Private equity in India: market and regulatory overview
A Q&A guide to private equity law in India.
The Q&A gives a high level 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.
This Q&A is part of the Practical Law global guide to private equity. For a full list of jurisdictional Q&As visit www.practicallaw.com/privateequity-mjg.
Private equity funds typically obtain their funding from:
High net-worth individuals.
Sovereign wealth funds.
Funds of funds.
The aggregate value of private equity investments in Financial Year 2015-2016 stood at US$23 billion. The estimate is inclusive of earnings from sectors such as real estate, infrastructure and smaller deals (source: India Private Equity Report May 2016, by Bain & Company).
An estimated 661 private equity deals across various sectors were reported (source: Grant Thornton: "PE investments touched a record high of US$16.8 billion in 661 deals", India Private Equity Report, May 2016, by Bain & Company).
There have been the following recent major trends in the market:
Co-investments by limited partners along with general partners have increased. This gives limited partners the ability to control the pace of the capital deployment and also of their own risk, as well as increasing the attention of general partners in the target company where co-investment is made.
Private equity investors are carrying out thorough due diligence, irrespective of the time it takes.
There has been increasing focus on e-commerce in the business-to-business sector, such as non-retail and logistics.
More interest has been shown in the setting up of funds for turnaround of stressed companies/stressed groups.
There are more management buyouts (MBOs) and control deals, as investors have been seeking majority control for overseeing returns from investments, improving performance, and structuring their exits in a suitable manner. A recent example is the management buyout of Intelenet Global Services Ltd. and Serco's India operations by the Blackstone Group (source: Business Standard: "India emerging a hub for FinTech start-ups", Times of India: "Blackstone buys back Intelenet for INR2,500 crore").
Despite a fall in the allocation of funds to the Asia-Pacific region by roughly 14% in 2015, Indian accessibility to capital from limited partners remained buoyant and reported an increase in funding.
Private equity investments saw a surge in the previous financial year, touching a record high of US$16.8 billion, which was 29% more than the value of the deals concluded in 2014 (excluding real estate) (source: India Private Equity Report May 2016, by Bain & Company).
Increased investment by venture capital in start-ups has been fuelled by the Make in India initiative. The government has taken a number of steps, including providing tax incentives, widening fund raising opportunities and relaxing certain foreign exchange laws to ease the regulatory environment and encourage investments in start-ups.
Private equity funding has increased in the following sectors:
IT and IT-enabled services (ITES).
Banking, financial services and insurance (BFSI).
Financial Technology (FinTech).
In the ITES sector, 2016 saw deals such as the purchase by Flipkart of PhonePe, a mobile phone banking utility.
With the entry of Barclays Bank PLC into the FinTech start-up software market, other investors like Nasscom are also seeking to collaborate in the Indian start-ups sector. The total investment in the FinTech ecosystem in India in 2015 was reported to be US$420 million across 36 deals (source: Business Standard: "India emerging a hub for FinTech start-ups"). Another development in this sphere has been the acquisition of online shopping platform Jabong by Myntra, which in turn was acquired by Flipkart last year.
See below for a snapshot of the recent trends in the private equity space in India:
Buyouts. Leveraged buyouts (LBOs) are not permitted under Indian law, except in limited circumstances. Accordingly, LBOs remain limited in the Indian context. While the majority of private equity investments are for a minority stake, majority control/buyouts have increased. Some buyout deals have been driven by the recent focus on stressed assets space and a drive to clean up the books of the banks.
Regulation-driven deals. In certain cases, due to regulatory conditions, companies are being forced to divest their assets and that has attracted considerable private equity interest. The sell-off of Lafarge's assets in India (following the Lafarge-Holcim deal) is an example of this; in this case, the regulator was the Competition Commission of India.
Construction sector. In the construction sector, foreign direct investment (FDI) is currently 100% under the automatic route (see Question 4, Relaxations under various foreign exchange laws in India). Buyouts of completed projects are, therefore, common. One example is the Gammon infrastructure's sale of six road and three power projects to BIF Holdings India for close to INR5,630 million.
Private investment in public enterprises. Private equity investments in public enterprises are currently rare due to regulatory issues which may involve the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations 2011 (Takeover Code) and SEBI (Prohibition of Insider Trading) Regulations 2015 (Insider Trading Regulations).
Start-up and tech sectors. M&A saw an increase in the start-ups sector, with 146 deals taking place specifically in the technology start-up sector (source: Economic Times, "More start-up buyouts poised to take place in the new fiscal, as funding winter continues"). Apart from start-ups, companies such as Snapdeal and Flipkart are actively seeking to make strategic purchases. The most prominent was the Flipkart transaction, where US$700 million was invested in the company by a string of funds. Many small ticket investments have also taken place in companies engaged in the technology sector, including in angel investments and venture capital funds.
2015 saw a number of exits. Secondary market sales and strategic sales were the preferred form of exits, followed by initial public offerings (IPOs). Exits in the sector were reported to be worth close to US$800 million. BFSI, consumer technology and IT sectors saw the highest value of exits (source: India Private Equity Report May 2016, by Bain & Company).
