Private equity in India: market and regulatory overview
A Q&A guide to private equity law in India.
This Q&A is part of the PLC multi-jurisdictional guide to private equity. It gives a structured overview of the key practical issues including, the level of activity and recent trends in the market; investment incentives for institutional and private investors; the mechanics involved in establishing a private equity fund; equity and debt finance issues in a private equity transaction; issues surrounding buyouts and the relationship between the portfolio company's managers and the private equity funds; management incentives; and exit routes from investments. Details on national private equity and venture capital associations are also included.
To compare answers across multiple jurisdictions, visit the Private Equity Country Q&A tool. The Q&A is part of the PLC multi-jurisdictional guide to private equity law. For a full list of jurisdictional Q&As visit www.practicallaw.com/privateequity-mjg.
Private equity (PE) funds typically obtain funding from the following sources:
High net-worth individuals.
Since 2007, a number of domestic funds have appeared on the market, including captive PE funds of large industrial groups. Prior to 2007, domestic PE funds were not common.
The total amount of committed but uncalled capital, known as the dry powder, in 2012 was estimated to be at least US$17 billion (source: India Private Equity Report 2012, by Bain & Company).
While the recent years have seen a general increase in the number of PE funds operating in the market, there has been an overall improvement in the sophistication of Indian entrepreneurs when approaching PE funds. Indian entrepreneurs are now carefully scrutinising the qualities and the suitability of PE funds, thereby shifting the focus onto the PE fund to show its suitability as a partner.
At the same time, the limited partners of PE funds are being cautious about the investments of the PE fund, with a view to securing better capital returns. This development could be on account of the overall increasing difficulty in fundraising at the PE entity level, as well as uncertainties in the overall regulations affecting foreign investment in India.
The appetite for PE investment remains strong and due to this, and an increase in domestic funds, fundraising activity is expected to continue to increase. However, the level of scrutiny in relation to an investment decision will be higher. In that sense, fundraising by fund managers who are raising funds for the first time may be tough.
Investment by PE and venture capital funds (VCFs) has been steady across all phases of a portfolio company's lifecycle. However, early stage and start up companies elicited greater interest among the PE funds and VCFs in 2012.
Investment in e-commerce companies, especially in early stage companies, has been the most popular. Based on publicly available information, about 36 e-retailing companies have received funding from VCFs. This sector is predicted to grow from close to US$900 million in 2012 to US$2.8 billion by 2016. Sectors such as infrastructure, information technology (IT) and IT enabled services continue to attract significant PE investments. Private investment in public companies (PIPE) deals have also been popular in the recent years.
Minority stake deals are the most popular transaction structure, buyouts are rare and leveraged buyouts (LBOs) are still not permitted.
2012 has witnessed increased activity in relation to exits, and it is predicted that there will be a further increase in exits in the following years. While sales to strategic acquirers or secondary sales continue to remain the preferred route, promoter buy-backs have also been considered as an exit option.
General Anti-Avoidance Rules (GAAR)
The government proposes to introduce GAAR, a law against tax avoidance through foreign investments. GAAR was first envisaged under the Direct Tax Code proposed in 2010, and was introduced in the Finance Act 2012. The Finance Act 2012 proposed GAAR to apply from 1 April 2013.
The GAAR, as incorporated in the Finance Act 2012, was harsh and drew criticism. Therefore the Prime Minister appointed a committee headed by Dr Shome, to examine the draft GAAR proposed under the Finance Act 2012 and to recommend suitable changes. The government is currently considering the recommendations of the Dr Shome committee, and is revising the draft guidelines. The implementation of GAAR has therefore been deferred until April 2016.
Direct Tax Code
The Direct Tax Code was first proposed in 2008 to consolidate and amend the law relating to direct taxes. The draft Direct Tax Code is currently being considered by the government. The announcement of the implementation of the DTC is yet to be made.
Tax incentive schemes
Various tax incentives apply to PE investments. Some important incentives include:
PE funds and VCFs that are registered with the Securities and Exchange Board of India (SEBI) have:
tax exemptions (section 10(23FB), Income Tax Act 1961 (Income Tax Act)); and
tax pass through status (section 115U, Income Tax Act).
Dividends earned from investments made in portfolio companies are exempt from tax in India.
