Leading to the world of LBOs: RBI opens up acquisition finance

Vinod Kothari, Payal Agarwal and Simrat Singh | finserv@vinodkothari.com

The RBI recently opened the avenues for banks to provide funding for acquisitions. For domestic banks, enabling changes were made vide Amendment Directions on Capital Market Exposure dated 13.02.2026, covered in our write up here, and for global banks, the enabling amendments were made in ECB Regulations by relaxing the end-use restrictions vide notification here, covered in our write up here.

This write up discusses what is acquisition finance, what are the global structures and risks, and whether India will now be ushered in the new, arguably risky world of leveraged finance.

What is acquisition finance?

Acquisition finance, known by various names such as M&A finance, leveraged finance, LBO finance, etc is globally practiced by banks. Wherever there are inflexibilities or restrictions on banks lending for acquisitions, the gap has given room for private credit lenders, special situation funds and alternative investment funds to chip in – which is what accounts for the sharp rise in private credit funds. See our  article on private credit AIFs here. 

LBO financing added to approximately US $214 Billion globally for 2024. As per a 2024 S&P report, banks funded only about 23% of LBO financing globally with private debt players covering the other 77%. The reasons for such reduced share for banks include intensive capital charge applicable to banks, lower profitability on such loans and over-leverage risks (see discussion below). 

Source: S&P Global

How is acquisition finance structured?

The end-use of acquisition finance is the control or significant holding over the target. Therefore, quite naturally, the collateral for acquisition finance are the shares of the target. Taking the collateral is intuitive, but the issue is, how is the loan repayment structured? The most logical way to structure an LBO is to align the loan repayment with the residual cash flows from the target. Hence, it is returns on equity from the target that pay the loan.

Lenders may quite structure the loan with the possibility of refinancing the acquisition, such that the initial funding term is not as long as the payback period of the target is. For example, a company borrows ₹500 Crores to acquire a business generating ₹100 Crores annually, repays only ₹20 Crores of loan each year for 5 years, leaving ₹400 Crores outstanding at maturity, which it then refinances with a new ₹400 Crores loan instead of fully repaying from operating cash flows. The key risk in such a case would be refinancing risk i.e. if credit markets tighten, the company may be unable to roll over the ₹400 Crores at maturity. There is also interest rate risk, as the new loan may be available only at a higher cost, increasing the debt burden.

Acquisition finance is quite risky, as it is funding the residual return which itself is impacted by all the risks of the target’s business; any downturn in performance directly impairs debt servicing capacity. It is a leverage created on structure, which itself is leveraged. Therefore, lenders may quite often be comfortable with the strength of the acquirer’s own business, etc. But the standalone strength of the cash flows of the target’s business is the ultimate comfort for an LBO investor.

Debt tranching in acquisitions

Usually a LBO is undertaken by multiple lenders so as to cut down on individual exposure and risk further and in such cases each lender may have varying risk and return expectations. In such a multi-lender LBO, instead of issuing one big, uniform loan, the capital stack is layered into tranches with different priority, pricing, maturity and covenants. Therefore, there can be senior and mezzanine debt, with tranches itself within these such as high-yield debt within the mezzanine tranche. The senior tranche typically ranks first in repayment and is secured against the company’s assets and cash flows, carrying lower interest with tighter covenants and amortization requirements. 

Below this sits the mezzanine or subordinated debt, which ranks junior in the repayment waterfall, bears higher interest to compensate for greater risk. This is usually provided by non-banks and is secured by second-lien and may also be partially unsecured.. 

Equity sits at the bottom of the capital structure and represents the residual ownership in the company. It has no fixed repayment or guaranteed return; instead, equity holders receive whatever value remains after senior and mezzanine debt are fully repaid. Because it is last in priority, equity bears the highest risk and absorbs first losses if the company underperforms.

However, equity also captures all upside beyond debt obligations. As leverage increases, the amount of equity invested decreases, which magnifies potential returns if the company performs well and is sold at a higher value.

Sometimes, subordinated tranches may also carry a PIK or pay-in-kind feature, which implies that the periodic interest will not be serviced, but will be added to the outstanding exposure.