Although general partners expect a rise in the number of exits in 2016, factors such as volatile macroeconomic conditions, IPO market volatility, market non-response and a mismatch in the valuation of exits could hamper them.
Some of the largest exits in 2015 were (source: India Private Equity Report May 2016 by Bain & Company):
Apax Partners' exit from iGate Corp, valued at US$1.15 billion.
ru-Net, Sequoia, Tybourne, Valian and Sofina's exit from Freecharge valued at US$450 million.
The following are some of the major regulatory reforms and reform proposals impacting private equity in India.
Relaxations under various foreign exchange laws in India
Foreign direct investment (FDI) by non-residents into India is regulated through two routes: the automatic route for which no approval is required, such as FDI in the manufacturing sector and the approval route, for which government approval is required (see Doing business in India, Foreign investment).
FDI relaxations in various sectors. The Indian foreign exchange laws have been considerably liberalised and simplified to provide ease of doing business in the country, with a view to attracting larger FDI inflows. Regulations have been relaxed (in terms of threshold limits and approvals required) in sectors such as:
Single brand retail trading.
FDI in investment vehicles. The Reserve Bank of India (RBI) in November 2015 permitted foreign investments under the automatic route, subject to certain conditions, in the following investment vehicles registered with the Securities and Exchange Board of India (SEBI):
Alternative investment funds (AIFs) (which all domestic private equity funds are now registered as).
Real estate investment trusts (REITs).
Infrastructure investment trusts (InvITs).
Previously, RBI approval was required for foreign investment in trusts.
RBI norms relaxed for deferred payment of consideration. To promote ease of doing business, the RBI in May 2016 permitted under the automatic route deferment of purchase consideration and escrow mechanism in share purchase transactions involving foreign investment. Following this change, in the case of transfer of shares between a resident buyer and a non-resident seller or vice-versa, the buyer can pay 25% of the total consideration on a deferred basis within a period not exceeding 18 months from the date of the transfer agreement. Escrow arrangements in this regard have now been permitted as well.
Finance Act 2016. The Union Budget for Financial Year 2016-2017 announced changes to the tax regime in relation to REITS, InvITs and AIFs. A tax pass-through status (that is, tax is not paid at the level of the fund but only at investor level, and tax withholding at 10% is required on distributions to investors) has been extended to Category I and II AIFs under section 115UB of the Income Tax Act 1961. To make this tax pass-through status work effectively, among other things, the tax withholding now only applies in respect of distribution to Indian residents. For non-residents, the tax withholding will be at the applicable domestic law or double tax treaty rates. Accordingly, if income of the foreign investor is not taxable in India due to a favourable double tax treaty provision, the AIF is not required to withhold any tax. This amendment will boost foreign investment in AIFs.
REITs and InvITs have also been extended a tax pass-through status under the Act.
The government is providing various tax incentives to start-ups, including tax exemption for investments over a period of three years (see Question 3, Investment). In addition, a capital gains exemption has been provided for investors who re-invest their capital gains in start-up "fund of funds" recognised by the government.
There have also been changes in tax rates on sales of shares of listed companies and unlisted companies and their holding period (see Question 5, Incentive schemes).
General anti-avoidance rules (GAAR). To try and prevent structures aimed at tax avoidance, the government had introduced GAAR in the Finance Act 2012, originally planning to implement it by 1 April 2016. The rules are now to be effective from 1 April 2017. The regime will allow tax authorities to tax an entity at source regardless of the existence of a double tax treaty with the country of the entity, if the transaction itself lacks commercial substance and is undertaken to avoid tax. What constitutes ''commercial substance'' will be defined once the rules come into effect.
Amendment to the double tax treaty between India and Mauritius. Under the double tax treaty between India and Mauritius, capital gains arising from the sale of securities could only be taxed in Mauritius. This rule led to structures being set up aimed at tax avoidance and to erosion of revenue for the government.
To prevent these issues, India recently signed a protocol amending the double tax treaty which means India now has the right to tax capital gains arising from sale or transfer of shares to a Mauritius tax resident from an Indian resident. Shares acquired up to 1 April 2017 are exempt from taxation and shares acquired between 1 April 2017 and 31 March 2019 will be taxed at 50% discount on the domestic rate. After 31 March 2019, taxation will be at the full domestic rate.
Tax incentive schemes
The following are some of the tax incentives for encouraging investment in unlisted companies:
Domestic funds registered as Category I and Category II alternative investment funds (AIFs) have been provided a tax pass-through status (that is, tax is not charged at the level at the fund itself but on distributions to investors). Further tax withholding at 10% by AIFs will now only apply to Indian residents. For non-residents, the tax withholding will be at the applicable domestic law or double tax treaty rates (see Question 4, Tax-related reforms: Finance Act 2016).
The Central Board of Direct Taxes has clarified that income arising from transfer of unlisted shares is considered to be capital gains, irrespective of the period of holding (see below, Conditions).