Share premium amount received from a VCF by a portfolio company (not being a listed company) is exempt from being taxed as income from other source (section 56(2), Income Tax Act).
PE funds are exempted from paying withholding tax for dividends distributed to their investors.
Most of the incentives, as listed above, do not differentiate between investment in listed companies and unlisted companies.
At whom directed
Tax pass through status applies only to investments made by PE funds registered either as a VCF or as a foreign venture capital investment (FVCI) with SEBI. Shareholders are exempt from paying tax on the dividends.
Tax exemptions in case of share premium amount received applies to the portfolio company that receives the amount from a VCF.
To benefit from the tax pass through status, investments must be made by the PE funds/VCFs in certain specific sectors such as:
Seed research and development.
Information technology relating to hardware and software development.
Building and operating certain hotel and convention centres with seating capacity of more than 3,000 persons.
Developing, operating and maintaining certain infrastructure facilities.
Research and development in the pharmaceuticals sector.
Production of biofuels.
Dairy and poultry industries.
With effect from 1 April 2013, the benefit of a tax pass through status is proposed to become available to all investments by a VCF in a venture capital undertaking, except the following:
Non-banking financial companies.
Activities not permitted under the government's industrial policy.
Any other activity which may be specified by SEBI, in consultation with the government from time to time.
There are no special conditions for the payment of dividend and withholding tax related incentives.
To use tax exemptions relating to share premium amounts, the portfolio company must receive the amounts from PE funds registered either as a VCF or as an FVCI with SEBI.
The authors are not aware of any other schemes that are aimed at encouraging investment in unlisted companies.
The most commonly used vehicles for PE funds/VCFs are trusts, companies and limited liability partnerships (LLPs). On 21 May 2012, the SEBI issued the SEBI Alternative Investment Funds Regulations 2012 (AIF Regulations), as an all-inclusive regulation that deals with all forms of privately pooled collective investment vehicles (including PE funds, VCFs and hedge funds), under one overall regulation. The AIF Regulations maintain the earlier position, and continue to permit domestic funds to be formed as a trust, company or LLP.
A trust is created by a trust deed that identifies the:
Beneficiaries of the trust.
Property to be administered by the trustees.
To establish a trust there is no requirement for minimum capitalisation or amount to be settled, or contributed as the trust property.
Stamp duty and registration charges are payable on the trust deed, depending on the:
Initial settling amount.
Where the fund was created.
The trust deed must be registered with the jurisdictional sub-registrar (a revenue authority) and it takes about three weeks to establish a trust.
The process of establishing a trust is fairly simple, inexpensive and quick. Trusts, as structures, are more tax efficient.
There are three types of companies:
Public company, which is an entity subject to more corporate governance requirements than a private company.
Private company that is a subsidiary of a public company, which is an entity that keeps its structure as a private company and is subject to higher corporate governance requirements than a pure private company.
Incorporating a company takes about three to four weeks.
An LLP can be incorporated by a minimum of two partners, individuals or body corporates, who enter into an LLP agreement. There is no limit to the maximum number of partners and incorporation takes about three to four weeks.
Income earned by a trust is exempt from tax if earned by SEBI-registered domestic VCFs.
Companies set up to raise funds for investment in a venture capital undertaking are exempt from tax.
There are no specific tax exemptions for offshore investors, although favourable tax options may be available from a double tax avoidance treaty (DTAT), depending on the jurisdiction of incorporation of the offshore fund.
LLPs used as PE vehicles are not commonly preferred tax efficient structures. This is because the tax is levied on the LLP at the entity level. The income of the LLP is not taxed in the hands of the individual partners.
Recent amendments to section 9 of the Income Tax Act empower the tax authorities to impose retroactive tax claims on offshore transactions that have an underlying asset in India, negating the Supreme Court decision on the tax claims made against Vodafone ((2012) 6 SCC 613). Therefore, if an overseas PE fund is transacting abroad with a non-resident, and the transaction involves an indirect transfer of Indian assets, the parties to the transaction will have to factor the tax payable in India in connection with the transfer, as it will no longer be tax exempt.
There is no other tax authority guidance generally on the issue of transactions that are tax opaque. It may be necessary to obtain advice on a case-by-case basis.