This layered structure allows risk to be allocated according to each lender’s appetite, reduces the overall cost of capital by pricing safer debt more cheaply and increases total borrowing capacity without overexposing any single lender. 

The following chart is an illustration of a typical LBO capital structure with a bank (senior) debt of 50%, high yield debt is 15%, mezzanine is 15% and common equity is 20%. (source: hold.co):

Risks in acquisition finance

Acquisition finance is risky because it combines ownership transition, financial leverage and forward-looking projections all in one. The risks are interlinked; operational underperformance quickly becomes financial stress. Few of the risks for the lender are as follows:

Over-leverage risk: The acquisition is funded with high debt relative to cash flows. A small decline in earnings can disproportionately hurt repayments. For example, a company acquired at 6x EBITDA (₹600 debt on ₹100 EBITDA). EBITDA drops 20% to ₹80. Leverage jumps from 6.0x to 7.5x overnight.

Acquisition finance combines operating leverage (extent of fixed costs in the operating cashflows, from which the residual cashflows will arise) and financial leverage (such residual cash flows being financed by debt which carries fixed interest burden). That is what makes acquisition finance a bunch of two mutually exacerbating risks. Typically, the presence of operating leverage is balanced by keeping the financial leverage low: however, in this case, the two forms of leverage co-exist.

Projection/business case risk: Acquisition pricing may be based on forecasted synergies,  ie , the combined disproportionate increase when the target comes into the group as well as growth, or margin expansion that may not materialize.

Beyond the above, financially, acquisition finance also faces valuation and cyclicality risk if the business was acquired at peak multiples or during an economic upcycle. Operationally, some of the risks in a typical M&A deal may also loom for the lender such as inadequate due diligence, top-talent attrition and integration issues.

Acquisition finance versus leveraged finance:

The two terms quite often overlap, but both refer to distinct aspects of a lending transaction. Acquisition finance specifically refers to purpose; leveraged finance, though mostly used for acquisitions, refers to the prevalence of high leverage, lower rating and cashflow-based funding structure.

Some definitions of “leveraged finance” may be pertinent, for instance, a 2021 thematic note by EBA on leveraged loans refers to a loan as ‘leveraged’, if some of the given conditions are met:

• high indebtedness of the borrowing firm (e.g. debt to earnings before interest, taxes, depreciation and amortisation (EBITDA) ratio of four times (4x) or higher); 
• below investment grade credit rating for the loan (or borrower) (i.e. below BBB); 
• loan purpose to finance an acquisition (e.g. leveraged buyouts); 
• presence of a private equity sponsor (e.g. financing of borrowers owned by financial sponsors); 
• high loan spread at issuance.

This is based on a combination of definitions used by various regulators and data providers. 

A definition based on combination of various aspects as per the policies prevalent in the financial sector industry was also given in the 2013 guidelines published by the US FRB as follows: 

• Proceeds used for buyouts, acquisitions, or capital distributions.
• Transactions where the borrower’s Total Debt divided by EBITDA (earnings before interest, taxes, depreciation, and amortization) or Senior Debt divided by EBITDA exceed 4.0X EBITDA or 3.0X EBITDA, respectively, or other defined levels appropriate to the industry or sector.
• A borrower recognized in the debt markets as a highly leveraged firm, which is characterized by a high debt-to-net-worth ratio.

Transactions when the borrower’s post-financing leverage, as measured by its leverage ratios (for example, debt-to-assets, debt-to-net-worth, debt-to-cash flow, or other similar standards common to particular industries or sectors), significantly exceeds industry norms or historical levels.

The end-use of leveraged finance are variegated: including mergers, acquisitions, re-capitalizations, refinancings, and equity buyouts, as well as for business and product line buildouts and expansions, whereas, acquisition finance has limited end-use.   

Waves of regulatory concerns on leveraged finance: 

Regulatory concerns on leveraged finance have been coming in waves – they come and recede.
The oft-quoted “warning” was issued by the IMF in 2018 in its Global Financial Stability Report. The concerns lie in the ever-increasing volume of leverage loans coupled with deteriorating underwriting standards and credit quality as well as strong investor demands, resulting in fewer investor protection covenants. The BIS also raised concerns on the rise of the leveraged loans causing an increasing default rate in the US.