Tax on share premium received from venture capital funds (a type of Category I AIF) is exempt in the hands of unlisted companies.
Capital gains arising from the sale of unlisted shares held for a period of 24 months can qualify for long-term capital gains tax and therefore be taxed at a lower rate (see Question 15, Restrictions).
At whom directed
The tax pass-through applies only to investments made by private equity funds registered as a Category I AIFs (which include venture capital funds and angel investors) and Category II AIFs (which are typically private equity funds), or Foreign Venture Capital Investors (FVCI) (registered as domestic funds under the SEBI FVCI Regulations 2000 (FVCI Regulations)). There is a proposal to extend tax pass-through status to Category III AIFs (which include hedge funds).
The other incentive schemes listed above are directed at promoting investment in unlisted companies.
Tax pass-through status is only applied to Category I and II AIFs (see above, At whom directed ).
The treatment of unlisted share transfer income as a capital gain as mentioned will not be applied if the:
Genuineness of transactions in unlisted shares itself is questionable.
Transfer is related to an issue relating to lifting of the corporate veil.
Transfer is made along with the control and management of underlying business.
The tax exemption for share premium received from venture capital funds applies automatically.
The tax treatment of income from the sale of unlisted shares as qualifying for long term capital gains tax applies if the holding period is met (see above, Incentive schemes).
Typically, funds are set up as trusts, registered as an alternative investment trust (AIF) with the Securities and Exchange Board of India (SEBI) (see below, Trusts). AIFs can only be set up as a trust, company or limited liability partnership (LLP) (SEBI AIF Regulations 2012).
This is the most common structure for setting up a fund in India.
Private equity funds can be set up as companies under the Companies Act 2013. However, this structure is rarely used, as there are not clear precedents for raising funds in a company structure, and because there are stricter compliance requirements than those relating to a trust structure.
Limited liability partnerships (LLPs)
AIF funds can be set up as LLPs under the Limited Liability Partnership Act 2008. The Registrar of Companies (a governmental body which is responsible for granting registration to LLPs and companies) does not, however, permit LLPs to be set up merely as investment vehicles and therefore their use for private equity funds is rare.
As introduced by the Finance Act 2015 and with effect from 1 April 2016, income earned by Category I and II alternative investment funds (AIFs) (except from business or profession) is not taxed at the level of the fund (see Question 5). This applies to AIFs set up as trusts, companies and LLPs. Withholding tax is charged on distribution of income to the unitholders who are Indian residents; that taxation of other unitholders will depend on their jurisdiction and whether a double taxation treaty applies (see Question 5, Incentive schemes).
In jurisdictions such as Mauritius, Singapore and The Netherlands, funds are typically set up as companies or limited liability partnerships (LLPs). Prior to 1 April 2016, due to tax benefits, trusts were the most preferred structure in India. While a trust, company or LLP set up as a Category I or Category II alternative investment fund (AIF) now all receive positive tax benefits as of 1 April 2016, a trust remains the most preferred mode of structure (see Questions 6 and 7).
Fund duration and investment objectives
The average duration of a fund is between five and seven years, but the period differs from fund to fund depending on, among other factors, the:
Sectors in which the private equity fund is targeting its investment.
Purpose for which the fund is set up.
Private equity funds investing in the infrastructure sector are set up for a longer period, usually seven to ten years, and social sector-focused funds usually have a life of about five years.
Under the AIF Regulations, the private equity fund must clearly describe certain matters at the time it makes an application for registration to the Securities and Exchange Board of India (SEBI) (see Question 11). These matters are the:
Proposed corpus (that is, the capital of the fund).
Investment style or strategy.
Proposed tenure of the fund or scheme.
The following are some of the key investment objectives of a fund.
Returns on investment. The primary objective of a private equity fund is to obtain optimum/higher returns on investment. The rate of return that a fund seeks to make depends on the sector in which it invests:
Typically, private equity funds expect to make an average internal rate of return (IRR) of 18% to 24%.
Funds that invest in the infrastructure sector expect a higher rate of 25% to 28%.
Social sector focus funds expect to make a lower IRR of 10% to 14%.
Investment strategy. Private equity funds make investments based on factors such as sector, size of the company, and potential for growth. Certain funds are "special situation" funds and their strategy depends on their mandate. There are other private equity funds that target investment only in start-ups and medium size companies.
Social purpose. Private equity funds set up as social sector focused funds differ in nature from other private equity funds, as they provide grants and capital support for socially relevant sectors.
Fund regulation and licensing
Promoters of a private equity fund do not require any authorisation or licence but must meet eligibility criteria under the AIF Regulations, including being a fit and proper person under the SEBI (Intermediaries) Regulations 2008 (Intermediaries Regulations) to be granted the certificate of registration to the alternative investment fund (AIF).
The fund manager must be registered with the Securities and Exchange Board of India (SEBI) under the SEBI (Investment Advisers) Regulations 2013, which set out eligibility criteria for investment managers including:
Adequate experience in the financial sector.