The main objective of PE funds is to maximise the return on investment. There are certain PE funds that invest to achieve certain social goals, for example the International Finance Corporation (the private sector arm of the World Bank Group) and the Pragati Fund and Aavishkaar India Fund II (which aims to bring about development in the low income states in India).
The expected average internal rate of return (IRR) of a PE fund is between 20% and 25%. The average span of investment is from three to five years and the average life of a PE fund is about ten years.
Fund regulation and licensing
On 21 January 2013, the SEBI notified the SEBI (Investment Advisers) Regulations, aimed at regulating investment advisers (Adviser Regulations). The Adviser Regulations defines an Investment Adviser as any person engaged in the business of providing advice to clients or other person(s), in relation to investing, purchasing, selling or otherwise dealing in securities or investment products, and advice on an investment portfolio containing securities or investment products, for the benefit of the client, except for:
Insurance agents/brokers who offer investment advice solely in insurance products and who are registered with the Insurance Regulatory and Development Authority.
Pension advisers who offer investment advice solely on pension products, and who are registered with the Pension Fund Regulatory and Development Authority.
Mutual fund distributors, subject to certain conditions.
Registered stockbrokers or sub-brokers, portfolio managers or merchant bankers.
Professionals such as chartered accountants, company secretaries, legal advisers and cost and works accountants.
Any person who provides investment advice exclusively to clients based outside India.
Every Investment Adviser must register with the SEBI. Existing Investment Advisers will have six months, from the Adviser Regulation coming into effect, to apply for registration, failing which the Investment Adviser must stop providing such investment advice. The registration requirement must be met, irrespective of the threshold limit of advisory fees that may be charged in connection with the advice.
An Investment Adviser, and the partners and representatives of an Investment Adviser, must meet the following criteria, to be eligible for registration:
A professional qualification or postgraduate degree or postgraduate diploma in finance, accountancy, business management, commerce, economics, capital markets, banking, insurance or actuarial science, from a university or an institution recognised by the government or any state government, or a recognised foreign university or institution or association.
At least five years' experience in activities relating to advice in financial products or securities, or fund or asset or portfolio management.
The Adviser Regulations also require various other general information and declarations to be provided by an applicant, including that the applicant is a fit and proper person in the manner prescribed by the SEBI (Intermediaries) Regulation 2008.
The Adviser Regulations also require an Investment Adviser (if an individual), and the partners and representatives of an Investment Adviser (if a corporate body), to maintain certain certifications on financial planning, fund/asset/portfolio management or other investment advisory services, in the prescribed manner. Existing investment advisers seeking registration must ensure that these certifications are obtained within two years from the date of commencement of the Adviser Regulations.
To seek registration as an Investment Adviser:
A corporate body must have a net worth of at least INR2.5 million.
Individuals or partnership firms must have a net worth of at least INR100,000.
In addition, a promoter, principal or manager must also satisfy certain criteria prescribed by the AIF Regulations, including being a fit and proper person in the manner prescribed by the SEBI (Intermediaries) Regulation 2008.
Fund managers who qualify as portfolio managers must register with SEBI.
PE funds and VCFs are regulated by the SEBI (Foreign Venture Capital Investors) Regulations 2000 (FVCI Regulations) and AIF Regulations. Consequently, a PE fund or VCF must be registered with the SEBI as an FVCI and/or as an alternative investment fund in the relevant category, to undertake private equity/venture capital activities.
Existing VCFs registered with SEBI under the VCF Regulations will continue to be governed by the VCF Regulations.
PE funds registered as a company must also comply with the Companies Act 1956.
FVCIs wishing to invest in PE funds/VCFs must be registered with SEBI and the central bank (the Reserve Bank of India (RBI)).
PE funds/VCFs must invest no more than:
25% of the fund in one venture capital undertaking.
One-third of the investible funds by way of:
an IPO of a VC undertaking whose shares are to be listed;
unlisted debt or debt instrument of a VC undertaking in which the PE funds/VCFs have made an equity investment;
preferential allotment of shares of a listed company subject to a lock-in period of one year;
equity shares or equity linked instruments of financially weak companies, or a sick company whose shares are listed;
special purpose vehicles created by the PE funds/VCFs for facilitating or promoting investment.
In addition, certain other criteria prescribed by the AIF Regulations must be met by VCFs registered as a small and medium enterprise fund, or as a social venture fund.
