Large Indian IT companies are increasingly using debt to fund acquisitions, moving away from their traditional debt-free models. Firms like Persistent Systems and Coforge are borrowing money to accelerate growth in AI and gain specialized talent as organic growth slows. While this strategy aims to boost future earnings, it introduces new financial risks regarding interest costs and the successful integration of new businesses.
What Happened
The Indian information technology (IT) sector, historically known for maintaining “zero debt” or cash-rich balance sheets, is seeing a strategic shift. Companies are now increasingly opting for debt financing to fund large acquisitions. A notable example is Persistent Systems, which recently secured a $1.5 billion bridge loan to fund its acquisition of a German IT firm. This marks a departure from the industry’s long-standing preference for using internal cash reserves to fund growth and expansion.
Why IT Firms Are Changing Strategy
The primary driver for this shift is the need to stay competitive in the rapidly evolving artificial intelligence (AI) space. Organic growth—the growth generated by the company's existing business—has slowed for many IT firms. To counter this, companies are using mergers and acquisitions (M&A) to quickly gain AI capabilities, specialized talent, and access to new geographic markets.
For instance, Coforge recently secured $550 million in debt to support its $2.3 billion acquisition of Encora. Similarly, Cognizant has utilized debt for its $1.3 billion acquisition of Belcan. For management teams, this is a race to remain relevant. By borrowing money, these companies aim to scale faster than they could through their own profits alone.
The Trade-Off Between Debt and Equity
When a company needs large sums of money for an acquisition, it has two main options: raise debt (borrow) or raise equity (issue more shares to shareholders). Many IT executives are currently choosing debt because they believe their stock is undervalued. If they issued new shares to raise money, existing shareholders would face “dilution,” meaning their ownership percentage would decrease.
Persistent Systems CEO Sandeep Kalra noted that the company received interest from private equity firms, but chose debt to avoid equity dilution. The company expects the acquisition to add to its earnings per share by 5% to 6% in the first year, even after accounting for the costs of paying back the loan.
Risks Investors Should Track
While debt can boost growth, it also brings specific risks. Unlike cash, which does not require monthly payments, debt comes with interest expenses that must be paid regardless of how well the company performs. If the acquired company does not perform as expected, or if the integration process is delayed, these interest costs can put pressure on profit margins.
Industry experts have cautioned that taking on debt simply to increase revenue figures is a risky approach. The success of these deals depends on the company's ability to achieve sustainable growth and successfully combine the new business with their own operations. If the expected growth does not materialize, a company with high debt will have less financial flexibility than a cash-rich company.
What Investors Should Monitor
Investors may want to keep a close eye on several key indicators as this trend continues:
- Debt-to-Equity Ratio: How much debt is the company taking on relative to its equity? A rising ratio indicates higher leverage.
- Interest Coverage Ratio: Can the company easily pay its interest expenses from its operating profit?
- Integration Progress: Are the acquired companies contributing to revenue and profit as promised, or are there hidden costs?
- Organic Growth Trends: Is the company growing its core business, or is it relying entirely on acquisitions to show a revenue increase?