Being a fit and proper person under the Intermediaries Regulations.
Entities who are exempt from registration include:
Insurance agents/brokers who offer investment advice solely in insurance products, and are registered with the Insurance Regulatory and Development Authority.
Pension advisers who offer investment advice solely on pension products and are registered with the Pension Fund Regulatory and Development Authority.
Mutual fund distributors, subject to certain conditions.
Stockbrokers or sub-brokers, portfolio managers and merchant bankers registered with the SEBI.
Any advocate, solicitor or law firm who provides investment advice to their clients, incidental to their legal practice.
Anyone who provides investment advice exclusively to clients based outside India.
Domestic private equity funds must be set up as AIFs and registered with the Securities and Exchange Board of India (SEBI) under the AIF Regulations. Private equity funds that were set up before the AIF Regulations must be registered under the VCF Regulations.
Existing funds registered under the VCF Regulations may continue to act as such without obtaining registration under the AIF Regulations until the end of the fund term or scheme.
The AIF Regulations set out three categories of funds to be registered:
Category I AIFs. These funds invest in venture capital or early stage or social ventures or infrastructure sectors. Examples include: venture capital funds, social venture funds and infrastructure funds.
Category II AIFs. Most private equity funds would fall in this category.
Category III AIFs. These funds employ diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives. Hedge funds are examples of this type of fund.
Some of the key features of an AIF are:
They must have a minimum corpus of INR200 million per scheme.
They are permitted to solicit or collect funds except by way of private placement.
The minimum investment to be made by an investor is INR10 million.
The manager's or sponsor's continuing interest in the AIF must be at least 2.5% of the fund or INR50 million, whichever is less, and this must not be through waiver of management fees.
Sponsors/investment managers must disclose their investment in the AIF to the investors.
The minimum tenure of a Category I and Category II AIF is three years. Category III AIFs can be open ended.
No scheme of the AIF can have more than 1,000 investors.
A lock-in period/minimum investment of one year for certain types of investment is required (for example, for private equity funds registered as Category II AIFs investing in listed companies pursuant to due diligence).
Private equity funds registered under the VCF Regulations must comply with the requirements under those regulations.
If a private equity fund carries on activities without being registered (except where it is exempt), the SEBI can levy penalties and bar it from undertaking any further activities.
The following are exempt from obtaining registration under the AIF Regulations:
Private equity funds in existence before the AIF regulations were in force.
Existing funds which are not able to comply with the requirements under the AIF Regulations may apply to SEBI for an exemption from strict compliance. The SEBI examines these applications on a case-by-case basis.
Existing private equity funds not seeking any fresh commitments, subject to submitting information on their activities to SEBI.
Funds managed by securitisation companies/asset reconstruction companies registered with the Reserve Bank of India (RBI).
There are no specific restrictions on investors in private equity funds. There are, however, restrictions on fund raising from investors, mainly under the following regulations:
AIF Regulations. An alternative investment fund (AIF) cannot have more than 1,000 investors if the AIF is formed through an investment vehicle other than a company.
Companies Act. If the AIF is set up as a private limited company, the company cannot issue shares to more than 200 shareholders.
Foreign investment regulations. In November 2015, foreign investment in units of AIFs was permitted to residents outside India (other than citizens of or any other entity which is registered or incorporated in Pakistan or Bangladesh) subject to certain conditions. Prior to this, foreign investment in AIFs required Reserve Bank of India (RBI) approval.
There are no specific restrictions on net worth.
The AIF Regulations set out conditions with respect to maximum and minimum investment periods and amounts (see Question 11).
The relationship between investors and the fund is governed by the:
Statute applicable to the type of fund set up (that is, trusts, companies or limited liability companies (LLPs) (see Question 6).
Constitutional documents of the fund.
Binding agreement entered into between the fund and the investor.
Trusts are set up under the Indian Trust Act 1882 and registered as an AIF under the SEBI AIF Regulations 2012. The relationship is governed by the provisions of the trust deed, the contribution agreement and the private placement memorandum.
The contribution agreement between the fund and the investor will cover such matters as minimum contributions by the investor, period of contribution, object of the fund, returns on investment and distribution mechanism.
Types of protection that investors seek in the contribution agreement include:
Adequate representations and warranties from the promoters/sponsor of the fund.
Corporate governance requirements, such as conduct of investors' meetings.
Covenants about critical decisions such as:
removal or replacement of the trustee or the investment manager;
winding up of the fund;
investments in excess of the threshold limits permitted.
Non-compobligation on the managers/sponsors of the fund during the commitment period.
Companies are set up under the Companies Act 2013. A company will be governed by the articles of association of the company, the shareholders' agreement and the private placement memorandum. The protections sought by an investor under a shareholders' agreement vary from those sought under a contribution agreement as above.
Interests in portfolio companies
The foreign exchange regulations permit foreign direct investments only in equity shares, compulsorily convertible preference shares (CCPs), compulsorily convertible debentures (CCDs), and warrants. The issue of any other instrument, such as optionally convertible debentures (OCDs) and optionally convertible preference shares (OCPs), is treated as debt and is governed by the external commercial borrowing (ECB) norms. These debt instruments are subject to certain restrictions in relation to their end-use and minimum average maturity.