Since the Global Financial Crisis in 2008, regulators have, time and again, taken policy decisions to regulate the risks emanating from leveraged lending. In the context of US, reference may be made of a 2013 Interagency Guidance on Leveraged Lending read with the 2014 FAQs thereon setting out the expectations from financial institutions w.r.t. leveraged loans. In fact, guidelines for leveraged financing were issued in the US as early as in April 2001, subsequently replaced by the 2013 version. 

Regulatory directives have been issued by the EU, coupled with a 2017 Guidance on Leveraged Transactions by the European Central Bank to address the risks of excessive leverage. The ECB Guidance lays down the minimum expectations from the credit institutions on leveraged transactions. A March 2019 briefing states that the 2017 guidance issued by ECB seems less effective than expected. It also refers to the warnings issued by international institutions as well as the US and EU authorities in relation to the potential risks of leveraged finance. 

However, come the end of 2025, at least the US regulators have withdrawn their regulatory statements on leveraged finance, leaving it for banks to use their own prudence. The agencies, in fact, went to term leveraged finance as vital: “Leveraged lending plays a vital role in the U.S. financial system. It provides a wide range of businesses, including those that are highly indebted or highly leveraged or that have low obligor ratings..” It said the 2013 guidelines were overly restrictive and led to reduced activity by US banks. 

The 2025 Global Financial Stability Report, however, continues to highlight the vulnerabilities associated with leveraged financing and the degrading credit quality: “Despite the wave of restructurings, liquidity remains strained among the more vulnerable borrowers in the leveraged loan and private credit markets. This has contributed to an increase in borrower downgrades”. “In reality, default rates, especially for leveraged loans, have been climbing, even though some of the defaults are voluntary liability management exercises, including debt exchanges…”

Impact of the RBI move

Are banks bracing up to jump into acquisition finance? Therefore, is the growing segment of the AIF market, private performing credit, going to be put to challenge?

In our estimate, it will be quite sometime before banks will really pose a competition to the fund industry. At the end of the day, banks are highly rule-driven, with multiple layers of approval processes and very tight corporate governance structures. Banks have RBI supervisors breathing down the neck. Acquisition finance needs flexibility, fast turnaround, structuring skills and bespoke terms which may be difficult for banks to match. At the same time, it is also important to note that most of the private credit funds also have a bank behind. Therefore, the move surely adds to the funding muscle that private credit funds will now enjoy – they will be able to “syndicate” acquisition finance by roping in bank lenders to take a share. In essence, it is a cake that will be shared. We also see distinct possibilities of structured funding transactions with banks taking a senior slice, and AIFs taking the role of a deal maker and risk taker.

Will the RBI move set the sails for leverage financing in India? There are several reasons to contend that the RBI’s move is far more conservative than expected by the typical leveraged finance landscape:

• First, the RBI expects the acquirer’s rating to be at least BBB- (where the acquirer is an unlisted company),  whereas leveraged finance is mostly below investment grade;
• Second, the RBI has put a limit of D/E at consolidated level of 3: 1,  leveraged finance, definitionally as well as by its very structure, works on higher levels  of leverage;
• Third, Section 19(2) of the Banking Regulation Act, 1949 imposes a limitation on banks by restricting them from holding shares in any company, whether as owner, pledgee or mortgagee, beyond 30% of the company’s paid-up share capital or 30% of the bank’s own paid-up capital and reserves, whichever is lower. Since leveraged buyouts commonly involve acquisition of controlling stakes with shares offered as primary security, this statutory cap constrains the extent to which banks can take equity as collateral, thereby further tempering the scope for large-ticket LBO financing.
• Lastly, the apparent text of the RBI regulations on acquisition finance suggest that acquisition finance is permitted only to non-financial companies which also excludes a Core Investment Company (CIC) hence barring CICs from availing acquisition finance under the RBI framework.