PE funds/VCFs must invest at least two-thirds of their investible funds in unlisted equity shares or equity linked instruments of VC undertakings.
There are no other regulations governing PE funds, whether as investment companies or otherwise.
There are no exemptions recognised under the above regulations.
While there are no restrictions on the nationality, net-worth or age of investors in a PE fund, there may be restrictions under the PE registration requirements or India's foreign direct investment policy (FDI).
PE funds/VCFs can raise money from any investor, whether domestic or foreign, through the issue of units. A PE fund/VCF can only raise money through a private placement of its units.
Foreign investment into trusts registered with SEBI under the VCF Regulations or the AIF Regulations, as the case may be, is permitted under the FDI policy. Trusts not registered with SEBI require prior approval from the RBI and the Foreign Investment Promotion Board (FIPB), the government arm that encourages and promotes foreign investments.
Overseas investors must register with SEBI as FVCIs before investing in a VCF. All other overseas investors need prior approval from the RBI and the FIPB.
The total number of investors permitted under the AIF Regulations is 1,000.
PE funds and VCFs face certain restrictions (see Question 11, Regulation).
The minimum investment to be made by each investor in a PE fund/VCF is INR10 million, and the total amount of funds committed by investors in such PE fund or VCF must be at least INR200 million before operations start.
The manager or promoter of a PE fund or VCF must have a continuing interest in the fund of at least 2.5% of the total amount of funds committed by investors in such PE fund or VCF, or INR50 million, whichever is lower, as an investment in the fund.
The trust deed and placement memorandum govern the PE fund and the relationship between investors (beneficiaries) and the fund. The placement memorandum normally provides for the following key rights of an investor:
Nominees of investors are included in the investment committee and usually counted to achieve a quorum.
Most decisions at meetings are taken only with the investors' majority or supermajority approval. Supermajority approval is normally required for:
critical decisions such as the removal or replacement of trustees;
the appointment of the investment manager;
the winding up of the fund or the establishment of rival funds.
Investors have veto on various key business decisions that are decided only with the investors' supermajority approval.
Investors have various information rights in relation to the business and fund's operations.
Principal investors have the right to co-invest in the portfolio company in addition to the fund, in certain circumstances.
The common law provides additional protection and penalises trustees' acts that breach fiduciary responsibilities towards the investors.
The governing documents in companies are the:
Articles of association.
Shareholders' agreement as entered into by the investors, which typically contains various protective provisions such as:
veto rights over key business decisions;
information rights relating to the functioning of the company;
representation on the board of directors;
Each of the protective provisions, other than the indemnity provision, are incorporated into the company's articles of association. This ensures that any violation is void from its beginning.
The LLP agreement governs the relationship between the investors and the PE fund.
Interests in portfolio companies
PE funds usually subscribe to equity or equity-linked instruments such as compulsorily convertible preference shares (CCPS) or compulsorily convertible debentures (CCD).
Advantages and disadvantages
Equity shares. Subscription to equity shares allows the PE investor to exercise voting and dividend rights in the portfolio company.
The investor does not receive preference payment on liquidation and the shareholding cannot be adjusted on a further share issue to third parties, except on a fresh issue or a transfer of existing equity shares.
CCPSs and CCDs. CCPS holders have preference payment rights over equity shareholders on liquidation and holders of CCDs have preferential payment rights as debtors. Holders of both CCPSs and CCDs can adjust their shareholding by adjusting their conversion formula on a fresh issue of shares or transfer of existing equity shares. The disadvantage of subscription to CCPSs or CCDs is that the holder does not have voting or dividend rights on par with equity shareholders.
Subscription to partially convertible or non-convertible instruments by any foreign investor is treated as external commercial borrowings under the Foreign Exchange Management Act 1999 (FEMA), subjecting the subscription to higher restrictions.
FVCIs can subscribe only to fully and compulsorily convertible instruments such as CCPSs and CCDs. There are no other restrictions on the allotment or transfer of shares.
Buyouts are not common (see Question 16).
If a listed public company intends to convert to a private company, the company must comply with the Companies Act 1956 and the SEBI (Delisting of Equity Shares) Regulations 2009.
The following key buyer protections are commonly required by PE funds.