Most common form
The following are the most common forms:
Equity shares. Equity shares provide voting rights and the right to dividends in the target company. On the other hand, the receipt of dividends on equity shares is subject to the company making profits and is usually at the discretion of the company. In a liquidation/winding up scenario, an equity holder is subordinated to holders of CCDs and CCPs.
CCPs. CCP holders do not enjoy voting rights except where dividends have not been paid to them for a continuous period of two years or on votes concerning matters affecting their interest. They have a preferential dividend rate and preference in liquidation over equity shares. This allows a private equity investor to structure its ratchet provision.
CCDs. CCD holders enjoy neither voting rights nor dividends. However, they are entitled to interest. CCD holders get a preference over CCP holders and equity share holders in a liquidation scenario. They otherwise have features similar to those listed for CCPs.
The following other forms are also used:
Share warrants. Share warrants are instruments in the nature of options which give rights to the holder to subscribe to the equity shares of the company at a pre-determined price, and at an agreed time. The issue of warrants to offshore private equity funds is permitted, subject to certain conditions.
OCDs. OCDs are debentures which may either be redeemed on maturity or converted into equity shares of the company at the option of the private equity fund, and at a pre-agreed price at the time of issuance. The Reserve Bank of India (RBI) treats OCDs as debt (see above).
OCPs. OCPs are preference shares which may be converted into equity shares at the option of the private equity fund. Similar to OCDs, they are construed as debt under the foreign exchange laws (see above).
Pricing restrictions under the Indian foreign exchange laws apply to the issue or transfer of equity shares, CCDs and CCPs by residents to non-residents.
Issue of CCDs, CCPs or equity shares. Issue of any kind of securities is subject to the provisions of the Companies Act, for example:
Equity shares of a private company cannot be issued to more than 200 shareholders at any time. For private placement/preferential allotment of shares, CCDs and CCPs, no issue or offer can be made to more than 200 shareholders in a financial year.
No issue can be made unless allotments under an earlier issue have been completed or withdrawn.
Preference shares must be issued for a period less than 20 years.
Pricing guidelines apply in relation to the issue of shares, CCDs and CCPs to a non-resident.
Transfer of CCDs, CCPs or equity shares. The following applies:
Contractually, under a shareholders' agreement, clauses restricting transfer of shares such as lock-in periods, rights of first offer, rights of first refusal, and tag-along rights (that is, where a shareholder sells their stake, the rights of other shareholders to join that deal at the same conditions) and drag-along rights (compelling other shareholders to join the deal) are usually provided. Private companies have to provide for restrictions on transferability.
The RBI has prescribed certain restrictions with respect to transfer where an offshore investor is involved, including:
pricing guidelines apply in relation to transfer of shares, CCPs and CCDs;
a transfer of shares in an unlisted company is valued according to any internationally accepted pricing methodology on an arm's length basis;
a transfer of shares in a listed company is valued at a price in accordance with the applicable SEBI guidelines.
Taxes. The following apply to the sale or transfer of shares:
Where shares are sold or transferred by a non-resident to a resident, the resident must withhold tax (see Question 4). However, such a transfer is subject to any relevant double taxation treaty with the other country. For example, where the non-resident is in Mauritius, no withholding of tax may be required.
Capital gains are subject to taxation. Usually, in the case of unlisted companies, long-term capital gains are taxable at a rate of 10% and short-term capital gains are taxable at a rate of 30%. In the case of listed companies, long-term capital gains are exempt if sold on the stock exchange, if securities transaction tax (STT) is paid and in the case of short term capital gains, if STT is paid. The tax rate is 15%. Capital gains are subject to any applicable double taxation treaty.
Buyouts by auction of a private company are not common but can be used where there is a perceived high interest in the target company. Such auctions are usually governed by the rules drafted by the auctioneer.
The Reserve Bank of India (RBI) has under its strategic debt restructuring framework provided for the compulsory sale of a majority stake in a stressed borrower company supported by bank lending (subject to the conditions specified). Where this sale takes place by auction, it is usually governed by the terms drafted by the banks.
Buyouts of listed companies are not very common because:
Any such news can have a potential impact on the prices of the company.
All listed companies are required, under SEBI regulations, to maintain a minimum public holding of 25%.
Under the Takeover Code, shares must be offered to the public where the acquisition of a controlling share (either direct or indirect) or acquisition above specified thresholds is proposed.
Under the Insider Trading Regulations, investors are prohibited from acquiring trading in securities of the listed company on the basis of unpublished price-sensitive information (UPSI).
The principal documents in a buyout transaction are:
Share purchase agreement/buyout agreement.
If the buyout takes place through a bidding process, the principal documents will also include the bid document.
In the buyout of a listed company under the Takeover Code, an offer letter and the public announcement of an open offer will also be prepared.
