The much expected reverse merger pick up may just be around the corner. In the US, this route has flourished in the last 3 years
Reverse merger as a means to gain listing could just be gaining ground. Check these cases we met in the last two weeks. A small outsourcing company – 6 year old, 150 people – is getting investment from a US based PE fund, which is also making this company merge with a listed company. Another small Mumbai based construction services company, with FY07 revenue of Rs 50 crore, has been approached by a PE fund which wants it to reverse merge.
Now two instances need not make a trend, but clearly reverse merger as a method of listing and then raising public capital, is a phenomenon waiting to pick. If it can achieve serious scale in the US and even in China, there is no reason why it cannot pick up in India.
To be fair, there have been expectations even in the last 1-2 years that reverse mergers will gain ground in India. Somehow, that has not come to pass yet. “Perhaps because it is easy to do an IPO in India” says Bhavesh Shah, executive director, JM Financial. It does not too much capital to list, says Bhavesh.
From a PE fund’s perspective, a reverse merger remains an attractive option though. It provides instant liquidity. It is not easy to take a Rs 40-50 crore turnover company public. The cost of the issue, and the pricing you could command, could both make it unattractive. If the issue devolves, it is a serious loss of face. If the promoter, PE or the merchant banker has to bail the issue out, then instead of providing liquidity, the issue could do exactly the reverse. “While reverse merger route has merits, it is open to abuse. For a good company, we would still advise a private placement or an IPO” says Sharad Rathi, head-investment banking, at Almondz Global Securities.
Reverse mergers are far more popular in the US. There have been about 200 reverse mergers per year since 2004, according to DealFlow Media, a US based outfit tracking alternative investments. Reverse mergers have also proved a very popular way for foreign companies to list in US markets. As many as 150 Chinese companies are believed to have listed in US through this route in two years, according to a Businessweek article.
Most of these reverse mergers are where a normal operating, but unlisted, company merges into a listed shell company. In the merger, the operating company shareholders are issued shares of the shell in exchange for the operating company shares. Post-merger, the former operating company shareholders own 85-95% of the shell, which now contains the assets and liabilities of the operating company, with the remaining 5-15% owned by the existing shell company shareholders.
These shell companies are often companies which have either gone bankrupt or ceased to do business for other reasons, but have retained their listing. The risk with such shell companies is that there could be hidden liabilities, lawsuits or collections agents waiting for the former public shell company to gain assets that could be seized. The new entity could become responsible for those liabilities.
US capital markets are also the most innovative in the world. Since bankrupt shells have risks, ‘virgin’ shells are available as well. Says William Sjostrom, a business law professor, “The promoter incorporates a company, registers its shares and files the required quarterly and annual reports with the SEC. Because the shell has no operations, its fairly simple and inexpensive to make these filings. In exchange for letting an operating company merge into a shell, the promoter charges the operating company a fee and retains a stake in the shell post-merger. They pitch the shell as quicker, easier and cheaper way to go public than through a conventional IPO”.
There are investment banks in US specializing in shell creation and reverse merger. They regularly create pure shells and other special purpose acquisition companies (SPACs). A SPAC like a blank check company may even raise capital first before reverse merging, thereby achieving two objectives – capital raising and listing in one go. Broadband Capital Management or American Union Securities are examples of two such banks.
Earlier this year, a shell was even offered on auction on eBay. The company offered for $150,000, ultimately didn’t sell. A Wall Street securities attorney David N. Feldman has written a book ‘Reverse Mergers: Taking a company public without an IPO’, which is a bestseller at the moment.
Reverse merger seems to have emerged as a rigorous art form in the US. In India, there is no reason why it cannot. Remember, ICICI Bank listed through a reverse merger. There has been talk of BSNL listing through merging with MTNL. Perhaps it needs a innovative financial firm to show the way.