Representations and warranties
The seller typically gives representations and warranties on the nature of the business and company operations. Breach of a representation or warranty allows the PE investor to claim damages. However, most transaction documents in India allow the PE investor to claim an indemnity, in line with similar structures adopted in other jurisdictions.
Indemnity rights survive completion and continue for a further period of three years, in most transactions. Tax law gives a seven-year framework for survival of any tax claims and tax indemnity is, in practice, rarely less than seven financial years post completion.
PE funds typically require a list of matters (veto matters or affirmative right matters) in shareholders' agreements relating to key business or financial decisions and the company's capitalisation structure. The company's board and shareholders cannot take any action on these veto matters if the investor does not grant prior written consent or exercises its veto.
Share transfer restrictions
As most PE investors are not in charge of the company's day-to-day management, retaining the promoters is important. Promoters' shares are normally subject to lock-in restrictions. A private agreement that imposes restrictions not included in the articles of association has not been treated as binding, either on the shareholders or on the company.
A variety of covenants can be included to correct any irregularities in the business or operations, including non-compete clauses limited by time and geographical limits.
Buyouts are not common (see Question 16). The nature of protection sought in a buyout will be similar to other PE transactions.
Promoters must exercise due care and diligence in a way that promotes the company's best interests while performing their duties as directors. Typically, a promoter is expected to maintain confidentiality of the business and other proprietary matters of the company, and devote all his time and efforts to the business and progress of the company. A director must disclose his interest to ensure there is no conflict of interests.
Management buyouts are not common (see Question 16). Typical terms of employment imposed in a PE transaction include:
Performance linked incentives.
Grant of stock options.
Veto rights (see Question 19) and board representation are important management control measures used by PE funds. The number of nominees that can be appointed to a board is usually negotiated and a PE fund retains the right to remove or replace its nominee. The PE fund's presence (as an investor / shareholder) normally forms part of the quorum, ensuring that no shareholders' meetings are conducted in its absence.
These management control provisions form part of the shareholders' agreement and the articles of association. This ensures that there is a contractual remedy for breach of shareholders' agreements and the action may be rendered void, simultaneously, for breach of the company's constitutional documents.
The percentage of debt finance in a transaction varies from one transaction to another. Most companies seek debt finance from banks in the form of term loans and working capital facilities and some companies also issue debentures.
Issuing partially, optionally or non-convertible debentures to non-residents is treated as external commercial borrowing and is subject to higher restrictions both in terms of the investment amount and end-use. There is no preference for one form of debt finance over another.
Debt providers normally seek the following forms of security to protect their investment:
Pledge of the promoters' shares.
Mortgage of the company's assets (mortgage of land is very common in real estate transactions).
Information on current assets and book debts and projections.
Contractual and structural mechanisms
Creditors normally impose various restrictions on the company, including on:
Payment of dividends.
Transfer of shares by the promoter group.
In practice most loan documents specify that the company needs the lender's prior written consent before:
Altering the company's share capital.
Change of control, including any change of the board's structure.
Borrowing money or making any debt commitments.
Creating an encumbrance over any of the company's assets.
Most loan documents include a condition that any future or other debts acquired by the company will not rank as superior to the loan being granted by the creditor.
A public company, or a private company which is a subsidiary of a public company, is not permitted to provide financial assistance for the purchase of its shares. The scope of financial assistance extends to the provision of a loan, guarantee or security.
There are no exemptions recognised.
Workmen (those employed in any industry to do manual, unskilled, skilled, technical, operational, clerical or supervisory work) and secured creditors have the highest priority and are paid first (Companies Act 1956). The official liquidator distributes the remainder in the following order of priority:
All revenues, taxes and other amounts due to the government.
Employees' wages and salary.
Accrued holiday and termination pay.
Contributions under labour welfare legislation.
Payments to any other debtors.
Domestic debt holders can achieve equity appreciation through conversion features such as rights, warrants or options. Foreign investors can only invest into CCPS or CCDs (see Question 15, Restrictions). Any agreement among the parties for conversion features such as rights, warrants or options are subject to pricing guidelines and other regulations under FEMA.
Portfolio company management
Forms of exit
Qualified IPOs, sales to strategic buyers and drag along are some of the commonly used exit mechanisms.