Some key contractual protections commonly requested by buyers are:
Adequate representations and warranties relating to, for example, the business and operations of the company, title to the shareholding, litigation, and defaults prior to the date of the buyout.
Covenants requiring promoters to undertake certain activities, including relating to running businesses as per the agreed business plan. Certain private equity funds require covenants in relation to anti-corruption and anti-bribery provisions (in line with the US Foreign Corrupt Practices Act 1977 (FCPA)).
Indemnities from the seller/promoter of the company, typically for three years after the buyout (seven years for tax indemnities).
Restrictions on transfer of shares by the promoters.
Board seat and veto rights: private equity funds generally retain the right to appoint nominees onto the board of directors of the target company.
The contractual protections for investments in a public listed company are limited compared to those available to an unlisted company. Representations, warranties and indemnities can be negotiated with the seller. Governance-related rights are difficult to obtain and no exit rights will be agreed as the company is listed. In addition, private equity investors usually want a veto on matters on which no action may be taken without consent of investors (for a list of veto matters, see Question 22).
Directors on the board of a company must comply with statutory duties prescribed under the Companies Act, including:
Acting in good faith to promote the objects of the company and acting in its best interests.
Acting for the benefit of the members, shareholders and employees as a whole.
Acting for the benefit of the community for the protection of the environment.
These duties are usually owed to the company, its members and other stakeholders, such as depositors and creditors. In the case of MBOs by a director, it will be important for a director to ensure balancing of the obligations.
In addition, for a listed company, the Takeover Code imposes other obligations, including setting up a committee of independent directors to provide reasoned recommendations on the open offer and to facilitate verification of shares tendered in the acceptance offer.
In an MBO of a listed company, an insider (as defined under the Insider Trading Regulations, which includes a director, officer or employee that is allowed or would reasonably be expected to be allowed access to unpublished price-sensitive information) cannot trade in securities on the basis of that information.
MBOs are not common in India. Standard terms of employment imposed on key managerial personnel include:
The obligation to devote substantial time to the business.
A restriction on taking up any other full time employment/directorship.
Non-compete and non-solicitation clauses.
Provisions related to usage and ownership of intellectual property.
The most common measure is a right to appoint a nominee on the board of the company. The number of directors and who may be appointed is subject to contract. In addition, private equity investors typically require veto powers for decisions by the board or by shareholders, including approval rights over:
A business plan.
The appointment and removal of directors.
Entering into any joint venture, collaboration or any similar arrangement.
Entering into related party transactions.
Entering into an important contract.
Provisions relating to transfer of shares such as put option, tag-along and drag-along rights, right of first refusal and right of first offer.
These provisions are usually included in the shareholders' agreement as well as the constitutional documents of the company.
The percentage of debt finance varies from transaction to transaction and on the debt requirements of the company or promoter. Typically, the debt to equity ratio is 70:30.
Debt financing is usually taken either in the form of:
A term loan.
An issue of non-convertible debentures.
Under the Indian foreign exchange laws, if the private equity investor is a non-resident, the issue of partially, optionally or non-convertible debentures is treated as external commercial borrowing (ECB) and subject to the relevant restrictions (see Question 15, Most common forms).
Companies raising ECBs have more stringent restrictions as regards end-use and require approval from the Reserve Bank of India (RBI), if the facility amount exceeds US$750 million (except in certain cases where the threshold amount is lower for specified entities). Accordingly, this is not the preferred route for foreign direct investment (FDI).
The typical forms of security taken by a debt provider are:
Mortgage over immovable property.
Hypothecation (a charge over existing or future movable property).
Pledge of shareholding of the borrower by the promoters.
Personal guarantee by the individual promoters or corporate guarantee by the holding company.
Contractual and structural mechanisms
Some of the key protections that debt providers obtain to protect their facility are:
Prior consent of the debt provider (and/or the trustee appointed on its behalf) in matters such as:
incurring additional financial indebtedness;
creation of security over assets of the company;
changes in the majority shareholding or promoter of the borrower;
related party transactions above a specified threshold;
declaration of dividends to the shareholders of the borrower;
amendment to the constitutional documents of the borrower.
Events of default whereby the debt provider would be entitled to accelerate the facility and/or enforce the security. Such events would include:
failure to repay the facility or any part of that on the due date;
failure to pay interest;
cross-default under any other credit documentation;
any steps or proceedings with respect to winding up/liquidation of the borrower;
non-compliance with the covenants.
A covenant with respect to subordination of all other facilities obtained by the company from its group companies/holding company or promoter to the facility provided by the debt provider.
A public company, or a private company which is a subsidiary of a public company, is prohibited from providing financial assistance for the purchase of its shares (Companies Act). The scope of financial assistance extends to the provision of a loan, guarantee or security.
The following are the exceptions to the rules on financial assistance:
Private companies and one-person companies.
The provision of monies accepted by a company in accordance with any scheme approved by the company for the subscription of fully paid up shares in the company or its holding company. This is as long as the subscription or purchase of the shares is either held by a company employee, or held by trustees for the benefit of the employees.
