flat. Those first checks are the things without which no plan can be carried out at all. A fund that has not settled who reports what and who can move money has no way to notice a problem and no way to act on one, and every one of those five items gets harder rather than easier to fix as the months pass.

Who runs the business afterwards, and who decides that?

The person running the company on the day before completion is still running it on the day after, unless somebody decides otherwise. The incumbent staying is the starting position, and a real one rather than a formality. Reserved matter 5 in the table above is appointing or removing the chief executive or the chief financial officer. The fund therefore has a say in this whether or not it holds a single board seat.

There are three honest answers to the question and no fourth. The incumbent stays and runs the business as before. The incumbent stays for a defined period while a successor is found and handed over to. Or the incumbent leaves and a successor is appointed. Each is a decision with different consequences, different costs and a different timetable, and each is defensible.

A fund that reaches the end of the first hundred days without having decided has decided that the incumbent stays, and has done it without ever holding the discussion. Naming the chief executive question is worth doing for exactly that reason. Nothing happens when nobody decides, and nothing happening is one of the three answers. Reserved matter 5 gave the fund a say on the day the transaction completed, so the fund cannot afterwards claim it had none.

Item 3 on the hundred day list sits next to this. Item 3 settles the chief financial officer position, either by confirming the person in it or by filling it. The chief executive question is separate and is not on the six item list at all. The list is about what the fund needed in order to see the business rather than about who ran it.

What does the fund owe the company once it has control?

Control runs in both directions, and the return direction is the one readers skip. Once a fund appoints three of five directors, three things become the fund's to supply: money when the case needs it, people who will actually turn up, and a decision whenever the business needs one.

Money first, with the record. Holding 1 took a follow-on investment of Rs 15,00,00,000 in Fund II's Year 4 Q1, exactly 2.50 years after the entry in Year 1 Q3, taking the total cost of the holding to Rs 70,00,00,000. The follow-on is 21.4 per cent of the cost of the holding, being 15 divided by 70. Only two of Nilgiri Growth Partners Fund II's nine holdings ever received a follow-on at all.

And immediately, in the same breath, the uncomfortable half of that. Both of this fund's follow-ons went into holdings that were above cost at the time. The opposite case is the one the fund's own governance record names as a conflict: putting more money into a holding that is struggling. Marking a loss is unwelcome, and a fresh cheque postpones it. The invented fund's answer to that conflict is a process, being the consent of its investor advisory committee on any follow-on above a size its own documents fix. An account that names a follow-on as a fund supporting its company without naming the same act as a way of avoiding a mark has given only half of it.

People next. The fund's three directors at holding 1 are three people who sat through 23 quarterly board meetings across 5.75 years, from entry in Year 1 Q3 to the sale in Year 7 Q2. Twenty three meetings is a number with weight to it. Sitting through them is what three of five seats costs in attention before the seats produce anything at all.

Then decisions. Once the fund holds three of five seats there is no other party the difficult question can be sent to, so control is not only a set of powers but a standing obligation to answer. A minority holder can wait to see how the majority acts. A controlling holder is the party everybody else is waiting for, and waiting is itself an answer, as the chief executive question showed.

Where did the money for the purchase come from?

The amount paid has been stated throughout; how the payment was assembled has not. A purchase of this kind is often funded partly with money borrowed against the company being bought, and the arithmetic of what a return looks like when part of the price was borrowed is a subject of its own, covered separately and in full.

One part of a buyout does not depend on the funding at all. Whatever the price was assembled from, the shares bought at holding 1 were existing shares, the Rs 55,00,00,000 reached the founding shareholders, the board of five was reconstituted, and the seven reserved matters carried on exactly as they had before. Not one of those four facts changes if the purchase was funded entirely with the fund's own money or partly with borrowing. All four can therefore be taught without the funding question being settled first.

There is a general habit worth taking from this. A subject whose boundaries cannot be stated is usually a subject that cannot be stated either. Being able to draw the line between the governance of a transaction and the funding of it is not a limitation on understanding. Drawing that line is most of the understanding.

What does control cost when the business does not work?

Put the two control holdings side by side and the point stops being an argument and becomes a record. Same manager, same contracted board of five, same three seats, same seven reserved matters, same monthly pack. Opposite outcomes.

Both columns belong to one invented fund over the periods stated against them, and neither outcome is typical of anything at all. The reason for setting them next to each other is not to show that control produced one of them. The reason is that the governance was identical in both columns and the outcomes were not.

Do the multiples say that control worked?

The multiples do not. The two numbers involved are exactly the kind that get quoted without their arithmetic, so the working is worth doing rather than asserting. Nilgiri Growth Partners Fund II is a growth and buyout fund, so its nine holdings split two ways. Four of them are control positions and five are minority positions.

At the fund's record date, the end of Fund II's Year 9 Quarter 2, the four control holdings had a total value of Rs 4,34,00,00,000 against Rs 2,10,00,00,000 of acquisition cost, being 2.07 times. The five minority holdings had Rs 2,86,00,00,000 against Rs 1,90,00,00,000, being 1.51 times. Both figures belong to that one invented fund at that one date.

Now take one holding out of each side and watch what happens. Remove holding 1 from the control group and the remaining three are Rs 2,31,00,00,000 on Rs 1,40,00,00,000, being 1.65 times. Remove holding 4 from the minority group and the remaining four are Rs 1,78,00,00,000 on Rs 1,30,00,00,000, being 1.37 times. The difference between the two headline figures was 0.56 on the multiple. After removing one holding from each side the difference is 0.28, exactly half.

Four holdings against five, one manager, one fund, one period, and half the difference disappears when a single position comes out of each side, so nothing whatever about control as an approach follows from 2.07 against 1.51. A reader who carries those two numbers away without the strip-out has been handed a conclusion the arithmetic does not support.

Two more facts finish the refusal off. The four control positions include holding 5, the only one of the nine that produced no cash at all. The five minority positions include holding 4, carried at 1.80 times. The groups are not clean, they are not large, and they were never designed as an experiment.

What does a buyout not change?

Almost every reader arrives expecting more, and the list of what a buyout does not change is the shortest to write and the most useful to carry. On the morning after completion the customers walk in the same way they did the week before. The contracts with them run on. The people doing the work are doing the same work on the same terms. Everything the company owes, it still owes, to exactly the same people.

Two things established earlier belong on that list. The Rs 55,00,00,000 went to the founding shareholders, so the company's own cash did not move at completion. And the seven reserved matters were in the shareholders agreement before completion and stayed there afterwards, unchanged.

A buyout changes who the directors are, what the company must report and how often, who may move the company's money, and who is answerable for the outcome, and it leaves the customers, the contracts, the staff and everything the company owes exactly where they were. Set that against how transactions are usually described and the mismatch is obvious. The description is about the transaction. The company mostly carries on.

How does an analyst, a director or a lender actually use this?