Advantages and disadvantages
IPOs are a preferred form of exit, however sales are often made to strategic investors or third parties as it allows the investor to exit at a desired price. To sell shares to a strategic investor or third party, the PE investor may also exercise its drag-along or tag-along rights.
For foreign PE investors exit options (including drag-along and tag-along rights) are subject to pricing guidelines for the transfer of shares from non-resident entities to resident entities, or vice versa. FVCIs are exempt from complying with the pricing guidelines.
Forms of exit
Sale to buyers, buyback and put options are the most commonly used forms of exit.
Advantages and disadvantages
The sale of investor shares to any interested third party allows the investor to exit the company. The investor can sell his shares by exercising his tag-along right during the promoters' sale of their shares in the company.
The investor can require the company to buy back his shares. A company can only buy back up to 25% of its paid-up equity share capital in a single year. Exercise of this exit option does not depend on any third parties. A buyback can only be made from either:
Proceeds of a fresh issue of securities (most commonly used in a distressed company).
Put options have been the most preferred form of exit from distressed companies, as the exit does not depend on third parties or the company's reserves. While the government is of the view that put options are permissible in the context of FDI, some uncertainty surrounds the legality of put options, and regulatory bodies such as SEBI and the RBI do not favour them.
Private equity/venture capital association
Indian Private Equity and Venture Capital Association (IVCA)
Status. The IVCA is a non-governmental organisation.
Membership. Membership is open to funds and service providers. Subscription to the organisation is through paying fees and the amounts payable depend on the size of the fund or the amount of revenues generated.
Principal activities. The IVCA encourages promotion, research and analysis of PE and VC and facilitates contact with policymakers, research institutions and trade associations, among others. It also promotes PE and supports entrepreneurial activity.
Published guidelines. The IVCA has published various newsletters and research findings but has not published any guidelines.
Information sources. The website provided above gives details of information sources.
Siddharth Raja, Partner
Samvād Partners (formerly Narasappa, Doraswamy & Raja)
Professional qualifications. Admitted to practise law in India and in England and Wales (currently not practising); BA, LLB (Hons) from the National Law School of India University, Bangalore (1997); LLM in International Economic Law from the University of Warwick Law School, UK 1998, where he was a Foreign and Commonwealth Office Chevening Scholar and a JN Tata Scholar.
Areas of practice. Private equity and venture capital transactions; cross-border and domestic M&A; corporate finance and general commercial law.
- Acted for Vijay Nirman Company Private Limited (a Hyderabad-based construction firm), and one of the funds managed by Aquarius (an existing investor), in connection with an investment in the company by funds managed by ICICI Venture Funds.
- Acted for Peepul Capital LLC, on its investment into Vishal Personal Care Private Limited, a manufacturer and distributor of herbal cosmetics, under brand "Banjara's", a Hyderabad-based company.
- Acted for Madison India Real Estate Fund Ltd, a Mauritius based PE fund focusing on investments in the emerging real estate market in India, with respect to its exit from Daman Hospitality Private Limited.
Languages. English, Hindi
Professional associations/memberships. Indo-German Chamber of Commerce (IGCC), Bangalore Chamber of Industry and Commerce (BCIC), The Madras Chamber of Commerce and Industry (MCCI), The Indus Entrepreneurs (TiE), Society of Indian Law Firms (SILF).
Ashwini Vittalachar, Senior Associate
Samvād Partners (formerly Narasappa, Doraswamy & Raja)
Professional qualifications. Admitted to practise law in India; BAL-LLB from the University Law College, Bangalore (2006); LLM from the Law School, University of Chicago, US 2007.
Areas of practice. Private equity and venture capital transactions; cross border and domestic acquisitions; joint ventures; general corporate and regulatory advisory matters.
- Acted for Inventus Capital Partners, a venture capital fund, in respect of its various investments, including in the New-Delhi based companies, eTechies and Power2SME.
- Acted for the promoters of Century Seeds Private Limited, in respect of the acquisition of the New-Delhi based company by French agri-company, Groupe Limagrain.
- Acted for Madison India Real Estate Fund Ltd, a Mauritius based PE fund focusing on investments in the emerging real estate market in India, with respect to its investment in a Bangalore based project developed by Shriram Land Development India Limited.
Languages. English, Hindi, Kannada.