The giving of loans by a company to employees of the company, other than its directors or key managerial personnel, for an amount exceeding their salary or wages for a period of six months, with a view to enabling them to purchase or subscribe for fully paid-up shares.
The order of priority on liquidation is set out in the Bankruptcy and Insolvency Code 2016, which consolidated all the existing laws in relation to liquidation applicable to companies, and is as follows:
Costs of the insolvency resolution and liquidation costs.
Debts to secured creditors (who have relinquished their security interest).
Workmen's dues (for 24 months before commencement).
Wages and unpaid dues to employees (other than those falling within the definition of workmen, for 12 months before commencement).
Financial debts to unsecured creditors and workmen's dues for the earlier period.
Balance of remaining debts owed to secured creditors remaining after enforcement of their security interests.
Equity shareholders or partners.
Certain types of debt holders are permitted to achieve equity appreciation through conversion:
A domestic debt holder can convert its debt into equity in the manner set out in the facility agreement. If the debt holder is a bank, it will be governed by the Banking Regulation Act 1949, under which banks are permitted to hold up to a maximum of 30% of the share capital of the company. This does not apply in the event of default.
An offshore debt holder is permitted to convert the external commercial borrowing (ECB) into equity, subject to the conditions specified by the Reserve Bank of India (RBI).
The RBI under its strategic debt restructuring (SDR) framework, allows creditors to acquire a majority stake in a stressed borrower company in accordance with the conditions set out in the framework, and to sell those assets to another company within an 18-month period.
A foreign investor can subscribe to compulsorily convertible preference shares (CCPs) and compulsorily convertible debentures (CCDs) and convert them in accordance with the terms of such instruments (see Question 15). However, the conversion price of such instruments will be in accordance with the relevant foreign exchange regulations.
Portfolio company management
Under the Companies Act, the company can declare a dividend out of its profits after deducting amounts for depreciation and setting aside at least 10% into its reserves.
The company cannot declare a dividend from its reserves other than from its free reserves. Further, a company cannot declare a dividend, unless it has carried over previous losses and depreciation not provided in the previous year or years, which must be set off against profit of the company for the current year.
The Prevention of Corruption Act 1988 (PCA) does not apply to the private sector. However, the relevant provisions of the Indian Penal Code 1860, such as criminal breach of trust, cheating and ancillary sections, do apply in cases of corruption or bribery.
Given that most private equity funds are linked to entities or individuals based in the US or in the UK, private equity funds typically seek to implement relevant procedural safeguards in accordance with the US Foreign Corrupt Practices Act 1977 and the UK Bribery Act 2010. Relevant contractual provisions may be added in the private equity documentation to reflect these safeguards. Courts in India recognise and enforce awards and judgments passed by foreign courts in reciprocal territories.
If a funds executive or a director is held to be offering bribes to a public official, he is liable for criminal prosecution under the PCA and imprisonment for a period ranging from six months to five years.
Forms of exit
The most common form of exit preferred by a private equity fund in a successful portfolio company is listing of the company on the public market, or the sale of the stake to another financial or strategic investor.
Other forms of exit include strategic sale, financial sale and exercise of a put option (that is, an option to sell assets at an agreed price on or before a particular date).
Advantages and disadvantages
The advantages of listing of a company are that:
It provides good liquidity even if an investor cannot exit immediately at the time of listing.
There are certain tax advantages in the case of sale of floor exchange companies compared to off-market transactions.
It provides a good valuation, subject to market conditions.
The disadvantages of IPOs under the SEBI (Issue of Capital and Disclosure Requirements) Regulations 2009 are that the shares of a private equity fund are locked in for a period of one year if a complete exit is not provided. This does not apply to a venture capital fund and a foreign venture capital investor (FVCI) holding shares for a period of at least one year, prior to the date of filing the draft prospectus with the Securities and Exchange Board of India (SEBI).
In a strategic sale or a financial sale, the advantage for a private equity fund is the ability to negotiate desired return on investment.
The disadvantages of this method are that:
It requires involvement and support of promoter.
It is a longer process.
The process usually involves diligence and negotiations.
Forms of exit
The following are typically used to end the private equity fund's investment in an unsuccessful/distressed company:
Buybacks (purchases by the company of its outstanding shares).
In addition, investors typically have tag-along rights, and in some cases drag-along rights in the shareholders' agreement.
Advantages and disadvantages
Put options. Put options are the preferred exit method now that the regulatory uncertainty surrounding them has been cleared. However, the disadvantage is that a sale of shares from a non-resident to a resident investor is subject to fair market value, which may not always give the investor the desired return (see Question 15). It is also dependent on the liquidity position of the person on whom the put option is exercised.
Buyback. A buyback can be a useful exit option if the company has cash reserves. Under the Companies Act, a company can make buybacks only up to 25% of the companies' paid up capital and free reserves (15% in the case of a listed company).
The ratio of the aggregate of secured and unsecured debts owed by the company after the buyback cannot exceed more than twice the paid-up capital and free reserves. In addition, buybacks are not tax efficient. These conditions may not make the buyback commercially viable for a company.
Tag-along rights. Tag-along rights are useful if a promoter is looking at an exit. The disadvantage is that they are dependent on promoters and are subject to pricing norms (see Question 15).
Drag-along rights. Drag-along rights are rarely used and are heavily negotiated. They are also subject to pricing guidelines and the ability to find a strategic investor for a 100% is challenging.
Private equity/venture capital associations
Securities and Exchange Board of India (SEBI)
Status. The SEBI was established on 12 April 1988 as a non-statutory body and was recognised as a statutory body on 21 February 1992 in accordance with the provisions of the Securities and Exchange Board of India Act 1992.
Membership. A Chairman who is nominated by the Union Government, two officers from the Ministry of Finance and Ministry of Corporate Affairs, one member from the Reserve Bank of India, and the remaining five members of whom at least three must be full-time members nominated by the Union Government of India.
Principal activities. Their activities are to:
Protect the interests of investors in listed securities.
Promote the development of the securities market.
Regulate the securities market.
SEBI undertakes the following in relation to its principal activities:
Issue rules and regulations.
Administration and implementation of these rules and regulations and acts as a quasi-judicial body in relation to the same.
Information sources. SEBI website.
Tax incentive schemes/exemptions
What tax incentive schemes/exemptions exist to encourage PE/VC investment?
Name of scheme
At whom are the schemes directed?
What conditions must be met?
What benefits are conferred?
Domestic funds registered as Category I and Category II AIFs.
AIFs and investors.
The fund must be registered as a Category I AIF, Category II AIF, REIT, or InvIT.
Tax pass-through status for the fund, the income is taxed at investor level.
Transfers of shares in unlisted companies
Holders of unlisted shares.
The shares must be held for 24 months.
10% tax rate (as opposed to 30% for short-term capital gains).
Transfers of shares in listed companies
Holders of listed shares.
The shares must be held for 12 months.
Exemption from long-term capital gains tax, subject to payment of securities transaction tax.
Share premium from venture capital funds (Category I AIFs).
Exemption from tax on share premium.
Reserve Bank of India (RBI)
Description. This is the website of the RBI, and provides details, among other things, of regulation, monetary policy, and payment and settlement systems.
Securities and Exchange Board of India (SEBI)
Description. This is the website of the SEBI, and provides, among other things, the legal framework, such as the SEBI AIF Regulations.
Department of Industrial Policy & Promotion
Description. This is a department of the Ministry of Commerce & Industry of the Government of India. It contains links to legislation, foreign direct investment (FDI) policy, and so on.
Foreign Investment Promotion Board
Description. This is part of the Department of Economic Affairs, of the Ministry of Finance, and provides an e-filing facility for people seeking FDI under the approval route.
Abhinav Surana, Partner
Juris Corp, advocates & solicitors
Professional qualifications. Member of Bar Council of Rajasthan; Solicitor of England & Wales (non-practising), BBA LLB (Honours), National Law University, Jodhpur.
Areas of practice. Private equity; venture capital; M&A; general corporate, commercial and restructuring.
Advised a private equity fund in relation to its exit from a portfolio company by way of sale of stake.
Acted on behalf of bond holders (which were part of a global debt fund) in relation to restructuring of foreign currency convertible bonds (FCCBs) of about US$97.2 million.
Acted for a blue chip listed Indian company in the optical fibres, telecommunication cables and power transmission sector in relation to investment of INR5 billion in its subsidiary by a reputed private equity house. The investment was made by way of optionally convertible redeemable preference shares. The transaction also involved onward funding in subsidiaries using non-convertible debentures (NCDs).
Advised an LLP in relation to its distribution arrangement for its products in the EU and US for exploring a possible joint venture with the distributor.
Languages. English and Hindi.
Apurva Kanvinde, Senior Associate
Professional qualifications. Member of Bar Council of Maharashtra and Goa; BLS LLB, Government Law College, Mumbai.
Areas of practice. Capital markets; private equity; venture capital; general corporate commercial.
Acted for Reliance Industries Limited in the first Export-Import Bank of the United States guaranteed note issuance aggregating to US$225 million globally.
Advised Societe De Promotion Et De Participation Pour La Cooperation Economique, DEG-Deutsche Investitions- Und Entwicklungsgesellschaft Mbh, GS Power Co., Ltd and Asia Clean Energy Limited in relation to their cross-border investment in a renewable energy company in India.
Advised BanyanTree Growth Capital LLC in relation to its cross border investment in a steel manufacturing company through a combination of convertible instruments and equity shares.
Advised an LLP in relation to its distribution arrangement for its products in the EU and US for exploring a possible joint venture with the distributor.
SEBI & Corporate Laws - SARFEASI cannot override rent control act: relief to tenants, barrier to the banking sector.
International M&A and Joint Ventures Committee Newsletter - Recent development in airline joint ventures in India.
Languages. English, Hindi and Marathi.